Finance Test 2
you are planning to place your money in safe government securities, which currently offer a 4% riskless rate of return. before making this investment, an entrepreneur approaches you and asks you to purchase her new business venture, fastdrop, a delivery service for legal documents that would produce a single cash inflow of $80,000 at the end of the year. you have determined that 6% is an appropriate risk premium for this investment. how much would you be willing to pay for fasrdrop?
OC = 4% + 6% $80,000 / 1.10 = $72,727 $72,727 is the value of the expected future cash flow and thus the economic value of the investment in FastDrop.
natureapp inc has current assets of $2,030, net fixed assets of $9,780, current liabilities of $1,640, and long term debt of $4,490. what is the value of the shareholders' equity amount for this firm? how much is net working capital?
Shareholder' equity = Total assets - Total liabilities = $11,810 - $6,130 = $5,680 NWC = Current assets - Current liabilities = $2,030 - $1,640 = $390
why is it that the revenue and cost figures shown on a standard income statement may not be representative of the actual cash inflows and cash outflows that occurred during a period?
Guiding Principles of Accounting show that accounting follows the accrual/matching principle, which calls 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. This matching of revenues and expenditures is quite logical, as the firm is not likely to spend/invest money unless they expect to get revenue from the expenditure. However, the accrual/matching principle uses revenues, not actual cash inflows, and expenses, not actual cash outflows. While the focus on accounting-defined flows rather than cash flows is quite useful in making short-term working capital decisions, it may not be a good guide for measuring net cash flow (cash in minus cash out) for capital budgeting and financing decisions, which should be based on expected future cash flows.
a firm evaluates all of its projects by applying the IRR rule. the required rate of return is 14%. what is the IRR if a project that requires an investment today of $158,500 and has an expected cash flow in one year of $175,000?
IRR = ($175,000 - $158,500) / $158,500 IRR = 10.41% investment should be rejected
you are planning to place your money in safe government securities, which currently offer a 4% riskless rate of return. before making this investment, an entrepreneur approaches you and asks you to purchase her new business venture, fastdrop, a delivery service for legal documents that would produce a single cash inflow of $80,000 at the end of the year. you have determined that 6% is an appropriate risk premium for this investment. the economic value of fastdrop is $72,727. the opportunity cost is 10%. what is the IRR of this offer?
IRR = ($80,000 - $70,000) / $70,000 IRR = 14.29% As this investment offers a rate of return higher than the opportunity cost it is a wealth-increasing investment and should be adopted
what are the differences between the IRR and NPV? are there any situations in which you might prefer one method over the other? explain?
IRR measures the rate of return on an investment and answers the first question. intuitively, the higher the rate the better; however, rates of return are a relative measure, saying that you're earning 6% doesn't tell you whether 6% is a good return or not. to make effective decisions the IRR must be compared to the rate of return available from equivalent investments, the opportunity cost. the NPV, as cost / benefit analysis, answers the second question. NPV takes every aspect of economic value into account: the cash flows, their timing, and the opportunity cost. as there is a time value of money, amounts can be compared only when they occur at the same point in time. NPV therefore consolidates all cash flows today, and allows a proper comparison of inflows and outflows. NPV is a dollar measure of wealth created, stated in current time. as the goal is to increase wealth, NPV is better than IRR. a high rate of return on a small investment won't benefit you as much as an investment with a higher NPV.
tazer has sales of $643,000, costs of $328,000, depreciation expense of $73,000, interest expense of $38,000, a tax rate of 21%, and paid out $43,000 in cash dividends. what is the addition to the retained earnings?
111,050 sales - COGS - depreciation = NOI NOI + other income = EBIT EBIT - interest = NPBT NPBT - taxes = NI NI - dividends = RE
tazer has sales of $643,000, costs of $328,000, depreciation expense of $73,000, interest expense of $38,000, and a tax rate of 21%. what is the net income for this firm?
154,050 sales - costs - depreciation = NOI NOI + other income = EBIT EBIT - interest = NPBT NPBT - tax = NI
prepare a balance sheet - what was the change in networking capital in 2020?
2019 2020 Current assets $2,140 $2,346 Net fixed assets $6,770 $7,087 Total assets $8,910 $9,433 Current liabilities $994 $1,126 Long-term debt $2,869 $2,956 Total liabilities $3,863 $4,082 Equity $5,047 $5,351 Total Liab. and sh. Equity $8,910 $9,433 There are three items that are not part of the balance sheet. Dividends are payments to shareholders. They are very important but are not part of the balance sheet. Interest expense is an expense listed in the income statement. While you are given the tax rate, this rate should be applied to income, which is in the income statement.
prepare an income statement with 21% corporate tax rate
448.72 sales - COGS - depreciation = NOI NOI + other income = EBIT EBIT - interest = NPBT NPBT - tax = NI tax = tax rate x NPBT
your house needs a new coat of paint. you could hire a painter for $1,200 or spend $300 for materials and devote 8 hours of your time to the project. (it's a small house!) if you normally make $200/hour at your consulting job, what is the opportunity cost of having the house painted by the professional painter?
