Bus1 170 Fundemantal of Finance Midterm 1
How to calculate pretax income needed to pay $1 of dividends with a 40% federal-plus-state tax:
$1/(1-Tax Rate) $1/(.6) = 1.67 To clarify: put what ever $ you wish to pay out as dividends, the formula will tell you what your pretax income is needed.
Calculate: if a firm have $1.67 pre-tax income, and are under the 40% federal-plus-state tax bracket, how much tax is applied on the total amount of $1.67?
(.4)(1.67) = $0.67 in tax.
What is the formula for FCF?
(EBIT (1-T) + Depreciation and Amortization) - (Capital Expenditures + Change in Net Operating working capital) or in simplified words: modified income minus modified expenses, so that you know the actual minimum required money needed to run the operation. Detailed explanation: First bracker, first part: Net income after tax deduction. First bracker, second part: Take out depreciation and amortization expense by adding money back. Minus. Second bracket, first part: Investment into the business. Second bracket, second part: last years NOWC minus current NOWC. 1-T equals = what is left after tax. Change in NOWC is essentially the money needed to run its operation. So, to word this: FCF = (Net Income after tax plus dep. and amort) minus (investments and money needed to run the operation). To understand this, read the whole paragraph on page 75 "Looking at Allied...." and also look at pg. 67 2011 column.
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.
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.
What jobs are in Finance?
Banking, Investments, Insurance, corporations, and the government.
Corporate Capital Gains, pg. 82
Before 1987, capital gained was taxed lower than ordinary income. Today taxed same as operating income.
Tax on Dividends
15%. Taxed as income, also when paid out as dividends. Double taxed, congress consider lowering it.
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.
Who are the top two governing positions in an organization?
Board of Director. Chief Executive Officer. (CEO, who also sits at the BOD).
How did GM reported a double cash flows in their Operating Cash Flows? Did it affect their Balance sheet?
By credit account receivable as Financing Activity for selling car loans to dealers instead of crediting their account receivable as Operational Activity. pg. 71. It did not affect their Balance Sheet, but made Operational Activities look better, instead of Financial Activity. Operational Activities are the most important section for investors to look at.
Would IBM, GE, and MS choose S or C Corporation, why or why not?
C corporation, easier to raise capital.
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.
Progressive Tax
A Tax system where the rate is higher on higher incomes. US tax range between 0% on lowest income to 35% on highest income, progressive.
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 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 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.
What is the Statement of Cash Flows?
Cash Activities, divided into three: Operating, Long-Term Investing, and Financing (investments).
Interest and Dividends Paid by Corporate
A firm finance itself to receive $1, either by a loan or offer stocks. If the money received was by loan, they have to pay interest, say $1.10, but the 10 cents of interest can be deducted. If the firm issued stocks, dividends paid cannot be deducted. So, with a 40% federal-plus-state tax, they have to earn pretax of $1.67 in order to pay back $1. Next flash card shows how to calculate that. So, dividends require higher earnings compare to interest loans in order to pay back. However, it may be easier to raise more funds via stock market rather than banks.
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.
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.
What questions does Statement of Cash Flows Answer?
A report that shows how money was used, how much Cash Flow the period started and ended with, and where in the Balance Sheet funds were used.
Statement of Cash Flows
A report that shows how things that affect Income Statement and Balance Sheet affects Cash Flows.
Taxation of Small Businesses: S Corporations.
A small corporation that, under sub-chapter S of the Internal Revenue Code, elects "to be taxed as a proprietorship or a partnership" yet retains "limited liability" and other benefits of the corporate form of organization. Only taxed once, investors take it out as dividends. Ask teacher: C Corporations only pay tax 30% of the total amount for dividends, how does this relate to S Corporations and being taxed as proprietorship? It's hard to understand the benefit here. Do they get the same benefit of only tax 30% of the total amount, and also, getting the lower tax bracket like proprietorship and partnership does?
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
Statement of Stockholders' Equity
A statement that shows by how much a firm's equity changed during the year and why this change occurred.
