Exam 1 (Chap 1 - 3) Flashcards
(24 cards)
Use some real business examples to illustrate the advantages of corporations over sole proprietorships and partnerships. Please indicate at least two advantages.
- no unlimited liability due to being separate from owners. The most shareholders lose to debt is some investments (e.g. Microsoft & borrowing)
- ownership is easily transferrable. This is not the case with a sole proprietorship (lifespan) or partnership (need to find new partnership) e.g. housekeeping business vs. Apple
Use some real business example to illustrate what a capital budgeting decision is and what a capital structure decision is.
- Capital Budgeting is the management of long term investment and looking for investment opportunities. e.g. Amazon always invests huge amounts of capital to grow their business. $54 billion Cash Expenditures in 2020.
- Capital structure is the mixture of long term debt and equity a company uses to finance operations. e.g. Tesla, had a strategy of borrowing a lot which hurt their debt/equity ratio, but now they reap the benefits and manage their debt well helping them grow and having a d/e ratio of 0.68.
The textbook says that the goal of financial management is to maximize the value of current
shareholders in general, or to maximize the current stock price if for publicly traded companies. What are the underlying assumptions about the shareholders in this statement? Do you think these assumptions are valid or not? Please explain briefly.
The assumption is that stockholders are only interested in investing in company’s for their own personal financial gain. With this goal, if financial managers increase the value per share, than stockholders gain more cash, which is what they care about.
I think this assumption is a bit of an overstatement. While yes, shareholders want to earn money themselves, which is why they invest. I think most of them invest because they think the company has growth potential and they want to see it prosper. So yes, while there are some shareholders who only care about personal gain, I think overall, they care about what they earn, but also if the company is earning.
- What is agency problem and why does it exist in corporations? How can we reduce the agency problem in corporate world? Please indicate at least two approaches.
An agency relationship is the relationship between a principal and an agent. In other words the relationship between an owner and shareholders. A conflict of interest between them is an agency problem
we can use managerial compensation (incentives to align goals) or corporate control (threats of takeover to improve management) to reduce the agency problem.
- What is Du Pont Identity and what are the components of Du Pont Identity? How will each component on the right-hand side of Du Pont Identity affect ROE?
The du pont identity is a system that breaks return on equity (ROE) into three parts, operating efficiency (as measured by profit margin), asset use efficiency (as measured by total asset turnover) and financial leverage (as measured by equity turnover).
If operating and asset use efficiency are weak it will return lower assets and then lower ROE. However if they are strong it will increase. A company can increase its financial leverage through high debt if EBIT and total assets are more than interest rate. Though high debt can also lead to financial risk
- We discussed in class that companies in certain industries such as airline industry are likely to borrowmore, whereas companies in some other industries such as information technology industry are likely to borrow much less. Please briefly explain the major reasons that cause the debt level differences across industries.
- Financial Flexibility - if a company wants to grow they need to have more capital so they need to manage their money well to do so
- Risks with borrowing - borrowing too much can lead to financial issues and bankruptcy and lenders might increase their rates. Companies have to consider this when taking on debt
- Lenders willingness to lend - is there a collateral (security for loan repayment). If so it might be a good idea. This is also a factor to consider.
All three of these reasons are why different industries have different debt levels. Some need to take on more debt, be more financially flexible etc.
- What are the possible disadvantages for small private firms to follow a conservative debt borrowing strategy? Please list at least two and use some examples to explain briefly.
- limited growth opportunities (failure to fund expansion / new products)
Example: small bakery can’t grow or reach audiences - Missing tax benefits (debt can bring tax benefits because interest is tax deductible. being debt conservative could miss out on these benefits)
Example: small manufacturer could utilize debt to improve production equipment but because they’re debt conservative, they are unable to.
- What are the possible disadvantages for small private firms to follow an aggressive debt borrowing strategy? Please list at least two and use some example to explain briefly.
- Increased financial risk (layoffs, financial distress, struggle to pay off loans, revenues dont come quickly)
Example: J.W. Hulme borrowed too much and had to shut down - Reduced flexibility (high debt can prevent adaptation to economic downturns or market changes)
Example: J.W. Hulme wasn’t able to respond to economic crisis in US well
- Why do upstarts tend to take too much debt? If an upstart does take too much debt, which number, internal growth rate or sustainable growth rate, is more relevant to the firm? Please use some example to explain briefly.
upstarts take too much debt due to a need to grow quickly. If they do this they can fund projects and expansion. The sustainable growth rate would be more relevant to the firm if they take on too much debt because it helps them reach maximum growth potential while keeping the amount of debt constant, and not taking on new debt.
Example: EV company invests a lot of production but takes on a lot of debt because of it, the SGR will help their financial future without adding more debt.