8 x $200 = $1,600 (losing $1,600 in income from the 8 hours spent) $1,600 + $300 = $1,900 for painting the house yourself this is the opportunity cost
positional goods
goods and services that people value because of their limited supply, and because they convey a high relative standing within society they derive most of their value if they succeed in distinguishing their owners as members of a favored group extends to luxury services, memberships and vacations, etc.
preferred stock
has a higher, or preferred, claim on the company's profits before common stock preferred stockholders receive dividends before common stockholders represents a claim that is senior to common stock but subordinate to liability claims get a set payment, a dividend, and do not have voting rights except under certain conditions where there are promised payments in jeopardy
capital budgeting decision
how businesses obtain productive assets
cash ratio
how capable your business is of covering its debts using only cash
record performance
how efficiently they use the firm's assets to produce goods and services do investments produce more revenues than costs?
inventory turnover ratio
how much inventory you've sold in a year or other specific period
leverage ratios
how much of your company's capital comes from debt and how likely it is that your company can meet its financial obligations
profit margin
how much of your income comes from sales
price to earnings ratio
how much they are paying for each dollar earned per stock
performance
how well have the managers used assets and claims to produce a profit over a given period of time
financing decision / capital structure decision
how will the company obtain the capital to obtain its productive assets? involves how a firm obtains the capital to finance the production of the product it wants to sell to its customers most use borrowed investment capital to supplement the investment capital provided by the firm's owners (shareholders) bondholders get interest on the funds they lend to the company (business expense and are tax deductible) the company may raise capital by issuing bonds, which require the company to pay interest - a tax deductible expense
operating cash flow ratio
how your current liabilities are covered by cash flow
financing
impact of the managers financing decision on the net income of the company interest expense, NPBT, tax, NI
operating
impact of the managers product and production on the operating profitability of the company revenues, variable costs, fixed costs, depreciation, NOI, other income, EBIT
income statement equation
income = revenues.- expenses inflows = revenues cost of production = variable and fixed costs cost of financing (borrowing money from bondholders) taxes paid (expense)
accumulated depreciation
increases each year, as the depreciation expense taken in the income statement is used to lower the net fixed asset value in the balance sheet cumulative depreciation of an asset up to a given point in its life equal to last period's accumulated depreciation plus the current period's depreciation expense
return on assets
indicates how much profit businesses make compared to their assets
earnings per share
indicates your profitability from the outstanding shares at the end of a given period
assets turnover ratio
indicator of how good your company is at using your assets to produce revenue
investors
interested in what will happen in the future
change in net working capital
investing or disinvesting in current assets
economic decision making
involves calculating economic values and comparing the economic value of an asset to the cost of obtaining the asset
capital structure decision
issuing claims against themselves
common stock
represents equity, or ownership, of shares in the company have the right to all profits after the other claimants of the firm are satisfied control corporation bear the residual risk of the company (aren't promised any set rate of return)
earnings before interest and taxes (EBIT)
represents the income from every source (other income added)
property, plant, equipment
represents the value recorded when specific assets are obtained by the company (accounting cost principle)
debt capital
requires payment of interest, as well as eventual repayment of loans and bonds
realized return
return that is actually received at the end of the investment period
calculating inflow
revenues = units sold x sales price
accounting principles
rules and guidelines that companies must follow when reporting financial data focus on revenues and expenses investors are interested in future cash flows and thus market prices are based on the expected future cash inflows and outflows produced by managers' decisions
the little shop on the corner has sales of $38,530, operating costs of $12,750, depreciation expense of $2,550, and interest expense of $1,850. if the tax rate is 21%, what is the net cash flow?
sales - operating costs - depreciation = NOI NOI + other income = EBIT EBIT - interest = NPBT NPBT - taxes = NI NI + depreciation = NCF 19,440
current liabilities
short term claims that must be paid within a year liabilities that will be satisfied within one year accounts payable, notes payable, short-term debt, current maturities of long-term debt, salary or taxes owed, and deferred or unearned revenue
US treasury bills
short term debt issued by the federal government risk free investment - assured to pay the promised future amount and this earn the promised rate of return
balance sheet (statement of financial position)
shows at any specific point in time the assets of a company, the claims against those assets, and the residual ownership interest of the shareholders reflects the accounting value of the firm's productive assets and the claims against those assets
return on equity
shows your business's profitability from your stockholder's investments
flat tax system
tax rate is the same for every dollar of taxable income, regardless of the total income of the payer corporations will pay a flat rate of 21% on all taxable income
the little shop on the corner had $243,000 in taxable income. assuming that corporations face marginal tax rates, use these rates to calculate its income tax.
