Corporate Finance Exam 1

operating cash flow

EBIT + Depreciation - Taxes

PE investment strategies

buyouts growth capital restructuring special situations

Book value: is more of a financial than an accounting valuation. generally tends to exceed market value when fixed assets are included. is equivalent to market value for firms with fixed assets. is based on historical cost. is adjusted whenever the market value of an asset changes.

is based on historical cost.

corporation

liquidity: shares can easily be exchanged voting rights: usually each share gets one vote taxation: double reinvestment and dividend payout: broad latitude liability: limited liability continuity: perpetual life

partnership

liquidity: subject to substantial restrictions voting rights: general partner is in charge; limited partners may have some voting rights taxation: partners pay personal taxes on partnership profits reinvestment and dividend payout: all net cash flow is distributed to partners liability: general partners may have unlimited liability; limited partners enjoy limited liability continuity: limited life

interest only loans

loan has a repayment plan that calls for the borrower to pay interest each period & to repay entire principal in the future.

earnings management

managing earnings year to year -big tax implication -ex: some companies borrow $ for dividends

When you are making a financial decision, the most relevant tax rate is the ________ rate when the tax rate schedule is progressive. average total marginal variable fixed

marginal

In the financial planning model, the external financing needed (EFN) as shown on a pro forma balance sheet is equal to the changes in assets:

minus the changes in both liabilities and equity

benchmarks

time trend analysis industry average peer group analysis pre specified values

asset turnover decision tree

total assets turnover I. current assets turnover A. cash turnover B. receivables turnover C. inventory turnover II.fixed assets turnover

the debt-equity ratio is measured as:

total debt divided by total equity

financial leverage

use of borrowing

operating leverage

use of fixed cost

book value

value on financial statements

Summa model

1. long term value creation and growth 2. traditional PE practices of implementing best practices and productivity improvement 3. building purpose driven and future proof organization 4.invested in 4 thematic areas mapped to megatrends (UN) 5. integrated ESG issues to create value during ownership phase 6. exit strategy

how to minimize agency problem

1. managerial compensation 2. control of firm: proxy fight 3. threat of a take over: synergistic effect 4. job market pressures

does the buyer matter (Summa)

1. sell to the highest bidder(even if ESG-agnostic): ESG should produce superior financial performance, thus, Summa needs to produce strong returns as proof of concept -higher returns can establish summa as a leader in buying positive impact firms, would give Summa voice in the PE field 2. prioritize alignment of goals (ESG conscious): while returns are critical, so is reputation which could be harmed by not adhering to purpose -would lose position as preferential buyer -a firm's long term growth and performance after exit is important reflection (investing in future proof firms)

Jones Mfg. has current assets of $26,900, net working capital of $8,200, long-term debt of $21,500, and total equity of $57,800. What is the equity multiplier?

1.7

simple vs compound interest

1.The amount of interest based on a principal amount and not on earned interest. VS. 2. Interest earned on both the principal amount and any interest already earned.

Deep Falls Timber has net sales of $642,100, net income of $50,800, dividends paid of $12,700, total assets of $658,000, and total equity of $444,400. What is the internal growth rate?

6.15 %

profitability measures

income statement margins I.profit margin A. net income B. operating income C. EBITDA balance sheet ratios I. return on assets (ROA) II. Return on equity (ROE)

cash flow to creditors

interest paid - net new borrowing

financial models related decisions

investment in new assets: determined by capital budgeting decisions degree of financial leverage: capital structure decisions cash paid to shareholders: determined by dividend policy decisions liquidity requirements: net working capital decisions

corporate growth rates (financial analysis)

investors need to know how rapidly a firm's sales can grow--> if sales are to grow, assets have to grow--> if assets are to grow, the firm must find a way to finance using internal and external financing

what is private equity

investors raise capital from limited partners, and the investment professionals (who serve as the general partner) deploy that capital by investing in private investments into (typically) private companies

capital structure

the mixture of debt and equity maintained by a firm

agency theory

the possibility of conflict b/w shareholders (principal) and the management team (agents) -theory of equity: potential conflict b/w management and shareholders theory of debt: potential conflict b/w management and bondholders

capital budgeting

the process of planning and managing a firm's long-term investments

solvency ratios

-Debt Ratio -Equity multiplier -Debt-to-Equity Ratio -Times Interest Earned -Cash coverage

material ESG issues (Summa is betting on)

