Finance Midterm

What is financial leverage?

"Financial leverage" = the use of debt

Net New Equity

(ending common stock + ending additional paid in surplus) - (beg stock + beg additional paid in equity)

What are two issuing with float?

*"Kiting"*: - Systematic overdrafting - Writing checks for no economic reason other than to exploit float *Electronic Data Interchange & Check 21*: - EDI: Direct, electronic information exchange - Check 21: Bank receiving a customer check may transmit an electronic image and receive immediate payment

What are five kinds of secure loans that use short-term borrowing?

*Accounts Receivable Financing*: - Assigning Receivables - Factoring Receivables *Inventory Loans*: - Blanket Inventory Lien - Trust Receipt - Field Warehouse Financing

What are the two types of Accounts Receivable financing? *Short-Term Borrowing Secured Loans*

*Assigning Receivables*: - Lender has Accounts Receivable as security but borrower still responsible for collection *Factoring Receivables*: - Accounts Receivable discounted and sold to a factor - Collection is the factor's problem

What is the basic form of terms of sale?

*Basic Form*: *2/10 net 45* - 2% discount if paid in 10 days - Total amount due in 45 days if discount is not taken - Buy $500 worth of merchandise with the credit terms given above + Pay $500(1 - .02) = $490 if you pay in 10 days + Pay $500 if you pay in 45 days

What are four aspects of a Dutch or Uniform Price Auction?

*Buyers*: - Bid a price and number of shares *Seller*: - Work down the list of bidders - Determine the highest price at which they can sell the desired number of shares - All successful bidders pay the same price per share. - Encourages aggressive bidding

Optimal Credit Policy (slide)

*Carrying Costs* are the cash flows that must be incurred when credit is granted. *Opportunity Costs* are the lost sales from refusing credit. These costs go down when credit is granted.

What are the duties related to short-term financial management that a *Cash Manager* carries out? What Assets/Liabilities are influenced?

*Cash Manager* *Duties Related to Short-Term Financial Management*: - Collection, Concentration, Disbursement - Short-Term Investments - Short-Term Borrowing - Banking Relations *Assets/Liabilities Influenced*: - Cash - Marketable Securities - Short-Term Loans

What are the Five C's of Credit?

*Character:* Willingness to meet financial obligations *Capacity:* Ability to meet financial obligations out of operating cash flows *Capital:* Financial reserves *Collateral:* Assets pledged as security *Conditions:* General economic conditions related to customer's business

What are the duties related to short-term financial management that a *Controller* carries out? What Assets/Liabilities are influenced?

*Controller* *Duties Related to Short-Term Financial Management*: - Accounting Information on Cash Flows - Reconciliation of Accounts Payable - Application of Payments to Accounts Receivable *Assets/Liabilities Influenced*: - Accounts Receivable - Accounts Payable

Optimal Size of Inventory Orders (slide)

*Costs of Holding Inventory:* Restocking costs are greatest when the firm holds a small quantity of inventory. Carrying costs are greatest when there is a large quantity of inventory on hand. Total costs are the sum of the carrying and restocking costs.

What are the duties related to short-term financial management that a *Credit Manager* carries out? What Assets/Liabilities are influenced?

*Credit Manager* *Duties Related to Short-Term Financial Management*: - Monitoring and Control of Accounts Receivable - Credit Policy Decisisons *Assets/Liabilities Influenced*: - Accounts Receivable

What four aspects of credit information are used in credit analysis?

*Credit information:* - Financial statements - Credit reports/past payment history - Banks - Payment history with the firm

What are the three short-term solvency, or liquidity ratios?

*Current Ratio = Current Assets / Current Liabilities* The current ratio is a measure of short-term liquidity. The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations. *Quick Ratio = (Current Assets - Inventory)/ Current Liabilities* The quick ratio, also known as the acid-test ratio, is a liquidity ratio that further refines the current ratio by measuring the level of the most liquid current assets available to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which generally are more difficult to turn into cash. A higher quick ratio means a more liquid current position. *Cash Ratio = Cash / Current Liabilities* The cash ratio is the ratio of a company's total cash and cash equivalents (CCE) to its current liabilities. The metric calculates a company's ability to repay its short-term debt; this information is useful to creditors when deciding how much debt, if any, they would be willing to extend to the asking party. The cash ratio is generally a more conservative look at a company's ability to cover its liabilities than many other liquidity ratios because other assets, including accounts receivable, are left out of the equation. As with most liquidity ratios, a higher cash coverage ratio means that the company is more liquid and can more easily fund its debt.