Why do firms also produce modified Accounting Statements?
Accounting Statements are produced to satisfy IRS requirements, but modified Accounting Statements are produced to provide managers and investors with better analytical tools.
HOMEWORK 3-4 Statement of Stockholders' Equity Net Income $50M Retained Earnings $810M Previous Retained Earnings $780M How much dividends were paid to shareholders during the year? Assume that all dividends declared were actually paid.
Answer: Cash Dividends = $780M + $50M - $810M = $20M. Look this up again, since I learned the more difficult one below.
Negative Retained Earning
Accumulated Deficit since the birth of the company. If a firm have invested, over time, more than the profit generated, the Retained Earning is negative. Retained Earning Statement is a great quick tool for investors to see the life investments of the firm.
Why do changes in retained earning occur?
Any change in net income and/or dividends affects Retained Earnings. When new profit/loss are recorded, and if dividends payout or new if investments are recorded.
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.
Alternative Minimum Tax (AMT)
Created by congress to make it difficult for tax avoidance by wealthy individuals. Created in 1969, didn't include inflation, very complex tax law.
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.
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 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.
HOMEWORK 3-9 EVA $22.5M Sale $18M Operating Cost (incl. dep. cost) $15M received investment operational capital 9% average cost of capital 35% Federal and state tax What was the firms EVA (how much value did managers add to stockholder's equity)?
EVA = NOPAT - Annual Cost of Capital EVA = (EBIT (1-T) - (Total Investor-supplied Operating Cost) (after-tax percentage cost of Capital)) EBIT $22.5M Sale - $18M OC ---------------- $4.5M NOPAT or EBIT (1-T) = $4.5(1-0.35)= $2.925M Annual Cost of Capital $15M (0.09) = $1.35M EVA = $2.925M - $1.35M = $1.575M NOTE: EBIT(1-T) is the actual money left over from deducting all the costs, like taxes and operations. The Annual Cost of Capital is the minimum return that investors expect for providing capital to the company. So, every year so that has to be taken into account in running the business. Wendy
How does EVA differ from accounting Net Income?
EVA is Net Income After Capital Charge (cost of equity capital), basically, deduct income from capital costs (fixed costs only), and you will see how profitable the department/factory is. useful for investors, not interesting for IRS.
What is EBIT?
Earnings Before Interest and Taxes (EBIT), another name for Operating Income.
EBITDA
Earnings Before Interest, Tax, Depreciation, and Amortization.
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.
Economic Value Added (EVA) or Economic Profit
Excess of NOPAT over Capital Costs (Net Operating Profit After Tax, akna NOPAT) - (Annual dollar Cost of Capital) or EBIT (1-T) - (Total Investor-Supplied Operating Capital * After-Tax Percentage Cost of Capital) EVA can help understand divisional profit/loss, whereas MVA only focus on overall economic condition. If EVA is positive, than after-Tax operative income exceeds cost of capital needed to produce income. Note: NOPAT only explains the operating income after tax, whereas EVA takes that and subtract the operating costs, to see the profitability of its operating activities are: is this fatory/department/whatever, producing more income than its cost of running it. However, cost of capital only count fixed costs, such land, installation, but variable costs such as labor cost.
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
Financing Activities, line by line:
Financing Activities: Loan and payments to investors. Increase in Accounts Payable: positive, when borrowing from supplier. Negative, once they want to pay it back. Increase in Bonds (Long-term Debt): Positive, borrowing cash from investors. Negative, once paid back. Payment of Dividends to Stockholders: negative, stockholders are paid in cash. Net Cash Provided by Financing Activities: Positive, this can be used to invest in new plants/production facilities etc...
What is FCF?
Free Cash Flow
Which single number is considered the most important accountant statement?
Free Cash Flow (FCF), it shows how much money that can be distribute to its investors. (in non-public companies, how much can be set a side for rainy days, withdrawn, reinvested, or attract potential buyers for acquisition of the firm). pg. 76 "Free Cash Flow Is Important..."
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 answers can be retained from Financial Statements?
