Finance 3610 Test 1 Study Guide
Finance 3610 Test 1 Study Guide FINC 3610
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This 7 page Study Guide was uploaded by Hanna Fowler on Friday September 2, 2016. The Study Guide belongs to FINC 3610 at Auburn University taught by Darrell Crutchley in Fall 2016. Since its upload, it has received 166 views. For similar materials see Principles of Business Finance (FINC 3610-011) in Finance at Auburn University.
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Date Created: 09/02/16
FINC 3610 Test 1 Study Guide Chapter 1 Areas of Finance Capital Budgeting Deals with long-term assets Managing a firm’s long-term investments Essence: evaluating the size, timing, and risk of future cash flows Assets = liability + short term equity Capital Structure Policy Deals with long-term liabilities and equity Specific mixture of long-term debt and equity used to finance operations How much should we borrow? Debtholders get first claim to value of assets Ex: value of assets = $75. Debt = $75. Debtholders get $75 and stockholders get $0. Value of assets = $500. Debtholdres get $75. Stockholders get $425. Money that stockholders get is equity Bankruptcy: when you owe more than you have in assets Working Capital Management Deals with short-term assets and liabilities Inventory and money owed to suppliers Should we purchase supplies on credit or pay cash? Net working capital = current assets – current liabilities Types of Business Organizations Sole proprietorship Pros: Most predominant form Easy to setup Good tax treatment Cons: Limited life: lasts only as long as the person Difficult to transfer ownership Unlimited liability General Partnership Pros: East startup: simple agreement between two people Taxed on personal income rate Partners pool capital Cons: Limited life Difficult to transfer ownership Unlimited liability o Except in limited partnership: Limited partner is not active participant in business and is only liable for what they invest. Corporation Separation of ownership and control Owners = shareholders Hire managers to run business Pros: Liability limited to investment: only responsible for what you invest Permanency: easily transferable o Owners change as stock is exchanged Cons: Double taxation: pay corporate tax and individual income tax on earnings from the corporation Incorporation is costly and time-consuming Goal of the Firm Maximize shareholder’s wealth Maximize current value per share of stock Maximize market value of existing owner’s equity Primary Market Corporation is seller and transaction raises money for corporation Public offering: selling securities to the general public Private placement: negotiated sale with specific buyer Secondary Market One owner or creditor selling to another The Agency Problem Business not actually run by owners Need them to act on your best behalf Managerial compensation: Allow them to buy stock at discount, this encourages them to make it worth something Promotions Proxy fight: authority to vote someone else’s stock. Used to replace managers Agency cost: the cost of the conflict of interest between stockholders and management Direct: expenditure that costs stockholders and benefits managers Buying a luxurious corporate jet Not being able to trust your managers and having to hire outside auditors to do finances. Indirect: lost opportunity Sarbanes-Oxley Act Protect investors from corporate abuses Makes managers responsible for accuracy of company’s financial statements Chapter 2 Financial Statements Annual Report includes: Balance sheet Income statement Statement of Cash flows Balance Sheet Owned on left, owed on right Assets = liabilities + owner’s equity Current assets: life of less than one year cash + MS, A/R, inventory Fixed assets: relatively long life Tangible: land, plant, equipment Intangible: trademark, patent, depreciation Current liabilities: A/P, notes payable, accruals Long-term liabilities: Bonds, preferred stock Owner’s equity: Common stock: par value, paid-in capital, retained earnings Market Value v. Book Value Market value only in the market place Book value is not actual worth o Historical cost Market value is not on balance sheet Shares of stock show true market value on balance sheet Market capitalization shows how much a company is worth Income Statement Net income = revenues (sales) – expenses (COGS) Measures accounting profits Doesn’t take into account actual cash flow Cash flow = money in and money out Statement of Cash flows Summarizes a firms revenue and expenses over time Cash flow from assets Cash flow generated through operations and investments in assets = cash flows paid to investors or received by firm’s investors Operating