What are the two types of demand?

*Derived (Dependent) Demand*: - The demand for an inventory item is usually derived because the firm's need for these inventory types depends on its need for finished items *Independent Demand:* - The firm's demand for finished goods is not derived from the demand of other inventory items.

What is one type of offer that uses the *Private* method for issuing new securities?

*Direct Placement*: Securities are sold directly to the purchaser, who, at least until recently, generally could not resell the securities for at least two years.

Direct Quotation

*Direct Quotation:* - Price of foreign currency expressed in U.S. dollars. (dollars per currency) - In $USD

What are the two kinds of FOREX quotations?

*Direct Quote*: USD per foreign currency i.e. *$1.5649* per £1 *Indirect Quote:* Units of foreign currency per USD i.e. *£0.6390* per $1

What are two types of offers that use the *Privileged Subscription* method for issuing new securities?

*Direct Rights Offer*: Company offers the new stock directly to its existing shareholders. *Standby Rights Offer*: Like the direct rights offer, this contains a privileged subscription arrangement with existing shareholders. The net proceeds are guaranteed by the underwriters.

What are the three kinds of float?

*Disbursement Float*: - Generated when a firm writes checks - A decrease in the firm's book balance but not in the firm's bank balance - (Available Balance at Bank - Book balance) > 0 - i.e when Bank Balance - Book Balance is greater than 0 (positive) *Collection Float*: - Checks received increase book balance before the bank credits the account - A increase in the firm's book balance but not in the firm's bank balance - (Available Balance at Bank - Book Balance) < 0 - i.e. when Bank Balance - Book Balance is less than 0 (negative) *Net float:* - Disbursement float + Collection float - Positive Net Float: The firm has more disbursement float than collection float. The available bank balance exceeds the book balance. - Negative Net Float: The firm has more collection float than disbursement float. The available book balance exceeds the cash balance.

What are two signaling explanations for SEOs?

*Equity overvalued*: If management believes equity is overvalued, they would choose to issue stock shares *Debt usage*: Issuing stock may indicate firm has too much debt and can not issue more debt

What are three types of offers that use the *Public Traditional Negotiated Cash Offer* method for issuing new securities?

*Firm Commitment Cash Offer*: Company negotiates an agreement with an investment banker to underwrite and distribute new shares. A specified number of shares are brought by underwriters and sold at a higher price. *Best Efforts Cash Offer*: Company has investment bankers sell as many of the new shares as possible at the agreed-upon price. There is no guarantee concerning how much cash will be raised. Some best efforts offerings do not use an underwriter. *Dutch Auction Cash Offer*: Company has investment bankers auction shares to determine the highest offer price obtainable for a given number of shares to be sold.

Indirect Quotation

*Indirect Quotation:* - The amount of a foreign currency required to buy one U.S. dollar (currency per dollar) - Per $USD

What are the three kinds of Inventory Loans? *Short-Term Borrowing Secured Loans*

*Inventory Loans* *Blanket Inventory Lien:* - Lender has lien against all inventories *Trust Receipt:* - Borrower holds specific inventory in "trust" for the lender - Auto dealer "floor plans" *Field Warehouse Financing:* - Public warehouse acts as control agent to supervise inventory for lender

What are the duties related to short-term financial management that a *Marketing Manager* carries out? What Assets/Liabilities are influenced?

*Marketing Manager* *Duties Related to Short-Term Financial Management*: - Credit Policy Decisions *Assets/Liabilities Influenced*: - Accounts Receivable

What are two types of derived-demand inventories?

*Materials Requirements Planning (MRP):* - Computer-based ordering/scheduling - Works backwards from set finished goods level to establish levels of work-in-progress required *Just-in-Time Inventory:* - Reorder and restock frequently - Japanese system + *Keiretsu*: industrial group + *Kanban*: card signaling reorder time

What are three factors would indicate a more liberal credit policy?

*More liberal credit policy likely if:* - Excess capacity - Low variable operating costs - Repeat customers A *variable cost* is a corporate expense that changes in proportion with production output. Variable costs increase or decrease depending on a company's production volume; they rise as production increases and fall as production decreases.

