Bus1 170 Fundemantal of Finance Midterm 1

What determines the value of an asset?

It is determined by the present value of the stream of cash flows that asset provides to its owner over time. So, for example, stock prices are based on the assets value over e long period of time.

Stockholder's Equity

It represents the amount that stockholders paid the company when shares were purchased AND the amount of earnings the company has retained since its origination. Equity: The process of raising capital through the sale of shares in an enterprise. Equity: the value of the shares. Equity: vardet av agandeskap. Equity = Assets - liability.

Should managers focus on to maximize the stocks Current Market price, or maximizing its Intrinsic Value?

Its intrinsic Value. Investors may wrongfully perceive the corporate's value wrong, but as soon as the true value is understood, the stock price will correct itself. Example: Managers choose to invest in a new factory, profit plummet, but five years from now, the future revenue will exceed current revenues.

Limited Liability Company & Limited Liability Partnership

LLC, a hybrid of Partnership and Corporation, but does not include the professional firms below. LLP is similar to LLC, but used for professional firms in the field of accounting, law, and architecture. It has limited liability like a corporate, but is taxed like Partnership. Their control of the firm is determined by the investment they made, which determines their voting power. It is popular, but doesn't attract capital as easy like a Corporation does.

Reasons why the value of Corporations is maximized than the other three?

Limited liability (lower individual risks). Unlimited life of the firm. Easier transferability. Raise capital.

How does Finance affect stakeholders?

Marketing needs approval from CFO, so understanding and bridge with them, they save time and resources while planing a campaign. Individuals needs to understand Finance, today, because firms are no longer providing investment service, it's up to the individual to diversify their pension assets.

Explain on words: NWC VS NOWC

NOWC are essential current assets available to run the business. It does not include Account Payable, such as loan with interest from bank, instead it includes equipment borrowed from a supplier who doesn't charge interest.

If Boeing decides to invest $5B in a new jet airliner, are managers certain of future profit and stock price?

No, but probability of increased stock price is high and risks are low because the market is stable, few players in the industry, and it is very expensive for new competition to enter, however, profits margins are low.

Is Maximizing shareholder value inconsistent with being socially responsible?

No, ignoring being social responsible can hurt the brand and plummet its value.

CHAPTER 2: Fundamental Concepts in Financial Management

Not Covered

Bulls and bears

Optimist and pessimist

Determine of Intrinsic Values and Stock Prices

True value: when investors have perfect information. Perceived value: when investors have limited information.

Security Analysis

Trying to figure out the Intrinsic value of a stock, using multiple tools to predict.

Holding the bag

When executives fake a stock value, sells their own, and leave shareholders with a true low value.

How can a firm's executive compensation plan lead to unethical behavior?

When profit is solely is determined by productivity rather than quality, such as the explosion of the Upper Big Branch Mine in West Virginia, who intentionally mislead quality reports in order to keep production going.

Capital Market

Where interest rates, stock and bond price, are determinated. Note: includes; stock market, bond market, and money market (bank institution/FEDS, loan/debts etc) They also study institutions/banks/FEDs/SEC etc..

What can Income Statement tell us?

Whether sales increased or declined, if it made a profit.

Non-operating Costs

Will deduct Operating Income: taxes and interests only. Explained: Costs like salary, rent, equipment, are all operating costs. Interest and Taxes will later be determined, but will be called non-operating costs. Not included = taxes and interest (from loans) has not been considered/applied/added yet. This is useful, since states and countries have different tax codes. Example, would you rather have your taxes being calculated elsewhere, or in the state you get revenue? If you sell only through internet, where would you rather be taxed? Example: NET SALES - Operating Costs -------------------------- OPERATING INCOME (EBIT) - non-operating costs (taxes and interest) ------------------------------ NET INCOME.

Should Managers help investors improve their estimates of its stocks intrinsic value.

Yes, but only if information doesn't hurt their competitive edge.

Do people have different conclusions on a stocks intrinsic value?

Yes, depending on perfect information or not.

Does it make sense for non-profit org., such as Hospitals and Universities to have a CFO's?

Yes, they, as well as profit org., have liability towards potential fraud, imposed by Sarbanes-Oxley Act.

Was Andersen's Accounting firm unethical, only a few employers were bad?

Yes, unethical practices, an incentive system promoted fraud.

What are companies doing to ensure good business ethics?

Training.

Formula for Expected Gain on Stock

(Price Sold - Purchase Price)/(Purchase Price*100%) so, example, a $10 stock investment on a $1,000 stock value, gives: $1000-$10/($10*100))

How to choose form of the firm:

1) Corporate have limited liability but high tax. The lower the risk is, the higher is its value. 2) The firms value depends on its growth, raising capital increases chance of growth, hence corporations have a higher growth opportunity. 3) The value of a firm depends on its liquidity, the time it takes to sell assets into cash at a fair market value.