cash flow o Change in net working capital o Flows generated from operations of the firm o Operating income = EBIT Net Working Capital o Difference between firms current assets and current liabilities o NWC = assets – liabilities Capital Spending: o Change in gross fixed assets Cash flow from assets = operating cash flow – change in net working capital – capital spending Cash Flows to Investors Cash flows to creditors + cash flows to stockholders Cash flow to creditors = - Interest paid – net new borrowing Cash flow to stockholders = - Dividends paid – net new equity raised Net new borrowing: change in bonds - If debt decreases as a result of paying off outstanding loans then net new borrowing is negative Equity: common stock + paid-in capital - If common stock decreases as a result of the firm repurchasing outstanding shares then net new equity raised will be negative Cash Flows to Investors = Interest Paid Dividends Paid - Net New Borrowing + - Net New Equity = Cash flow to creditors = Cash flow to stockholders Taxes Marginal tax rate: rate of the extra tax you would pay if you earned one more dollar Average tax rate: taxes paid divided by taxable income Tax liability/taxable income Progressive tax system: Average tax rate increases with taxable income All of your income is taxed at a different rate depending on where it falls chronologically in your earnings Ex: Total tax on $160,000 = $45,650 - 0-50,000: 15% - $50,000 = $7500 in tax - 50,000-75,000: 25% - $25,000 = $6250 - 75,000-100,000: 34% - $25,000 = $8500 - 100,000-335,000: 39% - $60,000 = $23,400 Chapter 3 Limitations of Ratios Ratio Analysis Attempt to standardize financial info Meaningful comparisons over time and between firms Six categories: Liquidity: ability to meet short-term financial obligations o Current ratio = current assets/current liabilities o Acid-test ratio = (current assets – inventory)/ current liabilities Long term solvency: measure extent to which non- owner supplied funds have been used to finance firm’s assets. o Debt management ratio= total debt/total assets o Debt/equity ratio= total debt/common equity o Equity multiplier ratio= total assets/common equity o Total debt: current liabilities + bonds o Common equity: total owner’s equity Coverage: measure firm’s ability to cover the finance charges associated with its use of financial leverage. o Times interest earned ratio= EBIT/interest expense. *EBIT=operating income o Cash coverage ratio= (EBIT+depreciation)/ interest expense Asset activity: provide basis for assessing how effectively the firm is using its resources to generate sales. o Average collection period ratio: accounts receivable/ (annual sales/365) o Inventory turnover ratio: COGS/inventory o Fixed assets turnover: sales/next fixed assets o Total assets turnover: sales/total assets Profitability: measure overall effectiveness of the firm’s management o Gross profit margin= gross profit/sales. *gross profit= sales-COGS o Operating profit margin= EBIT/sales o Net profit margin= net income/sales o Return on equity= net income/common equity Market value: relate stock price to earnings and book value of the firm o Price/earnings (P/E) ratio= stock price per share/ earnings per share. *earnings per share= net income/shares outstanding o Market/book ratio= market stock price per share/ book value per share. *book value= owners equity/shares outstanding Common size financial statement: everything is a percentage of the total Balance sheet: divide every number by the amount of total assets, or the total equity/liability Income statement: divide everything by sales Liquidity: speed and ease with which an asset can be converted to cash Least liquid: inventory Most liquid: accounts receivable Financial leverage: use of debt in a firm’s capital structure More debt=more leverage Limitations: Seasonality: make more during certain periods of the year Dressing up the numbers: look better than you actually are Differences in accounting practices Industry averages are NOT a goal Data from the balance sheet Market value v. book value DuPont System Summarizes key relationships to determine performance of firm Return on assets= net income/total assets Profit margin= net income/sales Total asset turnover= sales/total assets Multiply profit margin*total asset turnover=return on assets : this is Dupont’s finding Equity multiplier= total assets/common equity Return on equity= (net income/sales) * (sales/total assets) * (total assets/common equity) Return on equity= return on assets*equity multiplier Leverage Function of the debt ratio Debt ratio= money borrowed/money invested If assets controlled=equity used then no debt
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