How large is the company? Is it making or loosing money? Is operations generating or loosing cash?
What is the statement of Stockholders' Equity designed to tell us?
How much and why equity changed during the year.
What is Finance?
How well capital and investments are managed.
Consolidated Corporate Tax Returns
If a firm owns another firm, 80% or more, it can consolidate income and utilize "Corporate Loss Carry-Back or Forward" to get a refund of taxed income. Great for venture investment for Multi-divisional firms.
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.
Do you add or subtract depreciation in Statement of Cash Flows?
In the SoCF, you need to add depreciation sum back to "Net Income." The reason why the deduction of noncash was incurred in the IS is to lower your taxes, but the actual payment of the expense happened in the past. So, to track real money, that deduction must be undone in SoCF, to reflect the real "Net Income", since the firm didn't use real money to "pay" for the old expense in the current period.
HOMEWORK 3-2 Income Statement $3M Net income EBIT $6M Tax Rate 40% What was the interest expense? Hint: Write out the headings for an income statement, fill out the known values. Then divide $3M of net income by (1-T) = 0.6 to find the pretax income. The difference between EBIT and taxable income must be interest expense. Use this same procedure to complete similar problems.
Income Statement order, plugging in the given facts: EBIT $6M Less Interest (solve this) - Tax Rate 40% Net Income $3M Income Statement with given facts and N/A facts EBIT $6M Less Interest: n/A EBT: N/A Taxes (40%) Net Income: $3M Solved Income Statement EBIT $6M Less Interest Expense (solve this) = $1M. EBT = $5M Tax Rate 40% = Net Income $3M How I calculated EBT x - interest (.6) = $3M x = $3m/.6 x = $5M How I calculated "Less Interest Expense." Less Interest expense = $6M - $5M = $1M
HOMEWORK 3-3 Income Statement EBITDA $7.5M Net Income $1.8M Interest Expense $2M Tax Rate 40% What was the charge for Depreciation and Amortization?
Income Statement order, plugging in the given facts: EBITDA $7.5M Interest Expense $2M Tax Rate 40% Net Income $1.8M Income Statement order, plugging in the given facts and N/A: EBITDA $7.5M Depreciation and Amortization: N/A EBIT: N/A Interest Expense $2M EBT: N/A Tax Rate 40% Net Income $1.8M Solving EBT first: $1.8M/0.6 = $3M Solving EBIT: EBIT = EBT + Interest Expense EBIT = $3M + $2M = $5M Solving Depreciation and Amortization: Depreciation and Amortization = EBITDA - EBIT Depreciation and Amortization = $7.5 - $5M = $2.5M
Interest and Dividends Received by Corporate
Interest = same as corporate tax. Dividends: only 30% of the received dividends are taxed. Reason for why dividends is lower taxed: taxed 3 times. (1) firm taxed (2) second firm who received dividends is taxed (3) individuals receiving the final dividends is taxed. Calculation: if you are in the 35% tax bracket for your stock investment, you only pay (.3)(.35)($stock dividends) in tax. To clarify: you have a corporate income of $18.33M or more. Dividends taxed will be (.3) plus your bracket tax (.35), times the dividends received. Therefore, corporate favors stocks over bonds.
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.
How does firms use Retained Earnings?
It's used for investments and reduce liability. Once a firm have paid operational costs, paid its taxes and dividends, the comp[any can now offset the rest to Retained Earnings - to build its business and pay off its 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.
What is the FCF? Solve: EBIT $30M Depreciation $5M Tax 40% Plan to spend in new assets $10M Plan to increase current assets $15M Increase Payable by $2M Increase Accrual by $3M
Look above if you don't remember, the formula is there. SOLUTION: Formula: FCF = (ebit(1-T) + Depreciation and Amortization) Minus (capital expenditures + Change in ΔNOWC) Plugging in numbers: FCF = ($30M(.6) + $5M) Minus ($10M + ($15M - $2M - $3M)) FCF = $23M Minus $20M FCF = $3M The key here is that ΔNOWC is (Current assets) Minus (Current liabilities (Account Payable + Accrual)).
