Week 3 - Bus Finance

Capital Budgeting Process Section Review

1 Determine the relevant components of the initial investment outlay for the asset or project. 2 Estimate the future cash flows expected to be generated by the asset or project. 3 Evaluate the riskiness of the projected cash flows to determine the appropriate rate of return to use for computing the present value of the estimated cash flows. 4 Compute the discounted present value of the expected cash flows using the firm's cost of capital as the discount rate. 5 Compare the discounted present value of the expected future cash flows with the initial investment, or cost, that is required to acquire the asset. Alternatively, the expected rate of return on the project can be calculated and compared with the firm's required rate of return.

Steps in the Valuation Process

1 Determine the relevant components of the initial investment outlay for the asset or project. 2 Estimate the future cash flows expected to be generated by the asset or project. 3 Evaluate the riskiness of the projected cash flows to determine the appropriate rate of return to use for computing the present value of the estimated cash flows. 4 Compute the discounted present value of the expected cash flows using the firm's cost of capital as the discount rate. 5 Compare the discounted present value of the expected future cash flows with the initial investment, or cost, that is required to acquire the asset. Alternatively, the expected rate of return on the project can be calculated and compared with the firm's required rate of return. Capital budgeting decisions involve the valuation of assets or projects. Not surprisingly, then, capital budgeting involves the same steps used in general asset valuation. If a firm invests in a project with a present value greater than its cost, the value of the firm will increase. A very direct link therefore exists between capital budgeting and stock values: the more effective the firm's capital budgeting procedures, the higher the price of its stock.

Identifying Incremental (Relevant) Cash Flows

1. Cash flows that occur only at the start of the project's life - time Period 0 - which represent the amounts that are initially invested in the project. 2. Cash flows that continue throughout the project's life - time Periods 1 through n - which represent changes in the firm's operating cash flows that are associated with investing in the project. 3. Cash flows that occur only at the end, or the termination, of the project - time Period n - which represent the amounts that are associated with the disposal, or termination, of the project at the end of its life.

Incremental Cash Flows

1. Sunk costs are outlays that have been committed or that already have occurred which will not change if the project is purchased. They cannot be recovered regardless of whether the project is accepted or rejected. Because they are not affected by the decision under consideration, they should not be included in the cash flow analysis. 2. Opportunity costs are the cash flows that could be generated from assets that the firm already owns if they are not used for the project in question. 3. Externalities are effects that a project will have on other parts of the firm. Although they often are difficult to quantify, externalities must be estimated so that they are not mistakenly included as new (incremental) cash flows in the capital budgeting analysis. 4. Shipping and installation costs for project components are important to include in the project cost because they require cash payments. In addition, for depreciable assets, the total amount that can be depreciated (known as the depreciable basis) includes the purchase price and any additional expenditures required to make the asset operational, including shipping and installation. Although depreciation is a noncash expense (cash is not needed to pay the depreciation expense each year), depreciation affects the taxable income of a firm. In this way, it affects the amount of taxes paid by the firm, which is a cash flow. 4. Inflation should be recognized in capital budgeting decisions. If expected inflation is not built into the determination of expected cash flows, then the asset's calculated value and expected rate of return will be incorrect. That is, both of these values will be artificially low. It is easy to avoid inflation bias: simply build inflationary expectations into the cash flows used in the capital budgeting analysis. The firm does not have to adjust its required rate of return (weighted average cost of capital, WACC) to account for inflation expectations because investors include such expectations when establishing the rate at which they are willing to permit the firm to use their funds. In other words, investors decide the rates at which a firm can raise funds in the capital markets, and these rates include an inflation premium.

three types of project risk need to be considered to determine whether the required rate of return used to evaluate a project should be different than the firm's WACC:

1. The project's own stand-alone risk, or the risk it exhibits when evaluated alone rather than as part of a combination, or portfolio, of assets 2. The corporate, or within-firm, risk, which is the effect a project has on the total (overall) riskiness of the company 3. The beta, or market, risk, which is the project's risk assessed from the standpoint of a stockholder who holds a well-diversified portfolio

Advantages of Term Loans

1. corporate bonds: speed, flexibility, and low issuance costs. Because they are negotiated directly between the lender and the borrower, formal documentation is minimized. 2. future flexibility: the borrower generally can sit down with the lender and work out mutually agreeable modifications to the contract. 3. interest rate on a term loan can be either fixed for the life of the loan or variable. Generally, when interest rates become more volatile, banks and other lenders are more reluctant to make long-term, fixed-rate loans, so variable-rate term loans become more common.

Factors for risk

4 most important factors: 1. Federal Reserve policy 2. the federal budget deficit 3. the foreign trade balance 4. level of business activity. money supply has a major effect on both the level of economic activity and the rate of inflation, and in the United States, the Federal Reserve controls the money supply. If the Fed wants to control growth in the economy, it slows growth in the money supply. Such an action initially causes interest rates to increase and inflation to stabilize. most important tool used by the Fed to manage the supply of money is open market operations, which involve buying or selling U.S. Treasury securities to change bank reserves. If the federal government spends more than it takes in from tax revenues, it runs a deficit. Deficit spending must be covered either by borrowing or by printing money. If Americans buy more than we sell (that is, if Americans import more than we export), the United States is said to be running a foreign trade deficit. uantitative easing increases the money supply and floods financial institutions with capital to increase liquidity and promote lending. It also decreases interest rates since the supply of money increases. -held interest rates low

Cash Flow Estimation and the Evaluation Process

An expansion project calls for the firm to invest in new assets in an effort to increase sales. The first step in the analysis is to summarize the initial investment outlays required for the project. The next step is to estimate the cash flows that will occur once production begins. The final cash flow component that must be computed is the terminal cash flow. Identifying the incremental cash flows is more complicated with a replacement project than with an expansion project because the cash flows from both the new asset and old asset must be considered.

Project Risk Level

Average: "average" rate of return (the firm's WACC) Above average risk: higher than average rate Below average risk: lower than average rate

Project Classifications

Capital budgeting decisions generally are termed either replacement decisions or expansion decisions. Replacement decisions involve determining whether capital projects should be purchased to take the place of (replace) existing assets that might be worn out, damaged, or obsolete. Replacement projects are necessary to maintain or improve profitable operations using existing production levels. On the other hand, if a firm is considering whether to increase operations by adding capital projects to existing assets so as to produce either more of its existing products or entirely new products, expansion decisions are made. Some capital budgeting decisions involve independent projects, whereas others involve mutually exclusive projects. **Independent projects are projects whose cash flows are not affected by any other projects, so the acceptance of one project does not affect the acceptance of other projects. **Mutually exclusive projects, then accepting one project means that other projects must be rejected. Only one mutually exclusive project can be purchased, even if all of them are acceptable.

Importance of Capital Budgeting

Capital refers to fixed assets used in production, and a budget is a plan that details projected cash inflows and cash outflows during some future period. Thus, the capital budget is an outline of planned expenditures on fixed assets, and capital budgeting is the process of analyzing projects and deciding which are acceptable investments and which acceptable investments should be purchased. -Capital budgeting has long-term effects, so the firm loses some decision-making flexibility when it purchases capital projects. -An error in the forecast of asset requirements can have serious consequences. That is, investing too much will result in unnecessarily heavy expenses, whereas investing too little might create inefficient production and inadequate capacity that result in lost sales.

Estimating a Project's Cash Flows

Cash flow estimation is the most important, and perhaps the most difficult, step in the analysis of a capital project. The process of cash flow estimation is problematic because it is difficult to accurately forecast the costs and revenues associated with large, complex projects or projects that are expected to affect operations for long periods of time. -done before computing projects value The investment outlays and the net cash flows expected after the project is purchased. -uses data to create estimates 2 rules to avoid mistakes: 1. Capital budgeting decisions must be based on after-tax cash flows and not accounting income. 2. Only incremental cash flows are relevant to the analysis to accept or reject a project. after-tax cash flows: rather than accounting profits because it is cash that pays the bills and can be invested in capital projects, not profits.

