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Week 2 Notes (Ch1 Pt2 & Ch 2)

by: a-tark

Week 2 Notes (Ch1 Pt2 & Ch 2) FIN 300

Long Beach State
GPA 3.56

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About this Document

Notes from Week 2 lectures.
Business Finance
Dr. Chanwit Phengpis
Class Notes
business finance, FIN300
25 ?




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This 7 page Class Notes was uploaded by a-tark on Sunday January 31, 2016. The Class Notes belongs to FIN 300 at California State University Long Beach taught by Dr. Chanwit Phengpis in Winter 2016. Since its upload, it has received 38 views. For similar materials see Business Finance in Finance at California State University Long Beach.


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Date Created: 01/31/16
These are additional notes that I take during Dr. Phengpis’ lectures. The actual class notes are posted on his own website. The intention is to provide extra help. Chapter 1: Introduction to Financial Management (Part:2) Forms of Business Organizations (cont.) 1. Sole Proprietorship: SEE FIRST WEEK'S NOTES 2. Partnership: SEE FIRST WEEK'S NOTES 3. The Corporation: a. Made up of 3 distinct interests: i. shareholders/stockholders = the owners ii. board of directors iii. the corporate officers = top management = controls the firm b. Separation of ownership & control. Advantages: i. limited liability for shareholders. Maximum lost is the price paid for the stock. The company cannot ask for more from shareholders. ii. unlimited life for business. iii. funds can be easily raised and ownership (=stockholders) is easily transferable. c. Disadvantage: double taxation i. at corporate level - tax paid ii. at personal level (when the dividends (=distributed profits) are given out) - tax paid d. The goal of financial management in corporation: MAXIMIZE THE CURRENT MARKET VALUE OF EXISTING SHAREHOLDERS' (OWNERS') EQUITY i. current market value = number of shares outstanding x current stock price  number of shares is a constant number, and the current stock price is the value of stock ($ per stock) which is needed to be maximized.  EX: if the number of shares are 1 million and the current stock price is $5 per share the current market value of existing shareholders' equity is equal to $5 millions. ii. instead of using profit maximization because:  profit maximization is unclear.  profit maximization is inconsistent.  profit maximization is misleading. [EX: Credit Sales. "accrual bases". recorded as revenue but cash is not actually received.] iii. the riskiness of cash flows should not be too high since most investors are risk averse.  risk averse: given the same average of expected outcome, risk averse investor prefers the investment the least risk.  EX: two investments.  investment A high: 20% low: 0% ave=(20+0)/2 = 10%  investment B high: 30% low: -10% ave=(30+(-10))/2 = 10%  risk averse person would prefer investment A because risk is lower. The Agency Problem and Control of Corporation 1. Agency Relationship: a. the management team (agents) should run the firm for and in the best interest of shareholders (principals). -In an ideal world, but in real world we have the agency problem. b. agency problem: the possibility of conflict of interests between the owners and the managers. i. EX: fixed/constant salary ii. EX: avoid profitable projects that are very risky. iii. EX: if they gave bonuses rather than dividends. iv. due to personal relationships v. because each one has too little stake in the firm c. How to reduce/eliminate the agency problem? i. pay packages that have fixed (bonuses) and ownership (stock options or shares) components. ii. proxy: an authority to vote someone else stock. proxy fight: occurs when a group of shareholders solicit proxies to replace a board of director and management. d. Outside factors that influence managerial behavior: i. a badly managed firm is a likely target for takeover.Because profit is low, which means the stock price is low, so it's cheaper and easier to take over 2 the firm. current management is likely replaced reputation management, affect the job search. Chapter 2: Financial Statements, Taxes, and Cash Flow Financial Statements 1. Balance Sheet a. particular point in time = measure the value as of someday b. Total Assets = Liabilities + Shareholders' equity A = L (or D) + E c. Let's take a look at the given Balance Sheet (pg 6): i. Current assets (CA): life of a year or less, and they're normally converted to cash within a year. ii. Accounts Receivable (A/R): customer owes the company. iii. Fixed Assets (FA): life of a greater than 1 year. EX: machinery, equipments, buildings, lands. iv. Total assets must equal to CA + FA v. Current Liabilities (CL): debt that will be due within a year. vi. Accounts Payable: it's current because you should pay what you owe within a year. vii. Notes Payable: short-term loan viii. Long-term debt (LD): debt that will be due after a year. ix. ...Paid-in surplus: the amount above par value at issuing. EX: par value = $1, price issuing = $10, paid in surplus = $9 x. Retained earnings: accumulated profits retained within the firm. xi. Total liabilities and owners' equity must equal to CL + LD + E d. Liquidity: speed and ease an asset can be converted to cash. Cash has the most liquidity. e. Net working capital (Net current assets, NCA) = CA + CL EX: (pg.6) 2010; CA = $1403, CL = $389 -> NCA = $1014 i. NCA measures short-term solvency. ii. We like positive NCA because it means we're financially solvent and we have enough cash to cover our debt. f. Book Value vs. Market Value 3 i. book values are determined by GAAP or prices at which the assets were bought and sometimes we call them "historical costs." ii. market values are determined by current values or prices at which the investors are currently willing to pay. iii. equity and asset "market values" are usually not equal to their "book values"  price of real estate tend to appreciate over time. MV > BV  price of stock tends to increase overtime. MV > BV  some assets are not recorded regularly. EX: goodwill. amount above book value at the time the company is taken over. MV is not equal to BV.  