Corporate finance
Chapter 1
Sole proprietorship– ran and owned by one person, all is their asset and don’t share business decisions, least regulated, taxed once as personal income
Disadvantages- 1 person with all liabilities, capital limited to personal wealth
Partnership- ran by 2 people and people have general liabilities, more capital available, taxed once as personal income
Disadvantages- unlimited liability, dissolves with death, limited partnership
Corporation- legal person is distinct from owners, limited liability, easier to raise capital, transfer ownership is easy
Disadvantages- double taxation(income tax and dividends)
Limited liability company– hybrid business form of partnership and corporation, taked only as personal profit
Subchapter corp– taxed individually, subject to IRS restriction on type and number of owners
C-corp– taxed corporate tax rate, larger than S corp
Goal of financial management is to maximize the current value per share of company’s existing stock
Stakeholders- owners, employees, clients, suppliers, etc
All shareholders are stakeholders, but not all stakeholders are shareholders.
Securities– bonds, stocks, etc
Corporate governance mechanism: shareholder → board of directors → top management
Sarbanes Oxley act: driven by corporate scandals to strengthen protection against fraud and malpractice
Chapter 2
Balance sheet- snapshot of firm’s assets and liabilities at a point in time.
Assets on left in order of decreasing liquidity
liabilities/ owner’s equity on right in order of when due to be paid
Net working capital is positive for a healthy firm
Book value– balance sheet value of the assets, liabilities, and equity
Market value- true value, price which assets, liabilities, or equities can actually be bought or sold
Income statements- measures performance over specific period of time
Report revenues first then deduct expenses
Net sales |
|
|
= earnings before int and tax |
|
= taxable income |
|
= Net income |
|
Add to retained earnings |
GAAP matching principle– recognize revenue when fully earned- match expenses required to generate revenue to the period of recognition
Noncash items– expenses that don’t affect cash flow (depreciation and deferred taxes)
Marginal percent– tax paid on next dollar earned
Average tax rate- total tax paid / taxable income
Operating cash flow- CF that results from daily operation
Net capital spending- CF spent/ invested in fixed assets
Change in net working capital- net CF invested in working capital
Chapter 3
Common size balance sheet- all accounts = percentage of total assets
Common size income statement– all line items = percent of sales or revenue
Standardized statements are useful to compare financial info year to year
Comparing companies of different sizes in same industry
Know what happened to every dollar
Inventory is least liquid of all assets held
An increase in the capital intensity ratio is not good (compare with the industry though)
Profit margin measures the firm’s operating efficiency
Total asset turnover measures firm's asset use efficiency
Increase in the equity multiplier means can use assets more efficiently
If market to book ratio is too high then the business is overpriced
Enterprise value- tells us market value of all assets, how much you’ll spend to get not liquid assets
P/E ratio– want low bc shows price/$1 earned
EV/EBITDA want low ratio amount
Internal growth rate– how much a firm can grow without external funding
Sustainable growth rate- how much a firm can grow using only debt financing but keeping the same capital structure. Has to keep same D/E ratio
Determinants of growth
Profit margin- operating efficiency
Total asset turnover- asset use efficiency
Financial leverage- choice of optimal debt ratio
Dividend policy- choice of how much to pay to shareholders vs reinvesting in the firm
Chapter 4
Time vlaue of money- equivalent relationship between CF occurring on diff points of time
Factors: inflation, time of investment, principle amnt, #periods, and interest rate
PV= present value– current value of future CF discounted at appropriate discount rate
FV= future value– amnt an investment is worth after 1+ periods of time
Interest rate- r- can be called discount rate, cost of capital, required return, opportunity cost of capital– terminology depends on usage
Simple interest- interest earned on original principle =PRT
compound interest- interest earned on principle and on interest received = ((Px(1+i)^t)-P
Why is money worth less than face value– opportunity cost, risk, and uncertainty
Discounting- finding PV of 1+ future payments
Finding PVs is discounting and reverse of compounding
Chapter 5
Annuity- finite series equal CF that occur at regular intervals.
ordinary annuity– CF at end of period (assume this one if not specified)
Annuity due– CF occurs at beginning of period (if calculating this change calculator to beginning)
Perpetuity- infinite series equal payments
Higher discount rate = lower PV over time
Annual percentage rate– nominal - annual raate quoted by law
For APR multiple I/Y x 12 to get annual
Effective annual rate- interest rate expressed as if it were compounded 1x per year.
