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Finance Management

by: Danielle Tata

Finance Management FN-215-F

Danielle Tata
Sacred Heart University

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Financial Management
Xin Gao
Study Guide
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This 36 page Study Guide was uploaded by Danielle Tata on Wednesday October 5, 2016. The Study Guide belongs to FN-215-F at Sacred Heart University taught by Xin Gao in Fall 2016. Since its upload, it has received 11 views. For similar materials see Financial Management in Management at Sacred Heart University.

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Date Created: 10/05/16
Financial Management Notes  Chapter 1: Fundamentals of Financial Management Concise 8E o Finance Within the Organization  o Forms of Business Organization  Proprietorship / Partnership  Proprietorship: an unincorporated business owned by one individual  Partnership: a legal arrangement between two or more people who decide to do business together.  Limited liability company (partnership), LLC (LLP)  LLC: a popular type of organization that is a hybrid between a partnership and a corporation.  LLP: used for professional firms in the fields of accounting, law, and architecture, while LLCs are used by other businesses.  Corporation  A legal entity created by a state, and it is a separate and distinct from its owners and managers. o Proprietorships and Partnerships  Advantages  Ease of formation  Subject to few regulations  No corporate income taxes  Disadvantages  Difficult to raise capital  Unlimited liability  Limited life  Often set up through LLCs/LLPs. o Corporation  Advantages  Unlimited life  Easy transfer of ownership  Limited liability  Ease of raising capital  Disadvantages  Double taxation  Cost of setup and report filing o Stock Prices and Intrinsic Value  In equilibrium, a stock’s price should equal its “true” or intrinsic value.  Intrinsic value is a long-run concept. 2  To the extent that investor perceptions are incorrect, a stock’s price in the short run may deviate from its intrinsic value.  Ideally, managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run. o Determinants of Intrinsic Values and Stock Prices   Intrinsic value: an estimate of a stock’s true value based on accurate risk and return data; can be estimated but not measured precisely.  Market price: the stock valued based on perceived but possibly incorrect information as seen by the marginal investor.  Marginal Investor: An investor whose views determined the actual stock price.  Equilibrium: The situation in which the actual market price equals the intrinsic value, so investors are indifferent between buying and selling a stock. o Stockholder-Manager Conflicts  Managers are naturally inclined to act in their own best interests (which are not always the same as the interest of stockholders). 3  But the following factors affect managerial behavior:  Managerial compensation packages  Direct intervention by shareholders  The threat of firing  The threat of takeover o Stockholder-Debtholder Conflicts  Stockholders are more likely to prefer riskier projects, because they receive more of the upside if the project succeeds.  Bondholders receive fixed payments and are more interested in limiting risk.  Bondholders attempt to protect themselves by including covenants in bond agreements that limit the use of additional debt and constrain managers’ actions. o Stockholder Wealth Maximization: the primary goal for managers of publicly owned companies implies that decisions should be made to maximize the long-run value of the firm’s common stock.  Chapter 2: Financial Markets and Institutions o How is capital transferred between savers and borrowers?  Direct transfers  Investment banks  Financial intermediaries 4 o o The Capital Allocation Process  In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it.  Suppliers of capital: individuals and institutions with “excess funds.” These groups are saving money and looking for a rate of return on their investment.  Demanders or users of capital: individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow. o What is a market?  A market is a venue where goods and services are exchanged.  