FM Quiz 1 Chapters 1-4

 INTRODUCTION TO CORPORATE FINANCE

I. What Is Corporate Finance?

Corporate finance addresses three fundamental questions:

1. Capital Budgeting:

   • Definition: The process of planning and managing a firm’s long-term investments in assets.

   • Question: In what long-lived assets should the firm invest?

   • Example: Should a company open a new plant or develop a new product line?

2. Capital Structure:

   • Definition: The mix of debt and equity a firm uses to finance its operations.

   • Question: How should the firm raise capital to fund investments?

   • Implication: Affects risk and return for investors. Too much debt increases bankruptcy risk.

3. Working Capital Management:

   • Definition: Managing the firm’s short-term assets and liabilities.

   • Question: How should the firm manage its everyday financial activities (cash, inventory, receivables, payables)?

   • Goal: Ensure liquidity while maximizing efficiency.

II. The Balance Sheet Model of the Firm

Visual Framework (Figure 1.1):

Left Side = Firm’s Assets

Right Side = Financing Sources (Debt + Equity)

• Assets:

  • Current Assets: Cash, inventory, receivables.

  • Fixed Assets: Tangible (buildings, machines) & Intangible (patents, trademarks).

• Liabilities:

  • Current Liabilities: Short-term debts, accounts payable.

  • Long-Term Debt: Bonds, loans beyond one year.

• Equity: Residual interest of shareholders (assets – liabilities).

 Net Working Capital (NWC) = Current Assets – Current Liabilities

A key metric in understanding short-term liquidity.

III. The Financial Manager’s Role

The financial manager is tasked with answering the three fundamental questions of corporate finance.

Organizational Roles (Figure 1.2):

• CFO (Chief Financial Officer):

  • Oversees both:

    • Treasurer – Handles capital expenditures, cash management, financial planning.

    • Controller – Handles financial reporting, accounting, taxes, and information systems.

Financial management is about decision-making aimed at increasing firm value.

IV. Business Organization Types

Note: Most large firms opt for the corporate form due to scalability, transferability of shares, and access to capital markets.

V.  Cash Flow Is King

 Corporate finance focuses on cash flows, not accounting profits.

• Cash Flow vs. Accounting Income:

  • GAAP may report profits when no cash is received (Example: Midland Company sells gold but hasn’t collected payment).

  • Finance focuses on actual cash received and spent.

• Key Concepts:

  1. Value Creation = Buy assets that generate more cash than they cost.

  2. Cash Flow Identification = Not always straightforward—requires interpretation of financial statements.

  3. Timing Matters:

     • Time Value of Money: $1 today > $1 tomorrow.

     • Early cash flows are more valuable (Example: Product B vs. Product A).

• Risk Considerations:

  • Cash flows are uncertain, and investors are generally risk-averse.

  • Risk-adjusted decisions must weigh potential loss against potential gain (Example: Europe vs. Japan expansion).

VI. The Goal of Financial Management

Common (but flawed) goals:

• Maximize sales, minimize costs, beat competitors, avoid bankruptcy.

Problems:

• Not necessarily aligned with owner/shareholder interests.

• May ignore timing, risk, and sustainability.

Correct Objective:

Maximize the current value per share of the existing stock.

This goal:

• Reflects ownership interests.

• Accounts for timing and risk of cash flows.

• Avoids the short-run vs. long-run dilemma.

• Applies to any ownership structure by rephrasing as:
  ➤ Maximize the value of owners’ equity.

VII. The Agency Problem

 What is it?

An agency relationship arises when one party (agent) is expected to act on behalf of another (principal).

Agency Problems:

• Misaligned incentives between managers (agents) and shareholders (principals).

• Examples:

  • Avoiding risky but value-enhancing investments.

  • Spending on unnecessary luxuries (private jets).

  • Pursuing personal prestige or job security over firm value.

Agency Costs:

• Direct:

  • Expenditures benefitting managers (e.g., luxury offices)

  • Monitoring expenses (e.g., audits)

• Indirect:

  • Missed opportunities due to risk aversion or misalignment.

VIII. Managing Agency Conflicts

1. Compensation Tied to Performance:

   • Stock options, restricted stock, performance bonuses.

   • Aligns manager incentives with shareholder value.

2. Market for Corporate Control:

   • Poor management → risk of takeover or proxy fight.

   • Proxy fight: Shareholders attempt to replace the board.

   • Example: Darden Restaurants vs. Starboard Value.

3. Job Market Reputations:

   • Strong performance → better jobs and pay elsewhere.

4. Board Oversight:

   • Independent directors enhance governance.