-a tighter regulatory market: 1. EcoOnline: a tech enabled firm providing compliance assistance 2. Milarex: salmon value-added products (obesity and climate change) -innovation leaders that makes ESG issues material: 1. Sortera: convert waste materials into valuable resources (reducing CO2) -Evolving industry norms: 1. Egain: reduce energy consumption and thus Co2 emission -more stakeholder pressure and active NGOs

what to look for in private equity

-alignment of interests -experienced general partners who know the market -reasonable fee structure -strategy that is differentiated and makes sense

cash flow from assets

-cash flow to creditors + cash flow to stockholders -operating cash flow - net capital spending - change in net working capital

fundraising (PE business model)

-closed end -listed -captive

sourcing (PE business model)

-deal selection -due diligence -financing/structuring

adviser led model

-fund adopts less interventionist approach to portfolio companies -fund will selectively lean in on particular investments -fund has not dedicated portfolio team but rather used external experts as needed

general activist model

-fund has dedicated multi-disciplinary teams that bring a high level of engagement to each portfolio company -teams wrk closely with newly acquired companies to support and promote value creation

functional playbook model

-fund takes a hands on prescriptive approach to value creation -fund employs full time experts to implement a dedicated playbook to deliver operational improvements

managing/growing value (PE business model)

-grow business -improve operating results -buy and build -incentivize management

Summa learning outcomes

-idea of investing for impact and the importance of ESG issues in investing -relationship b/w ESG and financial performance -understand how to build an investment organization and processes that deliver financial returns and positive social impact -impact is a function of direct impact from investments and the voice of an organization exercizes influencing its ecosystem

private equity drawbacks

-investments are not immediately liquid -ability to invest thru retirement accounts mitigates this drawback -once you commit, you are commited

Value proposition during sourcing (summa case)

-megatrend and thematic approach allowed them to identify high growth deals: also believed the market had yet to internalize growth potential -became preferred buyer and got deeper discounts: sometimes Summa was only bidder or chosen over higher bidders due to future proofing and LT growth; automatically increases IRR

maestro model

-model places considerable emphasis on engagement with portfolio management but is well suited for funds that lack resources or desire to staff expensive in-house teams -fund designates a seasoned leader in-house to coordinate external resources to implement value-creation plans

financial analysis limitations

-scattered around the globe -different regulatory environment -no underlying theory on which ratios to use -don't fit into an industry category: difficult to build a relevant benchmark -different accounting procedures, fiscal years, unusual/one-time/extra-ordinary events

Regulation

-securities act (1933; issuance of securities) and securities exchange act (1934; creation of SEC and reporting requirements) -SarBox: increased reporting requirements and responsibility of corporate directors -Dodd-Frank: post financial crisis 2008

create liquidity (PE business model)

-timing -buyers universe -right process -valuation

exit takeaway (summa case)

-trade off between premium and alignments will be done on a case by case basis; the size of the premium is a major factor -bottom line: return gives summa voice but remaining faithful to purpose gives credible voice -synergies: an ESG aligned buyer would realize more synergies by building on the core capabilities summa developed

value proposition during ownership (summa case)

-traditional PE strategies to drive value: financial engineering (create strong equity incentive for portfolio company management; debt pressure not to waste resources), governance engineering (taking control of firm board/active role in governance), operational engineering (development of industry and operating learning) -controlling ownership allowed direct operation changes: reducing costs, improving efficiencies, integrating ESG into firm culture, developing firm purpose

corporate taxes

-typically largest cash outflow -codes are the result of political rather than economic forces -progressive vs. flat -average vs. marginal