What three finance areas is this book covering? Are they independent of each other?

1) Financial Management: see above. 2) Capital Market 3) Investments They are interrelated. Example: Banking is studied under Capital market, however, in order to lend money, they need to understand Financial Management (how well capital and investments are managed)

What are the important business trends?

1) Globalization of business. 2) IT and Communication Technology: providing real-time data and quick email/phone responses. 3) Corporate Governance: Stockholders have more power to replace board members, which can replace managers. SEC impose rules of transparency of CEO's compensations, which affects their decision making.

What are the three techniques stockholders can use to motivate managers to maximize their stock's long-run price?

1) Reasonable compensation package, get paid in portions over time, not lump sum because intrinsic value can only be truly known over time. 2) Firing managers who don't perform well. 3) The threat of hostile takeovers. Today, institutions owns and have more power than individuals, CEO's have less voting power and have to listen to lobbying institutions.

HOMEWORK CHAPTER 1 1-1 a) What is the firms intrinsic value? b) Current stock price? c) Is the Stock's "true" long-run value more closely related to its intrinsic value or to its current price? 1-6 a) What are the four forms of business organization? b) What are the advantages and disadvantages? 1-13 a) If you would be deciding management compensation for a CEO, and three divisional managers (oil, natural gas, and retail gas station, would you put weight on salary and/or stock options?

1-1 a) An estimate of a stock's "true" value based on accurate risk and return data. The Intrinsic value can be estimated but not measured precisely. b) Based on the assets value over a long period of time. c) To its intrinsic value. 1-6 a) Proprietorship, Partnership, S & C Corporation, LLC and LLP. Proprietorship: Pro = easy to form, low tax. Con = fully liability for life, owners influence has significant impact on the business. Partnership: Pro = low tax, shared investment. Con = fully liability, even for the other partners mistake, hard to transfer ownership. S and C Corporation: Pro = limited liability, easy to transfer ownership, easier to attract investment. Con = Higher taxed. S Colcrporation has restrictions in how many investors it can have. LLC (Limited Liability Company) and LLP (Limited Liability Partnership: Pro = hybrid of partnership and Corporation, limited liability but taxed as partnership. Votes are determined by owners investment made. Con = harder to attract investors. LLC doesn't include professionals such as law firms and accounting firms. 1-13 For a CEO, the compensation should be based on intrinsic values, paid out over time, to create a culture of long term performance over short gain. Last years sales results should have little impact on management compensation, but long-term results should. Therefore, a low salary, plus stock options with a delay of compensation, until the results are measurable. For a manager, say, a divisional structure, should be measured according to its divisions results, less to its stock performance over the long run. Productivity over the long-run, perhaps larger proportion for salary and bonuses, rather than stock options.

Proprietorship

A form of business org.. An unincorporated business owned by one individual. 3 Pro: easy & inexpensive to form, few gov. regulations, and low income tax. 3 Con: Unlimited personal liability (invest $10k, but lawsuit $1M), life of business = life of owner, investors will change structure.

History of Accounting standards

1973 formation of IASC, International Accounting Standard Committee. 1998 formation of IASB International Accounting Standard Board: nine countries created International Financial Reporting Standard (IFRS). 2002 IFRS convergence process of Norwalk Agreement to initiate removal of differences in GAAP and IFRS. 85 Financial Institutions surveyed: 92% wanted a single system. 2010 An aggressive agenda set by FASB and IASB to change Financial Reports.

Accounts Payable VS Notes Payable

A bank can lend money with accumulated interest, a written promissory. Accounts Payable: supplier lend you supplies, no interest, and can be paid later.

What is Business Ethic?

A company's attitude toward its employees, customers, community, and stakeholders. It can be measured in work life balance, product quality, community involvement, and accounting practices.

Working Capital

Current Assets, money to spend for day-to-day operations. A poor measurement of the health of the company, only reveal its assets, not its liabilities.

C Corporation & S Corporation

A form of business org.. A Legal entity created by a state, separated and distinct from its owners and managers, having unlimited life, easy transferability of ownership, and limited liability. Owners can only loose money invested. Easier to raise capital. Higher taxes. Earnings are taxed, dividens taxed again. S Corporations are taxed like partnership, but limits stockholders to 100. Once large enough, public announcement as a C corporation.

Partnership

A form of business org.. An unincorporated business owned by two or more persons. A legal arrangement. Easy and inexpensive to form, taxed individually. Liability is interdependent. Hard to raise capital.

What is a cash outlay?

A large purchase that immediately reduce earnings. The only thing that doesn't depreciate is land because it is considered indefinite.