Used to compare 2 alternative investments with different compounding periods
Chapter 6
Bond- debt contract, interest only loan
Coupon rate- how you pay interest
Par value is repaid at maturity
Coupon interest rate is YTM (multiply % x par to get pmt)
YTM= market required rate of return for bonds of similar risk and maturity
Discount rate used to value a bond, return if bond held to maturity
Usually coupon rate at issue
As interest increases, PV decreases
As interest decreases bond price increases
If PV is less than 1000 then discount bond
Greater then premium bond
Coupon rate= YTM then price= par
Coupon rate < YTM then price < par
Interest rate risk= risk raised for bond holders from fluctuating interest rate
Bond price sensitivity- change in price (bond value) due to changes in maket interest rates
Maturit: long term bonds= high price risk
Coupon size: low coupon rate= high price risk
Reinvestment risk: uncertainty concerning market interest rates at which CF can be reinvested.
Reinvestment: long term bonds=low reinvestment rate risk
Low coupon rate bonds= low reinvestment risk
Lower coupon rate on bond, risk is greater (greater price sensitivity)
Bond of indenture: deed of trust: contract between issuing company and bondholders include:
Basic terms of bonds, total amnt bonds issued, secured (has collateral) vs unsecured, sinking fund provisions, call provision (call premium/ deferred call), details of protective covenants
Mortgage- secured by real property
Debentures- unsecured bonds for which no specific pledge of property is made– risky
Treasury securities- federal government debt
Tbills- pure discount bonds, maturity 1 year or less– greater price risk
Treasury notes- coupon debt, maturity 1-10 years
treasury bonds– coupon debt, maturity >10 years
Zero coupon bonds- no periodic interest pmts, entire YTM from difference between purchase price and par (capital gains), and can’t sell for more than par
Floating rate bonds- coupon rate no longer fixed
Bond ratings-
High rating- Moody’s Aaa and S&P’s AAA- capacity to pay is strong
Very Low grade- C - income bonds with no interest paid
D is in default with principal and interest in arrears
Nominal rate of interest (R ) - change in purchase power and inflation, quoted rate of interest
Real rate of interest- (r ) change in purchasing power only
Fisher effect- defines relationship between real rates, nominal rates, and inflation
R=nominal, r= real, h= expected inflation rates
Equity- ownership interest, common stockholders vote to elect board of directors and on other issues, dividends are NOT tax deductible, dividend not a liability of firm until declared, stockholders have no legal recourse in div not declared, an all equity firm can’t go bankrupt
Call price increases when interest rates decrease
Bellwether bond- gov bond whose changes in interest rates are believed to show the future direction of the rest of the bond market
Chapter 7
Stockholders get cash either from company paying dividends (cash income) to selling their shares (capital gains)
Estimate future dividend payments
Constant div/zero growth– pay constant div forever, like preferred stock, compute w perpetuity formula
Constant div growth- firm will inc dividend by constant % every period
Supernormal growth- div growth not consistent initially but settles down to constant growth eventually
Gordon growth model- div and stock prices grow at g forever, div yield is constant, capital gains yield is constant and equal, total return (R ) must be >g
Stock price sensitivity to dividend growth increases exponentially– price sensitive to dividend growth
As dividend growth increases, price of stock increases
Required rate increases, price of stock decreases
Nonconstant CF- when div don’t grow at the same rate
Valuation using multiples- for stocks that don’t pay dividends– value them using the price-earnings ratio and/or price-sales ratio
Price sales ratio useful when earnings are negative
Dividend characteristics- not a liability of firm until declared by board of directors
Can’t go bankrupt from not declaring
Not tax deductible
Common stock features
Voting rights- common shareholders elect directors and control firm
Cumulative voting- directors elected together and number of votes is shares x directors
Straight voting- directors elected individually and number of votes equals number of shares
Proxy voting- grant authority by shareholder to someone else to vote with shareholders vote
Dividend is not a liability until declared by board of directors
Features of preferred stock– div pd before div is paid to common stockholders
Can defer indefinitely
Cumulative or noncomulative–
Cumulative- carried forward as arrearage and missed pref div pd before common div is paid
Noncumulative- holders forgo unpaid div, compensated with voting rights
Primary market- new issue market
Secondary- existing shares traded among investors
Dealers- maintain inventory, ready to buy/sell
Broker- brings buyers and sellers together
NYSE- members buy a trading license (own a seat)
One assigned broker/dealer per stock- trade occurs at DMM’s post
NASDAQ- multiple market makers
Electronic
Bid-ask spread— provides income amount
Chapter 10
Risk– return trade off– lesson from capital market history
Increase in reward, increase risk