How to interpret Corporate Tax Rate table
Look at the taxable income of firm. Any money above the bracket will add the marginal rate. Example: $65k would be; $7,500 plus $15k(.25). = $11,250. To calculate the "average tax rate": $11,250/$65k = 17.3%
3-1: Currents assets and net plant and equipment. Total Assets: $2.5M Net plants and equipment: $2M Notes Payable: $150k Long term debt: $750K Common equity: $1.5M both Accounts Payable and Accruals exist on balance sheet. Financed by debt and Common Equity. a) What is total liability and equity? b) What is the balance on current Assets on its balance sheet? c) What is the balance of current liabilities? d) What is the amount on Accounts Payable and Accruals (hint consider as a single line on balance sheet) e) What is the firms Networking Capital? f) What is the Net Operating Working Capital? g) Explain the differences in part e and f.
Looking at the balance sheet on page 62. a) Total liability and Equity = Total assets Total liability and Equity = $2.5M b) 0 because their is no cash, receivable (A/R), nor inventories listed. Current Assets = Total assets minus Long-Term (fixed) Assets $2.5M - $2M = $500k. c) Total Liability and Equity - Long-Term bonds - Total Debt $2.5M - $750K - $1.5M = $250K d) $100K Since total Assets are $2.5M, the Total liability and Equity is also $2.5M. The Accounts Payable and Accruals are the difference between the Total Liability of $2.5M and the sum of N/P + Long Term Debt + Common Equity = $100k. e) Net Working Capital = Current Assets - Current Liabilities Net Working Capital = $500k - $250k = $250k f) Net Operating Working Capital = Current Assets - (Current Liabilities - Notes Payable) NOWC = $500k - ($250K - $150K) NOWC = $400K g) Difference or "Notes Payable" = NOWC - NWC Difference or "Notes Payable" = $400k - $250k = $150k. NWC is capital needed to run its operation, all other interests that can be paid later are not included. This is useful information for expanding firms or if they see a slower trend in revenue stream.
HOMEWORK 3-6 MVA $35M Stock Investment, over the years. 2M outstanding stocks (numbers, not dollars) $30/share How much value has management added to stockholders, i.e., what is the MVA?
MVA = Market Value of Equity minus Book Value. MVA = Outstanding stocks (stock value) - Stock Investment MVA = $25M. Note: Book Value is the same as "contributed by investors." So, the total accumulated wealth is $60M, but since the previous investments are not available, the actual current market value added is $25M.
HOMEWORK 3-5 MVA $500M Common Equity $60/share $130M MVA How many common shares are currently outstanding?
MVA = market value minus book value. MVA = (stockprice)(number of outstanding shares) minus book value $130M = $M minus (MVA + Book Value)/stock price ($130M + $500M)/$60 = 10,500,000 outstanding shares.
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.
What is Retained Earning Account?
Money that is saved without further taxation imposed, can be used for investments or rainy days. If too high, stockholders (which happened with Apple recently) may ask for higher dividends. So, when a firm makes a profit (revenues minus all costs), it now may choose to pay out dividends to stockholders, what ever is left is put into an a Retained Earning Account, which accumulates over time. This account is not taxed because it has already been deducted.
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.
How do you calculate ΔNOWC
NOWC(2011) - NOWC2010. NOWC = (Current Liabilities - Accounts Payable). Correct way of thinking?: ΔNOWC stands for change, comparing two years operational costs. It will guide investors and managers whether the operations is trending profit or not. if the number is negative, the operational costs has gone down. NOWC = Net Operating Working Capital Or simply: Money required to run the business Accounts Payable = debts to suppliers, non-interest bearing.
what is NOPAT
Net Operating Profit After taxes.
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.
Is net Income cash?
No, it includes both cash, depreciation, interest, non liquid assets, etc. This is why Statement of Cash Flow is an important tool for investors to see what the cash flow goes, like, accounts: receivable, payable, etc...
If a firm wants to pay out interest to bond investors, is the EBIT income taxed before it is paid out to the investors? Explain.
