BUS: Chapter 9, Finance

Explain how financial managers evaluate capital budgeting proposals to identify the best long-term investment options for their company.

Capital budgeting is the process financial managers use to evaluate major long-term investment opportunities. Capital budgeting investments are expected to generate cash flows for many years, so financial managers must take the time value of money into account. The time value of money recognizes that the sooner a cash flow is received, the sooner it can be reinvested to earn more money. Financial managers take the time value of money into account by computing the present values of all cash flows the proposal will generate. The present value of a sum of money received in the future is the amount of money today that will become that future amount if it is invested at a specified rate of interest. The net present value (NPV) of the project is the sum of the present values of all the estimated future cash flows, minus the initial cost of the investment. If the NPV of a project is positive, it will increase the value of the firm. If the NPV is negative, it will decrease the value of the firm.

Identify the key issues involved in determining a firm's capital structure.

Capital structure refers to the mix of equity and debt financing a firm uses to meet its financing needs. Debt financing enables the firm to finance activities without requiring the owners to put up more money. When the firm earns more on borrowed funds than it pays in interest, the excess goes to the owners, thus magnifying the return on their investment. And the interest payments on debt are tax deductible. However, the interest payments and the requirement to repay the amount borrowed can put a strain on companies when business conditions are poor. Equity financing is safer and more flexible than debt financing. But dividend payments are not tax deductible. And issuing new stock can dilute the ownership share of existing stockholders.

financial ratio analysis

Computing ratios that compare values of key accounts listed on a firm's financial statements.

dividing net income of a firm minus preferred dividends by the average number of shares of common stock outstanding.

Earnings per share (EPS) is calculated by:

Evaluate the major sources of funds available to meet a firm's short-term and long-term financial needs.

Established firms have several sources of short-term funds, including bank loans, trade credit, factoring, and commercial paper. Trade credit arises when suppliers ship materials, parts, or goods to a firm without requiring immediate payment. Banks extend short-term loans to firms with good credit ratings. Factors provide immediate cash to firms by purchasing their accounts receivable at a discount. Major corporations sometimes raise funds by selling commercial paper, which are short-term IOUs. Firms that want to build up their permanent financial base have two basic options. First, they can rely on equity financing, which consists of funds provided by owners. The second option is long-term debt financing.

asset management ratios

Financial ratios that measure how effectively a firm is using its assets to generate revenues or cash.

liquidity ratios

Financial ratios that measure the ability of a firm to obtain the cash it needs to pay its short-term debt obligations as they come due.

spontaneous financing

Financing that arises during the natural course of business without the need for special arrangements.

Describe how financial managers acquire and manage current assets.

Firms must have cash, but cash earns little or no interest. Firms with a surplus of cash often hold cash equivalents such as T-bills, commercial paper, and money market mutual funds to earn interest. Accounts receivable are what customers who buy on credit owe to a firm. Firms must establish credit policies that balance the higher sales generated by accounts receivable against these risks that credit customers might not make their payments. Inventories are the stocks of materials, work in process, and finished goods a firm holds. For many firms, the costs of storing, handling, and insuring inventory items are significant. In recent years, many firms have become very aggressive about keeping inventories as low as possible.

debt financing

Funds provided by lenders (creditors).

equity financing

Funds provided by the owners of a company.

Identify the goal of financial management and explain the issues financial managers confront as they seek to achieve this goal.

Historically, the goal of financial management has been to maximize the value of the firm to its owners. But many of today's businesses have adopted a broader perspective, believing that they have responsibilities not just to stockholders but also to customers, employees, and other stakeholders. Treating these other stakeholders well often builds value, which benefits stockholders, but other stakeholder groups also sometimes have goals that conflict with those of stockholders. When this happens, financial managers generally adopt the policies they believe are most consistent with the interests of ownership. Another challenge that financial managers face is the need to find the appropriate balance between risk and return. The risk-return trade-off suggests that sources and uses of funds that offer the potential for high rates of return tend to be riskier than those that offer lower returns.

pro forma financial statements

In the context of basic financial planning tools, the budgeted income statement and budgeted balance sheet are referred to as _____.

Describe the tools financial managers use to evaluate their company's current financial condition and develop financial plans.

One way financial managers evaluate the firm's current financial condition is by computing ratios based on key accounts listed on their firm's financial statements. Financial managers look at four basic types of ratios. Liquidity ratios indicate whether the firm will have enough cash to pay its short-term liabilities as they come due. Asset management ratios tell financial managers how effectively a firm is using various assets to generate revenues for their firm. Leverage ratios measure the extent to which a firm relies on debt in its capital structure. Profitability ratios measure the firm's overall success at using resources to create a profit for its owners. The budgeted income statement, the budgeted balance sheet, and the cash budget are the key tools that financial managers use to develop and present their financial plans. The budgeted income statement develops a forecast of net income for the planning period. The budgeted balance sheet forecasts the types and amounts of assets the firm will need to implement its plans, and the amount of additional financing necessary to obtain those assets. The cash budget identifies the timing of cash inflows and outflows to help the firm identify when it will have shortages and surpluses of cash.

leverage ratios

Ratios that measure the extent to which a firm relies on debt financing in its capital structure.

profitability ratios

Ratios that measure the rate of return a firm is earning on various measures of investment.

cash equivalents

Safe and highly liquid assets that many firms list with their cash holdings on their balance sheet.

commercial paper

Short-term (and usually unsecured) promissory notes issued by large corporations.