Financing Strategies

Conservative Strategy: Uses more expensive long-term financing to finance both permanent assets and temporary assets Agressive Strategy: Use the less expensive but riskier short term debt to fiance both seasonal peaks and part of long term growth in sales and assets Matching Strategy: Finance permanent assets with long funding sources and temporary asset requirement with short term financing

Derivative

Contract that derives its value from the performance of an underlying entity such as asset, an index, or an interest rate. Common derivatives include forwards, futures, options, and swaps. firms use derivatives to hedge, or insure, against a variety of risks

Convertibles

Convertible securities are bonds or preferred stocks that can be exchanged for, or converted into, common stock at the option of the holder. Conversion does not bring in additional capital for the issuing firm - rather, debt or preferred stock is simply replaced by common stock. If the company wants to ensure that a convertible security will be converted into common stock once stock prices rise, the original convertible will include a call provision

Exchange Risk

Exchange rate risk reflects the inherent uncertainty about the home currency value of cash flows sent back to the parent. In other words, foreign projects have an added risk element that relates to what the basic cash flows will be worth in the parent company's home currency, because actual exchange rates might differ substantially from expectations

Which of the following is not one of the fundamental factors that affect the cost of money?

Exchange rates (foreign)

Short-Term Debt: Federal Funds

Federal Funds: often referred to simply as "fed funds," represent overnight loans from one bank to another The interest rate associated with such debt is known as the federal funds rate. Federal funds have very short maturities, often overnight.

Earnings Available for Common Stockholders & EPS

If a firm has preferred stock, it deducts preferred stock dividends from net income. Net income less preferred stock dividends is earnings available for common stockholders. Dividing earnings available for common stockholders by the number of shares of common stock outstanding results in earnings per share (EPS).

Cost o Money - Financial asset value

In general, when the rates in the financial markets increase, the prices (values) of financial assets decrease.

Income Statement (aka Profit-and-loss-statement)

Income= revenue-expenses aka profit, earnings, margin Measures of Income: 1. Gross profit is the first income measure. It is the amount by which sales revenue exceeds the cost of goods sold (the direct cost of producing or purchasing the goods sold) 2. Next, a firm deducts from gross profits various operating expenses, including selling expense, general and administrative expense, and depreciation expense. -resulting operating profit represents the profits earned from the sale of products, although this amount does not include financial and tax costs -Other income, earned on transactions directly related to producing and/or selling the firm's products, is added to operating income to yield earnings before interest and taxes (EBIT) - - When a firm has no "other income," its operating profit and EBIT are equal 3. Next, the firm subtracts interest expense - representing the cost of debt financing - from EBIT to find its pretax income 4. final step is to subtract taxes from pretax income to arrive at net income, or net profits after taxes.

Incremental Operating Cash Flow

Incremental operating cash flows are the changes in day-to-day operating cash flows that result from the purchase of a capital project. They occur throughout the life of the project, continuing to affect the firm's cash flows until the firm disposes of the asset. Incremental operating CFt = ΔCash revenuest-ΔCash expensest-ΔTaxest

Initial Investment Outlay

Initial investment outlay refers to the incremental cash flows that occur only at the start of a project's life, CF0. It includes such cash flows as the purchase price of the new project and shipping and installation costs. he addition or replacement of a capital asset also affects the firm's short-term assets and liabilities, which are known as the working capitalaccounts. The difference between the required increase in current assets and the increase in current liabilities is the change in net working capital. If this change is positive (as it generally is for expansion projects), then additional financing, over and above the cost of the project, is needed to fund the increase.

Activity Ratios

Inventory turnover provides a measure of how quickly a firm sells its goods IT= cost of goods sold (CGS)/inventory -convert inventory turnover into an average age of inventory by dividing the turnover figure into 365 (the number of days in a year) -Average collection period or average age of accounts receivable in evaluating credit and collection policies avg daily sales= annual sales/365 avg collect period= accounts receivable/avg daily sales -Average payment period to evaluate their payment performance. This metric measures the average length of time it takes a firm to pay its suppliers. The average payment period equals the firm's average daily purchases divided into the accounts payable balance avg daily purchases= Ann purchases/365 avg pmt period= accts payable/avg daily purchases Fixed asset turnover ratio: measures the efficiency with which a firm uses its fixed assets. The ratio tells analysts how many dollars of sales the firm generates per dollar of investment in fixed assets. Fixed Asset Turnover = Net Sales / Average Net Fixed Assets Total asset turnover ratio: indicates the efficiency with which a firm uses all its assets to generate sales. Like the fixed asset turnover ratio, total asset turnover indicates how many dollars of sales a firm generates per dollar of total asset investment. -analysts favor a high turnover ratio because it indicates that a firm generates more sales (and, ideally, more cash flow for investors) from a given investment in assets.

Types of Ratios

Liquidity Ratios •Current Ratio •Quick (Acid Test) Ratio -measure a firm's ability to satisfy its short-term obligations as they come due. Because a common precursor to financial distress or bankruptcy is low or declining liquidity, liquidity ratios are good leading indicators of cash flow problems. Activity Ratios •Turnover ratios •Collection/Payment Period -measure the speed with which the firm converts various accounts into sales or cash. Analysts use activity ratios as guides to assess how efficiently the firm manages its assets and its accounts payable. Debt Ratios •Debt-to-Equity Ratio •Times Interest Earned (TIE) Profitability Ratios •Profit Margin •Return on Assets Market Ratios •Price/Earnings (P/E) Ratio•Market-to-Book Ratio

Liquidity Premium (LP)

Liquidity generally is defined as the ability to convert an asset into cash on short notice and "reasonably" capture the amount initially invested. financial assets as government securities and stocks and bonds trade in extremely active and efficient secondary markets, whereas the markets for real estate are much more restrictive.

Long-Term Debt: Term Loans

Long-term debt refers to debt instruments with maturities greater than 1 year. Owners of such debt generally receive periodic payments of interest. A term loan is a contract under which a borrower agrees to make a series of interest and principal payments on specific dates to the lender. Term loans usually are negotiated directly between the borrowing firm and a financial institution, such as a bank, an insurance company, or a pension fund. For this reason, they are often referred to as private debt. -vary from 2 to 30 years, most maturities are in the 3-year to 15-year range.

Risks

Lowest to highest risk A. Short Term B. Floating rate C. First mortgage D. Second mortgage E. Subordinated debentures F. Income bond G. Preferred Stock H. Common stock

_____ projects are a set of projects where the acceptance of one project means that other projects cannot be accepted.

Mutually exclusive

"Bottom Line"

Net income is the proverbial "bottom line" and the single most important accounting number for both corporate managers and external financial analysts.

Derivitaves Section Review

Options: The most basic types of options include a call and a put. A call option gives the holder the right to purchase, or call in, shares of a stock for purchase at a predetermined price at any time during the option period. In contrast, a put option gives the holder the right to sell, or put out, shares of a stock at a specified price during the option period. Convertibles: Convertible securities are bonds or preferred stocks that can be exchanged for, or converted into, common stock at the option of the holder. Conversion does not bring in additional capital for the issuing firm - rather, debt or preferred stock is simply replaced by common stock. Of course, this reduction of debt or preferred stock will strengthen the firm's balance sheet and make it easier to raise additional capital, but this effect represents a separate action. Futures and Swaps: A futures contractrepresents an arrangement for delivery of an item at some date in the future; the details of the delivery, including the amount to be delivered and the price that will be paid at delivery, are specified when the futures contract is created. The futures contract provides the company with insurance against unfavorable changes in exchange rates - the company has hedged its risk. A swap is an agreement to exchange, or swap, cash flows or assets at some time in the future. For example, firms might agree to exchange interest payments on outstanding debt. Hedge Fund: A hedge fund is a relatively new, innovative, and complex investment that takes many different forms. In simple terms, a hedge fund is a private pool of funds that is constructed for the purpose of generating a specific range of returns, no matter what happens in the general stock market. To do so, hedge fund managers follow complex combinations of investment strategies that include borrowing large amounts of money and taking a variety of investment positions in stocks, bonds, options, swaps, and other derivatives.

