Professional Documents
Culture Documents
Chapter 1
In a business context, finance involves the same types of decisions: how firms
raise money from investors, how firms invest money in an attempt to earn a profit,
and how they decide whether to reinvest profits in the business or distribute them
back to investors.
Financial Services is the area of finance concerned with the design and delivery of
advice and financial products to individuals, businesses, and governments.
A firm with a stakeholder focus consciously avoids actions that would prove
detrimental to stakeholders. The goal is not to maximize stakeholder wellbeing but to preserve it.
Business ethics are the standards of conduct or moral judgment that apply
to persons engaged in commerce.
Robert A. Cooke, a noted ethicist, suggests that the following questions be used
to assess the ethical viability of a proposed action:
Is the action arbitrary or capricious? Does the action unfairly single out
an individual or group?
Does the action affect the morals, or legal rights of any individual or
group?
Are there alternative courses of action that are less likely to cause actual or
potential harm?
Ethics programs seek to:
The expected result of such programs is to positively affect the firms share price.
The firms finance and accounting activities are closely-related and generally
overlap.
In small firms accountants often carry out the finance function, and in large
firms financial analysts often help compile accounting information.
Agency problems arise when managers place personal goals ahead of the
goals of shareholders.
Agency costs arise from agency problems that are borne by shareholders
and represent a loss of shareholder wealth.
The threat of takeover by another firm, which believes it can enhance the
troubled firms value by restructuring its management, operations, and
financing, can provide a strong source of external corporate governance.
Chapter 2
Financial Institutions & Markets
Firms that require funds from external sources can obtain them in three ways:
1. through a financial institution
2. through financial markets
3. through private placements
The key suppliers and demanders of funds are individuals, businesses, and
governments.
Commercial banks are institutions that provide savers with a secure place
to invest their funds and that offer loans to individual and business
borrowers.
The primary market is the financial market in which securities are initially
issued; the only market in which the issuer is directly involved in the
transaction.
The key capital market securities are bonds (long-term debt) and both
common and preferred stock (equity, or ownership).
Broker markets are securities exchanges on which the two sides of a transaction,
the buyer and seller, are brought together to trade securities.
Dealer markets are markets in which the buyer and seller are not brought
together directly but instead have their orders executed by securities dealers that
make markets in the given security.
As compensation for executing orders, market makers make money on the spread
(bid price ask price).
The Role of Capital Markets
These people point to episodes such as the huge run up and subsequent
collapse of the prices of Internet stocks in the late 1990s, or the failure of
markets to accurately assess the risk of mortgage-backed securities in the
more recent financial crisis, as examples of the principle that stock prices
sometimes can be wildly inaccurate measures of value.
As banks came under intense financial pressure in 2008, they tightened their
lending standards and dramatically reduced the quantity of loans they made.
Corporations found that they could no longer raise money in the money
market, or could only do so at extraordinarily high rates.
Business Taxes
A capital gain is the amount by which the sale price of an asset exceeds the
assets purchase price.
This creates a built-in tax advantage for using debt financing as the following
example will demonstrate.
As the example shows, the use of debt financing can increase cash flow and
EPS, and decrease taxes paid.
The tax deductibility of interest and other certain expenses reduces their
actual (after-tax) cost to the profitable firm.
Chapter 3
The Four Key Financial Statements: The Income Statement
Although they are prepared quarterly for reporting purposes, they are
generally computed monthly by management and quarterly for tax purposes.
The statement balances the firms assets (what it owns) against its financing,
which can be either debt (what it owes) or equity (what was provided by
owners).
Current and prospective shareholders are interested in the firms current and
future level of risk and return, which directly affect share price.
Creditors are interested in the short-term liquidity of the company and its
ability to make interest and principal payments.
Liquidity Ratios
Current ratio = Current assets Current liabilities
Smaller firms may not have the same access to credit, and therefore
they tend to operate with more liquidity.
Activity Ratios
Inventory turnover = Cost of goods sold Inventory
Average Age of Inventory = 365 Inventory turnover
Profitability Ratios
Return on total assets (ROA) = Earnings available for common stockholders Total
assets
Return on Equity (ROE) = Earnings available for common stockholders Common
stock equity
Price Earnings (P/E) Ratio = Market price per share of common stock Earnings per
share
Market Ratios
where,
It merges the income statement and balance sheet into two summary
measures of profitability.