Total percent return - return on an investment measured as percent of original investment
% return = $ return/ $ invested
Large cap stock– based on S&P 500 index, contains 500 largest US companies, in terms of market capitalization
Small cpa stocks- smallest 20% of companies listed in NYSE, measured by market capitalization
Risk free rate– rate returns on riskless investments (T-bills)
Risk premium– excess return on risky asset over risk free rate- reward for bearing risk
Liquidity risk- may sell with significant risk
Risk measured by dispersion, spread, and volatility
Normal distribution– symmetric frequency distribution– used for asset return analysis
Arithmetic average– return earned in average period over multiple periods
Answers the question what was your return in an average year over a particular period
okay for independent events
Geometric average- weighted return: average compound return/ period over multiple periods
Answers the question: what was average compound return/ year over particular period
Market value/ price– price which asset can be currently bought or sold
intrinsic/fundamental/fair value– value placed on an asset by investors if they had a complete understanding of asset’s investment characteristics
Form of market efficiency–
Strong form- public/private info, inside info of little use, price reflect all info, if true investment can’t earn abnormal returns. Evidence shows markets aren’t strong
Semistrong form efficient market– info is publicly available. If true investments can’t earn abnormal returns by trading on public info
Weak form efficient market– info is past price. If true inv can’t earn ab returns by trade on market info from past— most common for markets
Chapter 11
Variance and std deviation– measure volatility of returns
Variance is the weighted average squared deviations
Portfolio– collection of assets
Asset risk and return impact how stock affects risk and return of portfolio
Risk-return tradeoff for portfolio measured by expected return and std dev
portfolio return– weighted average of returns of component securities
P= -1 means perfectly negatively correlated
Principle of diversification– can decrease risk without an equivalent reduction in expected returns– decreases variability
Systematic risk– minimum level risk that diversity can’t fix, can’t diversify against systematic risk
No reward for bearing risk unnecessarily
Unsystematic risk– diversifiable, risk factors affect limited number of assets
As stock number increases, each new stock has smaller risk which reduces impact on portfolio
Well diverse portfolio eliminates ½ the risk
Investment compensated for diversifying portfolio depends on individual risk level/ limits
Beta coefficient– give idea how volatile a security/asset is relative to market
>1 asset is riskier than market average
=1 average risk
=0 when correlation coefficient of assets returns with market (rho)=0 or std dev on asset’s returns=0
As beta increases, risk premium increases for reward vs risk to stay in equilibrium
Numerator of risk-reward ratio is on the y-axis and denominator is on x-axis
CAPM defines relationship between risk and return
Rf= pure time value of money
RPm = measures reward for bearing systematic risk (E(Rm)-Rf)
Bj = measures systematic risk
If point is over SML like then it is underpriced
Is Po is overvalued then then RoR decreases
Chapter 8
Capital budgeting– used to access long term, significant amount investment, strategic business decisions
Payback period- how long does it take to recover initial cost of project– accept if period is less than some preset limit
Net present value: difference between cost and final product. Value created today from undertaking an investment
>0 project expected to add value to firm, will increase wealth of owners– direct measurement of how well project will meet goal of increasing shareholder wealth
=0 – accept if only job offer/ first time business does something (indifferent)
<0 do not accept
As I increases, NPV decreases
IRR is discount rate that makes NPV=0 (hurdle rate)
IRR decision rule– IRR>required RoR, then accept because +NPV
IRR– most important alternative to NPV, widely used in practice and intuitively appealing, based only on estimated CF, independent of interest rates
NPV profile– crossing over x axis gives IRR (where NPV=0)
Unconventional CF– signs CF change more than 1x
Accept between 2 IRR → positive NPV and RoR between 2 IRR
Independent project– CF of one are unaffected by the other
Mutually exclusive- CF of one can be adversely impacted by acceptance of other
Choose project based on highest NPV
NPV profiles cross because of:
size difference - small projects free up funds sooner for investment
High opportunity cost more valuable funds so increase discount rate, favors small projects
timing difference- project with faster payback period provides more CF in early years for reinvestment
High discount rate favors early CF
Accept project if Ror is between 2 IRR
Conflicts between NPV and IRR– NPV measure increase in value to firm, conflict between NPV and another decision use NPV, IRR unreliable if non-conventional CF or mutually exclusive
Profitability index– inc discount rate, decrease PI
Closely related to NPV (considers CF and TVM), easy to understand and communicate, useful in capital rationing.
