Financial Management: ***The present value of a financial asset is the future value of cash flows (PVFCV) Chapter 1: An Overview of Financial Management Forms of Business Organizations Creating Value for Investors Stockholder-Manager Conflicts (agency Issues) Stockholder-Debt Holder ConflicWe also discuss several other topics like What is the meaning of moles in elements?
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ts Balancing Shareholder Interests and Society Interests Forms of Business Organization: (Handout) ∙ Proprietorship ∙ Partnership o General o limited ∙ Corporation o Sub S o LLC o “C” What kind of organization you want to be depends on Taxation and Liability? Can migrate through organizations as you grow Finance (Job) within the Corporation: Shareholders elect board of directors Large shareholders have large voice in voting Every important decision goes through CFO Stock Prices and Intrinsic Value ∙ In equilibrium, a stock prices should equal its “true” or intrinsic value ∙ Intrinsic value is long-run concept ∙ To the extent that investor perceptions are incorrect, a stocks price in the short run may deviate from intrinsic value ∙ Ideally, managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run Stock: Normal: Buy, hold, sell Shorting: Sell, hold, buy (hope price falls) Return on Investment (ROI) Cost basis: the price you paid for the stock or bondCapital Gain or Loss: stock or bonds selling price less the cost basis Income: interest and dividends received Total Return: income received during your holding period plus the capital gain or loss divided by your cost basis ROI: (sell-basis)/basis Stockholder-Manager Conflicts Managers are naturally inclined to act in their own best interest (which are not always the same as the interest of stockholders), but the following factors affect managerial behavior: o Managerial compensation packages o Direct Intervention by shareholders o Threat of firing o Threat of hostile takeover Stockholder-Debt Holder Conflicts ∙ Stockholders are more likely to prefer riskier projects, because they receive more of the upside if he project succeeds. By contrast, bondholders receive fixed payments and are more interested in limiting risk. ∙ Bondholders are particularly concerned about the use of additional debt. ∙ Bondholders attempt to protect themselves by including covenants in bond agreements that limits the use of additional debt and constrain manager’s actions. Balancing Shareholder Interest and Society Interests: The primary financial goal of management is shareholder wealth maximization, which translate to maximizing stock price The value of any financial asset is the present value of its future cash flows. Most significant decisions are evaluated in terms of their financial consequences Stock prices change over time as conditions change and as investor obtain new information about a company’s prospects Know the difference between stakeholder and stockholder and shareholders Value = Free Cash Flows (FCF) Value=PV of free cash flows Free cash flows are the cash flows that are available (or free) for distribution to all investors (stockholders and creditors) FCF = cash sales- cash operating costs – operating taxes- required investments (working capital and capital expenditures) CHAPTER 2: Financial Markets and Institutions The Capital Allocation ProcessFinancial Markets Financial Institutions Stock Markets and Returns Stock Market Efficiency How is Capital transferred between savers and borrowers? 1) Direct Transfers a. Business Securities to savers b. Savers dollars to the business 2) Indirect transfers through investment bankers (help issue bank securities and recommend investment for savers) facilitator, flows through a. Business Securities -> investment banking houses -> savers b. Savers Dollars -> Investment banking houses -> Business 3) Indirect transfers through a financial intermediary (truly stands in middle. Take its risk instead of business. a. Business Securities -> Financial Intermediary -> savers b. Savers Dollars -> Financial Intermediary -> Business Side Topic of Discussion: Triple A investments are the best (AAA, AA, A, BBB, BB, B) best investment is Government. They print the money. They have lowest interest rate of issuers. Good investments are riskless. 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 of 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 What is a market? ∙ “Have you ever bought or sold something online?” No shit Sherlock! ∙ 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 What is an IPO? Initial Public Offering: 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 Types of Financial Markets: Physical assets vs. Financial assets Spot vs. FuturesMoney vs. Capital Primary vs. Secondary Public vs. Private The Importance of Financial Markets: Well-functioning financial markets facilitate the flow of capital from investors to the users of capital o Markets provide savers with returns o Markets provide users of capital with necessary funds for further investment Well-functioning markets promote economic growth o Economies with well-developed markets perform better than poorly functioning markets Types of Financial Institutions: 1. Investment banks 2. Commercial banks 3. Financial services corporations 4. Credit unions 5. Pension funds 6. Insurance companies 7. Mutual funds 8. Exchange traded funds 9. Hedge funds 10.Private equity companies Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets Auction market vs. dealer market Or NYSE vs. NASDAQ Financial Securities: Money Market: less than one-year maturity Capital Market: more than one-year maturity Indices: Dow Jones Industrial Average: 30 “blue chip,” or well known brands, stocks NYSE Composite: 2,000 stocks (listed on NYSE) S&P 500: 500 large cap US stocks (used as benchmark by most money managers) NASDAQ: 3,200 stocks – many tech sector 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 Highly inefficient (way left), small companies not followed by many analysts. Not much contact with investors o Highly efficient (way right), large companies followed by many analysts. Good communication with investorsProfessor Note: KNOW CASH CYCLE FOR TEST Chapter 4: Analysis of Financial Statements Ratio Analysis Interpreting ratios DuPont Equation Limitations of Ratio Analysis Qualitative Factors Why are ratios useful? Ratios standardize numbers and facilitate comparisons Ratios are used to highlight weaknesses and strengths Ratios comparison should be made though time and with competitors Industry analysis Benchmark (peer) analysis Trend analysis Five major Categories of Ratios 1. Liquidity a. Quick Ratio b. Current Ratio i. Can we make required payments? 2. Asset Management a. Cash cycle (in days) b. Inventory turnover c. Days sales outstanding d. Days in payables e. Fixed asset turnover ratio i. Right amount of assets vs. sales? 3. Debt Management a. Total debt to total capital b. Times interest earned i. Right mix of debt and equity? 4. Profitability a. Gross, operating, and profit margins b. Return on total assets i. Do sales prices exceed unit costs and are sales high enough as reflected in PM, ROE, and ROA? 5. Market Value a. Price/earnings ratio (P/E) b. Book value per share c. Market/Book ratio i. Do investors like what they see as reflected in P/E and M/B ratios? Net worth decreased for these reasons:1. Lose money 2. Dividends 3. Buy back stock 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 “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 firm’s balance sheets so analysis must be interpreted with judgment Problems with ROE 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. Analyzing the Market Value Ratios P/E: How much investors are willing to pay for $1 of earnings M/B: How much investors are willing to pay for $1 of book value equity P/E and M/B are high if expected growth is high and risk is low 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 EXAM: on Chapters 1,2, and 4 Download Excel took kits and understand them VOCABULARYChapter 1: “C” Corporation: a firm with more than 100 stockholders. Once S corporation decide to sell stock to the public, they become C corporation. LLC: Limited Liability Corporation is a popular type of organization that is a hybrid between partnership and corporation “S” Corporation: a special designation that allows small businesses that meet qualifications to be taxed as if they were a proprietorship or partnership rather than a corporation Agency problems: The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests. In corporate finance, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. corporate governance: Corporate governance is the system of rules, practices and processes by which a company is directed and controlled. Corporate governance essentially involves balancing the interests of a company's many stakeholders, such as shareholders, management, customers, suppliers, financiers, government and the community. Auctions: An auction market is a market in which buyers enter competitive bids, and sellers enter competitive offers at the same time. The price at which a stock is traded represents the highest price that a buyer is willing to pay and the lowest price that a seller is willing to sell. Dealers: include all facilities that are needed to conduct security transactions not conducted on the physical location exchanges Corporate raiders: individuals who target corporations for takeover because they are undervalued Financial intermediaries: A financial intermediary is an entity that acts as the middleman between two parties in a financial transaction, such as a commercial bank, investment banks, mutual funds and pension funds. Free cash flows (FCF): Free cash flows are the cash flows that are available (or free) for distribution to all investors (stockholders and creditors) Intrinsic value: an estimate of a stocks “true” value based on perceived but possibly incorrect information as seen by the marginal investor IPO: Initial Public Offering. The market for stocks of companies that are in the process of going public Market price: the stock value based on perceived but possibly incorrect information as seen by the marginal investor Maximize shareholder wealth: the primary financial goal for managers of publicly owned companies implied that decisions should be made to maximize the long-run value of the firms common stock Money markets: the financial markets in which funds are borrowed or loaned for short periods (less than one year)Capital markets: the financial markets for stocks and for intermediate, or long term, debt (one year or longer) Partnership: an unincorporated business owned by two or more persons LLP: Limited Liability Partnership, similar to LLC but used for professional firms in the fields of accounting, law, and architecture. It provides personal asset protection from business debts and liabilities but is taxed as partnership