No, the expense is deductible. They pay interest, but deduct the expense. Deductible, as in reduce other items that has been taxed.
CHAPTER 2: Fundamental Concepts in Financial Management
Not Covered
HOMEWORK 3-11 Statement of Cash Flow $100k End of 2014 cash. $5M Net income $750k Paid dividends common share $5.5M machinery investment (before depreciation) $450k annual depreciation Financing $1M Long-Term debt 6% Interest rate What was the firm's end-of-year cash balance?
Operating Activities $5M Net Income $450k depreciation of machinery ----------------------------------------- Net Cash provided by Operating Activities = $5.45M Long-Term Investing Activities -$5.5M Machinery investment ----------------------------------------- Net Cash used in Investing Activities = -$5.55M Financing Activities - $750K Paid Dividends $1M Long-Term Debt, issuing bonds. ------------------------------------------ Net Cash provided by Financing Activities = $250K (calculated by $1M - $750) Summary $200k Net in cash $100k Cash and equivalent at the beginning of the year $300k Cash and equivalent at the end of the year Note: 6% interest rate for issuing bonds is not included because it's already included in the $5M Net Income) Wendy
What are the four sections on a Cash Flow Statement?
Operating Activity, Long-term Investing Activities, Financing Activities, and Summary. See line by line explanation on pg. 69, or next slide. Learn which is noncash, and which one "used" up its cash.
Operating Activities, line by line
Operative Activities: normal ongoing operations. Net Income: revenues after operational expenses, tax and depreciation. Depreciation and Amortization: positive, to increase Net Income from IS because it was deducted as noncash depreciation for tax purpose. Increase in inventories: negative, paid for production. See it as money used up for buying goods/equipment. Increase in accounts receivable: negative, money here reflects future expected cash inflow from customers. Zero means that customers have fully paid all their debts to the firm. Increase in accounts payable: positive, money borrowed from suppliers, such as buying goods for credit. See it as assets which has value. Increase in accrued wages and taxes: positive: money reserved for future payments for wages and taxes. Net Cash provided by (used in) Operation Activities: summary of its cash flow in/out.
Bulls and bears
Optimist and pessimist
Corporate Loss: Carry-Back or Carry-forward.
Ordinary corporate operating losses can be carried backward for 2 years and forward for 20 years to offset taxable income in a given year. The loss is applied at earliest year first up until 20th year, if needed. Purpose is to not penalize firms whose income fluctuate.
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.
Health Care Tax (Obama care)
Proposed: Medicare tax on investment income 3.8% for upper-bracket ($250K for married, $200k for singles). 0.9% Medicare payroll on top of 2.9%. Increase top-bracket from 35% to 39.6%. (Meaning, rich will have a new total tax rate of 39.6% + 3.8 = 43.4%.) Taxes on capital gains from 15% to 20%. With 3.8% Medicare tax, high income will pay nearly total of 24%.
Describe Accounting?
Provides information regarding the likely size of the cash flows.
HOMEWORK 3-8 Statement of Stockholder Equity $22.5M Common Dividends paid out $278.9M Retained Earning at year-end. $212.3M Previous year Retained Earning. What was the net income? (Assume dividend was paid out).
Retained Earnings at Year end = Previous Retained Earning + net income minus Dividends $278.9M = $212.3M + Net Income - Dividends. Net Income = $278.9M - $212.3M + $22.5M = $89.1M Wendy
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.
Capital Gain (loss): Long Term Gain VS Short Term Gain
Short term if held an asset less than a year. Short term is taxed under income tax. Long term is taxed 15%, better than high income earners who pays 35% of income.
Why knowing EBITDA is useful?
Since amortization and depreciation is a noncash charge (virtual, spread out, based on past expense), investors wants to know what the actual cash generation is.
How is the Income Statement tied to the Balance Sheet?
Since the retained earning (net income minus paid dividends) is entered on the Retained Earning Account on the Balance Sheet.
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.
Why is Cash king?
Stocks value (price and share) is based on Cash Flow, the assets expected productivity.
