Exam 1

Question 1

The system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities

Answer 1

Finance

Question 2

What are the three interconnected areas in finance?

Answer 2

Financial Management (corporate finance)
Capital Markets (financial institutions)
Investments (asset pricing, portfolio theory

Question 3

Forms of Business Organization

Answer 3

Proprietorship
Partnership
Corporation

Question 4

Advantages of a Corporation

Answer 4

Unlimited life, easy transfer of ownership, limited liability, and ease of raising capital

Question 5

Disadvantages of a Corporation

Answer 5

double taxation and cost of setup and report filing

Question 6

The primary financial goal of management is _______________, which translates to ___________.

Answer 6

shareholder wealth maximization
maximizing stock price

Question 7

Value of any asset is ___________ of cash flow stream to owners.

Answer 7

present value

Question 8

Most significant decisions are evaluated in terms of their ____________________.

Answer 8

financial consequences

Question 9

_________ change over time as conditions change and as investors obtain new information about a company’s prospects.

Answer 9

Stock prices

Question 10

____________ recognize that being socially responsible and maximizing stakeholder welfare is consistent with maximizing long-term shareholder value.

Answer 10

Managers

Question 11

factors that affect managerial behavior

Answer 11

Managerial compensation packages
Direct intervention by shareholders
The threat of firing
The threat of takeover

Question 12

__________ are more likely to prefer riskier projects, because they receive more of the upside if the project succeeds.

Answer 12

Stockholders

Question 13

_________ receive fixed payments and are more interested in limiting risk, particularly concerned about the use of additional debt, and attempt to protect themselves by including covenants in bond agreements that limit the use of additional debt and constrain managers’ actions.

Answer 13

bondholders

Question 14

____________ have a progressive structure (the higher the income, the higher the marginal tax rate).

Answer 14

Personal taxes

Question 15

First, subject to flat tax rate of 21%. Also, can be subject to state tax (about 5% in Ms).

Answer 15

Corporations

Question 16

provides a snapshot of a firm’s financial position at one point in time based on book values.
Assets = Liabilities + Owner’s Equity

Answer 16

Balance sheet

Question 17

summarizes a firm’s revenues and expenses over a
given period – thus, shows profitability. Also known as profit and loss statement

Answer 17

Income statement

Question 18

reports the impact of a firm’s activities on cash flows
over a given period.

Answer 18

Statement of cash flows

Question 19

shows how much of the firm’s earnings were retained, rather than paid out as dividends.

Answer 19

Statement of stockholders’ equity

Question 20

______ accounts are listed in order of liquidity (convertibility to cash)

Answer 20

Asset

Question 21

Items expected to be converted to cash within one year

Answer 21

Current assets

Question 22

Cash, Marketable securities, Accounts receivable, Notes receivables, Prepaid expenses, and Inventory

Answer 22

Current assets

Question 23

(cash equivalents) - temporary investments of excess cash

Answer 23

Marketable securities

Question 24

(from sales on credit) - money owed to you by customers. includes allowance for bad debts to determine collection value

Answer 24

Accounts receivable

Question 25

from issued loans

Answer 25

Notes receivables

Question 26

represent future expense items already paid for

Answer 26

Prepaid expenses

Question 27

Long-term commitment of funds (at least one year). Includes stocks, bonds, investments in other corporations (McDonalds owning Chipotle, Coke owning Keurig)

Answer 27

Investments

Question 28

Carried at original cost minus accumulated depreciation

Answer 28

Property, Plant, and Equipment (Fixed Assets)

Question 29

___________ are financed through liabilities or stockholders' equity.

Answer 29

Total assets

Question 30

- Represent financial obligations of the firm and typically listed starting with current liabilities to longer-term obligations

Answer 30

Liabilities

Question 31

assumed due within one-year. consist of accounts payable, notes payable, and accrued expense,

Answer 31

current liabilities

Question 32

represents amount owed on open account to suppliers

Answer 32

Accounts payable

Question 33

short-term signed obligations to creditors

Answer 33

Notes payable

Question 34

is generated when a service has been provided to the company and a company has not yet been billed and made a payment (e.g. salaries to employees, interest expense)

Answer 34

Accrued expense

Question 35

assumed due in more than one year

Answer 35

long-term debt

Question 36

Represents total contribution and ownership interest of preferred and common stockholders. Consist of Preferred stock, Common stock, and Retained Earnings

Answer 36

Stockholders' Equity

Question 37

represent the firm’s cumulative earnings since inception minus dividends and other adjustments

Answer 37

Retained Earnings

Question 38

>Point-in-time snapshot >Values based on historical or original cost basis - book value >Market value may be worth two to three times original cost, so it may require many times original cost to replace

