1st+Half+Review
FIN513: Corporate Finance Review
Page 1
Course: FIN513
Content: 1st Half Review Slides
Page 2: Chapter Outline
1.1 What is Corporate Finance?1.2 The Corporate Firm1.3 The Importance of Cash Flows1.4 The Goal of Financial Management1.5 The Agency Problem and Control of the Corporation1.6 Regulation
Page 3: Capital Budgeting/Structure Decision
Key Components:
Current Assets: Assets expected to be converted into cash within a year.
Fixed Assets:
Tangible: Physical assets (e.g., machinery, buildings).
Intangible: Non-physical assets (e.g., patents, trademarks).
Working Capital:
Definition: Current Assets - Current Liabilities
Can be a use of funds if the net asset balance is growing or a source of funds if declining.
Long-Term Debt: Funds borrowed for a longer period.
Shareholders’ Equity: Represents ownership in the firm.
Valuation Considerations:
Total value of assets and considerations for firm investment and fund raising.
Page 4: Importance of Cash Flows
Cash flow dynamics:
Cash for securities issued by the firm (A)
Invests in assets (B)
Cash flows from firm (C) should exceed cash flows to financial markets (D) and government (F).
The firm must generate positive cash flows from operations.
Page 5: Goal of Financial Management
Critical Goals:
Maximize profit?
Minimize costs?
Maximize market share?
✅ Maximize shareholder wealth?
Conflicts may exist between management goals and shareholder goals.
Page 6: Chapter Outline
2.1 The Balance Sheet2.2 The Income Statement2.3 Taxes2.4 Net Working Capital2.5 Cash Flow of the Firm2.6 The Accounting Statement of Cash Flows2.7 Cash Flow Management
Page 7: The Balance Sheet
A snapshot of firm accounting at a specific time.
Balance Sheet Identity:
Assets = Liabilities + Stockholders' Equity
Key Concerns:
Liquidity: Ability to meet short-term obligations.
Debt vs. Equity: Claim priorities on cash flows—bondholders vs. stockholders.
Value vs. Cost: Market value vs. book value considerations.
Page 8: Liquidity
Definition: Ease of converting assets to cash without significant loss in value.
Current Assets: Most liquid.
Liquid firms are better positioned to meet short-term obligations; however, they may yield lower returns than fixed assets.
Page 9: The Income Statement
Measures financial performance over a period.
Important considerations:
GAAP: Income recognized when earned, despite cash flow timing.
Noncash Items: E.g., depreciation, amortization.
Cost Classification: Fixed vs. Variable costs
Equation: Revenue - Expenses = Income
Page 10: Net Working Capital
Importance: Grows with business expansion unless efficiency gains are realized.
Cash Conversion Cycle:
Calculated as (Days Sales Outstanding + Days Inventory Outstanding - Days Payables Outstanding)
Equation: NWC = Current Assets - Current Liabilities
Page 11: The Accounting Statement of Cash Flows
Official statement explaining changes in cash.
Components include:
Cash flow from operating activities.
Cash flow from investing activities.
Cash flow from financing activities.
Page 12: Cash Flow Management
GAAP allows manipulation of earnings; however, total cash flow offers a more accurate financial picture.
Moving cash flow types may misrepresent business stability.
Page 13: Chapter Outline
3.1 Financial Statements Analysis3.2 Ratio Analysis3.3 The DuPont Identity3.4 Financial Models3.5 External Financing and Growth3.6 Cautions Regarding Financial Planning Models
Page 14: Financial Statements Analysis
Standardized financials enable easier comparisons as companies grow.
Common-Size Balance Sheets: Percent of total assets.
Common-Size Income Statements: Percent of sales.
Page 15: Ratio Analysis
Ratios facilitate comparison over time/companies.
Key Questions to Consider:
How is it computed?
What does it measure?
What does the value indicate?
How can it be improved?
Page 16: Categories of Financial Ratios
Liquidity Ratios: Short-term billing capabilities.
Solvency Ratios: Long-term financial health.
Asset Management Ratios: Efficiency of asset utilization.
Profitability Ratios: Operational efficiency.
Market Value Ratios: For publicly traded companies.
Page 17: Using the DuPont Identity
Formula: ROE = PM × TAT × EM
Profit Margin (PM): Operating efficiency.
Total Asset Turnover (TAT): Asset utilization efficiency.
Equity Multiplier (EM): Financial leverage assessment.
Page 18: Financial Models
Key components include:
Investment in new assets.
Degree of financial leverage.
Cash distribution to shareholders.
Liquidity requirements.
Page 19: Financial Planning Ingredients
Sales Forecast: Key for cash flow estimation.
Pro Forma Statements: Projected financial consistency.
Asset & Financial Requirements: Necessary to meet growth projections.
Plug Variable: Ensures balance sheet equilibrium.
Economic Assumptions: Necessary for planning.
Page 20: Determinants of Growth
Profit Margin: Efficiency in operations.
Financial Leverage: Optimal debt selection.
Total Asset Turnover: Efficient asset use.
Dividend Policy: Redistribution vs. reinvestment.
