FIN 226- Final Study Guide CASH FLOW ANALYSIS ● Describe the first 4 moderated accelerated cost recovery system property classes and recovery periods Answer: The 3 year property class is defined as research equipment and certain special tools. The 5 year property class is defined as computers, printers, copiers, duplicating eqIf you want to learn more check out afi cfa
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uipment, cars, light-duty trucks, and qualified technological equipment. The 7 year property class is defined as office furniture, fixtures, most manufacturing equipment, railroad tracks, and single-purpose agricultural structures. The 10 year property class is defined as equipment used in petroleum refining or in the manufacture of tobacco products and certain food products. ● Describe the overall cash flow through the firm in terms of cash flow from operating, investment, and financing activities Answer: Cash flow is the primary ingredient in any financial valuation model. The statement of cash flows summarizes the firm’s cash flow over a given period of time. Operating flows are directly related to sale and production of a firm’s products and services. Investment flows are associated with the purchase and sale of both fixed assets and equity investments in other firms. ● Explain why a decrease in cash is classified as a cash inflow and why an increase in cash is classified as a cash outflow Answer: A decrease in cash is considered an inflow because it signifies a decrease in assets, an increase in liability, depreciation, and net profit after taxes. Whereas an increase in cash is considered an outflow because it signifies an increase in assets, a decrease in liability, dividends are paid, and a net loss after taxes. ● Why is depreciation considered a non-cash charge? Answer: A noncash charge is an expense that is reported on the income statement of the current accounting period where there was no related cash payment during the period. Depreciation is the portion of fixed assets charged against revenues, and under the modified accelerated cost recovery system, the depreciable value of an asset is its full cost, which means that there is no adjustment required for the expected salvage value. ● Define and differentiate between a firm’s operating cash flow and its free cash flow Answer: Operating cash flow is the cash flow a firm generates from normal operations and is used for managerial decision-making, whereas free cash flow is the amount of cash flow available to investors after the firm has met all operating needs and paid for investments in net fixed assets and net current assets. Free cash flow is commonly defined as operating cash flow minus capital expenditures. Free cash flow and operating cash flow are sometimes used to define a ratio that is useful when comparing competitors in the same or comparable industries. ● What is the financial planning process? Answer: The financial planning process is comprised of six steps: determine your current financial situation, develop financial goals, identify alternative courses of action, evaluate alternatives, create and implement a financial action plan, and finally reevaluate and revise your plan. Short term financial planning is defined as those which involve cash flows within the next 12 months, whereas long term financial planning is defined as longer than a year. Short term financing refers to business or personal loans that have a shorter-than-average timespan for repaying the loan, which is typically one year or less. Long term financial planning is the process of aligning financial capacity with long-term service objectives. ● What is the purpose of a cash budget? Answer: A cash budget provides details of a company’s cash inflow and outflow during a specified budget period, which is usually a month or year. The primary purpose of a cash budget is to inform the status of the company’s cash position at any point in time. ● How is the percent of sales method used to prepare pro forma income statements? Answer: The percent of sales method is used to prepare pro forma income statements when the financial manager assumes all costs to be variable and decides to begin with sales forecasts and use value for cost of goods sold, operating expenses, and interest expense, and then express them as a percentage of project sales. The strength of using the percent of sales method to prepare pro forma income statements is the ease of calculation. The percentage of sales method is a financial forecasting method that businesses use to predict their sales growth on an annual basis and predict the amount of financing they need to acquire to help accomplish their goal. ● What is the financial manager’s objective in evaluating pro forma statements? Answer: Pro forma statements must be based upon objective and reliable information in order to create an accurate projection of a small business's profits and financial needs. A company uses pro forma statements in the process of business planning and control. By arranging the data for the operating and financial statements side by side, management analyzes the projected results of competing plans in order to decide which best serves the interests of the business. During the course of the fiscal period management evaluates its