Finance Ch 2

The use of financial leverage can:

- Increase the chance of financial distress and business failure - Greatly magnify both gains and losses - Increase the potential reward for investors

Long term liabilities represent obligations of the firm lasting over...

1 year

What does a positive NWC indicate?

A firm has sufficient funds to meet its current financial obligations and invest in other activities

What does stockholders' equity represent?

A residual claim against book value of the firm's assets (book value of the firm's assets less the book value of the liabilities)

What is stockholder's equity stated at on the balance sheet?

Book value -price paid when a good was purchased and what the good cost

Fixed asset of balance sheet

Buildings, trademarks

In comparing accounting net income and operating cash flow, name two items you typically find in net income that are not in operating cash flow.

Depreciation & Interest Expense Depreciation is a noncash deduction that reflects adjustments made in asset book values in accordance with the matching principle in financial accounting. Interest expense is a cash outlay, but it's a financing cost, not an operating cost.

Operating cash flow =

EBIT + Depreciation - Taxes

A firm's enterprise value is equal to the market value of debt and equity, less the firm's holdings of cash and cash equivalents. This figure is particularly relevant to potential purchasers of the firm. Why?

Enterprise value is the theoretical takeover price. In the event of a takeover, an acquirer would have to take on the company's debt but would pocket its cash. Enterprise value differs significantly from simple market capitalization in several ways, and it may be a more accurate representation of a firm's value. In a takeover, the value of a firm's debt would need to be paid by the buyer. Thus, enterprise value provides a much more accurate takeover valuation because it includes debt in its value calculation.

***Suppose a company's cash flow from assets is negative for a particular period. Is this necessarily a good sign or bad sign?

For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly leading to negative cash flow from assets. In general, what matters is whether the money is spent wisely, not whether cash flow from assets is positive or negative.

GAAP

Generally Accepted Accounting Principles, are the measurement rules show assets at historical cost

In preparing a balance sheet, why do you think standard accounting practice focuses on historical cost rather than market value?

Historical costs can objectively and precisely measured whereas market values can be difficult to estimate, and different analysts would come up with diff numbers. Thus, there is a trade-off between relevance (market values) and objectivity (book value)

How can cash flow to creditors be negative?

If a company borrows more than it pays in interest, its cash flow to creditors will be negative.

Net income that is not paid does what to retain earnings?

It increases it

Explain the trade-off a firm faces between high liquidity and low liquidity levels

It's desirable for firms to have high liquidity so that they have a large factor of safety in meeting short-term creditor demands. However, since liquidity also has an opportunity cost associated with it--namely that higher returns can generally be founded by investing the cash into productive assets- low liquidity levels are also desirable to the firm. Up to the firm's financial management staff to determine needs

Suppose a company's operating cash flow has been negative for several years running. Is this necessarily a good sign or a bad sign?

It's prob not a good sign for an established company, but it would be fairly ordinary for a start-up so it depends

What is a primary concern for a bank lending funds to a business for the short term?

Liquidity

***Under standard accounting rules, it is possible for a company's liabilities to exceed its assets. When this occurs, the owners' equity is negative. Can this happen with market values? Why or why not?

Market values can never be negative. Imagine a share of stock selling for -$20. This would mean that if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How many shares do you want to buy? More generally, because of corporate and individual bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed assets in market value.

What does liquidity measure?

Measures how quickly and easily an asset can be converted to cash without significant loss in value

Operating Cash Flow

Measures of the amount of cash generated by a company's normal business operations. Operating cash flow indicates whether a company can generate sufficient positive cash flow to maintain and grow its operations, otherwise, it may require external financing for capital expansion.

retained earnings

Net Income - Dividends

Who is entitled to the residual value of a firm's cash flows?

Shareholders

Referring back to the Boeing example...

The adjustments discussed were purely accounting changes; they had no cash flow or market value consequences unless the new accounting information caused stockholders to revalue the derivatives.

Why might the revenue and cost figures shown on a standard income statement not be representative of the actual cash inflows and outflows that occurred during a period?

The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be "booked" when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid. Note that this way is not necessarily correct; it's the way accountants have chosen to do it

Net Working Profit

Total current assets= Total current liabilities

Could a company's change in NWC be negative in a given year? Explain how this might come about. What about net capital spending?

Yes NWC can be negative. For ex., if a company were to become more efficient in inventory management, the amount of inventory needed would decline. The same might be true if it becomes better at collecting its receivables. In general, anything that leads to a decline in ending NWC relative to beginning would have this effect. Negative net capital spending would mean that more long-lived assets were liquidated than purchased.

***Could a company's cash flow to stockholders be negative in a given year?

Yes. If a company raises more money from selling stock then it pays in dividends in a particular period, its cash flow to stockholders will be negative.

Long term debt requires a payout of cash within...

a stated time period

Non-cash items do not affect

cash flow

Operating cash flow

cash generated from a firm's normal business activities and does not include capital spending and working capital requirements

Net working capital + current liabilities =

current assets

When issuing new equity...

decrease cash flow to stockholders and paying dividends would increase cash flow

Cash flow to stockholders =

dividends paid - net new equity raised

Net Capital Spending

ending net fixed assets - beginning net fixed assets + depreciation

***Depreciation is the accountant's estimate of the cost of

equipment used up in the production process

What does negative cash flow to creditors means?

firm raised more money by borrowing and selling stock than it paid out to creditors and stockholders (received cash flow from creditors)

Statement of cash flows

helps to explain the change in cash and cash equivalents

Cash flow to creditors=

interest paid - net new borrowing

When customer pays with cash...

not result in immediate profit but not cash inflow

Cash flow from assets =

operating cash flow - net capital spending - change in net working capital

Residual value is the amount left over after paying...

other debt holders, bondholders, account payable

Marginal Income Tax Rate

rate of taxation on the last dollar earned (rate of extra tax you would pay)

Average Tax Rate (ATR)

rate of taxation on total taxable income (Taxes / taxable income)