Corporate Finance for Engineers Midterm

Sole Proprietorship

-A business owned by one person -Owner keeps all the profits -Unlimited Liability -Business income taxed as personal income -Hard to transfer ownership

Relevant Cash Flows (Incremental Cash Flows)

-A change in the firms overall future cash flow that comes about as a direct consequence of the decision to take that project -Called incremental cash flows -Interest and other financing costs such as dividends and principal repaid are not included in the proposed investment analysis -Avoid sunk costs

Working Capital

-A firms short-term assets -Inventory -Short-term liabilities

Financial Leverage

-A firms use of debt in their capital structure -More leverage = more % debt

LIBOR (London Interbank Offered Rate)

-A series of term interest rates on various currencies, each representing a fixing for an unsecured interbank loan -LIBOR is a ubiquitous rate

Balance Sheet

-Assets = Equity + Liabilities -Snapshot of what the firm owns (assets), owes (liabilities), and what is left over if they liquidate (Equity) -Left = Assets listed in decreasing liquidity -Right = Liabilities -Difference = Shareholders equity, common equity, or owners equity -Will show the asset cost minus the accumulated depreciation

Cash Flow

-Cash Flow from Assets = Cash Flow to creditors + Cash Flow to stockholders = OCF -Net Cap Spending - Change in NWC -the difference between cash coming in and cash going out of a business -Negative means that firm raised more money by borrowing or selling stock that it paid out this year

Interest Rate Swaps

-Contractual agreement between two parties to exchange a series of interest rate payments without exchanging the underlying debt -Fixed = buyer -Float = seller -Swap dealers act as intermediaries in order to avoid creditworthiness worries -Offer opportunity to reduce funding costs -Notional Value is the face value of the swap that is used to calculate payments -Payments are calculated on Reset Days -Swaps curve: lvl of fixed payments v. time (terms)

Sunk Cost

-Cost we have already paid or have already incurred the liability to pay

Agency Cost

-Costs of the conflict of interest between stockholders and management

Internal Rate of Return (IRR)

-Discount rate that makes the cost of a project equal to the present value of its future cash flows -Want projects where IRR > Cost of Capital -Yield to maturity is the % rate of return for a bond being held till maturity -The yield to maturity is the IRR on a bond

Conclusions of Lorie and Hamilton on Valuation

-Dividend policy does not affect the value, if one assumes no taxes, no transaction costs, and a fixed internal investment program

Efficient Markets

-Eugene Fama -Prices in capital markets reflect all knowable and relevant information -Random Trading led to discovery of 9%/yr rates of return

Modified ACRS Depreciation (MACRS)

-Every asset is assigned to a particular class that establishes asset's life for tax purposes.

Opportunity Cost

-Giving up a benefit/opportunity by doing something else

Stand-alone principle

-Idea that once incremental cash flows have been identified, we can isolate them as a "minifirm"

What happens to the balance sheet when sales increase?

-Leads to needing more capital -Hence some combo of liabilities and equity will be brought on the company

Corporation

-Legal "person" separate and distinct from its owner -Require Articles of incorporation and set of bylaws -Relatively easy to transfer ownership -Limited liability for business debts -unlimited life of the business -Double taxation, at corporate level when they are earned and at personal level when they are paid out

Feds 3 Objectives

-Maintain Employement -Long term and stable bond yields -Avoid Super inflation

Proxy Fight

-Mechanism in which unhappy stockholders can act to replace existing management

Capital Spending

-Money spent on fixed assets less money received from the sale of fixed assets -Ending net fixed assets minus beginning net fixed plus depreciation

Net Present Value (NPV)

-NPV = -I + PV of future cashflow -Discount rate used is called the cost of capital which applies to the risk of the project -Accept project only if NPV > 0

Erosion

-Negative impact on the cash flows of an existing product from the introduction of a new product

Net Working Capital

-Net Working Capital = Current Assets - Current Liabilities -Usually positive for healthy firms -A firm's investment into the NWC of a project resembles a loan since winding down a project frees up the cash initially invested in NWC