taxes = 0.15($50,000) + 0.25($24,999) + 0.34($24,999) + 0.39($143,002) = $78,020.78
liquidity
the ability of a company to handle its current expenses
sufficient liquidity
the ability to pay the organization's current obligations
realization principle
the accountant recognizes revenues when a contractual obligation occurs, such as a formal sales contract where a customer purchases a product from the company, or its debt incurred
3 important guiding principles of accounting
the accrual method / matching principle the revenue recognition principle the cost principle accountants follow rules for recognizing revenues and costs, for matching revenues with the costs used to generate the revenues, recording items at their cost
book value
the acquisition cost of an asset less its accumulated depreciation the net value of a firm's assets found on its balance sheet, and it's roughly equal to the total amount of all shareholders would get if they liquidated the company the value of a business according to its books or accounts, as reflected on its financial statements difference between a company's total assets and total liabilities problems: companies report the figure quarterly or annually (only after reporting would an investor know how it has changed over the months)
fairly valued asset
the asset offers an acceptable rate of return equal to the rate of return offered on assets of equivalent risk IRR is equal to the opportunity cost, and the NPV = $0 acceptable investment
undervalued asset
the asset's rate of return is greater than the rate of return on assets of equivalent risk IRR exceeds the opportunity cost, and the NPV is positive this is a desirable investment
overvalued asset
the asset's rate of return is less than the rate of return offered on assets of equivalent risk IRR is less than the opportunity cost, and the NPV is negative not an acceptable investment
average tax rate
the average tax rate you pay on total income average rate = total tax payments / total income
PV(inflows)
the cash inflows from the project, stated in present value
assets
the cash, inventory, property, plant and equipment, and other investments a company has made that can be used to produce goods and services
assets and claims
the company needs productive assets it gets these assets from investors who lend the company money (bondholders) or take on the ownership role (shareholders)
market price
the current price at which an asset can be exchanged between a willing buyer and a willing seller
book value of equity / shareholder equity
the difference between the book value of a firm's assets and its liabilities, also called stockholders' equity, it represents the net worth of a firm from an accounting perspective
goodwill
the difference between the price paid for a company and the book value assigned to its assets
net cash flow (NCF)
the different between cash received and cash paid out measures the difference between cash inflows and cash outflows calculated by adding back all non-cash expenses (depreciation) NCF = NI + depreciation
risk premium
the extra return above the risk-free rate that is required given the uncertainty of the future cash flows
future value
the future value of an amount given today
net operating income (NOI)
the income (profit) from producing a good or service and selling it to customers represents the operating efficiency of the managers in running the business a firm's gross profit less its operating expenses
PV(outflows)
the outflows (costs) of the project generally incur at the beginning of a project but could occur at other time periods
report to stockholders
the owners need regular reports of how the managers they've hired are using the business' assets to produce profits
market value (market capitalization)
the price at which buyers and sellers would trade the assets depends on what people are willing to pay for a company's stock company's worth based on the total value of its outstanding shares in the market, which is its market capitalization tends to be greater than a company's book value since market value captures profitability, intangibles, and future growth prospects the value of a company according to the stock market dollar amount computer based on the current market price of the company's shares calculated by multiplying a company's outstanding shares by its current market price market price of shares changed throughout the day because of per share price changes (usually)
undervalued IRR
the price you pay for future cash flows gives an IRR that is greater than other equivalent investments bargain - pay less for an asset than its economic value
overvalued IRR
the price you pay for future cash flows gives an IRR that is less than other equivalent investments not attractive - paying more than investment is worth
fairly valued IRR
the price you pay for future cash flows gives an IRR that matches that of other equivalent investments acceptable outcome
riskless investment
the return you expect to get is the return you'll actually end up receiving with certainty
generally accepted accounting principles (GAAP)
the system of accounting rules that guide businesses a common set of rules and a standard format for public companies to use when they prepare their financial reports
gross profit
the third line of an income statement that represents the difference between a firm's sales revenues and its direct costs
economic entity principle
the transactions of a business should be kept separate from those of its owners and other businesses
value in use
the value that a user expects to get from the use of an asset
long term liabilities
these claims are long term debt (usually bonds which are in effect a special type of IOU issued to investors in return for cash) company must pay bondholders interest on the amount borrowed and repay the amount borrows after a set amount of years obligations that will come due in future years and include long term debt and deferred taxes ie. long term debt, deferred taxes support long term assets
time value of money
time and cash are related because most economic decisions involve multi-period cash flows ie. investments involve paying out cash today in return for a promise to receive cash payments in future periods, debt involves receiving cash today in return for a promise to pay the borrowed cash back with interest in future periods must compare cash at one point in time with cash at other points in time money available at the present time is worth more than the identical sum in the future due to its potential earning capacity money can earn interest, any amount of money is worth more the sooner it is received
goal of any set accounting principle
to ensure that a company's financial statements are complete, consistent, and comparable --> makes it easier for investors to analyze and extract useful information from the company's financial statements over a period of time, facilitates comparison of financial information across different companies, help mitigate accounting fraud by increasing transparency
turnover ratios
used to measure your company's income against its assets
establish value
what assets does the firm have? what are the claims against those assets? value of assets relative to the financial securities that finance those assets
accounting records
what has happened in the past
product decision
what is the product that the company sells? involves identifying the company's customers, determining their needs, and designing products that will satisfy those needs consumers are important - no consumers no revenue
production decision / capital budgeting decision
what productive assets will the company obtain? production costs incurred to make the product fixed costs and variable costs depreciation expense production costs must be carefully managed size and nature of costs (fixed vs variable)
positive NPV
you should accept the project, as it increases wealth measured in dollars stated as of today
full disclosure principle