A banker considering loaning money to a firm for ten years would most likely prefer the firm have a debt ratio of _______, and a times interest earned ratio of _______. .50; .75 .50; 1.00 .45; 1.75 .40; .75 .40; 1.75

.40; 1.75

growing perpetuity

A growing stream of cash flows that lasts forever

You would like to compare your firm's cost structure to that of your competitors. However, your competitors are much larger in size than your firm. Which one of these would best enable you to compare costs across your industry?

B - Common-size income statement

Which one of the following statements concerning liquidity is correct? The less liquidity a firm has, the lower the probability the firm will encounter financial difficulties. Balance sheet accounts are listed in order of decreasing liquidity. If you can sell an asset next year at a price equal to its actual value, the asset is highly liquid. Liquid assets are defined as those assets obtained within the past year. Liquid assets generally earn higher rates of return than fixed assets.

Balance sheet accounts are listed in order of decreasing liquidity.

To which of the following PE approaches to value creation does Summa belongs:

D - General-activist

private equity structure

I. outside investors: limited partners that contribute cash II. general partner (LLC): contribute cash III. individual fund managers (as part of LLC): fund direction ---> A. private equity fund invests into porfolio

Which term defines the tax rate that applies to the next dollar of taxable income earned? Residual Average Marginal Deductible Total

Marginal

If you sell an asset, you are most apt to receive which value for that asset? Historical value Book value Original cost minus accumulated depreciation Market value Carrying value

Market value

ROA

NI/assets -breakdown: NI/sales(profit margin) * sales/assets (asset turnover)

ROE

Net Income/Total Equity -breakdown: NI/sales (profit margin) * sales/assets (asset turnover) * assets/equity (equity multiplier-capital structure)

The projected addition to retained earnings can be calculated as: PM × Δ Sales. PM × Δ Sales × (1 − Dividend payout ratio). PM × Projected sales × (1 − Dividend payout ratio). Projected sales × (1 − Dividend payout ratio). PM × Projected sales.

PM × Projected sales × (1 − Dividend payout ratio).

profit margin vs. asset turnover

PM: measures efficiency-input/output AT: measures effectiveness-did you achieve your goal

extended Du Pont identity

ROE = Net profit/equity I. ROA = net profit/assets A. asset turnover 1. sales 2. total assets a. long term assets b. current assets i. cash reserves ii. receivables iii. current financial assets B. profit margin 1. net profit a. sales b. cost i. depreciation ii. taxes iii. interest iv. other costs 2. sales II. Assets/equity

The Du Pont Identity

ROE = PM (operating efficiency measured by profit margin) x TAT (asset use efficiency measured by total asset turnover) x EM (financial leverage measured by equity multiplier)

"Terri Simmons is single and had $189,000 in taxable income. Using the rates from Table 2.3 in the chapter, calculate her income taxes. What is the average tax rate? What is the marginal tax rate?"

Taxes = .10($9,525) + .12($38,700 - 9,525) + .22($82,500 - 38,700) + .24($157,500 - 82,500) + .32($189,000 - 157,500) Taxes = $42,169.50 The average tax rate is the total tax paid divided by taxable income, so: Average tax rate = $42,169.50/$189,000 Average tax rate = .2231, or 22.31% The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate is 32 percent.

"If Muenster, Inc., has an equity multiplier of 1.35, total asset turnover of 1.87, and a profit margin of 6.1 percent, what is its ROE?"