A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds. o Types of Financial Markets 5  Physical assets vs. Financial assets  Spot vs. Futures  Money vs. Capital  Primary vs. Secondary  Public vs. Private o The Importance of Financial Markets  Well-functioning financial markets facilitate the flow of capital from investors to the users of capital.  Markets provide savers with returns on their money saved/invested, which provide them money in the future.  Markets provide users of capital with the necessary funds to finance their investment projects.  Well-functioning markets promote economic growth.  Economies with well-developed markets perform better than economies with poorly- functioning markets. o What are derivatives? How can they be used to reduce or increase risk?  A derivative security’s value is “derived” from the price of another security (e.g., options and futures).  Can be used to “hedge” or reduce risk. For example, an importer, whose profit falls when the dollar loses value, could purchase currency futures that do well when the dollar weakens. 6  Also, speculators can use derivatives to bet on the direction of future stock prices, interest rates, exchange rates, and commodity prices. In many cases, these transactions produce high returns if you guess right, but large losses if you guess wrong. Here, derivatives can increase risk. o Types of Financial Institutions  Investment banks  Commercial banks  Financial services corporations  Credit unions  Pension funds  Life insurance companies  Mutual funds  Exchange traded funds  Hedge funds  Private equity companies o Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets  Auction market vs. Dealer market (Exchanges vs. OTC)  NYSE vs. Nasdaq  Differences are narrowing o Stock Market Transactions  Apple Computer decides to issue additional stock with the assistance of its investment banker. An investor purchases some of the 7 newly issued shares. Is this a primary market transaction or a secondary market transaction?  Since new shares of stock are being issued, this is a primary market transaction.  What if instead an investor buys existing shares of Apple stock in the open market. Is this a primary or secondary market transaction?  Since no new shares are created, this is a secondary market transaction. o What is an IPO?  An initial public offering (IPO) occurs when a company issues stock in the public market for the first time.  “Going public” enables a company’s owners to raise capital from a wide variety of outside investors. Once issued, the stock trades in the secondary market.  Public companies are subject to additional regulations and reporting requirements. o S&P 500 Index, Total Returns: Dividend Yield + Capital Gain or Loss, 1968-2012  8 o Where can you find a stock quote, and what does one look like?  Stock quotes can be found in a variety of print sources (The Wall Street Journal or the local newspaper) and online sources (Yahoo!Finance, CNNMoney, or MSN MoneyCentral).  o What is meant by stock market efficiency?  Securities are normally in equilibrium and are “fairly priced.”  Investors cannot “beat the market” except through good luck or better information.  Efficiency continuum  o Implications of Market Efficiency  You hear in the news that a medical research company received FDA approval for one of its products. If the market is highly efficient, can you expect to take advantage of this information by purchasing the stock? 9  No. If the market is efficient, this information will already have been incorporated into the company’s stock price. So, it’s probably too late for her to “capitalize” on the information.  “Just because it's a good company doesn't mean it is a good stock.” o Implications of Market Efficiency  A small investor has been reading about a “hot” IPO that is scheduled to go public later this week. She wants to buy as many shares as she can get her hands on, and is planning on buying a lot of shares the first day once the stock begins trading. Would you advise her to do this?  Probably not. The long-run track record of hot IPOs is not that great, unless you are able to get in on the ground floor and receive an allocation of shares before the stock begins trading. It is usually hard for small investors to receive shares of hot IPOs before the stock begins trading.  “Just because it's a good company doesn't mean it is a good stock.” o Possible Reasons Markets May Not Be Efficient  It is costly and/or risky for traders to take advantage of mispriced assets.  Cognitive biases cause investors to make systematic mistakes that lead to inefficiencies. This is an area of research know as “behavioral finance.” Behavioral finance borrows insights from psychology to better understand 10 how irrational behavior can be sustained over time. Some examples include:  Evaluating risks differently in up and down markets.  Overconfidence leads to self-attribution bias and hindsight bias.  Chapter 3: Financial Statements, Cash Flow, and Taxes o The Annual Report  Balance sheet – provides a snapshot of a firm’s financial position at one point in time.  Income statement – summarizes a firm’s revenues and expenses over a given period of time.  Statement of cash flows – reports the impact of a firm’s activities on cash flows over a given period of time.  Statement of stockholders’ equity – shows how much of the firm’s earnings were retained, rather than paid out as dividends. o 11 o o Additional Items from Balance Sheet  Net working capital (NWC) = Current assets – Current liability  = $1,000 - $310 = $690  Net operating working capital (NOWC)  = Current assets – Current liability + Notes payable  = $1,000 - $310 + $110 = $800  Total debt = Short-term debt + Long-term debt  = $110 - $750 = $860  Book value = Common equity / # of shares outstanding  = $940 / 50 = $18.80 12 o o Additional Items from Income Statement  AT Operating Income = EBIT(1 – Tax rate)  = $283.8(1 – 0.4)  = $283.8(0.6)  = $170.28 o o 13 o What was the free cash flow (FCF) for 2014?  Free Cash Flow: The amount of cash that could be withdrawn without harming a firm’s ability to operate and produce future CF. FCF   EBIT(1T)   Depr. and   Capital    NOWC   amortizatio expenditures    = [$283.8(1 – 0.4) + $100] – [$230 + ($800 – $650)]  = -$109.7  Is negative free cash flow always a bad sign? o Performance Measures for Evaluating Managers  Accounting statements insufficient for evaluating managers’ performance because they do not reflect market values. (Manager’s objective?)  Performance Measures  Market Value Added: Difference between market value and book value of a firm’s common equity.  MVA = (P 0 x Number of shares) – Book value  = ($23.06 x 50,000,000) – $940,000,000  = $213,000,000  => Stockholder’s value has been enhanced! o Economic Value Added  Economic Value Added: Estimate of a business’ true economic profit for a given year. 14  EVA=EBIT(1-T)-[total invested capital * cost of capital] o What is the relationship between EVA and MVA?  If EVA is positive, then AT operating income > cost of capital needed to produce that income.  Positive EVA on annual basis helps to ensure MVA is positive.  MVA applies to the entire firm; EVA can be determined for divisions as well as for the company as a whole. o Does Allied pay its suppliers on time?  Probably not.  A/P increased 100%, over the past year, while sales increased by only 5%.  If this continues, suppliers may cut off Allied’s trade credit. o Does it appear that Allied’s sales price exceeds its cost per unit sold?  Maybe  AT operating income = EBIT(1-T) = $283.8(1- 0.4) = $170.28  Cash position change = $10 - $80 = -$70 o What if Allied’s sales manager decided to offer 60- day credit terms to customers, rather than 30-day credit terms?  If competitors match terms, and sales remain constant...  A/R would . 15  Cash would .  If competitors don’t match, and sales double...  Short-run: Inventory and fixed assets  to meet increased sales. A/R , Cash . Company may have to seek additional financing.  Long-run: Collections increase and the company’s cash position would improve. o How did Allied finance its expansion?  Allied financed its expansion with external capital.  Allied issued short-term and long-term debt which reduced its financial strength and flexibility. o Would Alllied have required external capital if they had broken even in 2014 (Net income = 0)?  YES, the company would still have to finance its increase in assets. Looking to the Statement of Cash Flows, we see that the firm made an investment of $230M in net fixed assets. Therefore, they would have needed to raise additional funds. o What happens if Allied depreciates fixed assets over 7 years (as opposed to the current 10 years)?  