EBIT

Other income, earned on transactions directly related to producing and/or selling the firm's products, is added to operating income to yield earnings before interest and taxes (EBIT). When a firm has no "other income," its operating profit and EBIT are equal.

American depository receipts (ADRs

Ownership of foreign companies can be traded internationally through depository receipts, which represent shares of the underlying stocks of foreign companies. In the United States, most foreign stock is traded through American depository receipts (ADRs)

Political Risk

Political risk refers to any action (or the chance of such action) by a host government that reduces the value of a company's investment. At one extreme, it includes the expropriation (seizure) without compensation of the subsidiary's assets. Less drastic actions might reduce the value of the parent firm's investment in the foreign subsidiary through the imposition of higher taxes, tighter repatriation or currency controls, and restrictions on prices charged. Companies can take three major steps to reduce the potential loss from expropriation: (1) Finance the subsidiary with local capital. (2) Structure operations such that the subsidiary has value only as a part of the integrated corporate system. (3) Obtain insurance against economic losses from expropriation from a source such as the Overseas Private Investment Corporation (OPIC). If the third step is taken, insurance premiums would have to be added to the project's cost.

Statement of Retained Earnings (Beginning RE + Net income - Dividends paid = Ending RE)

Reconciles the net income earned during a given year, and any cash dividends paid, with the change in retained earnings between the start and end of that year. -used to see how the firm has made its investment/consumption decision.

Securities and Exchange Commission (SEC)

Regulates publicly traded U.S. companies as well as the nation's stock and bond market. It mandates that companies generate financial statements following international accounting standards (IAS). Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board (PCAOB), which effectively gives the SEC authority to oversee the accounting profession's activities. 4 key financial statements: (1) the balance sheet, (2) the income statement (3) the statement of retained earnings (4) the statement of cash flows.

Which of the following statements is correct?

Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.

The bottom-up method for forecasting sales?

Relies on the ability of sales personnel to assess future demand, usually without the aid of statistical models.

On what key input does a cash budget rely?

Sales forecast (cash inflow) --Production expenses is cash outflow

discounted securities

Securities that sell for less than their par value are said to be selling at a discount. Securities that sell at a discount when issued are called discounted securities. -investor holds a discounted security until its maturity date, the dollar return that he or she earns is the difference between the security's purchase price and its maturity, or face, value. Most discounted debt securities have maturities of 1 year or less.

A _________________ is a long-term guide driven by competitive forces

Strategic Plan

Problems with Determining incremental cash flows

Sunk costs: outlays that have been committed which will not change if project is purchased. Opportunity costs: cash flows that can be generated from assets the firm already owns if not used for project Externalities: effects that a project will have on other parts of the firm Shipping & inflation costs: important to include in the project cost because they require cash payments Inflation: included for the asset's calculated value and expected rate of return to be correct

Common Stock: Maturity and Voting Rights

The common stockholders have the right to elect the firm's directors, who in turn appoint the officers who manage the business. Stockholders also vote on shareholders' proposals, mergers, and changes in the firm's charter.

Net Income

The firm subtracts interest expense - representing the cost of debt financing - from EBIT to find its pretax income. The final step is to subtract taxes from pretax income to arrive at net income, or net profits after taxes. Net income is the proverbial "bottom line" and the single most important accounting number for both corporate managers and external financial analysts.

Capital Budgeting Evaluation Techniques (IRR)

The internal rate of return (IRR) is the rate of return the firm expects to earn if a project is purchased and held for its economic (useful) life. The IRR is defined as the discount rate that equates the present value of a project's expected cash flows to the initial amount invested. **the project's cash flows must only change sign one time during its life. -If the sign of the cash flows changes more than once during the project's life, then the IRR is not unique, and there are in fact multiple IRRs for the project − one for each sign change. In that case, none of the IRRs has meaning **important caveat concerning IRR is that it implies a constant reinvestment rate for the cash flows of the project. The IRR for a project will be its average annual rate of return over its life only if all of its cash flows can be reinvested in other projects that on average have the same IRRs. -As long as the project's IRR is greater than the rate of return required by the firm for such an investment (r), then the project is acceptable. An IRR greater than r also means that NPV is positive, so the two measures will produce the same decision to accept. IRR> R -> Accept (increase) IRR< R -> Reject (decrease) (1) the IRR is the rate of return that will be earned by anyone who purchases the project and (2) the IRR is dependent on the project's cash flow characteristics - that is, the amounts and the timing of the cash flows - not the firm's required rate of return.

Which of the following statements concerning common stock and investment banking process is false?

The pre-emptive right gives each existing common stockholder the right to purchase his or her proportionate share of a new stock issue.

Which of the following statements is false?

The term Eurobond specifically applies to any foreign bonds denominated in U.S.currency.

3 Popular Methods of Evaluating Capital

The three most popular methods used by businesses to evaluate capital budgeting projects are (1) net present value (NPV), (2) internal rate of return (IRR), and (3) payback period (PB). NPV: If the estimated NPV for a project is positive, then it is an acceptable investment because the value of the company will be increased. If the NPV is negative, then the project should be rejected because it will decrease the value of the company if it is undertaken. An NPV of zero would indicate that the project will have no effect on the value of the company. IRR: The internal rate of return (IRR) is the rate of return the firm expects to earn if a project is purchased and held for its economic (useful) life. The IRR is defined as the discount rate that equates the present value of a project's expected cash flows to the initial amount invested.

Bond Ratings

The triple-A and double-A bonds are extremely safe. Single-A and triple-B bonds are strong enough to be called investment-grade bonds; they are the lowest-rated bonds that many banks and other institutional investors are permitted by law to hold. Double-B and lower-rated bonds are speculative, or junk bonds; they have a significant probability of going into default, and many financial institutions are prohibited from buying them.

Yield Curves

The yield curve provides a snapshot of the relationship between short-term and long-term rates, usually for Treasury securities, on a particular date. *Downward sloping= inflation is high and expected to decline and the economy may weaken in the future. *Upward sloping= inflation is expected to increase downward sloping - inverted yield curve inflation on the yield curve: rtreasury = Rf + MRP = r* + IP + MRP When inflation is expected to increase, the yield curve is upward sloping, and vice versa. In either case, economists often use the yield curve to form expectations about the future of the economy.

Sustainable Growth

Three of the more popular measurements of growth are the accounting return on investment (ROI), economic value added (EVA®), and growth in sales or assets. All of these methods rely on accounting data and are typically measured on an annual basis. Growth can also be defined by increases in the firm's market value, its asset base, the number of people it employs, or any number of other metrics

The firm's managers cannot use ratios _____

To determine the ,market value of the firm's equity. They CAN: to generate an overall picture of the company's financial health, to monitor the firm's performance from period to period, to isolate developing problems.

Best Financial Instrument

Traditional bonds (as well as many other forms of debt) require fixed interest payments regardless of the level of operating earnings for a firm. Thus, a major advantage associated with debt issues is the firm's ability to limit its financial costs. Preferred stock has many of the same characteristics as debt, including a fixed payment and no voting rights. For these reasons, a firm might consider issuing preferred stock if prosperous times are expected so that existing common stockholders do not have to share the prosperity by issuing additional common shares. Like preferred stock, common stock does not legally obligate the firm to make payments to stockholders. Common stock carries no fixed maturity date: it never has to be "repaid" as would a debt issue. The sale of common stock generally increases the creditworthiness of the firm because common stock cushions creditors against losses. If a company's prospects look bright, then common stock often can be sold on better terms than can debt. Convertible securities can be used to take advantage of some of the benefits associated with both debt and equity. Debt with a conversion feature offers investors greater flexibility by providing them with the opportunity to ultimately be either a debtholder or a stock-holder.