you should include in or alongside the financial statements of a business all of the information that may impact a reader's understanding of those statements
conservationism principle
you should record expenses and liabilities as soon as possible, but to record revenues and assets only when you are sure that they will occur
negative NPV
you should reject the project as it would actually reduce wealth
long term debt ratio
your assets are available because debt for longer than a one year period
monetary unit principle
a business should only record transactions that can be stated in terms of a unit of currency
time period principle
a business should report the results of its operations over a standard period of time
going concern principle
a business will remain in operation for the foreseeable ftuure
first principle of finance
a dollar received today is worth more than a dollar received in the future (could be invested to grow to a larger amount)
capital lease
a lease considered to have the economic characteristics of asset ownership
decision rule
a quantitative rule that evaluates whether a course of action should be undertaken internal rate of return rule and net present value rule
comparability
ability for financial statement used to review multiple companies' financials side by side with the guarantee that accounting principles have been followed to the same set of standards
internal rate of return rule
accept an investment if its IRR (the rate of return that you're earning on the project) exceeds its opportunity cost (the rate of return you would earn on equivalent investments)
the accrual method / matching principle
accountant matches expenses (outflows) with revenues (inflows) in many instances a specific expense and the revenues it generations will occur in different periods - accountant will restate these numbers so that they are comparable when you record revenue you should record all related expenses at the same time requires revenues to be connected with the costs of producing those revenues revenues should be matched with the expenses used to produce them
revenue recognition principle
accountant recognizes revenues when a contractual obligation occurs (ie formal sales contract where a customer purchases a product from the company) substantial time may pass between key events (even a possibility that the customer may default on the contract and not pay) --> accounting revenue and cash flow aren't the same you should only recognize revenue when the business has substantially completed the earnings process
cost principle
accountant records the assets at their historic cost, which may not reflect the asset's current market value a business should only record its assets, liabilities, and equity investments at their original purchase the accountant generally records an item at cost, and doesn't adjust its value in the accounting statements
cash flow
accounting information is not sufficient to make market-based decisions economic activity and the decisions concerning economic value and cost/benefit analysis are stated in cash flows the flow of purchasing power that can be used to value and facilitate the transfer of economic assets
value investors
actively seek out companies with their market values below their book valuations sign of undervaluation and hope market participants turn out to be incorrect
financial accounting
addresses the current financial health of a business
marginal tax rate
adjusted on a marginal basis, meaning that if you earn more, you pay taxes at a higher rate
equity investors
aim for dividend income or capital gains driven by increases in stock prices
materiality principle
all material transactions should be accounted for in the financial statements and if not doing so may alter the decision making process of someone reading the company's financial statements
report to stakeholders
all the stakeholders want to understand how well the business is run, and whether their "stake" in the business is sound
depreciation expense
amount deducted, for accounting purposes, from an asset's value to reflect wear and tear over a given period fixed operating cost but not a cash expense annual depreciation = initial cost - salvage value / number of years asset's reduction in value through use application of the matching principle tax deductible expense --> lowers taxable income and thus taxes represents the use of capital assets in the production process tax shield: reduces taxable income (NPBT) and thus taxes accounting cost that represents the reduction of an asset's value over time
interest payment
amount of debt x interest rate
capital surplus
amount shareholders have invested in excess of the common or preferred stock accounts, which are based on par value than market price
amortization / impairment charge
an accounting adjustment that periodically lowers the book value of a loan or intangible asset not an actual cash expense
long term debt
any loan or debt obligation with a maturity of more than one year
as the interest rate rises, the present value of future cash flow: goes up, goes down, stays the same, could either rise or fall.
as the interest rate rises, the present value of cash flow goes down because C1/(1 + r)n
progressive tax system
as your tax rate progressively increases with income tax is divided into brackets federal individual income tax
cost accounting
assesses only costs associated with the production of your business
balance sheet (accounting identity)
assets = liabilities + shareholder equity
your company gives you the option of receiving your salary at the beginning of each month or at the end of each month. which option should you choose?
at the beginning of the month: if you were to receive $1 at the beginning of the month you could invest it and earn interest. at the end of the month you would have $1 plus interest. at the end of each month: you would receive $1. at the beginning of each month is better!
the little shop on the corner had $243,000 in taxable income. assuming that corporations face marginal tax rates, use these rates to calculate the average tax rate and marginal tax rate.
average tax rate = total taxes / total income average tax rate = 78,020.78 / 243,000 average tax rate = 32.11
difference between marginal and average tax rates
average tax rates measure tax burden marginal tax rates measure the impact of taxes on incentives to earn, save, invest, or spend
opportunity cost (discount rate, hurdle rate, benchmark rate, required rate of return)
best alternative that isn't chosen because another course of action is pursued ie. speed dating (choose the most attractive person) expressed as an interest rate opportunity cost = Rf + risk premium expected return / OC = appropriate value of investment
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?
book values can be negative, as they follow accounting principles. 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 the seller of the stock giving you a check for $2000. how many shares do you want to buy? given the market's dependence on supply and demand, if an asset is worthless, it's worthless!
marketable securities
businesses may store some of their liquid purchasing power in short-term investments these assets can earn interest but can be quickly liquidated (turned into cash) ie. treasury bills, commercial paper, certificates of deposits, and bankers' acceptances short-term, low-risk investments that can be easily sold and converted to cash (money market investments that mature within a year)
how to obtain assets?
by issuing debt or equity
liquidity ratios
calculate how capable a company is of paying its debt, usually by measuring liabilities and liquid assets
cash coverage ratio
calculates how likely it is that your bussiness can pay interest on its debts
compounding
calculating a future value Co(1 + r) = C1 Co = present value C1 = future value r = interest rate the process of using a rate of return to determine a future value
net working capital ratio
calculating the liquidity of your assets
what is the internal rate of return? what is the IRR criterion decision rule?