- What potential problems might arise if a company grows too fast? Please use some specific example(s) to explain briefly.
- Excessive debt (needed to sometimes fund fast growth but can cause revenue not materializing)
Example: J.W. Hulme aggressively borrowing then not adapting well too crisis, magazines not popping out fast enough then dying - Cash flow issues (rapid growth can cause increased expenses i.e. hiring, production, inventory, which can outpace revenue and strain cash flow and day to day activities)
Example: Small retailer invests heavily on expansion but finds itself low on cash for operations.
- What is net working capital? Why do investors, such as shareholders and debt holders, need to pay attention to the change of net working capital?
Net working capital is current assets - current liabilities. Investors (such as shareholders and debt holders/credit holders) need to pay attention to the change in NWC because they are the ones that contribute NWC to companies. So, paying attention to it will determine if they can support daily operations.
- If a company decides to increase its business scale, which accounts in the Balance Sheets and Income Statements are likely to increase? Please explain briefly.
Balance Sheet:
Current Assets (inventory, receivables)
non-current assets (new equipment or machinery)
current liabilities (short term obligations, accounts payable)
Income statement:
Revenue - increase in revenue
COGS - increase in COGS
Operating expenses (SGA, more employees, advertising)
depreciation
- What are the costs and benefits of holding a lot of cash within the company? Please use some specific example(s) to explain briefly.
Benefits - better prepared for emergencies, less expensive for new investments
Costs - inefficient use of resources compared to long term investments, pressures from investors
e.g. Microsoft
Microsoft was able to grow without paying dividends for a period of time allowing them to hoard cash as shareholders were content to forego regular income for a rise in share price
But with stock price flat since 1998 pressure on management to start payouts grew. First dividend was $1.7 billion of $12 billion cash flow – unimpressive. Then they did a $3.5 billion payout on 10 billion shares outstanding is the tenth biggest payout of a US company.
- Why small-sized companies with a lot of cash are good candidates for takeover?
because of lack of growth. it is much easier for a small company with less assets and hoards of cash, and weaker management to be taken over than a bigger company.
- Why do companies usually keep a smooth pattern of dividends even if net income in general always fluctuates? Please apply some of the theories and examples we discussed in class to explain briefly.
once a company starts issuing dividends its important to keep the dividends to maintain a good relationship between them and shareholders. stopping dividends sends a negative signal to investors.
Signaling is very important for growth and makes investors like you by managing dividends and cash well. Talking does nothing.
- What are the three options for a corporation to distribute cash back to shareholders? What kind of message does each option typically deliver to shareholders?
- regular dividends - good message cause it shows a company is in good financial standing and is committed with its payments
- share buybacks - sends message that company believes stocks are undervalued / doesn’t need to reinvest in the business. iffy
- one time dividends - meh message because it shows that the company was just in it to pay once and wasn’t committed.
What are the 5 areas of financial topics?
Corporate finance
Investments
Financial institutions
International finance
Fintech
Corporate finance or business finance is the study of how much long term investment a firm should take on and how they should manage day to day operations
What is a vice president of finance? What is a treasurer, what do they do? What is a controller, what do they do?
the vice president of finance overlooks the activities of a treasurer and controller. The treasurer manages cash and credit managers and capital expenditures, and the controller manages the tax and accounting managers and data processing.
What is the sarbanes oxely act?
It was an act passed in 2002 designed to protect against corporate fraud
What is the difference between a primary and secondary market?
A primary market is the original sale of securities between governments and corporations. These include public offerings, offering securities to the public and private placements, negotiated securities involving a specific buyer.
A secondary market is one owner or creditor selling to another. Dealer markets are over the counter, dealers have little involvement in auctions where people who sell are matched with those who buy.
what are noncash items? Give an example
expenses that do not affect cash flow
example: depreciation
what is average tax rate and marginal tax rate?
average tax rate = total taxes / total taxable income
average tax rate is the percentage of income that goes to pay taxes
marginal tax rate = amount of cash payable on next dollar
what is free cash flow?
cash that the firm is free to distribute to creditors and stockholders because it is not needed for working capital
Tell me each calculation and whether its better if its higher or lower
Current ratio high or low? Depends, high means more liquidity but it also could mean inefficient use of cash
Quick ratio - liquidity without inventory - higher is better
Cash ratio - how good a company is at using cash to cover short term obligations - higher is better
Total debt ratio - considers all debts of all maturities to all creditors - depends, high debt can be good or bad, more financing
Times interest earned - how well a company has its interest obligations covered - higher is better
Cash coverage - ability to pay interest with cash - depends
Inventory turnover - how fast they can turn inventory over (depends on high and low, remember hollys fashion)
Receivables turnover - how fast they’re able to collect receivables (depends high and low, remember hollys fashion)
Profit margin - high you want