Major Financial Asset Instruments

Treasury Bills: Short-term debt obligation backed by the U.S. government with a maturity of less than one year Repurchase Agreements: Contract for a future transaction between two parties to be concluded on a known deal date Federal Funds: Overnight borrowings between banks and other entities to maintain their bank reserves at the Federal Reserve Bankers Acceptances: Promised future payment which is accepted and guaranteed by a bank and drawn on a deposit at the bank Commercial Papers: Unsecured promissory note with a fixed maturity of not more than 270 days Eurodollars: Time deposits denominated in U.S. dollars at banks outside of the United States Negotiable Certificate of Deposit: CD with a face value of $100,000 or more, guaranteed by a bank, that cannot be cashed in before maturity Money Market Funds: Open-ended mutual fund that invests in short-term debt securities such as U.S. Treasury bills and commercial paper Treasury Notes and Bonds: U.S. Treasury securities with maturities of at least one year Municipal Bonds: Long-term debt issued by a local government or agency, generally used to finance public projects Term Loans: Loan from a bank for a specific amount that has a specified repayment schedule Corporate Bonds: Long-term debt issued by a corporation and sold to investors, backed only by the corporation's ability to pay Preferred Stock: Represents a class of ownership in a corporation with a higher claim on its assets and earnings than common stock Common Stock: Represents ownership in a corporation with rights to its assets and earnings after all other claims are satisfied

Mutually Exclusive Projects

Two basic conditions can cause NPV profiles to cross and thus lead to conflicts between NPV and IRR: (1) when project size (or scale) differences exist, meaning that the cost of one project is much larger than that of the other or (2) when timing differences exist, meaning that the timing of cash flows from the two projects differs such that most of the cash flows from one project come in the early years and most of the cash flows from the other project come in the later years, as occurs with Projects S and L. critical issue in resolving conflicts between mutually exclusive projects is this: How useful is it to generate cash flows earlier rather than later? The value of early cash flows depends on the rate at which we can reinvest these cash flows.

Financial ratio analysis

Use of ratios to analyze financial statements. Calculating and interpreting financial ratios to assess a firm's performance and status. -need relative measures that normalize size difference. Effective analysis of financial statements is based on ratios or relative values. -used to determine the company's strengths and weaknesses, its historical performance, and its present financial condition. -Managers use ratios to improve the company's performance. -Creditors use ratios to see whether the firm will be able to repay its debts, while -stockholders want to predict what future dividends and earnings will be.

The Cost of Money

We know that many factors, including conditions in the economy and financial markets, affect the determination of the expected cash flows and the rate people demand when investing their funds; thus, the process of determining value can be fairly complex. In general, when the cost of money increases, the value of an asset decreases. The cost of money - that is, interest rates (returns) - affects the prices of investments. In fact, changes in interest rats can have a significant effect on the prices of stocks and bonds. In general, when the rates in the financial markets increase, the prices (values) of financial assets decrease.

par value

When the market value of debt is the same as its face value, it is said to be selling at par par value, face value, maturity value, and principal valueare used interchangeably to indicate the amount that must be repaid by the borrower.

Indenture

a legal document that spells out any legal restrictions associated with the bond as well as the rights of the bondholders (lenders) and the corporation (bond issuer) trustee, usually a bank, is assigned to represent the bondholders and to guarantee that the terms of the indenture are carried out. restrictive covenants: cover such points as the conditions under which the issuer can pay off the bonds prior to maturity, the level at which various financial measures (such as the ability to pay interest) must be maintained if the company is to sell additional bonds, and restrictions against the payment of dividends when earnings do not meet certain specifications.

hedge fund

a relatively new, innovative, and complex investment that takes many different forms. In simple terms, a hedge fund is a private pool of funds that is constructed for the purpose of generating a specific range of returns, no matter what happens in the general stock market. To do so, hedge fund managers follow complex combinations of investment strategies that include borrowing large amounts of money and taking a variety of investment positions in stocks, bonds, options, swaps, and other derivatives. -private

A cash budget is____.

a statement of a firm's planned inflows and outflows of cash used to ensure that a firm has available cash to meet short-term financial obligations.

repurchase agreement

arrangement in which one firm sells some of its financial assets to another firm with a promise to repurchase the securities at a higher price at a later date. The price at which the securities will be repurchased is agreed to at the time the repo is arranged. One firm agrees to sell the securities because it needs funds, whereas the other firm agrees to purchase the securities because it has excess funds to invest

Short-Term Debt: Banker's Acceptances and Commercial Paper

banker's acceptance might be best described as a post-dated check. More accurately, a banker's acceptance is a time draft - an instrument, issued by a bank, that obligates the bank to pay a specified amount to the owner of the banker's acceptance at some future date. Commercial paper is a type of promissory note, or legal IOU, issued by large, financially sound firms. Like T-bills, commercial paper does not pay interest, so it must be sold at a discount. The maturity on commercial paper varies from 1 to 9 months, with an average of about 5 months. Generally, commercial paper is issued in denominations of $100,000 or more

Spontaneous current liability

changes occur automatically with changes in sales. They must, therefore, be deducted from current assets in order to find the net change in short-term investment for the determination of free cash flow.

During recessions, the demand for funds typically ____

decreases

Which of the following is not a cash disbursement?

depreciation expenses

yield

dollar return as a percentage of the dollar amount that was originally invested

The sustainable growth model gives managers a kind of shorthand projection that ties together _____ and ______.

growth objectives; financial needs

Payback Period (PB)

how long it will take a project to repay its initial investment (cost) from the cash flows it is expected to generate in the future. Thus, many firms compute a project's traditional payback period (PB), which is defined as the expected number of years required to recover the original investment (the cost of the asset). -Payback is the simplest and, as far as we know, the oldest formal method used to evaluate capital budgeting projects PB= # of yrs b4 year of full recovery of initial investment + (amount of initial investment/total cash flow generated during recovery year) -payback ignores the time value of money, relying solely on this method could lead to incorrect decisions - at least if our goal is to maximize value.

The one fixed asset that is not depreciated is _________

land

Most pro forma statements begin with a sales forecast. One approach to deriving a sales forecast is the top-down approach. Top-down sales forecasts rely heavily on_____.

macroeconomic and industry forecasts.

Price System

most capital in the U.S. economy is allocated through the price system

Securities and Exchange Commission

pproves indentures for publicly traded bonds and verifies that all indenture provisions have been met before allowing a company to sell new securities to the public.

Multiple IRR

projects with unconventional cash flow patterns present unique difficulties when the IRR method is used, including the possibility of multiple IRRs. There exists an IRR solution for each time the direction of the cash flows associated with a project is interrupted - that is, inflows change to outflows. COF refers to cash outflows (all negative numbers) and CIF refers to cash inflows (all positive numbers) associated with a project. The future value of the cash inflows is also called the terminal value, or TV. MIRR is superior to the regular IRR as an indicator of a project's "true" rate of return, or "expected long-term rate of return," but the NPV method is still better for choosing among competing projects that differ in size because it provides a better indicator of the extent to which each project will increase the value of the firm; thus, NPV is still the recommended approach.