Summary (of above Activities)
Summary of cash changes over the year. Net Decrease in Cash: Positive/negative, includes all three activities (Operating, Long-Term Investing, and Financing. Cash and Equivalents at the Beginning of the Year: Positive/negative, cash flow they start the new period with. Cash and Equivalent at the End of the Year: Positive/negative, how much cash they have left in the end of this period.
Average Tax Rate
Taxes paid, divided by income. Note: add all tax brackets and divide by total income. Instead of having multiple tax deductions, this will give one tax average. ( (0% for low income +..... 35%)/income)
Hostile Takeover
The acquisition of a company over the opposition of its management.
Free Cash Flow
The amount of cash that could be withdrawn from a firm without harming its operation and future cash inflows.
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.
Calculate Market Value Added
The excess of the market value of equity over its book value. Note: Market value Minus book value. Market value is not the same thing as MVA. Example: Market Value over Equity: total shares * stock price. Example, MVA = 50M shares * 23.06/stock = $1,153M Book Value: from balance sheet is $940M. MVA = $1,153M - $940 = $213M.
Market Value Added (MVA)
The excess of the market value of equity over its book value. The higher MVA a is, the better the job management is doing for its stockholders. BOD often look at MVA to determin compensation for managers.
Depreciation
The higher the depreciation value, the higher the operating cash flow (less taxed, keep more money). Congress determines which items can be depreciated and how much over time.
Capital Gain or Loss
The profit (loss) from the sale of a capital asset for more (less) than its purchase price.
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.
Marginal Tax Rate
The tax rate applicable to the last unit of a person's income. Note: each income bracket have an incremental tax accordingly. If you earn $1 above a current bracket, then only that dollar will face the higher tax rate, not the entire salary.
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.
Why might firms record similar transactions differently?
To make their statements look better, to attract more investors, such as reporting cash inflows in Operating Activities rather than in Financing Activities. pg. 71 "Massaging the Cash Flow (bottom left paragraph)
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.
Why calculate NOPAT?
To measure/evaluate operational efficiency, by solving: EBIT (1-T), knowing profit after operational costs and tax, but ignores debts. Note: EBIT = Sales - operating costs.
What are companies doing to ensure good business ethics?
Training.
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.
INCOME TAXES, pg. 78
Two kinds: Individual and Corporate. Remain same except annual inflation items.
Explain why retained earnings is not cash and is not available for dividend payments or anything else.
Used for reinvesting into the firm. It represents a claim on assets, not cash per se, and are not available for dividends or anything else. Old thought process: The retained earning represents assets that both exist today and that have already been used up.
Individuals pay taxes on:
Wages and salaries, investment income (dividends, interest, and profits from sale of securities), profits of proprietor-ships and partnerships.
Why is Depreciation and Amortization added as an income in FCF?
When a company prepares its income tax return, depreciation is listed as an expense, and FCF draws the data from Income Balance Sheet. However, in IBS it is there to reduce tax on income, but in FCF you treat Depreciation and Amortization as noncash, they are virtually added to reflect an assets value decline over time, so you need to get the expense out to release the money into FCF.
Give one reason when Free Cash Flow is negative?
When a firm is growing rapidly.
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.
If a firm receives income from Dividends, are they being taxed? How?
Yes, but only 30% is taxed as ordinary 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.
If a firm wants to pay out dividends, is the EBIT income used to pay for the dividends taxed? Explain.
Yes, the entire amount paid will be federal-plus-state taxed.
If a firm receives income (interest) from bonds, are they being taxed? Explain.
Yes, they will be taxed as ordinary income.
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.
Retained Earnings in Statement of Stockholders' Equity
a " A CLAIM AGAINST ASSETS" and not assets per see. As earlier described, the total lifetime earning of the firm, on the statement of the stockholders' Equity sheet, you can see how the earning during a period rise or fall.