Primary: markets in which corporations raise capital by issuing new securities Secondary markets: markets in which securities and other financial assets are traded among investors after they have been issued by corporations Proprietorship: an unincorporated business owned by one individual WACC: The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. Working capital: The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers. Hostile takeovers: the acquisition (possession) of a company over the opposition of its management Chapter 2 – Financial Markets and Institutions Behavioral finance: Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions. Financial statements: A financial statements (or financial report) is a formal record of the financial activities and position of a business, person, or other entity. ... A balance sheet, also referred to as a statement of financial position, reports on a company's assets, liabilities, and owners equity at a given point in time. Income taxes – progressive/regressive : That is, individuals who earn high incomes have a greater proportion of their incomes taken to pay the tax. A regressive tax, on the other hand, is one whose rate increases as the payer's income decreases. Investment banking: An organization that underwrites and distributes new investment securities and helps businesses obtain financing Market efficiency Mutual funds: Organizations that pool investor funds to purchase financial instruments and thus reduce risks through diversification hedge funds: a limited partnership of investors that uses high risk methods, such as investing with borrowed money, in hopes of realizing large capital gains. private equity funds: A private equity fund is a collective investment scheme used for making investments in various equity (and to a lesser extent debt) securities according to one of the investment strategies associated with private equity.NOPAT: Net operating profit after tax (NOPAT) is a measure of profit that excludes the costs and tax benefits of debt financing. Put another way, NOPAT is earnings before interest and taxes (EBIT) adjusted for the impact of taxes. Over-the-counter (OTC) market: A large collection of brokers and dealers, connected electronically by telephones and computers, that provides for trading in unlisted securities Private: Markets in which transactions are worked out directly between two parties Public markets: Markets in which standardized contracts are traded on organized exchanges ROIC / total return / basis Spot: The markets in which assets are bought or sold for "on-the-spot" delivery Futures markets: The markets in which participants agree today to buy or sell an asset at some future date Going public: The act of selling stock to the public at large by a closely held corporation or its principal stockholders Chapter 4 – Analysis of Financial Statements Days sales outstanding (DSO): Finds how many days' sales are tied up in receivables. This can show that customers aren't paying their bills on time. Receivables / (Annual sales / 365) Debt ratios: Firms can use debt to create higher returns if the economy is booming; interest is tax deductible, and if return on assets is greater than the interest on the debt the company can give its stockholders a little bonus. DuPont equation: Shows that the rate of return on equity can be found as the product of profit margin, total assets turnover, and the equity multiplier. It shows the relationships among asset management, debt management, and profitability ratios. Financial leverage ratios: Financial Leverage Ratios. Financial leverage ratios, sometimes called equity or debt ratios, measure the value of equity in a company by analyzing its overall debt picture. These ratios either compare debt or equity to assets as well as shares outstanding to measure the true value of the equity in a business. Interest coverage: The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period. Times interest earned: Measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. Inventory turnover ratio: Shows how many times the particular asset is turned over during the year. Sales / Inventors Liquidity ratios: Ratios that show the relationship of a firm's cash and other current assets to its current liabilities. current ratio: This ratio is calculated by dividing current assets by current liabilities. It indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future. Current Assets / Current Liabilities Market value ratios: Relates the stock price to earnings and book value price. Used in three primary ways: 1. by investors when they are deciding to buy or sell a stock /react-text 2. by investment bankers when they are setting the share price for a new stock issue 3. by firms when they are deciding how much to offer for another firm in a potential merger. Profitability ratios: A group of ratios that show the combined effects of liquidity, asset management, and debt on operating results. gross margin: Measures net income per dollar of sales. operating margin: Measures operating income, or EBIT, per dollar of sales. Return on Assets (ROA): the ratio of net income to total assets Return on Equity (ROE): the ratio of net income to common equity; measures the rate of return on common stockholder’s investment Trend analysis / Common size analysis : an analysis of a firms financial ratios over time; used to estimate the likelihood of improvement or deterioration in its financial condition