No effect on physical assets.  Fixed assets on the balance sheet would decline.  Net income would decline.  Tax payments would decline.  Cash position would improve. 16 o Federal Income Tax System  Individual Taxes  Corporate Taxes o Corporate and Personal Taxes  Both have a progressive structure (the higher the income, the higher the marginal tax rate).  Corporations  Rates begin at 15% and rise to 35% for corporations with income over $10 million, although corporations with income between $15 million and $18.33 million pay a marginal tax rate of 38%.  Also subject to state tax (around 5%). o Corporate and Personal Taxes  Individuals  Rates begin at 10% and rise to 39.6% for single individuals with incomes over $400,000 and married couples filing jointly with incomes over $450,000.  May be subject to state tax. o Tax Treatment of Various Uses and Sources of Funds  Interest paid: tax deductible for corporations (paid out of pre-tax income), but usually not for individuals (interest on home loans being the exception).  Interest earned: usually fully taxable (an exception being interest from a “muni”).  Dividends paid: paid out of after-tax income. o Tax Treatment of Various Uses and Sources of Funds 17  Dividends received: most investors pay 15% taxes.  Investors in the 10% or 15% tax bracket pay 0% on qualified dividends.  Single individuals with incomes over $400,000 and married couples filing jointly with incomes over $450,000 pay 20% taxes on dividends.  Dividends are paid out of net income which has already been taxed at the corporate level, this is a form of “double taxation”.  A portion of dividends received by corporations is tax excludable, in order to avoid “triple taxation.” o More Tax Issues  Tax Loss Carry-Back and Carry-Forward – since corporate incomes can fluctuate widely, the Tax Code allows firms to carry losses back to offset profits in previous years or forward to offset profits in the future.  Capital gains – defined as the profits from the sale of assets not normally transacted in the normal course of business, capital gains for individuals are generally taxed as ordinary income if held for a year or less, and at the capital gains rate if held for more than a year. Corporations face somewhat different rules.  Most taxpayers pay 15% taxes on long-term capital gains.  Single individuals with incomes over $400,000 and married couples filing jointly with incomes 18 over $450,000 pay 20% taxes on long-germ capital gains.  Chapter 4: Analysis of Financial Statements o D’Leon’s Balance Sheet: Assets  o D’Leon’s Balance Sheet: Liabilities and Equity  o D’Leon’s Income Statement  o D’Leon’s Other Data 19  o Why are ratios useful?  Ratios standardize numbers and facilitate comparisons.  Ratios are used to highlight weaknesses and strengths.  Ratio comparisons should be made through time and with competitors.  Industry analysis  Benchmark (peer) analysis  Trend analysis o Five Major Categories of Ratios and the Questions They Answer  Liquidity: Will the firm be able to pay off its debts that are maturing in a year?  Asset management: How efficiently is the firm using its assets?  Debt management: How has the firm financed its assets? Will the firm be able to repay its long-term debt?  Profitability: How profitably is the firm operating and utilizing its assets, and are sales high enough as reflected in PM, ROE, and ROA?  Market value: What do investors think about the firm and its prospects? 20 o D’Leon’s Forecasted Current Ratio and Quick Ratio for 2015  o Comments on Liquidity Ratios   Expected to improve but still below the industry average.  Liquidity position is weak.  The higher the quick ratio, the better? o Asset Management Ratios: Inventory Turnover  Inventory Turnover measures how many times the particular asset is “turned over” during the year   o Comments on D’Leon’s Inventory Turnover 21  Inventory turnover is below industry average.  D’Leon might have old inventory, or its control might be poor.  