IX. Stakeholders and Governance

Stakeholders = All parties with interest in firm’s operations:

• Employees, suppliers, customers, regulators, community.

 While the goal is to maximize shareholder wealth, ignoring stakeholders can harm long-term value (e.g., brand damage, legal risks).

X.  Regulation & Ethics in Finance

 Federal Laws:

• Securities Act of 1933 – Requires disclosure at time of issuing new securities.

• Securities Exchange Act of 1934 – Ongoing regulation (insider trading, financial reporting).

  • Requires annual (10-K), quarterly (10-Q), and major event (8-K) reports to the SEC.

 Insider Trading:

• Illegal to trade on non-public, material information (e.g., upcoming mergers or earnings).

 Sarbanes-Oxley Act (Sarbox, 2002):

• Passed after scandals (Enron, WorldCom).

• Requirements:

  • CEO/CFO personally certify financial statements.

  • Annual assessments of internal controls (Section 404).

  • Creation of PCAOB (audit regulator).

  • Independent audit committees.

• Costs: Expensive compliance → fewer IPOs, firms "go dark".

XI.  Summary of Key Concepts

FINANCIAL STATEMENTS AND CASH FLOW

I. Purpose of the Chapter

Understanding that cash flow, not net income or book value, is central to corporate finance. Financial statements offer different perspectives, but financial managers focus on the firm’s ability to generate cash.

II. The Balance Sheet

Definition: A snapshot of the firm's financial position at a point in time.

Equation:

Assets = Liabilities + Shareholders’ Equity

A. Key Concepts in Balance Sheet Analysis

1. Liquidity:

   • Definition: How easily an asset can be converted to cash without significant loss.

   • Hierarchy:
     Cash > Receivables > Inventory > Fixed Assets

   • Trade-off: Liquidity vs. Return

     • Liquid assets are safer but typically generate lower returns.

2. Debt vs. Equity:

   • Debt = Fixed obligation (interest + principal)

     • Failure to pay leads to default.

   • Equity = Residual claim

     • Only paid after debt obligations are met.

   • Implication: Too much debt increases financial risk.

3. Book Value vs. Market Value:

   • Book Value: Based on historical cost (GAAP).

   • Market Value: Current price someone is willing to pay.

   • Finance focuses on market value when evaluating investment decisions.

III. The Income Statement

Definition: Measures financial performance over a period.

Equation:

Revenues − Expenses = Net Income

Key Metrics:

• EBIT (Earnings Before Interest and Taxes):
  Focuses on operating performance.

• Net Income: “Bottom line” after interest and taxes.

• EPS: Net Income / Shares Outstanding

A. Important Considerations

1. GAAP & Matching Principle:

   • Revenues and expenses are recorded when earned/incurred—not when cash changes hands.

2. Non-Cash Items:

   • Depreciation: Allocated cost of fixed assets.

   • Deferred Taxes: Taxes owed in the future due to timing differences between accounting and tax rules.

3. Time and Cost Classifications:

   • Fixed Costs: Do not vary with output (e.g., rent).

   • Variable Costs: Change with production (e.g., raw materials).

   • Product Costs: Tied to production; included in COGS.

   • Period Costs: Not directly tied to production; expensed when incurred (e.g., SG&A).

IV. Corporate Taxes

• Tax Rate Structure (2015):
  Nonlinear; includes “tax bubbles” where marginal rates temporarily increase and then fall.

• Key Rates:

  • Marginal Tax Rate: Tax on the next dollar earned (used for decision-making).

  • Average Tax Rate: Total tax paid / Total taxable income.

• Example Calculation:
  Taxable Income = $200,000
  Total Tax = $61,250
  Avg Tax Rate = 30.625%
  Marginal Tax Rate = 39%

• Reality: Effective tax rates differ widely by industry (e.g., biotech: ~4.5%, utilities: ~34%).

V. Net Working Capital (NWC)

NWC = Current Assets – Current Liabilities

• Indicator of short-term financial health.

• A positive NWC suggests more cash will be received than paid in the near term.

• Change in NWC reflects short-term investment activity.

VI. Financial Cash Flow

A. Cash Flow from Assets (CFA)

CFA = OCF − Capital Spending − ∆NWC

1. Operating Cash Flow (OCF)

OCF = EBIT + Depreciation − Taxes

• Captures cash generated from core operations.