Answer 38

Balance Sheet Limitations

Question 39

>is sometimes referred to “operating profit” or “operating income,” and >is sometimes called “pre-tax income”

Answer 39

EBIT

Question 40

(or earnings before interest, taxes, depreciation, and amortization) also referred to sometimes as “gross profit”

Answer 40

EBITIDA

Question 41

▪ Income gained or lost during given period is function of verifiable transactions (but some transactions can be in the pipeline) ▪ Flexibility (AKA discretion) in reporting transactions can result in differing measurements of income gained from similar events at end of time period >>>i.e. depreciation

Answer 41

Income Statement Limitations

Question 42

companies have 2 options on what to do with net income

Answer 42

1. pay dividends (to shareholders) 2. keep it (add it to retained earnings)

Question 43

Emphasizes critical nature of cash flow to firm operations

Answer 43

Statement of Cash Flows

Question 44

Allows matching of revenues and expenses in period in which they occur to appropriately measure profits

Answer 44

Advantage of accrual method

Question 45

Adequate attention not directed to firm’s actual cash flow position

Answer 45

Disadvantage of accrual method

Question 46

__________ analysis helps in combating discrepancies faced through accrual method of accounting

Answer 46

Cash-flow

Question 47

net income, depreciation, changes in CAs and CLs

Answer 47

Cash flows from operating activities

Question 48

changes in long-term assets

Answer 48

Cash flows from investing activities

Question 49

changes in long-term debt and stock dividends

Answer 49

Cash flows from financing activities

Question 50

results of statement of cash flows added together to compute net change in _______

Answer 50

cash flow (total)

Question 51

Current Assets - Current Liabilities

Answer 51

Net Working Capital

Question 52

Operating Current Assets - Operating Current Liabilities (Current Assets - Excess Cash) - (Current Liabilities - Notes Payable)

Answer 52

Net Operating Working Capital

Question 53

“the amount of cash that could be withdrawn without harming a firm’s ability to operate and produce future cash flows.”

Answer 53

Free Cash Flow (FCF)

Question 54

[EBIT (1-T) + Depreciation and amortization] - [Capital expenditures + change in NOWC]

Answer 54

Free Cash Flow (FCF)

Question 55

change in Net Fixed Assets + Depreciation >this is calculated in the investing section of the statement of cash flows

Answer 55

Capital Expenditures

Question 56

Why are ratios useful?

Answer 56

-standardize numbers and facilitate comparisons -good starting point for strategic initiatives -highlight weaknesses and -comparisons should be made through time and with competitors (industry analysis, Benchmark (peer) analysis, and trend analysis)

Question 57

-Finding truly comparable companies is difficult because no two organizations are exactly alike. -Finding a comparable industry can be difficult for conglomerate firms with various segments (i.e. Disney) -Seasonal factors can distort

Answer 57

Issues/Limitations of Ratio Analysis

Question 58

5 major categories of Ratios

Answer 58

Liquidity, Asset management, Debt management, Profitability, and Market value

Question 59

what question does liquidity answer?

Answer 59

Can we make required short-term payments?

Question 60

What question does Asset management answer?

Answer 60

Are we utilizing our assets efficiently to generate sales revenue?

Question 61

What question does Debt management answer?

Answer 61

What is the mix of debt and equity?

Question 62

What question does Profitability answer?

Answer 62

Do sales prices exceed unit costs, and how profitable is the firm?

Question 63

What question does Market value answer?

Answer 63

How does the market value out assets/earnings?

Question 64

______ should be greater than one... A firm should have more current assets than liabilities. Current assets ÷ Current liabilities

Answer 64

Current ratio

Question 65

_______ removes inventory from the numerator. Inventory not as liquid and some may be not be sellable (damaged, obsolete, expired, etc.) (Current assets - Inventories) ÷ Current liabilities

Answer 65

Quick ratio

Question 66

How many times a year does a firm sell out all its inventory? Bigger is better! Cost of goods sold ÷ Inventories

Answer 66

Inventory Turnover (IT)

Question 67

How long does it take to get paid by customers? Smaller is better! this number should be compared to sales contracts and internal payment policies. =Receivables ÷ Average sales per day =Receivables ÷ (Annual sales ÷ 365)

Answer 67

Days Sales Outstanding (DSO)

Question 68

How well is the firm using its assets to generate sales? Bigger is better! =Sales ÷ Net fixed assets

Answer 68

Fixed Assets Turnover (FATO)

Question 69

How well is the firm using its assets to generate sales? Bigger is better? =Sales ÷ Total assets