Which of the following is NOT a source of equity on a firm's balance sheet?

property, plant, and equipment

A ____ is a financial instrument which gives the owner the tight, but not the obligation, to sell shares of stock at a specified price during a particular time period

put option

Required rate of return (r) = Risk-free rate + Risk premium Rate of return (r) = Rf + [DRP + LP + MRP]

r = the quoted, or nominal, rate of interest on a given security. There are many different securities, hence many different quoted interest rates. Rf = the quoted risk-free rate of return. Theoretically, this rate is the return associated with an investment that has a guaranteed outcome in the future - that is, it has no risk. DRP = Default Risk Premium, which reflects the chance that the borrower - that is, the issuer of the security - will not pay the debt's interest or principal on time. LP = Liquidity Premium, which reflects the fact that some investments are more easily converted into cash on a short notice at a "reasonable price" than are other securities. This is also called the marketability premium. MRP = Maturity Risk Premium, which accounts for the fact that longer-term bonds experience greater price reactions to particular interest rate changes than do short-term bonds. The risk premium on a security is the portion of the expected or required return that exceeds the risk-free rate of return, and thus represents payment for the risk associated with an investment. Risk Premium = DRP + LP + MRP. The nominal, or quoted, risk-free rate, Rf, is the interest rate on a security that has absolutely no risk at all - that is, one that has a guaranteed outcome in the future regardless of the market conditions.

Nominal, or Quoted, Risk-Free Rate of Interest

real risk-free rate of interest, r*, is an economic term defined as the interest rate that would exist on a security with a guaranteed payoff - that is, a risk-free security - if inflation is expected to be zero during the investment period. The difference between the quoted interest rate on a T-bond and that on a corporate bond with similar maturity, liquidity, and other features is the default risk premium (DRP).

Short-Term Debt: Money Market Mutual Funds

represent funds that are pooled and managed by investment companies for the purpose of investing in short-term financial assets. Investment companies accept money from savers and then use these funds to buy various types of financial assets.

A _____ is an agreement between two firms where one firm agrees to sell some of its financial assets to another and then buy the financial assets back from the firm at a later time.

repurchase agreement

Generally Accepted Accounting Principles (GAAP)

require public companies to generate financial statements based on widely accepted accounting rules. developed by the Financial Accounting Standards Board (FASB), a body that examines controversial accounting topics and issues standards that, in terms of their impact on accounting practices, almost have the force of law.

All else equal, investors generally prefer to hold ______________ securities because such securities are less sensitive to changes in interest rates and provide greater investment flexibility than their counterpart.

short-term

expectations theory

states that the yield curve depends on expectations concerning future inflation rates. Expectations can be used to help forecast interest rates.

cost of capital

the annual percentage cost of an average dollar of long-term funds employed in the firm from all sources and given the firms proportional mix of those sources, which is called its capital structure.

Factors That Affect the Cost of Money

the firm's production opportunities, investors' time preferences for consumption, risk, and inflation.

Stockholders' equity - 4 Account Types

the owners' residual share of the business including their original investment plus any money the firm has made and retained since its inception. This figure does not, and is not intended to, reflect the current market value of the stock. 4 Types of Accounts: 1. Preferred Stock shows the total proceeds from the sale of preferred stock. This form of ownership has preference over common stock when the firm distributes income and assets. 2. Common Stock (sometimes listed as Common Stock at Par Value) equals the number of outstanding common shares multiplied by the par value per share. Par value (often $1) is an artifact of earlier pre-computer accounting methods used to track the number of outstanding shares. It has no relation to the actual value of the shares. 3. Paid-in-capital in excess of par equals the number of shares outstanding multiplied by the original selling price of the shares, net of the par value. The combined value of common stock and paid-in-capital equals the proceeds the firm received when it originally sold shares to investors (including initial public offerings and rights offerings). 4. Retained earnings are the cumulative total of the earnings that the firm has reinvested in its assets and operations since its inception. Retained earnings are not a reservoir of unspent cash. When the retained earnings "vault" is empty, it is because the firm has already reinvested the earnings in new assets and/or has paid common stock dividends. -Treasury Stock entry records the value of common shares that the firm currently holds in reserve. Usually, treasury stock appears on the balance sheet because the firm has reacquired previously issued stock through a share repurchase program. - Stockholder's equity is a permanent funding source for the company that never matures and does not require repayment for as long as the company exists. -referred to as the book value of equity, to distinguish it from the market value which is not shown on the balance sheet -sum of all of the other amounts in this section

market segmentation theory

the slope of the yield curve depends on supply/demand conditions in the long-term and short-term markets. The yield curve could at any given time be flat, upward sloping, or downward sloping and have humps or dips. Interest rates would be high in a particular segment compared to other segments when there was a low supply of funds in that segment relative to demand, and vice versa. corporate bonds: r = Rf + [DRP + LP +MRP] = [r* + IP] + [DRP + LP + MRP]

Capital Budgeting Evaluation Techniques (NPV)

three most popular methods used by businesses to evaluate capital budgeting projects are (1) net present value (NPV), (2) internal rate of return (IRR), and (3) payback period (PB). If the estimated NPV for a project is positive, then it is an acceptable investment because the value of the company will be increased. If the NPV is negative, then the project should be rejected because it will decrease the value of the company if it is undertaken. An NPV of zero would indicate that the project will have no effect on the value of the company. NPV> 0 -> Accept (increase value) NPV <0 -> Reject (decrease value) NPV is a discounted cash flow technique that uses time value of money concepts. A graph that shows a project's NPV at various discount rates (required rates of return) is termed the project's net present value (NPV) profile. *Note that the IRR formula is simply the NPV formula solved for the particular discount rate that forces the NPV to equal zero. Thus, the same basic equation is used for both methods.

International Financial Reporting Standards (IFRS)

used in many countries as the regulatory basis for the preparation of financial statements. designed to provide a common global language for financial reporting, particularly in the European Union, so published financial information is comparable across international boundaries -not adopted by U.S.

maturity risk premium (MRP)

which is higher the longer the time to maturity. Everything else equal, maturity risk premiums raise interest rates on long-term bonds relative to those on short-term bonds. he prices of long-term bonds decline sharply whenever interest rates rise. Because interest rates can and do occasionally rise, all long-term bonds - even Treasury bonds - have an element of risk called interest rate price risk.

Balance Sheet

A firm's balance sheet presents a "snapshot" view of the company's financial position at a specific moment in time. a firm's assets must equal the combined value of its liabilities and stockholders' equity. The basic balance sheet equation is Assets = Liabilities + Stockholders' Equity. Thus, creditors and equity investors finance all of a firm's assets. Three sections: Assets, liabilities, stockholders equity. Liquidity: length of time it takes to convert accounts into cash during the normal course of business. most liquid asset (cash) appears first, and the least liquid (fixed assets) comes last.

Financial Planning

A long-term financial plan begins with strategy. Typically, the senior management team analyzes the markets in which the firm competes and tries to identify ways to protect and increase the firm's competitive advantage in those markets -not an exact science and will always involve uncertainty -Firms frequently set planning goals in terms of target growth rates, typically annual growth in sales or assets. A firm's growth can be measured by increases in its market value, its asset base, the number of people it employs, or any number of other metrics. Most firms define and measure growth targets in terms of sales as well. Long Term Planning: In what emerging markets might we have a sustainable competitive advantage? How can we leverage our competitive strengths across existing markets in which we currently do not compete? How can we respond to any threats to our current business? In which geographic regions should we produce? Where should we sell? Can we deploy resources more efficiently by exiting certain markets and using those resources elsewhere? Increase in assets = increase in liabilities+ increase in equity

Balance Sheet Assets

Cash and cash equivalents are assets such as checking account balances at commercial banks that can be used directly as means of payment. Marketable securities represent liquid short-term investments, which financial analysts view as a form of "near cash." They include Treasury notes, commercial paper, and others. Accounts receivable represent the amount customers owe the firm from sales made on credit. Inventories include raw materials, work in process (partially finished goods), and finished goods held by the firm. Intangible assets include items such as patents, trademarks, copyrights, or mineral rights entitling the company to extract oil and gas on specific properties. Gross property, plant, and equipment (PP&E) is the original cost of all real property, structures, and long-lived equipment owned by the firm. Net property, plant, and equipment is calculated as Gross PP&E less accumulated depreciation - the cumulative expense recorded for the depreciation of fixed assets since their purchase; this reflects a decline in the asset's economic value over time. The one fixed asset that is not depreciated is land because it seldom declines in value.