calculation: the IRR is the rate of return earned on an investment. the return is "internal" to the timeline as the calculating of the IRR doesn't involve the opportunity cost / discount rate. for simple one period time lines the calculation involves determining the difference between the ending and beginning value, and then dividing the beginning value into the difference: IRR = (ending - beginning) / beginning decision rule: the IRR decision rule is to accept projects with IRRs greater than the discount rate, and to reject projects with IRRs less than the discount rate. this makes sense when you consider that the discount rate is the opportunity cost (the return required to compensate the investor for not investing in other projects equivalent to the one being evaluated) if a project's IRR = 9%, and the discount rate is 6%, the project is a god deal, as you are earning 3% more than you should expect to receive from the project given the other alternatives available to you.
make investments
capital can be invested to make more capital business will hopefully get a rate of return on the invested capital which exceeds the rate of return promised their investors
a friend offers you a coke, a pepsi, or a diet coke. you don't like diet coke, so you take the pepsi. what is the opportunity cost of your choice?
coke
report to government
collecting income tax can occur only if the government can measure income collecting a capital gains tax can only occur if the government can measure the value at which an asset is purchased and then the value at which it is sold
liabilities
companies can borrow by issuing claims against themselves a firm's obligations to its creditors
long term assets (capital assets, fixed assets)
companies possess valuable tangible assets (buildings, vehicles, machines) and intangible assets (patents, copyrights, goodwill) large investments that have a substantial impact on the company's operations ie. property, plant, and equipment, intangibles support company's wealth producing activities
market to book ratio
compares your company's historic accounting value to the value set by the stock market
discounting
computing present values Co = C1 / (1 + r)^n the process if using a rate of return to determine a present value
dividends
considered a distribution of profits to shareholders and not a tax deductible business expense don't appear in income statement but are paid out of income
variable cost
costs that vary directly with the level of output ie. cost of goods sold: direct labor, materials, etc. cost of goods sold = units sold x variable cost per unit less risky
current assets
current, or short term, assets are expected to turn into cash within a year listed by their liquidity (ease which they can be converted to cash) ie. cash, marketable securities, inventory, accounts receivable, accounts payable, notes payable, accrued expenses support current operations
market value ratios
deal entirely with stocks and shares (overpriced or underpriced)
short term debt
debt with a maturity of less than one year
profit
defined as income
certificate of deposit
deposit in a bank for a specified period of time and interest rate offer a higher rate than a savings account, but account is locked in until the maturity date issued by the federal government's federal deposit insurance corporation (FDIC) - riskless and should earn the risk free rate of return
"book value vs market value: whats the difference" article
determining the book value of a company is more difficult than finding its market value, but it's more rewarding stocks often become overbought or oversold on a short-term basis relying solely on market value may not be the best method to assess a stock's potential when the market value is lower than the book valuation, it means the market lost confidence in the company company's get debt by taking loans from banks and other financial institutions or by floating interest-paying corporate bonds companies typically raise equity capital by listing the shares on the stock exchange through initial public offering (IPO)
book value per share (BVPS)
divide book value by the number of outstanding shares outstanding shares consist of all the company's stock currently held by all its shareholders (includes share blocks held by institutional investors and restricted shares) a way to measure the net asset value investors get when they buy a share
tazer has sales of $643,000, costs of $328,000, depreciation expense of $73,000, interest expense of $38,000, a tax rate of 21%, and paid out $43,000 in cash dividends. suppose tazer has 35,000 shares of common stock outstanding. what is the earnings per share figure? what is the dividends per share figure?
earnings per share = NI / # of shares earnings per share = 154,050 / 35,000 earnings per share = 3.17 dividends per share = dividends / # of shares dividends per share = 43,000 / 35,000 dividends per share = 1.23
creating wealth
economic decisions create wealth when the price paid for an economic asset is less than its economic value heart of financial decisions
"free exchange: the worth of nations" article
economists often assume that prices are all anyone needs to know - limits their relevance to some of the most serious issues facing humanity problem of value - equating money with value is in many cases a necessary expedient - people make transactions with money rather than utility or happiness economics can pay more attention to the way focusing on material well being influences and constraints their work not every dollar is of equal value - money has a diminishing marginal value: the more you have, the less you value an extra dollar economists generally ignore the value of non-market activity, like unpaid work
economic assets
entities functioning as stores of value and over which ownership rights are enforced by institutional units, individually or collectively, and from which economic benefits may be derived by their owners by holding them, or using them, over a period of time
shareholder equity
equity holders and the owners of the company - they get what is left over after all claims against the company have been satisfied represented by shares of stock; how much the owners of the company actually own (taking into account the assets of the company and the claims against those assets) shareholder equity = total assets - total liabilities ie. preferred stock, common stock
notes payable
establish a short term line of credit with a bank - credit is set up with a given limit and a company can draw on it as needed
GAAP allows participants to...