EX: (pg 7) firm has equity worth $6b, debt worth $4b, assets worth $10b. has 100m shares of common stocks currently trading at $75 per share and the market value of debt $4b. Find the MV. BV: A=D+E , A=$4b+$6b -> A=$10b MV: A=D+E, A=$4b+(100m x $75) -> A=$11.5b value addition = $1.5b -> management has done a good job in enhancing the firm 2. Income Statement a. b. flow of expenses and revenues of a firm over a period of time c. Let's take a look at the income sheet (pg 8): i. Net sales = revenue ii. Cost of goods sold (COGS) = cost iii. Earnings before interest and taxes (EBIT) = R - COGS - Depreciation iv. Addition to retained earnings = Net income - Dividends = $309 d. Questions: i. Addition to retained earnings ? Net income = Dividends + Addition to retained earnings $412 = $103 + ? -> ? = $309 ii. Earnings per share? EPS = NI / # of shares EPS = $412M / 200M -> EPS = $2.06 per share iii. Dividend per share? DPS = Dividends / # of shares 4 DPS = $103 M / 200M -> DPS = $0.52 per share e. GAAP's objective is to provide a consistent account of a firm's financial status based on historical cost, where revenues and expenses are matched over the appropriate time period. i. EX: match sales with COGS when the transaction occurs not necessarily when cash is received. f. Cash flow does not equal GAAP net income or profit because of the following reasons: i. "Profits" subtract depreciation (a non-cash expense);  fixed asset depreciation but it's not a cash expense. but since it's an expense it lowers the profit. cash balance stays the same.  Profit understates cash flow. ii. "Profits" ignore cash expenditures on new capital (the expense is capitalized);  EX: buy new equipment with cash Debit: Equipment Credit: Cash  in this case cash is paid but no effect on profit because it's a conversion of one asset to another, conversion of cash to an equipment.  Profit overstate cash flow. iii. "Profits" are calculated from items recorded on an accrual basis, not when the money actually comes into the firm.  EX: credit sales Debit: A/R Credit: Sales (recorded as revenue but cash isn't received yet)  Profit overstates cash flow. iv. "Profits" are calculated from items recorded on an accrual basis not when the actually flows out of the firm.  EX: tax payable Debit: Tax expense (recorded as expense but cash isn't paid yet) Credit: Tax payable  Profit understates cash flow. 3. Statement of Cash Flows 5 a. financial statement that shows the firm's cash receipts and cash payments over a period of time to account for the fact that cash flows are not necessarily equal to net income of profits. b. Cash flow from assets i. ii. Operating cash flow = EBIT + Depreciation - Taxes  EX: (use the #s from pg 8)  OpCF = $649 + $65 - $212 = $547 iii. Why add depreciation?  depreciation is a non-cash expense  related to #1 on pg 9 - profit understates cash flow iv. Net capital spending = NFAe - NFAb + depreciation expense  EX: (NFA ending (2010) and beginning (2009) use the #s from pg. 6 & for depreciation expense use the #s from pg. 8)  NCS = $1709 - $1644 + $65 = $130 v. Change in NWC = NWCe - NWCb  EX: (NWC ending (2010) and beginning (2009) use the #s from pg.7)  NWCe = CAe - CLe  NWCb = CAb - CLb  Delta NWC = (CAe - CLe) - (CAb - CLb)  Delta NWC = ($1403 - $389) - ($1112 - $428) = $330 vi. Cash flow from assets = op. cash flow - net capital spending - delta NWC  EX: (use the #s you got on pg 10 and 11)  cash flow from assets = $547 - $130 - $330 = $87 vii. Cash flow to creditors = interest expense - net new borrowing  EX: (for interest exp. use the # from pg 8 & for net new borrowing use the #s from pg 6)  net new borrowing = ending long-term debt - beginning long-term debt  cash flow to creditors = $70 - ($454 - $408) = $24 viii. Under important notes, delete the second bullet point (if the ending long- term debt is..........) because it's more confusing than helpful. ix. Cash flow to stockholders = dividend payments - net new equity raised  EX: (for dividend use the # from pg. 8 & for net new equity raised use the # from pg.6)  net new equity raised = ending common stock and paid in surplus - beginning common stock and paid in surplus  cash flow to stockholders = $103 - ($640 - $600) = $63 6 x. Conclusion - to verify  cash flow to creditors + cash flow to stockholders = cash flow from assets  combine the numbers we got on pg. 10, 11 , 12)  $24 + $63 = $87 c. Taxes i. Goodness: because the income decreases by $1, the tax bill will reduces by 35 cents. this the tax savings benefit. ii. Therefore, net cost of $1 interest expense is only 65 cents. -----skipped the page 13 and 14, and solved the problem on 15----- EX: page 15 EBIT = Sales - COGS - Depreciation expense EBIT = $1000 - $500 - $100 = $400 tax income = EBIT - interest expense tax income = $400 - $50 = $350 Net income = tax income - (tax rate x tax income) net income = $350 - ($350 x 35%) = $227.5 Operating cash flows = EBIT + depreciation expense - (tax rate x tax income) Operating cash flows = $400 + $100 - $122.5 = $327.5 7


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