ASU FIN 302 — Midterm 1 Full Study Guide

ASU FIN 302 — Midterm 1 Full Study Guide

Page 1 – Corporate Finance Foundations

1. C Corporations & Taxation

   • Definition: A C Corporation is a legal entity that is taxed separately from its owners under the Internal Revenue Code.

   • Tax Rate: Flat federal tax rate of 21%.

   • Double Taxation: Profits of the corporation are taxed at the corporate level and again at the individual level when distributed as dividends to shareholders.

   • After-tax Income Calculation: After-tax income is calculated as:
     $ext{After-tax Income} = ext{EBT} imes (1 – 0.21)$

   • Tax Shield: Interest on debt is tax-deductible which lowers the taxable income, thereby providing a tax shield to the corporation.

2. Goal of Corporate Managers

   • The primary objective is to maximize shareholder wealth or stock price leading to optimal corporate growth and profitability.

   • Compensation Alignment: Align the interests of managers and shareholders through compensation strategies that may include stock options, bonuses, and performance-linked incentives.

3. Executive Stock Options

   • Definition: A financial instrument that provides executives the right to buy shares of the company at a predetermined strike price.

   • Incentive Alignment: Aims to motivate executives to act in the best interests of shareholders.

   • Risks: Risks include dilution of shares and the potential for excessive risk-taking by executives in the pursuit of stock price appreciation.

4. Electronic Trading

   • Indicates that a significant proportion (80-90%+) of trades are executed electronically, impacting market efficiency and liquidity.

5. Sources & Uses of Cash

   • Sources of Cash: Include issuing stock or debt and selling assets.

   • Uses of Cash: Include purchasing assets, paying dividends, and repaying debt.

Page 2 – Cash Flow & Working Capital

6. Operating Cash Flow (OCF)

   • OCF can be calculated using two methods:

     • $ext{OCF} = ext{EBIT} + ext{Depreciation} - ext{Taxes}$

     • $ext{OCF} = ext{Net Income} + ext{Depreciation}$

7. Non-cash Items

   • Key non-cash items include depreciation, amortization, and depletion which affect the income statement but not cash flow directly.

8. Working Capital Metrics

   • Days Inventory Outstanding (DIO): $ext{DIO} = rac{ ext{Inventory}}{ rac{ ext{COGS}}{365}}$

   • Days Sales Outstanding (DSO): $ext{DSO} = rac{ ext{Accounts Receivable}}{ rac{ ext{Sales}}{365}}$

   • Days Payable Outstanding (DPO): $ext{DPO} = rac{ ext{Accounts Payable}}{ rac{ ext{COGS}}{365}}$

   • Cash Conversion Cycle (CCC): $ext{CCC} = ext{DIO} + ext{DSO} - ext{DPO}$

9. Accounting Ratios

   • Liquidity Ratios:

     • Current Ratio: $ext{Current Ratio} = rac{ ext{Current Assets}}{ ext{Current Liabilities}}$

     • Quick Ratio: $ext{Quick Ratio} = rac{ ext{Current Assets} - ext{Inventory}}{ ext{Current Liabilities}}$

   • Leverage Ratios:

     • Debt Ratio: $ext{Debt Ratio} = rac{ ext{Total Debt}}{ ext{Total Assets}}$

     • Debt to Equity Ratio (D/E): $ext{D/E} = rac{ ext{Total Debt}}{ ext{Equity}}$

   • Profitability Ratios:

     • Return on Assets (ROA): $ext{ROA} = rac{ ext{Net Income}}{ ext{Total Assets}}$

     • Return on Equity (ROE): $ext{ROE} = rac{ ext{Net Income}}{ ext{Equity}}$

   • Efficiency Ratios:

     • Inventory Turnover: $ext{Inventory Turnover} = rac{ ext{COGS}}{ ext{Inventory}}$

     • Accounts Receivable Turnover: $ext{AR Turnover} = rac{ ext{Sales}}{ ext{Accounts Receivable}}$

   • Market Ratios:

     • Earnings Per Share (EPS): $ext{EPS} = rac{ ext{Net Income}}{ ext{Shares}}$

     • Price to Earnings Ratio (P/E): $ext{P/E} = rac{ ext{Price}}{ ext{EPS}}$

10. DuPont ROE Analysis

    • The formula to calculate ROE using DuPont Analysis is:
      $ext{ROE} = rac{ ext{Net Income}}{ ext{Sales}} imes rac{ ext{Sales}}{ ext{Assets}} imes rac{ ext{Assets}}{ ext{Equity}}$

Page 3 – Time Value of Money (TVM)

11. Compounding

    • Future Value (FV): $ext{FV} = ext{PV} imes (1 + r)^n$

    • Present Value (PV): $ext{PV} = rac{ ext{FV}}{(1 + r)^n}$

12. Annuities

    • Ordinary Annuity:

      • Present Value: $ext{PV} = C imes rac{(1 - (1 + r)^{-n})}{r}$

      • Future Value: $ext{FV} = C imes rac{(1 + r)^n - 1}{r}$

    • Annuity Due:

      • Multiply ordinary annuity formulas by $(1 + r)$.