establish value, record performance, report to stockholders, report to stakeholders, and report to government
accounts payable
establishing trading credit with their suppliers and receive resources and then pay on their account on a regular basis the amounts owed to creditors for products or services purchased with credit
accounts receivable turnover ratio
evaluate how quickly your company is able to collect funds from its customers
noncash items
expenses against revenue but are not cash flows
"accounting principles" article
financial accounting standards board (FASB) issues a standardized set of accounting principles in the US referred to as generally accepted accounting principles (GAAP) accounting standards are implemented to improve the quality of financial information reported by companies GAAP is required for all publicly traded companies in the US (routinely implemented by non-publicly traded companies) international accounting standards board (IASB) issues international financial reporting standards (IFRS) --> accounting principles differ across the world FASB and IASB sometimes work together to issue joint standards on hot-topic issues
fixed costs
fixed and do not change with changes in the level of output ie. sales, general, administrative risky because they are incurred even if the company doesn't sell all of what it produces can produce a higher return because of operating leverage
expected return
future return, generally uncertain, that one expects to get from an investment used in most business making decisions
risk
getting a lower return than you had expected to get the future is unknown use estimates of what you think the cash flows will be, not necessarily what you end up with major concern of economic value the larger the risk, the larger the expected return expected return and realized return variability of future cash flows the uncertain nature of future cash flows and rates of return will cause current economic values to vary major issue with all financial decisions
reward delayed consumption
given scarce resources, we have a natural tendency to spend all of our available income delay consumption only if you're offered more consumption in the future increase in future consumption is produced by your earning a positive rate of return on your delayed consumption (savings)
in preparing a balance sheet, why do you think standard accounting principles focus on historic costs rather than market values?
Book values record what has already happened. The GAAP cost principle records the original purchase price of assets in the balance sheet. Accounting uses historical costs because they measure and reflect market values at the time the asset is obtained and they are thus considered more objective and not subject to estimation errors or attempts by managers to make them look better. Market values are estimates of what assets are worth. Are uncertain: A firm may decide to sell a building. While the CFO may estimate what the building is worth, she will not know what the actual value is until the building is actually sold in a market transaction. As many homeowners found out in the Great Recession, what one thinks an asset is worth may be very different than what it actually might sell for! Can be difficult to estimate: Different analysts would likely come up with different numbers. So, unless the accountant has a firm arms-length market transaction, where a buyer actually pays for the asset, book values reflect the historic cost of the asset and provide an objective, if imperfect, measure of value. This reliance on book values may mean that the balance sheet is not a true measure of current value.
you receive $750 today and deposited it in your savings account that has an interest rate of 3%. what will your savings account balance be in one year?
C1 = Co(1 + r) C1 = $750(1 + 0.03) C1 = $772.50
describe how NPV is calculated and describe the information this measure provides about a sequence of cash flows. what is the NPV criterion decision rule?
Calculation: NPV is simply economic cost-benefit analysis. All of the benefits (cash inflows) and costs (cost outflows) are identified. All amounts are taken to their present value using an appropriate discount rate, which is the project's opportunity cost. With all amounts stated at the same point in time the benefits and costs can be compared. Decision rule: If the present value of benefits exceed the present value of costs, then the project is wealth creating. If the present value of benefits is less than the costs, then the project would reduce wealth. Therefore, accept projects with positive NPVs and reject projects with negative NPVs. We would also accept projects with zero NPV, as they are offering us a fair rate of return.
your little sister tiffany has received a special piggy bank with a $20 bill in it. this is a special locked piggy and will unlock itself in one year. tiffany has offered to sell you piggy today. unfortunately, this nice piggy bank will completely destroy itself in one year and have no value, so plan on getting only the $20! if your savings rate is 5%, how much is the $20 in piggy worth to you today if you can't get at it for a year?
Co = C1 / (1 + r)^n Co = $20 / (1.05) Co = $19.05
your friend wants to pay back the money she borrowed from you. she offers you $300 today or $315 in one year. if you could save 6%, which one should you choose?
Co = C1 / (1 + r)^n Co = $315 / (1.06) Co = $297.17 the present value of the future payment is $297.17 $300 x 1.06 = $318 you could invest the money you get today and make $318 in a year you should take $300 today
as an incentive for you to stay in school your uncle henry offers to pay you in $5,000 in one year. if the interest rate is 4%, how much is the $5,000 payment worth to you today?
Co = C1 / (1 + r)^n Co = $5,000 / (1.04) Co = $4,807.69
your little sister tiffany is beginning to cause you some concern. she wants to borrow $480 from you today and promises to pay you $500 in one year. you earn 3% on your deposits. disregarding what your 9 year old sister would need $480 for, would this be a good loan for you to make?
Co = C1 / (1 + r)^n Co = $500 / (1.03) Co = $485.43 yes because the present value of the investment is more than what you are giving her
Given your financial situation, you can only make one investment. You want to consider both profitability and safety. You only have enough funds to invest in one of these attractive projects. What is the NPV of the best investment?