Using the DuPont identity, the ROE is: ROE = (Profit margin)(Total asset turnover)(Equity multiplier) ROE = (.061)(1.87)(1.35) ROE = .1540, or 15.40%

perpetuity

a constant stream of cash flows without end

proxy fight

a technique used to gather enough stockholder votes to control a targeted company

liquidity

assets: converted into cash quickly without losing significant value firm: when CA covers CL stocks: how easily you can sell

liquidity ratios

current ratio: CA/CL -use when inventory < 1 year quick ratio: CA-inv/CL -use when inventory turnover > 1 cash ratio: CA-inv-A/R/CL

If a firm bases its growth projection on the rate of sustainable growth, shows positive net income, and has a dividend payout ratio of 30 percent, then the: fixed assets will have to increase at the sustainable growth rate, even if the firm is currently operating at only 78 percent of capacity. number of common shares outstanding will increase at the same rate of growth. debt-equity ratio will have to increase. debt-equity ratio will remain constant while retained earnings increase. fixed assets, the debt-equity ratio, and number of common shares outstanding will all increase.

debt-equity ratio will remain constant while retained earnings increase.

Assets are listed on the balance sheet in order of: market value relative to book value. book value. increasing size. decreasing liquidity. acquisition.

decreasing liquidity.

noncash items on I/S

depreciation, ammortization, deferred taxes

cash flow to stockholders

dividends paid - net new equity raised

net capital spending

ending net fixed assets - beginning net fixed assets + depreciation

cash outflow

expense: current benefit expenditure: current and future benefit loss: no benefit

interest

financed using debt -tax deductible due to political pressures

dividends

financed using equity

"The advantages of the corporate form are enhanced by the existence of ___________

financial markets

Both of the following investment option cost $1000, and has no future value. Which do you prefer? First option: Pays a return of $200 per year for 10 years. Second option: Pays $145 per year for 300 years.

first option

typical PE life cycle

fundraising: 1-2+ years sourcing (closing deals): 2-5+ years managing and improving portfolio: 3-7+ years divestiture/exit: varied time frames

par value

historical value (IPO)

market value

how much people are willing to pay, demand and supply

The income statement: includes noncash expenses. treats dividends paid as a cash expense. excludes deferred tax expense. ignores any income other than operating revenues. measures performance for one specific day.

includes noncash expenses.

private equity benefits

over the last dozen years, greatly outperformed both venture capital and public markets (stock market) investing -less volatile (not looking at daily fluctuations) -actively managed -higher historical returns

intrinsic value

perceived value

market value ratios (stock prices)

price/earnings price/sales price/book value enterprise value multiples: EV/EBITDA Enterprise value(EV): Market cap + MV of interest bearing debt - cash

Projected future financial statements are called:

pro forma statements

determinants of growth

profit margin (operating efficiency) total asset turnover (asset use efficiency) financial policy (debt to equity) dividend policy (retention ratio)

how does an issue become material?

regulation, innovation, industry norms, shareholder pressure

The receivables turnover ratio is measured as:

sales divided by accounts receivable

% of sales approach (pro forma)

sales forecast: use economic assumptions, market condition, trend analysis -separate the income statement and balance sheet accounts into two groups: those that vary directly with sales and those that do not

financial analysis framework (matrix)

short term risk: liquidity ratio short term return: asset management decision tree, 2 sets of profitability ratios long term risk: solvency ratios long term return: market value ratios

the corporate controller is generally responsible for?

tax reporting

pure discount loans

the borrower receives money today and repays a single lump sum at some time in the future

external financing needed (EFN)

the difference b/w forecasted increase in assets and forecasted increase in liabilities and equity -at low growth levels, internal financing (retained earnings) may exceed the required investment in assets -as growth rate increases, internal financing will not be enough and the firm will have to go to capital markets

amortized loans

the lender require the borrower to repay parts of the principal & the interest over time.

Working Capital Management

the managing of short-term assets and liabilities -cash and cash equivalents

Sustainable Growth Rate

the maximum growth rate a firm can achieve without external equity financing while maintaining a constant debt-equity ratio

internal growth rate

the maximum growth rate a firm can achieve without external financing of any kind