U.S. Treasury bills (T-bills)

Short-term marketable IOUs issued by the U.S. federal government.

trade credit

Spontaneous financing granted by sellers when they deliver goods and services to customers without requiring immediate payment.

inventory turnover ratio

The _____ is computed by dividing a firm's cost of goods sold by average inventory levels.

leverage ratio

The _____ is computed by dividing a firm's total liabilities by its total assets.

present value

The amount of money that, if invested today at a given rate of interest (called the discount rate), would grow to become some future amount in a specified number of time periods.

risk

The degree of uncertainty regarding the outcome of a decision.

finance

The functional area of business that is concerned with finding the best sources and uses of financial capital.

financial capital

The funds a firm uses to acquire its assets and finance its operations.

fiduciary duty

The legal and ethical obligation of financial managers to make decisions consistent with the financial interests of their firm's owners is called their _____.

capital structure

The mix of equity and debt financing a firm uses to meet its permanent financing needs.

risk-return tradeoff

The observation that financial opportunities that offer high rates of return are generally riskier than opportunities that offer lower rates of return.

retained earnings

The part of a firm's net income it reinvests.

time value of money

The principle that a dollar received today is worth more than a dollar received in the future.

capital budgeting

The process a firm uses to evaluate long-term investment proposals.

covenants

The purpose of _____ is to protect creditors by preventing the borrower from pursuing policies that might undermine its ability to repay the loan.

net present value (NPV)

The sum of the present values of expected future cash flows from an investment, minus the cost of that investment.

financial leverage

The use of debt in a firm's capital structure.

promissory note

When a firm negotiates a loan with a bank, it signs a(n) _____, which specifies the length of the loan, the rate of interest the firm must pay, and other terms and conditions of the loan.

social responsibility

Which of the following is a major issue that confronts financial managers as they seek to maximize the market price of stock?

Treasury bills

_____ are short-term IOUs issued by the U.S. government that typically mature in 4, 13, or 26 weeks.

Retained earnings

_____ are the part of a firm's net income it reinvests.

Return-on-equity

_____ is calculated by dividing net income (profit) by owners' equity.

Trade credit

_____ is one of the most important sources of short-term financing for many firms and arises when suppliers ship materials, parts, or goods to a firm without requiring payment at the time of delivery.

Finance

_____ is the functional area of business that is responsible for finding the best sources of funds and the best ways to use them.

Capital structure

_____ is the mix of equity and debt financing a firm uses to meet its permanent financing needs.

Capital budgeting

_____ is the process a firm uses to evaluate long-term investment proposals.

Pro forma financial statements

_____ provide a framework for analyzing the impact of a firm's plans on the financing needs of the company.

Equity financing

_____ refers to funds provided by the owners of a company.

line of credit

A _____ is a financial arrangement in which a bank agrees to provide a firm with funds up to some specified limit, as long as the borrower's financial situation does not deteriorate, and the bank has sufficient funds.

budgeted income statement

A _____ is a projection showing how a firm's budgeted sales and costs will affect expected net earnings.

factor

A company that provides short-term financing to firms by purchasing their accounts receivables at a discount.

cash budget

A detailed forecast of future cash flows that helps financial managers identify when their firm is likely to experience temporary shortages or surpluses of cash.

line of credit

A financial arrangement between a firm and a bank in which the bank pre-approves credit up to a specified limit, provided that the firm maintains an acceptable credit rating.

revolving credit agreement

A guaranteed line of credit in which a bank makes a binding commitment to provide a business with funds up to a specified credit limit at any time during the term of the agreement.

Dodd-Frank Act

A law enacted in the aftermath of the financial crisis of 2008-2009 that strengthened government oversight of financial markets and placed limitations on risky financial strategies such as heavy reliance on leverage.

money market mutual funds

A mutual fund that pools funds from many investors and uses these funds to purchase very safe, highly liquid securities.

budgeted balance sheet

A projected financial statement that forecasts the types and amounts of assets a firm will need to implement its future plans and how the firm will finance those assets. (Also called a pro forma balance sheet.)

budgeted income statement

A projection showing how a firm's budgeted sales and costs will affect expected net income. (Also called a pro forma income statement.)

covenant

A restriction lenders impose on borrowers as a condition of providing long-term debt financing.

factor

A(n) _____ is a company that provides short-term financing to firms by purchasing their accounts receivables at a discount.

covenant

A(n) _____ is a restriction lenders impose on borrowers as a condition of providing long-term debt financing.

liquid asset

An asset that can quickly be converted into cash with little risk of loss.

certificate of deposit (CD)

An interest-earning deposit that requires the funds to remain deposited for a fixed term. Withdrawal of the funds before the term expires results in a financial penalty.