Answer 69

Total Assets Turnover (TATO)

Question 70

▪ How much debt is the firm using to fund invested capital? = Total debt ÷ Total invested capital = (notes payable + LT debt) ÷ notes payable + LT debt + equity)

Answer 70

Total Debt-to-Capital Ratio

Question 71

Is the firm earning enough to pay the interest on their debt? Bigger is better! =EBIT ÷ Interest expense

Answer 71

Times-Interest-Earned (TIA)

Question 72

Are assets being funded with debt or equity? The higher (lower) the value, the more debt (equity) is used. =Total assets ÷ Total equity =(total liabilities + total equity) ÷ total equity

Answer 72

Equity Multiplier (EM)

Question 73

Is the firm making money? How profitable is the firm? Bigger is better! Consists of Operating Margin (OM), Profit Margin (PM), Basic Earning Power (BEP), Return on Assets (ROA), Return on Equity (ROE), and Return on Invested Capital (ROIC)

Answer 73

Profitability

Question 74

Price-Earnings (P/E), Market-to-Book (M/B), and Market Value Added (MVA) For all, bigger is better! All will be large if expected growth is high and risk is low.

Answer 74

Market Value

Question 75

How much are investors willing to pay for $1 of earnings? =Price/Earnings per share =Price/(net income/ # of shares)

Answer 75

Price-Earnings (P/E)

Question 76

How much are investors willing to pay for $1 book value equity? =Market price/Book value per share =Market price/(total equity/ # of shares)

Answer 76

Market-to-Book (M/B)

Question 77

What is the difference between a firm's market and book value of equity? =(Market price X Shares Out) - Book value of equity =Market value of equity - Book value of equity

Answer 77

Market Value Added (MVA)

Question 78

breaks down the components of ROE as operating profitability (PM), asset utilization (TATO), and debt utilization (equity multiplier). ROE=Profit Margin X Total assets turnover X Equity multiplier ROE=(Net Income/Sales) X (Sales/Total assets) X (Total assets/Equity)

Answer 78

The DuPont Equation

Question 79

Qualitative Factors Should Also Be Considered

Answer 79

▪ 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 ▪ Major expected changes in the future ▪ Legal and regulatory environment

Question 80

Forecast an income statement and balance sheet using a ____________________.

Answer 80

percentage of sales method

Question 81

Use the ______________ equation and discuss the relation between asset growth and the need for funds.

Answer 81

Additional Funds Need (AFN)

Question 82

Excess capacity and other factors affect _______ if constant percentage of sales assumption is dropped

Answer 82

needed funds

Question 83

A Financial Plan typically starts with a ___________.

Answer 83

sales forecast

Question 84

Good sales forecasts typically start with historical information and account for changes in:

Answer 84

* Economic conditions * Interest rates/inflation/pricing * Marketing pressure * Products offered, and much more!

Question 85

We must figure out the __________ to facilitate the change in sales as well as the liabilities that will spontaneously change. * Funding options include using internal funds, additional debt or issuing equity. * Easiest method: percent of sales method

Answer 85

asset requirements

Question 86

How much additional funding (sometimes called external funds needed) will we need to support this growth? If % of sales ratios are expected to remain constant: (A0*/S0)change in S – (L0*/S0)S – M(S1)(RR)

Answer 86

The AFN (or EFN) Equation

Question 87

Higher dividend payout ratio?

Answer 87

Increase AFN: Less retained earnings

Question 88

Higher profit margin?

Answer 88

Decrease AFN: Higher profits, more retained earnings

Question 89

Higher capital intensity ratio?

Answer 89

Increase AFN: Need more assets for a given level of sales.

Question 90

Pay suppliers in 60 days, rather than 30 days?

Answer 90

Decrease AFN: Creditors supply more capital (i.e. L0*/S0 increases).

Question 91

When _____________ is dropped, the AFN formula no longer works, and the only way to determine AFN is by working through the financial statements.

Answer 91

Constant % of sales

Question 92

On example was determining required NFA when expecting changes in capacity usage:

Answer 92

1. Determine full capacity sales 2. Determine original NFA as a proportion of full capacity sales 3. Determine new level for needed NFA

Question 93

= actual sales/ % of capacity used

Answer 93

Full capacity sales

Question 94

Target fixed assets/sales = original fixed assets/full capacity sales

Answer 94

determine original NFA as a proportion of full capacity sales

Question 95

=(target fixed assets/sales) X projected sales

Answer 95

Required level of fixed assets

Question 96

dropping the constant percent of sales assumption:

Answer 96

1. Decreasing expected DSO 2. Purchasing a new facility (given new NFA) 3. Increasing expected inventory turnover