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UNIT I STUDY GUIDE

Introduction to Corporate Finance

Learning Objectives Reading Assignment


Chapter 1: The Corporation Chapter 2: Introduction to Financial Statement Analysis Chapter 3: Arbitrage and Financial Decision Making Chapter 4: The Time Value of Money Chapter 5: Interest Rates Upon completion of this unit, students should be able to: 1. Analyze balance sheets and classify transactions affecting a companys financial condition. 2. Assess the financial health of a firm and forecast a companys profit to determine the benefit of expanding or opening new lines of business. 3. Justify the managers role in evaluating a firms financial performance. 4. Distinguish between the four basic types of business organizations. 5. Discuss the agency problem that exists in business organizations. 6. Summarize the Balance Sheet Identity and what it reflects about a company. 7. Illustrate how the time value of money affects financial decision-making in businesses. 8. Describe how Net Present Value is calculated. 9. Distinguish between present value and future value. 10. Summarize how businesses calculate and use their internal rate of return. 11. Compare nominal interest rates and real interest rates. 12. Discuss how cost of capital is calculated and how cost of capital affects businesses.

Supplemental Reading
See information below.

Written Lecture
There are three traditional forms of doing business in the United States sole proprietorships, partnerships, and corporations and a relatively new form of doing business the limited liability company. There are also several hybrid business organizations that combine attributes of several of the primary forms of business organization. Each of these forms of business organization has its own unique combination of attributes, but the major attributes of business organization are the degree to which owners are responsible for the debts and legal obligations of the business organization and the degree to which the business organization pays income taxes. While each form of business organizations has appropriate uses, the most important of these business organizations is probably the corporation. A corporation is a legally defined being (a judicial person or legal entity) that has many of the legal powers people have. It can enter into contracts, acquire assets, incur obligations, and it enjoys the protection under the U.S. Constitution against the seizure of its property. The primary disadvantage of a corporation is that the profits of the corporation that are distributed to the owners of the corporation, or the shareholders, are taxed twice, once at the corporate level and once at the shareholder level, resulting in what is known as double taxation. The ownership of corporations is represented in the form of stock owned by shareholders who exercise their control of the corporation through a board of directors who are elected by shareholders. Within the firm, financial managers are responsible for making investments of the firm assets, making financial

Key Terms
1. Agency problem 2. Annual percentage rate 3. Annuities 4. Arbitrage 5. Balance sheet 6. Balance sheet identity 7. Corporate bankruptcy 8. Corporations 9. Cost/benefit analysis 10. Discounting 11. Earnings Before Interest and Taxes (EBIT) 12. Effective annual rate 13. Enterprise value 14. Financial statements

MBA 6081, Corporate Finance

15. Generally Accepted Accounting Principles (GAAP) 16. Income statement 17. Law of one price 18. Leverage ratios 19. Limited liability companies 20. Liquidation value 21. Net present value 22. Nominal interest rate 23. Opportunity cost of capital 24. Partnerships 25. Profitability ratios 26. Real interest rate 27. S corporations 28. Sole proprietorships 29. Statement of cash flow 30. Stock markets 31. Stockholders equity 32. Term structure of interest rates 33. Time value of money 34. Valuation ratios

decisions, and managing the firms cash flow. While the firms shareholders would like managers to make decisions that maximize the firms share price, managers often must balance this objective with the desires of other stakeholders (including themselves), which gives rise to the agency problem in corporations. Financial statements are accounting reports that a firm issues periodically to describe its past performance. Investors, financial analysts, managers, and other interested parties such as creditors rely on financial statements to obtain reliable information about a corporation. The main types of financial statements are the balance sheet, the income statement, and the statement of cash flows: The balance sheet shows the current financial position (assets, liabilities, and stockholders equity) of the firm at a single point in time. The income statement reports the firms revenues and expenses, and it computes the firms bottom line of net income, or earnings. The financial information that a firm reports can be analyzed in a number of ways. Profitability ratios show the firms gross profit, operating income, or net income as a fraction of sales, and they are an indication of a firms efficiency and its pricing strategy. Working capital ratios express the firms working capital as a number of days of sales (for receivables) or cost of sales (for inventory or payables). Interest coverage ratios are ratios of the firms income or cash flows to its interest expenses, and they are measures of financial strength. Return on investment ratios, such as ROE or ROA, express the firms net income as a return on the book value of its equity or total assets. The DuPont Identity expresses a firms ROE in terms of its profitability, asset efficiency, and leverage. Valuation ratios compute market capitalization or enterprise value of the firm relative to its earnings or operating income. The P/E ratio computes the value of a share of stock relative to the firms EPS. P/E ratios tend to be high for fast-growing firms. The statement of cash flows reports the sources and uses of the firms cash. It shows the adjustments to net income for non-cash expenses and changes to net working capital, as well as the cash used (or provided) from investing and financing activities.

To evaluate a decision, a firm must value the incremental costs and benefits associated with that decision. A good decision is one for which the value of the benefits exceeds the value of the costs. To compare costs and benefits that occur at different points in time, in different currencies, or with different risks, a firm must put all costs and benefits in common terms. A competitive market is one in which a good can be bought and sold at the same price. We use prices from competitive markets to determine the cash value of a good. The time value of money is the difference in value between money today and money in the future. The rate at which we can exchange money today for money in the future by borrowing or investing is the current market interest rate. The risk-free interest rate is the rate at which money can be borrowed or lent without risk. The Net Present Value (NPV) of a project is the difference between the present value of the cash outflow that the project will require and the present value of the

MBA 6081, Corporate Finance

cash inflow that will result from the project. A good project is one with a positive net present value. The NPV Decision Rule states that when choosing from among a set of alternatives, choose the one with the highest NPV. Arbitrage is the process of trading to take advantage of equivalent goods that have different prices in different competitive markets. The Law of One Price states that if equivalent goods or securities trade simultaneously in different competitive markets, they will trade for the same price in each market. The Effective Annual Rate (EAR) indicates the actual amount of interest earned in one year. The EAR can be used as a discount rate for annual cash flows. An Annual Percentage Rate (APR) indicates the total amount of interest earned in one year without considering the effect of compounding. APRs cannot be used as discount rates. Loan rates are typically stated as APRs. The outstanding balance of a loan is equal to the present value of the loan cash flows when evaluated using the effective interest rate per payment interval-based on the loan rate. Quoted interest rates are nominal interest rates, which indicate the rate of growth of the money invested. The real interest rate indicates the rate of growth of ones purchasing power after adjusting for inflation. Nominal interest rates tend to be high when inflation is high and low when inflation is low. Higher interest rates tend to reduce the NPV of typical investment projects. The U.S. Federal Reserve raises interest rates to moderate investment and combat inflation and lowers interest rates to stimulate investment and economic growth. This unit reviews all of these concepts and some related concepts in preparation for further analysis of corporate finance topics.

Supplemental Reading
Click here to access a PDF of the Chapter 1 Presentation. Click here to access a PDF of the Chapter 2 Presentation. Click here to access a PDF of the Chapter 3 Presentation. Click here to access a PDF of the Chapter 4 Presentation. Click here to access a PDF of the Chapter 5 Presentation.

MBA 6081, Corporate Finance