The Modified DuPont Formula relates the firms ROA to its ROE using the
financial leverage multiplier (FLM), which is the ratio of total assets to
common stock equity:
The DuPont system first brings together the net profit margin, which
measures the firms profitability on sales, with its total asset turnover, which
indicates how efficiently the firm has used its assets to generate sales.
ROA = Net profit margin Total asset turnover
The modified DuPont Formula relates the firms return on total assets to its
return on common equity. The latter is calculated by multiplying the return on
total assets (ROA) by the financial leverage multiplier (FLM), which is the
ratio of total assets to common stock equity:
Chapter 4
From a financial perspective, firms often focus on both operating cash flow,
which is used in managerial decision-making, and free cash flow, which is
closely monitored by participants in the capital market.
On the other hand, a variety of other depreciation methods are often used for
reporting purposes.
Under the basic MACRS procedures, the depreciable value of an asset is its
full cost, including outlays for installation.
For tax purposes, the depreciable life of an asset is determined by its MACRS
recovery predetermined period.
The statement of cash flows summarizes the firms cash flow over a given
period of time.
Financing flows: cash flows that result from debt and equity
financing transactions; include incurrence and repayment of debt, cash
inflow from the sale of stock, and cash outflows to repurchase stock or
pay cash dividends.
The statement of cash flows ties the balance sheet at the beginning of the
period with the balance sheet at the end of the period after considering the
performance of the firm during the period through the income statement.
The net increase (or decrease) in cash and marketable securities should be
equivalent to the difference between the cash and marketable securities on
the balance sheet at the beginning of the year and the end of the year.
Free cash flow (FCF) is the amount of cash flow available to investors
(creditors and owners) after the firm has met all operating needs and paid for
investments in net fixed assets (NFAI) and net current assets (NCAI).
Where:
Two key aspects of financial planning are cash planning and profit planning.
Capital structure
Sources of financing
These plans are generally supported by a series of annual budgets and profit
plans.
Key inputs include the sales forecast and other operating and financial data.
Key outputs include operating budgets, the cash budget, and pro forma
financial statements.
Typically, the cash budget is designed to cover a 1-year period, divided into
smaller time intervals.
The more seasonal and uncertain a firms cash flows, the greater the number
of intervals.
The sales forecast is then used as a basis for estimating the monthly cash
flows that will result from projected sales and from outlays related to
production, inventory, and sales.
Profit Planning:
Pro Forma Statements
The inputs required to develop pro forma statements using the most common
approaches include:
This method starts with the sales forecast and then expresses the cost
of goods sold, operating expenses, interest expense, and other
accounts as a percentage of projected sales.
Clearly, some of the firms expenses will increase with the level of
sales while others will not.
the use of past cost and expense ratios generally tends to understate
profits when sales are increasing. (Likewise, it tends to overstate
profits when sales are decreasing.)
The best way to generate a more realistic pro forma income statement
is to segment the firms expenses into fixed and variable components,
as illustrated in the following example.
Various ratios can be calculated from the pro forma income statement
and balance sheet to evaluate performance.
After analyzing the pro forma statements, the financial manager can
take steps to adjust planned operations to achieve short-term financial
goals.
Chapter 5
The Role of Time Value in Finance
Most financial decisions involve costs & benefits that are spread out over
time.
Time value of money allows comparison of cash flows from different periods.
The answer depends on what rate of interest you could earn on any money
you receive today.
For example, if you could deposit the $1,000 today at 12% per year, you
would prefer to be paid today.
The cash inflows and outflows of a firm can be described by its general
pattern.
The general equation for the future value at the end of period n is
FVn = PV (1 + r)n
Present Value of a Single Amount
It is based on the idea that a dollar today is worth more than a dollar
tomorrow.
Discounting cash flows is the process of finding present values; the inverse
of compounding interest.
The discount rate is often also referred to as the opportunity cost, the
discount rate, the required return, or the cost of capital.
The present value, PV, of some future amount, FVn, to be received n periods
from now, assuming an interest rate (or opportunity cost) of r, is calculated as
follows:
Annuities
An annuity is a stream of equal periodic cash flows, over a specified time period.