performance by comparing actual results to the expectations of the accepted plan using a similar pro forma format. Management's assessment consists of testing and re-testing the assumptions upon which management based its plans. NOT SURE WHICH CHAPTER THIS IS ● Define the money, capital, brokers, and dealer markets Answer: The money market is the trading of short term loans between banks and other financial institutions. The capital market is the trading of long term loans between banks and other financial institutions. A broker’s market is where people go to buy or sell a company; an example of this is the NYSE. A dealer’s market is where people display the prices of which companies people are willing to buy or sell; an example of this is the NASDAQ. ● What is securitization and how does it facilitate investment in real estate assets? Answer: Securitization is the process of taking an asset that is hard to sell and making it a security by financial engineering. It is the process of gathering together mortgages and other types of loans and then selling them. Individual mortgages then turn into assets that are sold in the secondary mortgage market. ● How do rising home prices contribute to low mortgage delinquencies? Answer: When there is an increase in home prices the gap between what a borrower owes and what the home is worth widens. To fix this problem lenders are allowing borrowers who are having difficulty paying their mortgage payments to use built-up home equity to refinance their loans and lower their payments. ● Why do falling home prices create an incentive for homeowners to default on their mortgages even if they can afford monthly payments? Answer: When the prices of homes fall the amount that these houses are worth declines which means that you can buy a nice house at a lower cost. However, for the people who bought a house and are paying a mortgage, their mortgage payments do not rise or fall with the housing market. They will continue to pay the rate at which the mortgage was when they bought the house, when in reality the rate is much lower now. As a result of this, these same people are now starting to pack up their belongings and leave because of how ridiculous the system is now and banks are losing money because people are not paying off their mortgages. ● Why do you think that so many pieces of legislation related to financial markets were passed during the great depression? Answer: I believe that so many documents of legislation were passed during the time of the Great Depression because the financial situation that everyone was placed in was so extraordinarily bad. The legislators did not want something of this magnitude to ever happen again, which is why they passed so many pieces of legislation. ● What benefit is from the tax deductibility of certain corporate expenses? Answer: Tax deductible expenses are any necessary expenses that help a company expand its income. Deductible expenses are those that can be subtracted from a company's income before it is subject to taxation. Spending money can bring you a double benefit, for it helps grow your company, and often times the money you spend to expand your company will be deducted in the company’s income. As a result, the benefit of tax deductibility of certain corporate expenses is that you may actually receive some of the money that you already spent. COST OF CAPITAL ● What are the typical sources of long-term capital available to the firm? Answer: The basic sources of long-term capital available to the firm are: long-term debt, preferred stock, retained earnings, and common stock. ● What methods can be used to find the before tax cost of debt? Answer: The before-tax cost of debt can be found through three different ways: by using market quotations, by calculating the cost, or by approximating the cost. ● How would you calculate the cost of preferred stock? Answer: The cost of preferred stock is the ratio of the preferred stock dividend to the firm’s net proceeds from the sale of preferred stock. r(P) = D/Net Proceeds. ● How do the constant growth valuation model and capital asset pricing model methods for finding the cost of common stock differ? Answer: The constant-growth valuation model assumes that the value of a share of stock equals the present value of all future dividends that it is expected to provide over an infinite time horizon. The capital asset pricing model describes the relationship between the required return and the non-diversifiable risk of the firm as measured by the beta coefficient. The CAPM technique differs from the constant-growth valuation model in that it directly considers the firm’s risk in determining the required return or cost of common stock equity. ● Why is the cost of financing a project with retained earnings less than the cost of financing it with a new issue of common stock? Answer: The cost of retained earnings is the same as the cost of an equivalent fully subscribed issue of additional common stock, which is equal to the cost of common stock equity. The net proceeds from sale of new common stock will be less than the current market price, which means that the cost of new issues will always be greater than the cost of existing issues, which is equal to the cost of retained earnings. ● What is the relationship between