Considering safety: Hive Bliss is the riskier investment, with a risk premium of 14%. FastDrop is safer, with a risk premium of only 6%. If you were thinking of safety, then FastDrop is the safest investment and should be chosen. Considering wealth: The NPV of FastDrop is $2,727; the NPV of Hive Bliss is $6,694. Thus, Hive Bliss would have a far greater positive impact on your wealth. Even though it is the riskier investment, Hive Bliss offers a better risk-return tradeoff. The higher risk of the Hive Bliss investment is taken into account in the discount rate that places a lower value on future cash flows. This discussion will make more and more sense as we go through our course.
what does liquidity measure? explain the trade-off a firm faces between high liquidity and low liquidity levels
Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in value. A liquid asset can easily and quickly be converted to cash, whereas an illiquid asset is difficult to convert to cash. By converting we mean selling, and here are two examples. A share of Apple stock is liquid. You can sell it instantly, face a low transaction cost, and lose none of your share's value. A condo is not liquid. If you were to sell your condo you'd list it for sale, which might take a few weeks to find a buyer and additional time to close the sale. You could certainly sell quickly, but would have to accept a much lower cost. And, there's the Realtor who helps you with the transaction and would be paid a commission, perhaps as much as 6% of the sales price. So, if you might need the funds quickly, investing in the apple stock is the way to go. Liquidity is not an either or situation. You would certainly like an illiquid asset such as the condo to provide shelter; while the stock is liquid, it would not provide adequate shelter in a rainstorm. You would therefore invest some of your wealth in shelter, some in investments. You should also have some very liquid assets, such as cash, to handle regular expenses as they occur and unexpected major expenses, such as a blown transmission or a broken leg. Similarly, it's desirable for firms to have sufficient liquidity so that they can more safely meet short-term creditor demands. However, liquidity for a firm has an opportunity cost. Firms need to invest in long-term, illiquid productive assets to satisfy their customers. Also, these long term assets reap higher returns than very liquid assets such as cash or marketable securities. It's up to the firm's financial management staff to find a reasonable compromise between these opposing needs.
you are planning to place your money in safe government securities, which currently offer a 4% riskless rate of return. before making this investment, an entrepreneur approaches you and asks you to purchase her new business venture, fastdrop, a delivery service for legal documents that would produce a single cash inflow of $80,000 at the end of the year. you have determined that 6% is an appropriate risk premium for this investment. the economic value of fastdrop is $72,727. the opportunity cost is 10%. the IRR is 14..29%. determine the NPV?
NPV = $80,000/1.10 - $70,000 NPV = $2,727.27 When you state the present value of the benefits ($80,000 in one year) to what you'd have to pay today to receive those benefits ($70,000) you find that this is a wealth-increasing investment and should be adopted.
a firm evaluates all of its projects by applying the IRR rule. the required rate of return is 14%. a project requires an investment today of $158,500 and has an expected cash flow in one year of $175,000. suppose the firm uses the NPV decision rule. what is the NPV of the project?
NPV = ($175,000 / 1.14) - $158,000 = -$4,991 reject the project
given the balance sheets calculated, what was the change in Mackie.inc's in net working capital in 2020?
NWC = short term assets - short term liabilities NWC = 74
Hive Bliss, a company that sells home bee hives as a personal source of honey. Hive Bliss would require an investment of $95,000 and offers a cash inflow of $120,000 at the end of the year. An apiculture consultant advises that this is a fairly risky investment and suggests a risk premium of 14%. What is its NPV?
OC = 4% + 14% OC = 18% NPV = $120,000/(1.18) - $95,000 NPV = $6,694 The decision: When all the dust settles, this project costs you $95,000 but offers expected cash flows with a present value of $101,695. NPV is cost/benefit analysis and Hive Bliss offers benefits that exceed its costs and is thus a wealth-increasing project that should be accepted.
major economic relationships
The opportunity cost: Economic decisions are comparisons of alternatives. We evaluate investments or other economic decisions using the opportunity cost, which is the rate we should earn on equivalent investments, with equivalent being largely based on risk. The opportunity cost is directly used in calculating NPV. The opportunity cost is not used in calculating IRR: the IRR is compared to the opportunity cost to reach a decision. The opportunity cost is often called the required rate of return, as it is the minimum rate of return that is acceptable. Economic value: We calculate how much the future cash flows of an investment are worth to us today-- their present value--which takes into account the amount of the cash flows, when they occur, and their risk. The present value of inflows is the economic value. NPV: Note that the PVInflows, a major component of the NPV calculation is, by the previous definition, the economic value of the benefits (expected future cash flows to be received from the investment). NPV thus calculates the economic value of an investment and then subtracts the amount you'd have to pay to get the future cash flows (economic value) of the investment. If the economic value exceeds the cost, it's a good investment. A good deal is a good deal: In this example we saw that at an opportunity cost of 14% the project is a bad investment, and both the NPV and IRR decision rules agreed that we should reject it. When the opportunity cost dropped to 8%, then both the NPV and IRR decision rules changed their recommendations to accept. For many projects these two decision rules will give the same decision.
suppose a company's operating cash flow was negative for several years running. is this necessarily a good sign or bad sign?
it's probably not a good sign for an established company. as cash balances go down, the company faces insolvency, where it does not have the underlying value to continue operations. a company that has several years of negative cash flow would eventually run out of cash and cease to exist. on the other hand, a start-up would likely face negative cash flow for several years. the negative cash flow would be a sign of growth as the company develops its concepts into a viable product. while substantial cash inflows would not come from sales, the company would use cash provided by angel investors and venture capitalists. liquidity: can the firm pay its short-term obligations, such as paying workers or its accounts payable? solvency: is the firm a viable company? can it meet its long-term financial obligations: meet its long-term contractual interest payments to its bondholders? a solvent company's assets are greater than the claims against those assets. cash flow analysis is crucial for making managerial decisions and involves not only the size of the cash flows, but also their timing and risks.