No improvement is currently forecasted. o Asset Management Ratios: Days Sales Outstanding  Days Sales Outstanding: Average number of days after making a sale before receiving cash  o Appraisal of D’Leon’s DSO   D’Leon collects on sales too slowly, and is getting worse  D’Leon has a poor credit policy  A potential problem for D’Leon’s? o Asset Management Ratios: Fixed Assets and Total Assets Turnover Ratios  Fixed Assets Turnover measures how effectively the firm uses its plant and equipment   Total Assets Turnover measures how effectively the firm uses all of its assets 22  o Evaluating the FA Turnover (S/Net FA) and TA Turnover (S/TA) Ratios   FA turnover projected to exceed the industry average.  TA turnover below the industry average. Caused by excessive current assets (A/R and Inv).  How to improve TA turnover ratio? o Debt Management Ratios: Debt-to-Capital Ratio and Times-Interest-Earned Ratio  Debt-to-capital ratio: the percentage of the firm’s capital provided by debtholders   Times-Interest-Earned ratio: the extent to which operating income can decline before the firm is unable to meet its annual interest costs  o D’Leon’s Debt Management 23   D’Leon’s Debt Ratio and TIE are better than the industry average. o Profitability Ratios: Operating Margin, Profit Margin, and Basic Earning Power  o Appraising Profitability with Operating Margin, Profit Margin, and Basic Earning Power  o Profitability Ratios: Return on Assets, Return on Equity, and Return on Invested Capital  o Appraising Profitability with ROA, ROE, and ROIC 24   All ratios rebounded from the previous year, but are still below the industry average. More improvement is needed.  Wide variations in ROE illustrate the effect that leverage can have on profitability. o Effects of Debt on ROA and ROE  Holding assets constant, if debt increases:  Equity declines.  Interest expense increases – which leads to a reduction in net income.  ROA declines (due to the reduction in net income).  ROE may increase or decrease (since both net income and equity decline). o Effects of Debt on ROA and ROE  Holding assets constant, if debt increases:  Equity declines.  Interest expense increases – which leads to a reduction in net income.  ROA declines (due to the reduction in net income).  ROE may increase or decrease (since both net income and equity decline). o Problems with ROE 25  ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure of performance.  ROE does not consider risk.  ROE does not consider the amount of capital invested.  Given these problems, reliance on ROE may encourage managers to make investments that do not benefit shareholders. As a result, analysts have looked to develop other performance measures, such as EVA. o Market Value Ratios: Price/Earnings and Market/Book Ratios  o The DuPont Equation   Focuses on expense control (PM), asset utilization (TA TO), and debt utilization (equity multiplier). o DuPont Equation: Breaking Down Return on Equity 26   o An Example: The Effects of Improving Ratios   Sales/Day = $7,035,600/365 = $19,275.62  How would reducing the firm’s DSO to 32 days affect the company? o Reducing Accounts Receivable and the Days Sales Outstanding  Reducing A/R will have no effect on sales   Initially shows up as addition to cash. o Effect of Reducing Receivables on Balance Sheet and Stock Price   What could be done with the new cash? 27  How might stock price and risk be affected? o Potential Uses of Freed Up Cash  Repurchase stock  Expand business  Reduce debt  All these actions would likely improve the stock price. o Potential Problems and Limitations of Financial Ratio Analysis  Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions.  Different operating and accounting practices can distort comparisons.  Sometimes it is hard to tell if a ratio is “good” or “bad.”  Difficult to tell whether a company is, on balance, in a strong or weak position. o More Issues Regarding Ratios  “Average” performance is not necessarily good, perhaps the firm should aim higher.  Seasonal factors can distort ratios.  “Window dressing” techniques can make statements and ratios look better than they actually are.  Inflation has distorted many firms’ balance sheets, so analyses must be interpreted with judgment. 28 o Consider Qualitative Factors When Evaluating a Company’s Future Financial Performance  Are the firm’s revenues tied to one key customer, product, or supplier?  What percentage of the firm’s business is generated overseas?  Firm’s competitive environment  Future prospects  Legal and regulatory environment  Chapter 5: Time Value of Money o Time Value of Money  Which would you prefer – $10,000 today or $10,000 in 5 years?  