Sarbanes-Oxley Act

A law passed by congress that requires the CEO and CFO to certify that their firm's financial statements are accurate.

What is Sarbanes-Oxley Act?

A law passed by congress that requires the CEO and CFO to certify that their firm's financial statements are accurate.

Amortization

A noncash charge similar to depreciation except that it is used to write off the costs of intangible assets (like trademarks, copy rights, and patterns). However, for consumers, it means paying of a debt from a house purchase.

Income Statement

A report summarizing a firm's REVENUES, EXPENSES, and PROFITS during a reporting period, generally a quarter or a year.

Balance Sheet

A statement of a firm's financial position at a specific point in time. A snap shot in time. Balance sheets: Assets = Liabilities + Equity For a one year balance sheet: Left side: Current Assets Right side: Current Liabilities & Stockholder's Equity For a two or more year balance sheet: Top: Current Assets Bottom: Liabilities & Equity

Intrinsic Value

An estimate of a stock's "true" value based on accurate risk and return data. The Intrinsic value can be estimated but not measured precisely. Another way of looking at Intrinsic Value is the assets value's R&D Breakthrough.

Corporate Raider

An individual who targets a coproration for takeover because it is undervalued.

Marginal Investor

An investor whose views determine the actual stock price. Marginal, as in multiple investors perceiving, on average, its value.

What is Net Worth?

Another name for Stockholders's/Shareholder's Equity: Networth = Assets - Liability. All assets minus all costs, this the true value of a persons/firms wealth.

What is the difference between the Balance Sheet Report and an Income Statement Report?

Balance Sheet report is a snap shot in time, where as the Income Statement reports the financial situation over a period of time, like a month, quarter, or yearly.

Net Working Capital

Current assets minus current liability. Gross assets minus liabilities, what assets you have whren everything is paid for. If the NWC is larger than previous statements, then it indicates the company is healthy. If red, costs are eating up assets.

Net Operating Working Capital

Current assets minus non-interest-bearing current liabilities. Example: NOWC = Current Assets - (Current liabilities - Accounts Payable)

What jobs are in Finance?

Banking, Investments, Insurance, corporations, and the government.

Who are the top two governing positions in an organization?

Board of Director. Chief Executive Officer. (CEO, who also sits at the BOD).

Would IBM, GE, and MS choose S or C Corporation, why or why not?

C corporation, easier to raise capital.

What is the CFO, where does this individual fit into the corporate hierarchy, and what are some of his or her responsibilities?

Chief Financial Officer (CFO) is a senior vice president and the third-ranking individual, controls the Accounting and Finance department department, credit policy, acquisition decisions, and investor relationships (stockholders and press). Think: non-operating decisions, equity concerns, what to do with the money not needed for operational activities.

Who controls accounting department?

Chief Financial Officer (CFO).

Who is the COO? Where does this individual fit into the corporate hierarchy, and what are some of his or her responsibilities?

Chief Operating Officer (COO), the firm's president. Focus on internal environment. Direct operations, manufacturing, marketing, HR, and sales. This class will focus on CFO, not COO.

What three areas in Finance are taught in Universities?

Corporate Finance, Capital Markets, and Investments.

If you want to invest, have low involvement of business operations, would you choose Corporation or Partnership?

Corporation, because of the risks it involves with partnership, that you are liable of your partners actions and the firms financial conditions, but also, higher returns on investments because you can easier attract investors to grow the business.

What Financial Management does?

Decides how much/types of assets to acquire and how to raise the capital needed. Same for profit/non-profit firms.

Investments

Decisions concerning stocks and bonds: 1) Security Analysis: finding proper value of individual securities. 2) Portfolio Theory: studies ways of how to structure "baskets" of stocks and bonds, diversify risks. 3) Market Analysis: .....a) Is the stock value too high or low? .....b) Behavioral Finance: is there a bubble? Or, an irrational low pessimism? Note: Individual, basket, and the whole market.

Annual Report

Definition: A report issued annually by a corporation to its stockholders. It contains basic financial statement's as well as management's analysis of the firm's past operations and future prospects. Annual Report contains two things: 1) verbal section where chairman discuss operational results and future impacts of its current investments. 2) Four basic financial statements: Balance sheet, Income statement, Cash flows, and Statement of Stockholder's Equity. See above for each description.

What is EBIT?

Earnings Before Interest and Taxes (EBIT), another name for Operating Income.

What is the bottom line?

Earnings Per Share, EPS: Of all items on income statement, EPS is the MOST IMPORTANT FOR STOCKHOLDERS.

Operating Income

Earnings from operations before interest and taxes. A tool for investors to measure a firms core business, profitability/health. If you compare two companies with same revenue and operational costs, the company that has no debt (interest rate) will have a higher net worth.