2. Capital Spending

Capital Spending = Net Fixed Assets (end) − Net Fixed Assets (beg) + Depreciation

3. Change in Net Working Capital (∆NWC)

∆NWC = NWC (end) − NWC (beg)

B. Cash Flows to Stakeholders

Cash Flow to Creditors:

= Interest Paid − Net New Borrowing

Example:

Interest = $49M, Debt Increased by $13M

→ Cash to Creditors = $49 − $13 = $36M

Cash Flow to Stockholders:

= Dividends − Net New Equity Issued

Example:

Dividends = $43M, Net Equity = $43 − $6 (repurchase) = $37M

→ Cash to Stockholders = $43 − $37 = $6M

VII.  Total vs. Operating Cash Flow

• Total Cash Flow of the Firm = Cash from operations available to creditors and stockholders.

• Sometimes referred to as Free Cash Flow.

• A negative total cash flow is not inherently bad—may indicate high investment/growth.

VIII.  Statement of Cash Flows (Accounting Format)

Divided into 3 sections:

1. Operating Activities:

   • Net Income

     • Depreciation

     • Deferred Taxes

   • +/− Changes in Working Capital Items (e.g., receivables, payables, inventory)

2. Investing Activities:

   • Purchases and sales of fixed assets.

3. Financing Activities:

   • Debt issuance/retirement

   • Equity issuance/repurchase

   • Dividends paid

IX. Differences Between Accounting and Financial Cash Flow

X. Real-World Accounting Manipulation Examples

• Tyco: Classified purchases as financing to inflate operating cash flow.

• Dynegy: Round-trip trades falsely boosted operating cash flow.

• Adelphia: Overcapitalized labor to understate operating costs.

 Lesson: Firms can manipulate operating cash flow, but total cash flow from assets is harder to spin.

XI.  Summary

1. Finance focuses on cash flow—not net income.

2. Cash flow from assets = Cash available to creditors and shareholders.

3. OCF, Capital Spending, and ∆NWC are the key components.

4. Accounting income ≠ cash flow due to timing, non-cash items, and accruals.

5. Tax rate differences matter—marginal rate is more relevant than average.

6. Accounting statement of cash flows is a helpful but limited summary.

🧾 I. Purpose of Financial Statement Analysis

• Goal: To use financial statements to assess a company’s financial health, performance, and position.

• Why it matters: Financial statements are the primary way financial information is communicated.

• Key insight: Raw financial statements are hard to compare across companies—standardization and ratio analysis help interpret them effectively.

📊 II. Standardizing Financial Statements

1. Common-Size Balance Sheet

• Express each item as a % of total assets.

• Helps compare companies of different sizes or over time.

• Example: If cash = $84 and total assets = $3,373, then cash = 2.5% of total assets.

2. Common-Size Income Statement

• Each line is shown as a % of total sales.

• Useful for cost control and margin comparison.

• Example: If COGS = $1,344 and sales = $2,311, then COGS = 58.2% of sales.

📐 III. Financial Ratios

Grouped into five categories:

I. Short-Term Solvency (Liquidity) Ratios

These measure a firm’s ability to meet short-term obligations. Essential for banks and short-term creditors.

II. Long-Term Solvency (Leverage) Ratios

Assess a firm’s long-term debt capacity and financial structure. Important for investors, rating agencies, and long-term lenders.

III. Asset Management (Turnover) Ratios

Measure how efficiently the firm uses its assets to generate sales.

IV. Profitability Ratios

These show how efficiently a company turns revenue into profit. Highly watched by investors and management.

V. Market Value Ratios

Useful for publicly traded companies. These involve stock price and reflect investor sentiment, growth potential, and valuation.

Bonus: 📐 Capital Intensity Ratio

• Formula: Total Assets / Sales

• What It Means: Amount of assets needed to generate $1 in sales.

• Why Important: High = capital intensive (e.g., manufacturing). Low = asset light (e.g., software).

• Unit: Dollars ($)

🧩 IV. DuPont Identity (Decomposition of ROE)

Breaks ROE into three components:

ROE = Profit Margin × Total Asset Turnover × Equity Multiplier

This shows how:

• Efficiency (PM)

• Asset usage (TAT)

• Financial leverage (EM)

… all combine to influence returns to equity holders.

⚠ V. Problems with Ratio Analysis

1. No Theory: Hard to determine "good" vs. "bad" ratios.

2. Different Accounting Methods: e.g., LIFO vs FIFO.

3. Timing Differences: Fiscal years vary.

4. Conglomerates: Mix of business lines distorts comparisons.

5. Global Firms: Different standards (GAAP vs IFRS).

6. Seasonality: E.g., retail businesses around holidays.

📈 VI. Financial Planning Models

A. Pro Forma Statements

• Project future income statements and balance sheets.