Chapter 9
Relevant CF–include only CF that will occur if project is accepted
Stand alone principle–allow us to analyze each project in isolation from the firm
Focusing only on incremental CF
Corp CF with and without project– view it as a mini firm
Sunk costs– any cost that has already been payed– won’t change based on if project is rejected or accepted. (not relevant CF)
Opportunity cost– next best thing you could do if you chose NOT to do a project. Should be included as a cost of project
Side effects/ erosion– if sales from new project either increase or decrease sales/costs in one of existing product lines
cost/benefits included as CF in new project analysis
Net working capital– sometimes new project requires investment in new working capital
Cost incurred at start of project t=0 and recovered at the end
Financing cost– any cost with financing are excluded from project analysis. (not relevant CF)
Tax effects– depreciation isn’t a CF itself but impacts taxes paid therefore must include the tax shield of depreciation as a CF but not depreciation itself
Pro forma statement and CF– projects future operations
sales |
|
= gross profit |
|
|
= EBIT |
|
= NI |
NFA declines by amount of depreciation each year– book or accounting value, not market value
OCF= (sales-costs)(1-Tc)+ dep(Tc)
Use this when major incremental CF are the purchase of equipment and associated depreciation tax shield
GAAP requirement– sales recorded when made not when cash is received
COGS recorded when corresponding sales made, whether suppliers are paid or not
Buy inventory/materials to support sales before any cash is collected
Modified cost recovery system– depreciation →0, recovery period= class life, ½ year convention, multiply % in table by initial cost
After tax salvage– if salvage value is different than bv, then there is a tax effect… value you can recover from assets
If you sell assets above bv, pay taxes on the gain. If loss there will be a tax shield
NPV estimates are only point estimates
Forecasting risk– sensitivity of NPV to changes to CF estimates, more sensitive= greater forecasting risk
Scenario analysis– examines best, worst, and base case scenarios
Considers few possibilities, assume perfectly correlated, focus on stand alone risk
Sensitivity analysis– show how changes in input variable affect NPV or IRR (change one variable at a time)
As units decrease, NPV will decrease
Managerial options: contingency planning– option to expand, wait, or abandon and strategic options
Capital rationing– occurs when firm or division has limited resources
Soft rationing– limited resources are temporary/ self imposed (PI used for this)
Hard rationing– capital never available for project
Chapter 12
RoR is same as appropriate discount rate
Cost to a firm for capital funding = return to providers of those funds
Cost of capital– usually composed of average of 3 sources– common stock eq, preferred stock, and debt (in order of high to low risk)
RoR can also be called cost of equity
RoR required by equity investors given risk of CF from firm
Dividend growth model– advantage: easy to understand
Disadvantage: only use for companies currently paying dividends, not used if div aren't growing at reasonably constant rate, doesn’t consider risk really, and sensitive to est growth rate
SML– explicitly adjusts for systematic risk and applicable to all companies
Disadvantage– must est expect market risk premium, est beta which varies, and rely on past to predict future
Cost preferred stock– pref div pays constant div every period, div expected to be pd forever, pref stock is perpetuity
Cost of debt– required return on company’s dividend
Method 1: compute yield to maturity on existing debt
Method 2: use estimates of current rates based on bond rating expected on new debt
Current cost of debt is not coupon rate
Use if firm doesn’t have existing bond debt
Can be estimated by looking at rates of similar bonds by rating
Interest is tax deductible so use R-R(1-Tc)
After tax cost is more relevant bc its actual cost to company
Weighted average of capital: use individual costs of capital to compete weighted average cost of capital for firms.
weights= % of firm that will be financed by each component– use target weights if possible (use market weights if not)
Common stock is riskier that preferred stock
WACC– riskier= higher WACC
WACC reflects risk of average project by a firm
Different projects/ divisions have different risk