Page 21: Chapter Outline
4.1 Valuation: One-Period Case4.2 The Multiperiod Case4.3 Compounding Periods4.4 Simplifications4.5 Loan Amortization4.6 Firm Worth
Page 22: Net Present Value – I
NPV Definition: Present value of expected cash flows minus investment cost.
Example: Investment of $10,000 in one year for $9,500 cost; decision based on NPV calculations.
Page 23: Net Present Value – I Continued
Reiteration of NPV principles and calculation example.
Page 24: Net Present Value – II
Example investment analysis yielding cash flows over four years; presenting decision metrics (NPV, Payback, Profitability Index, IRR).
Page 25: Chapter Outline
5.1 Why Use NPV?5.2 Payback Period Method5.3 Discounted Payback Period Method5.4 Internal Rate of Return5.5 Problems with the IRR Approach5.6 Profitability Index5.7 Capital Budgeting Practice
Page 26: Why Use Net Present Value?
Benefits accepting NPV projects for shareholders, proper discounting, and cash flow consideration.
Page 27: Payback Period Method
Disadvantages: Ignores time value, post-payback cash flows, biases against long-term projects, arbitrary criteria.
Advantages: Simplicity, liquidity focus.
Page 28: Internal Rate of Return (IRR)
Disadvantages: Investing vs. borrowing distinction issues, potential for multiple IRRs, etc.
Advantages: Easy communication.
Page 29: Problems with IRR
Concerns regarding multiple IRRs, borrowing/lending distinctions, variations in scale, timing of cash flows.
Page 30: NPV versus IRR
Generally align unless cash flow signs change multiple times or differ greatly in timing/initial investment.
Page 31: Profitability Index (PI)
Disadvantages: Issues with mutually exclusive investments.
Advantages: Useful in limited investment resources, intuitive understanding.
Page 32: Summary of Discounted Cash Flow
NPV: Market value minus cost—project accepted if positive.
IRR: Discount rate makes NPV = 0; project accepted if IRR exceeds required return.
PI: Benefit-cost ratio—accepted if PI > 1, used in project ranking.
Page 33: Summary of Payback Criteria
Payback Period: Time until initial investment recovery, no time value consideration.
Discounted Payback Period: Similar, but considers discounted cash flows.
Page 34: Chapter Outline
6.1 Incremental Cash Flows6.2 Baldwin Company Example6.3 Definitions of Operating Cash Flow6.4 Special Cases of DCF6.5 Inflation and Capital Budgeting
Page 35: Incremental Cash Flows
Focus on cash flows, not earnings; sunk costs are irrelevant; opportunity costs matter; taxes and after-tax cash flows are crucial.
Page 36: Estimating Cash Flows
Cash Flow from Operations: OCF = EBIT - Taxes + Depreciation.
Net Capital Spending: Consider salvage value.
Changes in Net Working Capital: Return of working capital when project concludes.
Page 37: Chapter Outline
8.1 Bonds and Bond Valuation8.2 Government and Corporate Bonds8.3 Bond Markets8.4 Inflation and Interest Rates8.5 Determinants of Bond Yields
Page 38: Bonds and Bond Valuation
Definition of bonds as agreements between borrower and lender specifying par value, coupon rate, payment schedule, and maturity.
Yield to maturity: market interest rate for the bond.
Page 39: Bond Valuation
Primary principle: bond value equals the PV of expected future cash flows (coupon payments and par value).
Interest rates inversely affect bond prices.
Page 40: Interest Rate Risk
Price Risk: Changes due to interest fluctuations; long-term bonds face more risk.
Reinvestment Rate Risk: Cash flow reinvestment uncertainties; short-term bonds have more risk.
Page 41: Inflation and Interest Rates
Real Rate: Change in purchasing power.
Nominal Rate: Rates inclusive of inflation.
Ex ante nominal rate includes desired real return and expected inflation adjustment.
Page 42: Real versus Nominal Rates
Formula: (1 + R) = (1 + r) × (1 + h), where R = nominal rate, r = real rate, h = expected inflation.
Approximation: R = r + h.
Page 43: Factors Affecting Required Return
Default Risk Premium: Bond ratings impact.
Taxability Premium: Differences between municipal and taxable bonds.
Page 44: Chapter Outline
9.1 Present Value of Common Stocks9.2 Estimates in Dividend Discount Model9.3 Comparables9.4 Valuing Stocks Using Free Cash Flows9.5 Stock Markets
Page 45: Present Value of Common Stocks
Asset value equates to present value of expected future cash flows (dividends and capital gains).
Stock valuation approaches: Zero growth, constant growth, and differential growth.
Page 46: Valuing Stocks Using Free Cash Flows
Firm value is based on consolidated present value of cash flows from all projects.
Page 47: Price-Earnings Ratio
Ratio calculated by dividing current stock price by annual EPS; often based on the last four quarters’ earnings.
Page 48: Enterprise Value Ratios
EV represents the value of the firm taking into account debt and cash.
Enterprise value ratio: EV/EBITDA for measuring overall cash flow of the firm.