These cash flows can be inflows of returns earned on investments or outflows of
funds invested to earn future returns.
An annuity due is an annuity for which the cash flow occurs at the
beginning of each period.
You can calculate the future value of an ordinary annuity that pays an annual
cash flow equal to CF by using the following equation:
As before, in this equation r represents the interest rate and n represents the
number of payments in the annuity (or equivalently, the number of years
over which the annuity is spread).
You can calculate the present value of an ordinary annuity that pays an
annual cash flow equal to CF by using the following equation:
As before, in this equation r represents the interest rate and n represents the
number of payments in the annuity (or equivalently, the number of years
over which the annuity is spread).
You can calculate the present value of an annuity due that pays an annual
cash flow equal to CF by using the following equation:
As before, in this equation r represents the interest rate and n represents the
number of payments in the annuity (or equivalently, the number of years
over which the annuity is spread).
You can calculate the present value of an ordinary annuity that pays an
annual cash flow equal to CF by using the following equation:
As before, in this equation r represents the interest rate and n represents the
number of payments in the annuity (or equivalently, the number of years
over which the annuity is spread).
If a perpetuity pays an annual cash flow of CF, starting one year from now,
the present value of the cash flow stream is
As a result, the effective interest rate is greater than the nominal (annual)
interest rate.
Furthermore, the effective rate of interest will increase the more frequently
interest is compounded.
The nominal (stated) annual rate is the contractual annual rate of interest
charged by a lender or promised by a borrower.
The effective (true) annual rate (EAR) is the annual rate of interest
actually paid or earned.
In general, the effective rate > nominal rate whenever compounding occurs
more than once per year
The following equation calculates the annual cash payment (CF) that wed have to
save to achieve a future value (FVn):
The loan amortization process involves finding the future payments, over the
term of the loan, whose present value at the loan interest rate equals the
amount of initial principal borrowed.
The following equation calculates the equal periodic loan payments (CF)
necessary to provide a lender with a specified interest return and to repay the
loan principal (PV) over a specified period:
The following equation is used to find the interest rate (or growth rate)
representing the increase in value of some investment between two time
periods.
Chapter 8
Risk and Return Fundamentals
Each financial decision presents certain risk and return characteristics, and
the combination of these characteristics can increase or decrease a firms
share price.
The expression for calculating the total rate of return earned on any asset
over period t, rt, is commonly defined as
Where:
rt
Ct
cash (flow) received from the asset investment in the time period t 1 to t
Pt
Pt 1
Risk Preferences
Risk neutral is the attitude toward risk in which investors choose the
investment with the higher return regardless of its risk.
Is it ever possible to know for sure that a particular outcome can never
happen, that the chance of it occurring is 0%?
In the 2007 best seller, The Black Swan: The Impact of the Highly
Improbable, Nassim Nicholas Taleb argues that seemingly improbable
or even impossible events are more likely to occur than most people
believe, especially in the area of finance.
The books title refers to the fact that for many years, people believed
that all swans were white until a black variety was discovered in
Australia.
Taleb reportedly earned a large fortune during the 20072008 financial crisis by
betting that financial markets would plummet
Risk Measurement
Where:
rj
Prt
In general, the higher the standard deviation, the greater the risk
Norman Companys past estimates indicate that the probabilities of the pessimistic,
most likely, and optimistic outcomes are 25%, 50%, and 25%, respectively. Note
that the sum of these probabilities must equal 100%; that is, they must be based on
all the alternatives considered
Table 8.4 The Calculation of the Standard Deviation of the Returns for
Assets A and B (Cont).
Matter of fact
All Stocks Are Not Created Equal
Stocks are riskier than bonds, but are some stocks riskier than others?
Coefficient of Variation
Risk of a Portfolio
In real-world situations, the risk of any single investment would not be viewed
independently of other assets.
New investments must be considered in light of their impact on the risk and
return of an investors portfolio of assets.
Where:
wj
rj
return on asset j
Combining assets that have a low correlation with each other can reduce the
overall variability of a portfolios returns.
Uncorrelated describes two series that lack any interaction and therefore
have a correlation coefficient close to zero.
International Diversification
The inclusion of assets from countries with business cycles that are not highly
correlated with the U.S. business cycle reduces the portfolios responsiveness
to market movements.