    • Perpetuity:

      • Present Value: $ext{PV} = rac{C}{r}$

13. Loans

    • Payment (PMT): $PMT = rac{L imes r(1 + r)^n}{(1 + r)^n - 1}$

    • Interest Calculation: $ext{Interest} = r imes ext{Bal}_{prev}$

    • Unpaid Balance: Present value of remaining payments.

14. Effective Annual Rate (EAR)

    • Calculation: $ext{EAR} = (1 + rac{r_{nom}}{m})^m - 1$

    • Continuous Compounding: $ext{Continuous} = e^{r_c} - 1$

15. Percentage Return

    • Holding Period Return (HPR): $ext{HPR} = rac{P1 - P0 + D}{P0}$

    • Geometric Return: ext{Geometric} = igg[ ext{(1+r1)(1+r2)…} igg]^{ rac{1}{n}} - 1

16. Rule of 72

    • Estimated years to double an investment can be calculated as: ext{Years to double} rac{72}{r ext{%}}

Page 4 – Risk, Return & CAPM

17. Normal Distribution

    • The empirical rule states that for a normally distributed variable:

      • Approximately 68% of values fall within ±1 standard deviation (σ).

      • Approximately 95% lie within ±2 standard deviations.

      • Approximately 99.7% fall within ±3 standard deviations.

18. Correlation & Portfolio Standard Deviation (σ)

    • The formula to calculate the standard deviation of a portfolio is:
      ext{σ}_p = igg[ ext{wA}^2 ext{σA}^2 + ext{wB}^2 ext{σB}^2 + 2 ext{wA} ext{wB} ext{ρAB} ext{σA} ext{σB} igg]^{ rac{1}{2}}

19. Beta (β)

    • Definition: Measure of the systematic risk of a security in comparison to the market.

    • Calculation: eta = rac{ ext{Cov}(ri, rm)}{ ext{Var}(r_m)}

    • Interpretation: A β > 1 indicates that the asset is riskier than the market.

20. Capital Asset Pricing Model (CAPM)

    • Provides a method to calculate the expected return on an asset.

    • Formula: $r<em>i = r</em>f + β<em>i(r</em>m - r_f)$; where:

      • $r_i$ = expected return of the asset

      • $r_f$ = risk-free rate

      • $r_m$ = expected market return

21. Portfolio Variance

    • Portfolio variance can be computed using the covariance matrix or the general formula that considers all assets within the portfolio.

Page 5 – Bonds, Fisher Effect & Market Efficiency

22. Bond Pricing

    • Formula for bond pricing: P = ext{Σ}igg[ rac{C}{(1+y)^t} igg] + rac{F}{(1+y)^n}

    • Premium occurs when the coupon payment (C) is greater than the yield (y), while a discount occurs if C < y.

23. Yield to Maturity (YTM) & Yield to Call (YTC)

    • YTM is the internal rate of return on a bond if held until maturity; it equates the present value of future cash flows to the current price of the bond.

    • YTC is the yield calculated if a bond is called before maturity.

24. Maturity & YTM

    • Generally, longer maturities are associated with higher risk and duration, leading to a higher yield to maturity (YTM).

25. Bond Ratings

    • Ratings are categorized as follows:

      • AAA/AA/A/BBB are considered investment-grade securities, while ratings below these are deemed junk bonds with higher risk.

26. Fisher Effect

    • Relationship between nominal interest rates, real interest rates, and inflation.

    • Formula: $1 + r<em>{nom} = (1 + r</em>{real})(1 + ext{π})$

    • Approximation: $r<em>{nom} ext{≈ } r</em>{real} + ext{π}$

27. Historical SBBI Returns

    • Average returns over the long term by asset class:

      • Large Stocks: 10-12%

      • Small Stocks: 13-15%

      • Bonds: 5-6%

      • T-Bills: 3-4%

28. Efficient Markets Hypothesis (EMH)

    • States that asset prices reflect all available information.

      • Weak Form: Prices reflect past information.

      • Semi-strong Form: Prices reflect all publicly available information.

      • Strong Form: Prices reflect all information (public and private).

    • Implication: It suggests that it is challenging to outperform the market consistently through stock selection or market timing.