the firm’s target capital structure and the WACC? Answer: The weighted average cost of capital (WACC) reflects the expected average future cost of capital over the long run. It is found by weighting the cost of each specific type of capital by its proportion in the firm’s capital structure. The WACC must account for all financing costs within the firm’s capital structure. A firm’s capital structure and the WACC is a direct relationship as they both correlate with each other. RISK AND RETURN ● What is risk in the context of financial decision-making? Answer: Risk in the context of financial decision-making is the possibility of a financial loss. The outcome of an investment has the potential to differ from the expected outcome. If there is a large range of possible outcomes then there will be a greater degree of risk. ● Define return and describe how to find the rate of return on an investment Answer: Return is the total gain or loss experienced on an investment over a period of time. It is calculated by dividing the asset’s cash distributions during that period, plus the change in value by the beginning of the periods investment value. ● Which risk preference is most common among financial managers? Answer: The most common risk preference among financial managers is risk-averse. Risk averse managers have an increase in risk when the required return increases. ● Explain how the range is used in scenario analysis Answer: Under scenario analysis the outcomes are defined as pessimistic, optimistic, and most likely. Risk is measured by the range of possible outcomes. To get the range you subtract the return associated with the pessimistic outcomes from the return associated with the optimistic outcomes. A greater range indicates more risk associated with that asset. ● What does the coefficient of variation reveal about an investment’s risk that the standard deviation does not? Answer: The coefficient of variation is used to compare assets that have different expected returns, whereas the standard deviation cannot do that. This means that the coefficient of variation considers the relative size or expected returns of the asset, whereas the standard deviation does not have that capability. ● What is an efficient portfolio? How can the return and standard deviation of a portfolio be determined? Answer: An efficient portfolio is a portfolio that maximizes return for a given level of risk or minimizes risk for a given level of return. The return and standard deviation of the portfolio is determined by using the equation: where = average annual rate, = known outcomes, n= number of observations and = probability of known outcomes. ● What do you think are the ethical limits that managers should observe when taking risks with other people’s money? Answer: With every investment there is risk and an ethical manager is someone that is honest with their client in every way possible. An ethical manager will explain to their clients what is going on in regards to where their money is and how it is being handled. It would be unethical for a manager to not inform a client that their money is invested in something that has the potential to make them a lot of money but also has a great degree of risk. CAPITAL BUDGETING ● Define capital budgeting and explain how it helps managers achieve their goals Answer: Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing wealth. *****Look at note packet instead***** CASH FLOW BUDGETING ● Why is it important to evaluate capital budgeting projects on the basis of incremental cash flows?Answer: An incremental cash flow is the difference between the cash flows of the firm with and without the investment project over the same period. Only incremental, after-tax cash flows are relevant in capital budgeting. Using incremental after-tax cash flow enables a manager to identify the changes in cash flow that are directly attributable to a specific project. A firm will eventually use these cash flows to invest in other projects, reduce liabilities, or pay them out to shareholders. ● How can currency risk and political risk be minimized when one is making foreign direct investment? Answer: Currency Risk: Companies making Foreign direct investment faces both long term and short term currency risks related to invested capital and cash flow generated out of that investment. Long term currency risk can be reduced by financing from local capital markets instead of using home country currency. This will ensure that cash flow will be in local currency. Short term risk can be reduced by using hedging instruments like options, Futures and forwards.Political Risks: Political risk can be minimized using operational and financial strategies. Companies can use tools like Joint venture with well established local partner reduces risk to a certain extent. Investments can be secured by structuring them as debt since debt has first claim in case of bankruptcy. ● How is the book value of an asset calculated? What are the two key forms of taxable income? Answer: The Book value of an asset can be calculated by deducting accumulated depreciation from an installed cost of an asset. Book Value=Installed cost of asset−Accumulated Depreciation ○ Two key forms of taxable income are 1. Gain on sale of asset 2. Loss on sale of asset. ● Referring