Bond

a long-term contract under which a borrower agrees to make payments of interest and principal on specific dates to the bondholder. periodic interest payments on bonds are determined by the coupon rate and the principal, or face, value of the bond. The coupon rate represents the total interest paid each year, stated as a percentage of the bond's face value.

A company's balance sheet shows the value of assets, liabilities, and stockholders' equity _____.

at a specific point in time

A company's balance sheet shows the value of assets, liabilities, and stockholders' equity______

at a specific point in time

Corporate Bonds Calls

call provision, which gives the issuing corporation the right to call the bonds for redemption prior to maturity. A call provision generally states that the company must pay the bondholders an amount greater than the par value for the bonds when they are called. call premium: additional sum, typically equals one year's interest if the bonds are called during the first year in which a call is permitted. The premium declines at a constant rate each year thereafter. call protection: Bonds usually are not callable until several years (generally 5 to 10) after they are issued. Bonds with such deferred calls

preemptive right

requires a firm to offer existing stockholders shares of a new stock issue in proportion to their ownership holdings before such shares can be offered to other investors. reemptive right protects stockholders against the dilution of value that would occur if new shares were sold at relatively low prices.

Preferred stock/hybrid security

similar to bonds in some respects and similar to common stock in other respects. The hybrid nature of preferred stock becomes apparent when we try to classify it in relation to bonds and common stock. Most preferred stock has a par value or its equivalent under some other name - for example, liquidation value.

Profitability Ratios

-Gross profit margin measures the percentage of each sales dollar remaining after the firm has paid for its goods. The higher the gross profit margin, the better. -Operating profit margin measures the percentage of each sales dollar remaining after deducting all costs and expenses other than interest and taxes. Ratio tells analysts what a firm's bottom line looks like before deductions for payments to creditors and tax authorities Gross profit margin= sales-cost of goods sold/sales operating profit margin= operating profit/sales -Net profit margin measures the percentage of each sales dollar remaining after deducting all costs and expenses including interest, taxes, and preferred stock dividends. Net profit margins vary widely across industries, so comparing a company's figure to industry averages is an important part of the performance analysis. Net profit margin= earnings available for common stockholders/sales Earnings per Share (EPS): -investing public considers to be a primary indicator of corporate success -represents the number of dollars earned on behalf of each outstanding share of common stock during the period. Many firms tie management bonuses to specific EPS targets -EPS is not the same as dividends. The amount of earnings actually distributed to each shareholder is the dividend per share. EPS= earnings avail for common stockholders/common shares outstanding

Developing the Statement of Cash Flows

-can be historical or forward looking -can show how the company has spent money and where it has received money in the past, or it can be used to predict what funds will be needed in the future.

current ratio

-most common -measures the firm's ability to meet its short-term obligations -current assets divided by current liabilities Current ratio= current assets/current liabilities -The more predictable a firm's cash flows, the lower the acceptable current ratio

quick (acid-test) ratio

-similar to the current ratio except that it excludes inventory -provides a better measure of overall liquidity only when a firm's inventory cannot be easily converted into cash. If inventory is liquid, then the current ratio is the preferred measure. Quick ratio= current assets-inventory/current liabilities Low liquidity of inventory 2 factors: 1. Many types of inventory cannot be easily sold because they are partially completed items, special-purpose items, etc; 2. Inventory is typically sold on credit, so it becomes an account receivable before being converted into cash.

Types of Financial Ratios

1. Creditors are primarily interested in ratios that measure the firm's short-term liquidity and its ability to make interest and principal payments. A secondary concern of creditors is profitability; they want assurance that the business is healthy and will continue to be successful. 2. Present and prospective shareholders focus on ratios that measure the firm's current and future levels of risk and return, because these two dimensions directly affect share price. 3. firm's managers use ratios to generate an overall picture of the company's financial health and to monitor its performance from period to period and examine unexpected changes in order to isolate developing problems. Complications: a normal ratio in one industry may be highly unusual in another. analysts compare the financial ratios in the current year with previous years' ratios and hope to identify trends that will aid in evaluating the firm's prospects. In addition, analysts compare the ratios of one company with those of other "benchmark" firms in the same industry (or to an industry average obtained from a trade association or third-party provider).

Cash Flow Divided (3 Types)

1. Operating Flows, which are the cash inflows and outflows directly related to the production and sale of products or services; 2. Investment Flows, which are cash flows associated with the purchase or sale of fixed assets and business equity; 3. Financing Flows, which result from debt and equity financing transactions.

Sustainable Growth Model

1. gives managers a shorthand projection that ties together growth objectives and financing needs. 2. provides hints about the levers that managers must pull in order to achieve growth beyond the sustainable rate. 3. identifies some financial benefits of growing more slowly than the sustainable rate. starts with a balance sheet identity, adds a few assumptions, and ultimately derives an expression that determines how rapidly a firm can grow while maintaining a balance between its outflows (increases in assets) and inflows (increases in liabilities and equity) of funds. Specifically, the sustainable growth model assumes the following: 1. The firm's only form of equity is common stock (E), and it will not issue new shares of common stock next year. 2. The firm's total asset turnover ratio, the ratio of sales divided by total assets (S/A), remains constant. 3. The firm pays out a constant fraction, d, of its earnings as dividends. 4. The firm maintains a constant assets-to-equity ratio (A/E). 5.The firm's net profit margin, m, is constant.

Real and Financial Assets

A real asset sometimes is called a physical asset because it typically is a tangible (that is, physically observable) item, such as a computer, a building, or an inventory item a financial asset is intangible because it represents an expectation, or promise, that future cash flows will be paid to the owner of such an asset. -a financial asset can be classified as debt, equity, or a derivative. -A company invests in real assets such as inventories and fixed assets to generate revenue and returns

Statement of Cash Flows

A statement of cash flows can be historical or forward looking. In other words, it can show how the company has spent money and where it has received money in the past, or it can be used to predict what funds will be needed in the future. Provides a summary of what cash has gone into and out of a firm because of its operations, investments, and financing activities during a year. It isolates the firm's operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the year. Financial managers are primarily focused on cash flow. -In the process of evaluating a firm's cash flows, analysts view cash and marketable securities as perfect substitutes. Both represent a reservoir of liquidity that increases with cash inflows and decreases with cash outflows. --Notes to financial statements are useful to managers and analysts. Provides info on accounting policies, calculations, and transactions that underlie entries in the financial statements.