accounts receivable / trade credit
many companies extend short term credit to their customers customer receives the product, and agrees to pay for it within a certain period of time accounts owed to a firm by customers who have purchased goods or services on credit
inventory
materials and products in the manufacturing process are assets of the company least liquid of current assets a firm's raw materials as well as its work-in-progress and finished goods
economic value
maximum dollar price someone will pay for an economic asset based on the future economic value = PVinflows
conservative slant
may yield lower reported profits, since revenue and asset recognition may be delayed for some time
net
means netting out of comparison of inflows with outflows
present value
means that all of the cash flows involved in the decision are restated as present valued using the appropriate opportunity cost / discount the value of a future cash flow stated as of today
profitability ratios
measure a business's earnings versus its expenses
current ratio
measure if your company can currently pay off short term debts by liquidating your assets
quick ratio
measure quick assets by considering accounts receivable and cash plus market securities
income statement
measures performance end result is the income (profit) to the owners (shareholders) of the company recording of flows of funds into and out of the company and the residual, or profit, from the firms operating and financing decisions a list of a firm's revenues and expenses over a period of time
net working capital (NWC)
measures the difference between assets that will turn into cash within a year and claims that must be paid with cash within a year NWC = short term assets - short term liabilities should be a positive number the difference between a firm's current assets and current liabilities that represents the capital available in the short-term to run the business measure of the firm's liquidity
accounts payable turnover ratio
measures the speed at which a company pays its suppliers
debt to equity ratio
measures your company's leverage by comparing your liabilities, or debts, to your value as represented by your stockholders' equity
what accounting item differentiates accounting net income from net cash flow?
net income: accounting rules guide how revenues and expenditures are recognized and thus provide objective information to decision makers. one of the major expenses is the use of the firm's productive assets. for example, major robotic lathe is used to produce a complex artificial heart valve. this asset is "used up" over time and thus loses value in exactly the same way that your car loses value of the years that you drive it. accounting convention and tax laws define this wearing out as depreciation. the firm is allowed to deduct a depreciation expense from revenues. this is a non-cash deduction that also requires adjustments made in asset book values in accordance with the matching principle in financial accounting. net cash flow: net cash flow is the cash flow produced by the company. as depreciation is not a cash expense it is not part of net cash flow. however, depreciation is a tax shield that reduces taxable income and thus the taxes paid, which are a cash flow.
net income (NI)
net profit before taxes - tax the difference between accounting revenues and accounting expenses recorded using GAAP and accrual method doesn't represent the cash that was received or paid out
intangible assets
not physical assets
deferred taxes
obligations of the company, but they are obligations that are not paid during the current period any asset or liability that results from the difference between a firm's tax expenses as reported for accounting purposes, and the actual amount paid to the taxing authority the difference between accounting income and taxable income
accrued expenses
obligations to pay something or someone, but don't do it everyday (salary, utility bill)
consistency principle
once you adopt an accounting principle or method, you should continue to use it until a demonstrably better principle or method comes along
reliability principle
only those transactions that can be proven should be recorded
elements of economic value
opportunity cost, cash flow, time value of money, risk
Are You in Control of Your Own Decisions? Ted Talk
other people influence our decisions we have such a feeling we are in control of making our own decisions that we have an illusion of making our own decisions things that are complex - we choose what is chosen for us don't know our preferences that well --> susceptible to all influences from external forces
minority interest
ownership of less than 50% of a subsidiary's equity by an investor or a company other than the parent company
price to book ratio (P / B)
popular way to compare book and market values, and a lower ratio may indicate a better deal
economic wealth
possession of economic assets increases if you get a good deal
net present value (NPV)
premier method of evaluating decisions is a cost / benefit analysis decision-making process using the time value and opportunity cost to compare the benefits of a decision with its costs NPV = PV(inflows) - PV(outflows) the increase or decrease in purchasing power (wealth) produced by the investment measures wealth creation by evaluating the joint impact of the magnitude, timing, and risk of expected cash flows
"International New York Times" Article
protocol economy - can use the same software at the same time by different people physical stuff economy - physical stuff is subject to the laws of scarcity society can be infected by new ideas very quickly protocols are intangible so the traits needed to invent and absorb them are intangible too protocol economy tends toward inequality because some societies and subcultures have norms, attitudes, and customers that increase the velocity of new recipes while other subcultures retard it
cash
purchasing power accepted by market participants in the form of money or its equivalent
total debt ratio
quick way to see how much of your assets are available because of debt
internal rate of return (IRR)
rate of return earned on an investment adjusted for time value IRR = (ending value - beginning value) - beginning value project is only acceptable if you earn a IRR that exceeds the opportunity cost
risk-free rate of return
rate of return on an asset whose future cash flows are certain given the known payment made today for the promise of future cash flows that will be received with certainty, the rate of return is also certain
interest rate
rate of return on an investment or a debt, which means that there is a time value of money
net profit before tax (NPBT)
records the profit after all business expenses, both production and financing, have been subtracted from revenues earnings before interest and tax - interest expense
consistency
refers to a company's use of accounting principles over time