to the basic format for calculating initital investment, explain how a firm would determine the depreciable value of the new asset. Answer: In order to determine the depreciable value of the new asset you would use the following equation: Straight-Line Method: Annual Depreciation Expense = (Cost of Asset – Salvage Value)/Estimate Useful Life Declining Balance Methods: (Book value at beginning of year) X (Depreciation Rate) Book Vale = Cost of asset – accumulated depreciation ● How are the incremental operating cash flows that are associated with a replacements decision calculated? Answer: The equation for incremental operating cash flows that are associated with a replacement decision is: Operating cashflows=operating cash flow¿newasset−operating cash flow¿old asset ● Diagram and describe three components of the relevant cash flows for a capital budgeting program. Answer: Initial Investment: the relevant cash outflow for a proposed project at time zero ¿ initialinvestment needed ¿acquirenew asset−aftertax cashinflows ¿ liquidationof old asset Operating cash inflows: the incremental after-tax cash inflows resulting from implementation of a project during its life ¿operating cash flows ¿newasset−operating cash flows¿ old asset Terminal cash flow: the after-tax non operating cash flow occurring in the final year of a project. It is usually attributable to liquidation of the project ¿aftertax cash flows ¿ terminationof newasset−aftertax cash flows ¿ terminationof old asset FINANCIAL STATEMENTS AND RATIO ANALYSIS ● Describe the purpose of each of the four major financial statements. ANSWER: - Income Statement: provides a financial summary of a company’s operating results during a specific period. -Balance sheet: presents a summary of a firm’s financial position at a given point in time. It balances the firm’s assets against its financing, which can be either debt or equity. -Statement of retained earnings: reconciles the net income earned during a given year, and any cash dividend paid, with the change in retained earning between the start and the end of that year. - Statement of cash flows: provides a summary of the firm's operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the period. This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets. ● What is the difference between cross-sectional and time-series ratio analysis? What is benchmarking? Answer: - Cross sectional: compares the firm’s ratios to other firms in its industry or to the industry average -Time series: evaluates a singular firms performance overtime, uses the past and present info and data to see progress or any trends -Benchmarking: process of comparing a firm's performance criteria and business process to other businesses within their market. ● What is financial leverage? Answer: Financial Leverage: the degree to which a company uses fixed-income securities such as debt and preferred equity. The more debt financing a company uses, the higher its financial leverage. It is the risk and return through debt and preferred stock ● What would explain a firm's having a high gross profit margin and a low net profit margin? Answer: Firms that have high gross profit margins and low net profit margins have high levels of expenses other than COGS. The high expenses more than compensate for the low cost of goods sold (i.e., high gross profit margin) which will make the earnings available to the common stockholders low. The management is performing well because the COGS are low as to make high gross profits. ● Which measure of profitability is probably of greatest interest to the investing public? Why?Answer: The return on equity profitability margin would be the greatest interest to the investing public because this margin measures the return earned on common stockholders’ investments in the firm. It deals directly with the return that the investors will receive if they invest in the company. ● Financial ratio analysis is divided into five areas: in your own words, differentiate each of these areas of analysis from the others. Answer: - Liquidity: the ability of a firm to satisfy short-term obligations when due, the solvency of a firm's overall position -Activity: measures how efficiently a firm operates along a variety of dimensions, such as inventory, management, disbursements, collections. Also measures the speed of the inflows and outflows, and how efficiently a firm operates. -Debt: measures the proportion of total assets financed by the firm’s creditors. (the amount of other people's money being used to generate profits) -Profitability: evaluates a firm's profit given relative sales, measures a firm's profitability upon different standpoints in time -Market: gives an inside about how investors feel about risk and return, measures the firm’s market and the behavior of investors ● Explain why the income statement can also be called profit and loss statement. Answer: The income statement can also be called the profit and loss statement because it keeps track of a company's revenues and gains as well as its expenses and losses. If you add the revenues and gains together and subtract the expenses and losses, if the number is positive the company experienced a profit. If the number is negative, the company experienced a loss, hence the Profit and Loss statement name.