3 Types of Liability Accounts

Accounts Payable are the amounts owed for credit purchases by the firm. -Accounts payable and accruals are often called spontaneous liabilities or spontaneous financing because they tend to change directly with changes in sales. Notes Payable are outstanding short-term loans, typically from commercial banks. Accrued Expenses are costs that have been incurred by the firm that have not yet been paid. Examples of accruals include taxes owed to the government and wages due to employees. Long-term DEBT: debt that matures more than one year in the future

DuPont System of Analysis

Approach uses both income statement and balance sheet information to break the ROA and ROE ratios into component pieces. It highlights the influence of both the net profit margin and the total asset turnover on a firm's profitability. In the DuPont system, the return on total assets equals the product of the net profit margin and total asset turnover: ROE - Net profit margin, total asset tournover, assets to equity

Assets

Assets include everything that can be used to benefit the business or give the company the right to receive benefits Current: easy to sell and turn into cash Fixed: physical assets like buildings and equipment

Short-Term Debt: Certificate of Deposit and Eurodollar Deposit

Certificate of deposit (CD) represents a time deposit at a bank or other financial institution. Traditional CDs generally earn periodic interest and must be kept at the institution for a specified time period. Negotiable CDs, however, can be traded to other investors prior to maturity because they can be redeemed by whomever owns them at maturity. Often called jumbo CDs, these financial assets typically come in denominations of $1 million to $5 million. They have maturities that range from a few months to a few years. A Eurodollar deposit is a deposit in a bank outside the United States that is not converted into the currency of the foreign country; instead, it is denominated in U.S. dollars. Such deposits are not exposed to exchange rate risk, which is the risk associated with converting dollars into foreign currencies

common stock

Each corporation issues at least one type of stock, or equity, most equity takes the form of common stock, and preferred shareholders have preference over common shareholders when a firm distributes funds to stockholders. -Dividends, as well as liquidation proceeds resulting from bankruptcy, are paid to preferred stockholders before common stockholders receive any payouts. Types: Some companies are so small that their common stocks are not actively traded; they are owned by only a few people, usually the companies' managers. Such firms are said to be privately owned, or closely held, corporations, and their stock is called closely held stock. stocks of most larger companies are owned by a large number of investors, most of whom are not active in management. Such companies are said to be publicly owned corporations, and their stock is called publicly held stock.

EVA = NOPAT - [WACC x (Total Assets - Current Liabilities)]

Economic value added (EVA®) is the difference between net operating profits after taxes (NOPAT) and the cost of funds. When applied correctly, EVA prompts managers to make the same investment decisions that the net present value (NPV) method directs them to do

Foreign Debt & Eurodebt

Foreign debt is debt sold by a foreign borrower but denominated in the currency of the country in which the issue is sold. Eurodebt is used to designate any debt sold in a country other than the one in whose currency the debt is denominated The institutional arrangements by which Eurobonds are marketed are different than those for most other bond issues, with the most important distinction being a far lower level of required disclosure than normally applies to bonds issued in domestic markets, particularly in the United States. -issued in bearer form rather than as registered bonds, so the names and nationalities of investors are not recorded Eurocredits are bank loans that are denominated in the currency of a country other than that where the lending bank is located. Many of these loans are very large, so the lending bank often forms a loan syndicate to help raise the needed funds and to spread out some of the risk associated with the loan. Euro-commercial paper (Euro-CP) is similar to commercial paper issued in the United States. This short-term debt instrument is issued by corporations, typically with a maturity of 1, 3, or 6 months. Euronotes are medium-term debt issues, typically with maturities ranging from 1 to 10 years. The general features of Euronotes closely resemble those of longer term debt instruments such as bonds. The principal amount is repaid at maturity, and interest often is paid semiannually. Most foreign companies use Euronotes just as they would a line of credit, continuously issuing notes to finance medium-term needs.

Common Bonds

Government bonds are issued by the U.S. government, state governments, and local or municipal governments. U.S. government bonds are issued by the U.S. Treasury and are called either Treasury notes or Treasury bonds. Both types of debt pay interest semiannually. Municipal bonds, or munis, are similar to Treasury bonds, except that they are issued by state and local governments. Revenue bonds are used to raise funds for projects that generate revenues that contribute to payment of interest and the repayment of the debt. General obligation bonds are backed by the government's ability to tax its citizens; special taxes or tax increases are used to generate the funds needed to service such bonds. Corporate bonds resemble term loans, but a bond issue generally is advertised, offered to the public, and sold to many different investors. a mortgage bond, the corporation pledges certain assets as security, or collateral, for the bond Second mortgages are sometimes called junior mortgages because they are junior in priority to the claims of senior mortgages, or first mortgage bonds. debenture is an unsecured bond. As such, it provides no lien, or claim, against specific property as security for the obligation subordinated debenture is an unsecured bond that ranks below, or is "inferior to," other debt with respect to claims on cash distributions made by the firm Income bonds pay interest only when the firm has sufficient income to cover the interest payments. Putable bonds are bonds that can be turned in and exchanged for cash at the bondholder's option Indexed, or purchasing power, bonds are popular in countries plagued by high rates of inflation. Floating-rate bonds are similar to indexed bonds except the coupon rates on these bonds "float" with market interest rates rather than with the inflation rate. -limits are imposed on how high and low (referred to as "caps" and "collars," respectively) original issue discount bonds (OIDs), commonly referred to as zero coupon bonds, were created. These securities were offered at substantial discounts below their par values because they paid little or no coupon interest. the junk bond, a high-risk, high-yield bond often issued to finance a management buyout (MBO), a merger, or a troubled company

Inflows Increase in any liability Net income (profit after taxes) Depreciation and non-cash charges Sale of common or preferred stock

Increase in any asset Decrease in any liability Net loss Dividends paid Repurchase or retirement of stock A decrease in an asset (such as inventory) is an inflow of cash because cash that has been tied up in the asset is released and can be used for some other purpose, such as repaying a loan. In contrast, an increase in inventory (or any other asset) is an outflow of cash because additional inventory ties up more of the firm's cash.

Bond Contract

Indenture: legal document that identifies restrictions of the bond and the rights of those involved Trustee: assigned to represent the bondholders and to ensure the terms of the indenture are upheld Restrictive Covenant: part of the indenture that covers multiple conditions and restrictions Call Provisions: gives the issuing corporation the right to call the bonds for redemption prior to maturity Sinking Funds: provision that facilitates the orderly retirement of a bond issue Conversion Feature: permits the bondholder to convert the bond into shares of common stock at a fixed price

Why is the quick ratio a more appropriate measure of liquidity than the current ratio for a large-airplane manufacturer?

It excludes inventory from the numerator of the ratio because it is difficult to convert inventory to cash and most sales are made on a credit basis. The quick ratio provides a better measure of overall liquidity only when a firm's inventory cannot be easily converted into cash. If inventory is liquid, then the current ratio is the preferred measure.

Which of the following statements is correct?

Large costs occur at the end of nuclear power plants' lives because these plants have to be closed down, and shutdown costs are high due to the difficulty of handling radioactive materials. For this reason, it is possible that a nuclear plant project could have two IRRs

Matching Ratio Types 1. Liquidity Ratios 2. Activity Ratio 3. Debt Ratio 4. Profitability Ratio 5. Market Ratio

Matching Ratio Types 1. Current Ratio & Quick (Acid Test) Ratio 2. Turnover ratios & Collection/Payment Period 3. Debt-to-Equity Ratio & Times Interest Earned (TIE) 4. Profit Margin & Return on Assets 5. Price/Earnings (P/E) Ratio & Market-to-Book Ratio

Debt Ratios

Measure the extent to which a firm uses money from creditors rather than from stockholders to finance its operations. -measures the proportion of total assets financed by the firm's creditors -debt comes in many forms from many different lenders. Firms borrow from suppliers, banks, and investors who buy publicly traded bonds. Equity comes from stockholders Creditors' claims must be satisfied before firms can distribute earnings to stockholders, current and prospective investors pay close attention to the debt on the balance sheet Coverage ratios, focuses more on income statement measures of the firm's ability to generate sufficient cash flow to make scheduled interest and principal payments. Investors and credit-rating agencies use both types of ratios to assess a firm's creditworthiness. Debt ratio= total liabilities/total assets Assets-to-equity (A/E) ratio, sometimes called the equity multiplier. This ratio is calculated as total assets divided by common stock equity. assets-to-equity (A/E) ratio, sometimes called the equity multiplier. This ratio is calculated as total assets divided by common stock equity. high equity multiplier indicates high debt and low equity, whereas a low equity multiplier indicates low debt and high equity. Debt-to-equity ratio: alternative measure that focuses solely on the firm's long-term debt. calculated as long-term debt divided by stockholders' equity *A word of caution: Both the debt ratio and the debt-to-equity ratio use book values of debt, equity, and assets. times interest earned ratio measures the firm's ability to make contractual interest payments. It equals earnings before interest and taxes divided by interest expense. A higher ratio indicates a greater capacity to meet scheduled payments.