HOMEWORK 3-12 Free Cash Flow (FCF) see pg. 88 table a) What is NOWC for 2010 and 2011. b) What was Bailey's 2011 free cash flow? c) Construct Bailey's 2011 statement of Equity. d) What was Bailey's 2011 EVA? Assume that its weighted average cost of capital is 10%.
a) NOWC = Current Assets - (Current Liabilities - Notes Payable) NOWC2010 = $59,000 - ($20,150 - $5,150) = $44,000 NOWC2011 = $72,125 - ($25,100 - $6,700) = $53,725 b) FCF = (EBIT (1-T) + Depreciation and Amortization) - (Capital Expenditures + Change in Net Operating working capital) FCF = ($39,000(.6) + $5,000) - (($5,000 +$3,000) + $9,725) FCF = $23,400 +$5,000 - $17,725 = $10,675 Note: to arrive at capital expenditures, add amortization with ΔFixed assets (like plants and equipment in this case). c) see notes in blue folder. d)
HOMEWORK 3-10 Statement of Cash Flow $55K in cash at year-end 2010 $25K in cash at year-end 2011 $250$ Investment made in plants/equipment etc.. + $170K Financing Activities a) What was the cash flow from operating activities? b) If accruals increased by $25K, receivables and inventory increased by $100k, and depreciation and amortization totaled$10K, what was the firm's Net Income?
a) To find Operational Activities we need to calculate two steps. step 1) Find (r) the sum of Operating, Long-Term, and Financing Activities, by deducting Cash and Equivalent at the end of the year by the cash and equivalent at the beginning of the year. r= $25K - $55K = -$30K Step 2) Deduct Long-Term and Financing Activities from the total sum of Operating, Long-Term, and Financing Activities. Operating Activities = r - (Long-Term + Financing Activities) CF from Operating Activities = -$30K - (-$250K) - ($170K) = $50K b) x Net Income $10k Dep. and amor. - $100k Accounts receiv. and inventory $25k Accruals ------------------------------------------------ $50k Net Cash in Operating Activities Solution: $50k Net Cash in OA = + 10k + $25k - $100k + x x = $50k - $10k - $25k + $100k x = $115k. NOTE: Accrual increase = add Receivable and inventory increase = expense (firm used resources, more debts to collect from customers in the future) Depreciation and amortization increase =add Below descriptions need improvement, they don't help me understanding its complexity: Accrued expenses, such as interest payable or tax payable mean that the expense has been incurred but has not yet been paid. They result in the increase of current liabilities. In the cash flow statement, the increase in current liabilities is added to net income to arrive at cash provided by operations. If accounts receivable decreases, this implies that more cash has entered the company from customers paying off their credit accounts. In contrast, if increases, the company has giving service but not yet being paid. depreciation reduces net income on the income statement, but it does not reduce the Cash account on the balance sheet. Wendy
HOMEWORK 3-7 EVA Which one is most likely to directly increase cash: a) It issues $2M of new common stock. b) It buys new plant and equipment at a cost of $3M. c) It report a large loss for the year. d) It Increases the dividends paid on its common stock.
a) By issuing stocks, you are receiving $2M in cash from new investors. The new plant investment will not generate income yet. CANVAS solution has a longer explanation, but a seems correct.
Economist view on assets?
argues that asset's value is based on the future cash flows the assets will provide.
STATEMENT OF STOCKHOLDERS' EQUITY
continue on pg. 72
Long-Term Investing Activities, line by line:
copy over from pg. 70 Long-Term Investing Activities: positive, if sold "fixed" assets. Negative if acquisition of "fixed" assets. Additions to property, plant, and equipment: negative outflow of money, purchase of "fixed" assets. Net Cash used in Investing Activities: summary of all fixed asset acquisition/sale.
what is part of ΔNOWC?: Payable current assets Spending accrual
current assets minus (Account payable and accrual).
Taxable income is:
gross income less a set of exemptions and deductions. High-income taxpayers lose most of any tax exemptions (deductions).
THE BALANCE SHEET
pg. 60
THE INCOME STATEMENT
pg. 66
STATEMENT OF CASH FLOWS
pg. 68.
FREE CASH FLOW
pg. 74
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.