Obviously, $10,000 today  You already recognize that there is TIME VALUE TO MONEY!! o Intuition Behind Time Value of Money  There are three reasons why $1 tomorrow is worth less than $1 today  Individuals prefer present consumption to future consumption  When there is monetary inflation, the value of currency decreases over time  If there is any uncertainty (risk) associated with the cash flow in the future, the less that cash flow will be valued o What is the future value (FV) of an initial $100 after 1 year, if I/YR = 5%?  Draw a time line 29   Write the FV equation  FV = PV(1 + I)  Solve for FV  = 100(1.05) = 105.00 o What is the future value (FV) of an initial $100 after 3 years, if I/YR = 5%?   After 1 years:  FV =1PV(1 + I) = 100(1.05) = 105.00  After 2 years:  FV =2PV(1 + I) = 100(1.05) = 105(1.05) = 110.25  After 3 years: 3 3  FV =3PV(1 + I) = 100(1.05) = 110.25(1.05) = 115.76  After N years (general case):  FV = PV(1 + I) N N o What is the FV of an even CF stream CF =$100, 0 CF 1$100 and CF =$102 after 3 years, if I/YR = 5%?   FV of CF a0ter 3 years: 30 3 3  FV (3F ) 0 CF (1 0 I) = 100(1.05) = 115.76  FV of CF af1er 2 years: 2 2  FV (3F ) 1 CF (1 1 I) = 100(1.05) = 110.25  FV of CF af2er 1 year:  FV (CF ) = CF (1 + I)= 100(1.05) = 105.00 3 2 2  FV of the CF stream:  FV = FV (CF ) + FV (CF ) + FV (CF ) = 3 3 0 3 1 3 2 331.01 o What is the FV of an even CF stream CF =$100, 1 CF 2$100 and CF =$1003after 3 years, if I/YR = 5%?   FV of CF af1er 2 years: 2 2  FV (3F ) 1 CF (1 1 I) = 100(1.05) = 110.25  FV of CF af2er 1 years:  FV (3F ) 2 CF (1 2 I)= 100(1.05) = 105.00  FV of CF af2er 0 year: 0  FV (3F ) 3 CF (1 3 I) = 100(1) = 100.00  FV of the CF stream:  FV =3FV (CF3) + 1V (CF ) 3 FV 2CF ) = 3 3 315.25 o Annuity Due and Ordinary Annuity 31  Annuity Due: constant payments, a fixed number of periods, payments occur at the beginning of each period   Ordinary Annuity: constant payments, a fixed number of periods, payments occur at the end of each period  o What is the present value (PV) of $100 due in 1 year, if I/YR = 5%?  Draw a time line   Write the PV equation (rearrange the FV equation)  PV = FV/(1 + I)  Solve for PV  100/1.05 = 95.24 o What is the PV of $100 due in 3 years, if I/YR = 5%?   Discount FV to the end of year 2:  PV 2 FV/(1 + I) = 100/1.05 = 95.24  Discount FV to the end of year 1: 32  PV = FV/(1 + I) = 100/(1.05) = 2 1 95.24/1.05 = 90.70  Discount FV to today: 3 3  PV = FV/(1 + I) = 100/(1.05) = 90.70/1.05 = 86.38  Discount over N years (general case): N  PV N = FV/(1 + I) o What is the PV of a 3-year $100 Annuity Due at 5%?   PV of CF :0  PV(CF ) 0 CF /(10+ I) = 100/1 = 100  PV of CF :1 1  PV(CF ) 1 CF /(11+ I) = 100/1.05 = 95.24  PV of CF :2  PV(CF ) = CF /(1 + I) = 100/(1.05) = 2 2 2 90.70  PV of the CF stream:  PV = PV(CF ) +0PV(CF ) + P1(CF ) = 2 285.94 o What is the PV of a 3-year $100 Ordinary Annuity at 5%?   PV of CF :1  PV(CF ) 1 CF /(11+ I) = 100/1.05 = 95.24  PV of CF :2 33  PV(CF )2= CF /(2 + I) = 100/(1.05) = 2 90.70  PV of CF :3 3 3  PV(CF )3= CF /(3 + I) = 100/(1.05) = 86.38  PV of the CF stream:  PV = PV(CF ) + PV(CF ) + PV(CF ) = 1 2 3 272.32 o Annuity Due vs. Ordinary Annuity  3-year $100 annuity at 5%   FV and PV evaluations are consistent! [Important: values must be compared at the same time point]  An interesting observation:   Coincidence or mathematical relation? Can you prove it? o Buy a bond at $100 today, sell the bond at $120 after 3 years. Find the rate of return (I).  34  o Invest $0.5 million at 5% today. How long will it take us to acquire $1 million?  o Loan Amortization  An amortized loan is to be repaid in equal amounts on monthly, quarterly, or annual basis. E.g. home mortgages, auto loans, business loans, retirement plans, etc.  Example: A recent graduate from SHU borrows $50,000 on an auto loan, and the loan is to be repaid in five equal payments at the end of each of the next 5 years. The lender charges 6% on the balance at the beginning of each year. What is the payment (s)he must make at the end of each year? o Amortized Loan Example  35  The payments must be such that the sum of their PVs equals $50,000  50,000 = PV + P1 + PV 2 PV + 3V 4 5   36


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