• Used for budgeting, forecasting, and strategic planning.

B. Percentage of Sales Method

• Assumes certain balance sheet and income items grow with sales.

• Items are classified as:

  • Varying directly with sales (e.g., inventory)

  • Not varying (e.g., long-term debt)

C. External Financing Needed (EFN)

• When projected assets > liabilities + equity, EFN is the gap.

• Shows whether more funds must be raised.

Formula:

EFN = Increase in assets – (Increase in spontaneous liabilities + Retained earnings)

🔁 Summary Tips for Studying:

• Memorize the five categories of ratios and examples in each.

• Practice calculating ratios using real or hypothetical data.

• Understand relationships: e.g., how increased debt raises ROE via DuPont.

• Be aware of limitations in ratio comparisons.

• Work through pro forma scenarios to understand financial planning.

💡 1. Time Value of Money (TVM)

A dollar today is worth more than a dollar tomorrow

Why?

• You can invest it and earn a return

• Inflation decreases value over time

• There's risk in future payments

The concept that money available now is worth more than the same amount in the future due to its earning potential.

💰 2. Future Value (FV)

Formula:

FV = C₀ × (1 + r)^T

Where:

• C₀ = initial cash invested today

• r = interest rate per period

• T = number of periods

The amount an investment is worth after one or more periods of growth at a specified interest rate.

💵 3. Present Value (PV)

Formula:

PV = C_T / (1 + r)^T

Where:

• C_T = future cash flow at time T

• r = discount rate per period

• T = number of periods into the future

The current value of a future amount of money, discounted back to today using a specific interest rate.

✅ 4. Net Present Value (NPV)

Formula:

NPV = -C₀ + Σ [ C_t / (1 + r)^t ]

Where:

• C₀ = cost/investment today

• C_t = cash flows over time

• r = discount rate

• t = time index

The difference between the present value of future cash inflows and the initial investment. It measures the profitability of a project.

📉 5. Discounting & Compounding

Compounding:

FV = C₀ × (1 + r)^T

The process of earning interest on both the initial principal and the accumulated interest from previous periods.

Discounting:

PV = C_T / (1 + r)^T

The interest rate used to calculate present value. It reflects the opportunity cost of capital or required return on investment.

🧠 6. Rule of 72 (Estimate doubling time)

Years to double ≈ 72 / Interest rate

Example: At 9%, doubling ≈ 8 years

A shortcut formula to estimate the time it takes for money to double at a given interest rate:

📆 7. Present Value of Multiple Cash Flows

Discount each cash flow separately and sum:

PV = C₁ / (1 + r)^1 + C₂ / (1 + r)^2 + ... + C_T / (1 + r)^T

🏦 8. Annuity (Level Payments for a Fixed Time)

A series of equal payments made at regular intervals for a fixed period of time.

Present Value of Annuity:

PV = C × [1 - (1 / (1 + r)^T)] / r

Future Value of Annuity:

FV = C × [(1 + r)^T - 1] / r

♾ 9. Perpetuity (Level Payments Forever)

A stream of equal payments that continues forever.

Present Value of Perpetuity:

PV = C / r

📈 10. Growing Perpetuity

A stream of cash flows that grows at a constant rate and continues forever.

Present Value of Growing Perpetuity:

PV = C / (r - g)

Where:

• C = cash flow one year from now

• r = discount rate

• g = growth rate
  (must have r > g)

⏳ 11. Solving for Time or Interest Rate

Solving for Rate (r):

r = (FV / PV)^(1/T) - 1

Solving for Time (T):

T = log(FV / PV) / log(1 + r)

🔢 12. APR vs. EAR

APR - The nominal yearly interest rate that does not account for compounding within the year.

EAR (Effective Annual Rate):

EAR = (1 + r/m)^m - 1

Where:

• r = annual percentage rate (APR)

• m = number of compounding periods per year

The actual annual interest rate earned or paid after accounting for compounding.

📈 13. Continuous Compounding

A theoretical concept where interest is compounded an infinite number of times per year.

Future Value with Continuous Compounding:

FV = C₀ × e^(r × T)

A factor used to calculate the future value of an annuity:

Present Value with Continuous Compounding:

PV = C_T / e^(r × T)

Where e ≈ 2.718

A factor used to calculate the present value of an annuity:

🧾 14. Excel / Spreadsheet Formulas

• Use decimals for rate (e.g. 8% → 0.08)

• Input outflows (like pv) as negative numbers

📊 15. Example: Colin Kaepernick’s Contract

• Total quoted = $121 million

• PV = ~$84 million

• Why? Payments spread over years and discounted using TVM