ROA/ROE

Measures management's overall effectiveness in using the firm's assets to generate returns to common stockholders. -to improve ROA, a firm needs to improve its cost control, for example, by reducing labor costs, purchases, and overhead; or the company needs to increase its revenues through higher pricing or changing its product mix or volumes ROA= Return on total assets (ROI) ROE= captures the return earned on the common stockholders' (owners') investment in the firm. -Return on common equity a firm that uses only common stock to finance its operations, the ROE and ROA figures will be identical.

Market Ratios

Relate the firm's market value, as measured by its current share price, to certain accounting values. These ratios provide insight into how investors think the firm is performing, and they also reflect the average common stockholder's assessment of the firm's expected future performance given information about the past. Price/earnings (P/E) ratio measures the amount investors are currently willing to pay for each dollar of the firm's current earnings. Investors often use the P/E ratio, the most widely quoted market ratio, as a barometer of a firm's long-term growth prospects and of investor confidence in the firm's future performance. A high P/E ratio indicates investors' belief that a firm will achieve rapid earnings growth in the future; hence, companies with high P/E ratios are referred to as growth stocks. Simply stated, investors who believe that future earnings are going to be higher than current earnings are willing to pay more for today's earnings, and vice versa. price/earning ratio= market price per common share/ earning per share Market/Book (M/B) ratio provides another assessment of how investors view the firm's performance. It relates the market value of the firm's shares to their book value. Book value per share = common stock equity/common shares outstanding

Stockholders

The last entry. Stockholders' equity is the owners' residual share of the business, including their original investment plus any money the firm has earned and retained since its inception. --stockholders equity Includes preferred stock, common stock, paid-in-capital in excess of par, and retained earnings. However, the net worth of the firm includes only the common stock, paid-in-capital in excess of par, and retained earning.

Debt Features

debt is a loan to a firm, a government, or an individual. Many types of debt instruments exist: home mortgages, commercial paper, term loans, bonds, secured and unsecured notes, and marketable and nonmarketable debt, among others -Debtholders have priority over stockholders with regard to distribution of earnings and liquidation of assets. That is, they must be paid before stockholders can be paid. Features: Secured or unsecured? Principal repayment value (amount borrowed) Single or multiple cash inflows? Interest rate and type (fixed, variable, or deducted from the original loan amount) Time to maturity Frequency of payments (single, monthly, quarterly, etc.) Presence of balloon payment? (Is the last payment larger than the rest?) Amortizing or not? (Does the balance decline over time?)

Liabilities

debts that the firm owes to others Current liabilities: due within one year, while long-term debt liabilities are due after more than a year, (e.g., bonds, mortgages, long-term loans, etc.). Long-term liabilities: include deferred taxes and long-term debt. Current liabilities: must be paid within one year and include accounts payable, notes payable, and accrued expenses. Long-term liabilities: due after more than a year and include deferred taxes and long-term debt.

Treasury bills (T-bills)

discounted securities issued by the U.S. government to finance operations. When the U.S. Treasury issues T-bills, the prices are determined by an auction process where interested investors and investing organizations submit competitive bids for the T-bills offered. T-bills are issued electronically with face values ranging from $1,000 to $5 million, and with maturities of 4, 13, 26, or 52 weeks at the time of issue.

Derivatives

drefers to financial assets that have values based on, or derived from, the values of other assets, such as stocks or bonds. Without the other assets, derivatives would be worthless. Because the values of derivatives depend on the values of other assets, they can be rather complex investments. An option is a contract that gives its holder the right to buy (sell) an asset at some predetermined price within a specified period of time. "Pure options" are instruments that are created by outsiders (generally investment firms) rather than by the firm itself; they are bought and sold primarily by investors (or speculators). call option gives the holder the right to purchase, or call in, shares of a stock for purchase at a predetermined price at any time during the option period put option gives the holder the right to sell, or put out, shares of a stock at a specified price during the option period transaction price established in the option contract - that is, the purchase price for a call and the selling price for a put - is called the striking, or exercise, price.

principal value of debt

epresents the amount owed to the lender, which must be repaid at some point during the life of the debt. For much of the debt issued by corporations, the principal amount is repaid at maturity. often refer to principal value as maturity value. principal value generally is written on the "face" - that is, the outside cover - of the debt instrument, so it is sometimes called the face value.

Income Statement Entries of Net Income

f a firm has preferred stock, it deducts preferred stock dividends from net income. Net income less preferred stock dividends is earnings available for common stockholders. Dividing earnings available for common stockholders by the number of shares of common stock outstanding results in earnings per share (EPS). Earnings per share represents the amount earned during the period on each outstanding share of common stock. The final entry in the income statement is the cash dividend per share (DPS) paid to common stockholders.

Futures and Swaps

futures contract represents an arrangement for delivery of an item at some date in the future; the details of the delivery, including the amount to be delivered and the price that will be paid at delivery, are specified when the futures contract is created. A swap is an agreement to exchange, or swap, cash flows or assets at some time in the future

Short-Term Debt

generally refers to debt with a maturity of 1 year or less

Most firms, when focusing on growth, focus on ________.

meeting sales target growth rates.

sinking fund

provision that facilitates the orderly retirement of a bond issue. Typically, the sinking fund provision requires the firm to retire a portion of the bond issue each year. Failure to meet the sinking fund requirement will throw the bond issue into default, which might force the company into bankruptcy. A conversion feature permits the bondholder (investor) to exchange, or convert, the bond into shares of common stock at a fixed price.

Free Cash Flow (FCF)

the amount of cash flow available to investors - the providers of debt and equity capital. It represents the net amount of cash flow remaining after the firm has met all operating needs and has made all required payments on both long-term (fixed) and short-term (current) investments. -calculated in two steps. STEP 1: First, we must examine the firm's net operating profits after taxes (NOPAT), which is the firm's earnings before interest and after taxes NOPAT = EBIT x (1-T) T is corp tax rate Adding depreciation back into NOPAT yields operating cash flow (OCF), which is the amount of cash flow generated by the firm's operations OCF = NOPAT + Depreciation = [EBIT x (1-T)] + Depreciation Noncash charges - such as depreciation, amortization, and depletion allowances - are expenses that appear on the income statement but do not involve an actual outlay of cash STEP 2: convert operating cash flow to free cash flow by deducting the firm's change (denoted by the Greek letter Delta, the "change" symbol ∆) in net investments, fixed assets, and current assets from operating cash flow. FCF = OCF − ∆FA − (∆CA − ∆AP − ∆Accruals) ∆FA = change in gross fixed assets ∆CA = change in current assets ∆AP = change in accounts payable ∆accruals = change in accrued expenses

Book Value & Net PP&E

the amount shown for Net PP&E is not intended to reflect the true current value of these assets. The true value cannot be known unless the assets are sold. Net PP&E on the balance sheet is the total "book value" of the assets, which is the original cost of the assets less accumulated depreciation to date. Depreciation is taken according to standardized formulas and does not reflect the reduction in actual value of the assets which can vary for many reasons. assets are listed at book value rather than market value (and for other reasons as well), the Total Assets figure on the balance sheet is not, and is not intended to be, an accurate indicator of the current value of the company. Information provided in financial statements must be objective and verifiable. True values for most assets can only be estimated until they are sold, it is not possible to compile them through objective and verifiable calculations.

A & B Bonds

triple-A and double-A bonds are extremely safe. Single-A and triple-B bonds are strong enough to be called investment-grade bonds; Double-B and lower-rated bonds are speculative, or junk bonds; they have a significant probability of going into default, and many financial institutions are prohibited from buying them.