Operating Cash Flow

-OCF = Revenue - Costs = EBIT + Deprec - Taxes -Cash flow generated from firms day-today activities -Tells you whether or not a firms cash inflows cover its everyday outflows

Primary Markets

-Original sale of securities by governments and corporations -IPO's -Private Placements

Sensitivity Analysis

-Process of holding all but one variable constant and seeing how the NPV reacts to changes in that variable -High changes in NPV to small changes in variable means high risk

Miller and Modigliani

-Proved that the dividend and earnings theories, under certain assumptions, are equivalent. -The equivalence arises once one knows the investment policy bc then one knows its earnings -Increase in dividend is equal to the reduction in the value of the share caused by issuing new shares -Earnings, defined correctly, have the same present value as dividends -Appropriate rate for discounting is the opportunity cost of making the investment i.e. the expected rate of return on alternative assets of similar riskiness -Sharpe: Appropriate rate of discount for future earnings or dividends in determining the present value of a stock is the expected rate of return on assets whose riskiness is similar to that of the security in question

Marginal Tax Rate

-Rate of the extra tax per dollar earned

Fixed Assets

-Relatively long life -Tangible or non-tangible

Income Statement

-Revenues - Expenses = Net Income -Net Income expressed on a per-share basis (EPS) -Accrual = estimating cash flows -"Tax the Rich" means tax on accrued earnings -Will reflect a cost item for each years depreciation

Submartingale Processes

-Roulette double down strategy -Expectation on future price > current price -Why you never sell

Amortization

-Same thing as depreciation but for intangible assets -As wich depreciation, can be tax write offs

Capital Structure of the Firm

-Specific mix of long-term debt and equity the firm finances its operations with -Corporations are legal people so owners are "immune" from their debts -Debt -Preferred Stock -Common Stock

Liquidity

-Speed and ease at which an asset can be converted to cash -Highly Liquid means it can be sold quickly without great loss of value

Average Tax Rate

-Tax bill/taxable income -Percentage of income that goes to taxes

Effective Fed Funds Rate

-The average rate for fed funds transactions done on a particular day -Actual Fed Funds rate is a market determines interest rate -Federal Reserve's Open Market Committee establishes target rate for monetary policy

Goal of Financial Management

-The goal of financial management is to maximize the current value per share of the existing stock -Can also be said as "Maximize the market value of the existing owners equity"

Scenario Analysis

-The process of investigating "What If" scenarios in a DCF in order to forecast risk

Financial Break Even

-The sales level that results in a zero NPV -First determine OCF for 0 NPV

Secondary Markets

-Those in which securities are bought and sold after the original sale -Dealer Markets (OTC) buy and sell for themselves at their own risk -Auction Markets take place in physical locations

Partnership

-Two or more owners -General Partners have unlimited liability -Limited Partners have limited liability -Amount of equity that can be raised is limited to the partners combined wealth -Hard to transder ownership

Fundamental Value

-What a good informed Investor would pay for the stock

Current Assets

-Will convert to cash within 12 months

Limited Liability Company (LLC)

-a form of business ownership that offers both limited liability to its owners and flexible tax treatment

Capital Budgeting

-the process of planning and managing a firm's long-term investments -Financial Managers try and find investments that are worth more than they cost to acquire

Two Basic Rules for Bonds

1. For a constant term to maturity and initial yield, the price volatility is greater for lower coupon rate bonds 2. For a constant coupon rate and initial yield, the price volatility is greater the longer is the maturity of the bond

Long-Term Assets

Book Value = Original Cost - Accumulated Depreciation

Operating Leverage

Degree to which a project or firm is committed to fixed production costs -Projects with high investment in plant and equipment have a high degree of operating leverage and are capital intensive

Du Pont Identity

ROE = Profit Margin * Total Asset Turnover * Equity Multiplier -Tells us that the ROE is affected by Operating Efficiency, Asset Use Efficiency, and Financial Leverage -Equity value and equity multiplier are inversely related

Coupon Rate

annual income an investor can expect to receive while holding a particular bond