Formula for Expected Stock Price

Expected Stock Price = .5($2,000) + .5(0) = $1,000. If are offered a stock for $10 and have a 50% chance of getting double the value of stock value from $1,000 to $2,000, or running a 50% risk of loosing it all, you will get following expected stock price: .5($2,000) + .5(0) = $1,000. You will probably gain $1,000 with your $10 investment.

CHAPTER 3

FINANCIAL STATEMENT, CASH FLOW, AND TAX. pg 56.

What is the relationship between economics, finance, and accounting?

Finance grew out of Economics and Accounting, Finance Management utilize both.

What is another name for Corporate Finance?

Financial Management

GAAP VS IFRS

GAAP is the US accounting system General Accounting Agreement Principles. IFRS International Financial Reporting Standards.

Finance stems from?

Grew out of Economics and Accounting, requires knowledge of both Economics and Accounting.

Why might conflicts arise between stockholders and bondholders?

High risk can yield high returns for stockholders, but high risk doesn't benefit bondholders, because they will either lose their value of the bonds or gain the same low fixed return if successful. Bondholders prefer low risks, stockholders enjoy higher returns for riskier investments. Example: A firm wants to invest by borrowing on their $100M assets. If they borrow $5M from bonds, and $95M from stockholders, it would be less risky for bondholders, but risky for stockholders. If flipped, Bondholders are at risk.

What can you learn from the Balance Sheet

How large a company is, types of assets, and how they are financed.

What is Finance?

How well capital and investments are managed.

What can statement of Cash Flow tell us?

If any new investments were made, if it raised any funds through financing, repurchased any debt (pay off their loan) or equity (buy shares to increase ownership of its firm so that they have more control), or if they paid out any dividends.

How should business do to ensure its workers to act ethically?

Promote and encourage whistle-blowers, provide ethical training, and implement ethical codes of conduct.

Describe Accounting?

Provides information regarding the likely size of the cash flows.

How are LLC and LLP related to the other three forms?

See above.

What are the key differences between Proprietorship, Partnership, and Corporations?

See above.

Why is S Corporation an advantage over C corporation?

See above.

What is the Managers primary goal?

Shareholder Wealth Maximization

The primary goal for managers of publicly owned firms?

Shareholder Wealth Maximization. Decisions should be made to maximize the long-run value of the firm's common stock.

Should managers focus to maximize current stock price or its intrinsic value?

Stockholder are interested in long-term profit, therefore, focus on maximizing its intrinsic value.

Hostile Takeover

The acquisition of a company over the opposition of its management.

What is the managers primary goal?

To maximize the value of the firm's stock, the value is based on the firm's future cash flows.

Depreciation

The charge that reflect the cost of assets used up in the production process. Depreciation is not a cash outlay. Why depreciation is mandatory? To avoid tax fraud. Example: the value of a computer declines by time. Material purchased decrease by use, less material leads to less value of its its original purchase value. The reason depreciation limits writing off the purchase as a whole, is to reflect the true value of the assets as it is being used up by time, you can still sell your assets. Firms could otherwise escape tax by writing of their profit, and then later sell the asset and keep the profit without being taxed because it is not in the books any more. A cash outlay would be purchasing land, it doesn't deplete, it last indefinite.

What is the difference between a stock's current price and its intrinsic value?

The current price is a perceived value, whereas the intrinsic value is the true value gathered and analyzed by competent analytical tools based on available data.

Equilibrium

The situation in which the actual market price equals the intrinsic value, so investors are indifferent between buying or selling a stock.

Market Price

The stock value based on perceived but possibly incorrect information as seen by the marginal investor.

FORMS OF BUSINESS ORG.

Their are four main forms, however, 80% of businesses are done by corporations.

Retained Earnings

They represents the cumulative total of all earnings kept by the company during its life.

Should managers estimate intrinsic value or rely on outside security analysts?

They should try to reach perfect information.

Should Managers focus on the stock's actual market price or its intrinsic value, or are both important?

To avoid a hostile takeover, which happens when a stock perceived overvalued and is dumped in the market, managers need to make sure the intrinsic value is as close to the actual value as possible over time without giving away company strategic secrets.

Finance Departments principle task

To evaluate proposed decisions and judge how they will affect the stock price and thus shareholder wealth.

Why do managers sometime hide a stocks Intrinsic value?

To keep their competitors in the dark of new strategies, a strategy Apple uses.

Economist view on assets?

argues that asset's value is based on the future cash flows the assets will provide.

THE BALANCE SHEET

pg. 60

THE INCOME STATEMENT

pg. 66

How is the order of items on a balance sheet determined?

see notes above.

What is a balance sheet, and what does it provide?

see notes above.