What are two forms of credit instruments?

*Open account:* - Most basic form - Invoice only *Promissory Note:* - Basic IOU - Not common - Signed after goods delivered

What are three forms of cash collection?

*Over-the-counter-collection"*: - Point of sale collection - Pay with Cash, Check, or Credit Card at the Point of Sale *Preauthorized Payment System*: - Payment amount and dates fixed in advance - Payments automatically transferred *Payments via Mailed Checks*: - One mailing address or - Various collection points (to reduce mailing times)

What are the duties related to short-term financial management that a *Payables Manager* carries out? What Assets/Liabilities are influenced?

*Payables Manager* *Duties Related to Short-Term Financial Management*: - Decisions on Payment Policies and on whether to Take Discounts *Assets/Liabilities Influenced*: - Accounts Payable

Alternative Asset Financing Policies (slide)

*Policy F* or a Flexible Short Term Financing Policy on the right always implies a short-term cash surplus and a large investment in cash and marketable (short-term) securities. *Policy R* or a Restrictive Short-Term Financing Policy uses long-term financing for permanent asset requirements only and short-term borrowing for seasonal variations.

What are four market value ratios?

*Price-Earnings Ratio = Price per Share / Earnings per Share* The price/earnings ratio (often shortened to the P/E ratio or the PER) is the ratio of a company's stock price to the company's earnings per share. In essence, the price-earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company's earnings. This is why the P/E is sometimes referred to as the price multiple because it shows how much investors are willing to pay per dollar of earnings. *Price-Sales Ratio = Price per Share / Sales per Share* The price-to-sales ratio is a valuation ratio that compares a company's stock price to its revenues. The lower the ratio, the more attractive the investment because investors are paying less for each unit of sales. *Market-to-Book Ratio = Market Value per Share / Book Value per Share* The book-to-market ratio is used to find the value of a company by comparing the book value of a firm to its market value. Book value is calculated by looking at the firm's historical cost, or accounting value. Market value is determined in the stock market through its market capitalization. A ratio greater than one indicates an undervalued company, while a ratio less than one means a company is overvalued. *EBITDA Ratio = Enterprise Value / EBITDA* The EBITDA to sales ratio is a financial metric used to assess a company's profitability by comparing its revenue with earnings. More specifically, since EBITDA is derived from revenue, this metric indicates the percentage of a company's earnings remaining after operating expenses. A high ratio of net debt to EBITDA reveals a company that's deep in debt. It will have a lower credit rating and be forced to offer higher yields on bonds.

What are the duties related to short-term financial management that a *Production Manager* carries out? What Assets/Liabilities are influenced?

*Production Manager* *Duties Related to Short-Term Financial Management*: - Setting of Production Schedules and Materials Requirements *Assets/Liabilities Influenced*: - Inventory - Accounts Payable

What are four profitability ratios?

*Profit Margin = Net Income / Sales* The profit margin ratio, also called the return on sales ratio or gross profit ratio, is a profitability ratio that measures the amount of net income earned with each dollar of sales generated by comparing the net income and net sales of a company. *Return on Assets (ROA) = Net Income / Total Assets* The return on assets ratio, often called the return on total assets, is a profitability ratio that measures the net income produced by total assets during a period by comparing net income to the average total assets. *Return on Equity (ROE) = Net Income / Total Equity* The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate profits from its shareholders investments in the company. In other words, the return on equity ratio shows how much profit each dollar of common stockholders' equity generates. *ROE = (Net income / Sales) x (Sales / Assets) x (Assets / Equity)* *ROE = (Profit Margin) x (Total Asset Turnover) x (Equity Multiplier)* The DuPont identity is an expression that shows a company's return on equity (ROE) can be represented as a product of three other ratios: the profit margin, the total asset turnover and the equity multiplier. 1. Operating efficiency, which is measured by profit margin; 2. Asset use efficiency, which is measured by total asset turnover; and 3. Financial leverage, which is measured by the equity multiplier. If the ROE is unsatisfactory, the DuPont identity helps analysts and management locate the part of the business that is under performing.

What are the duties related to short-term financial management that a *Purchasing Manager* carries out? What Assets/Liabilities are influenced?

*Purchasing Manager* *Duties Related to Short-Term Financial Management*: - Decisions on Purchases, Suppliers - May Negotiate Payment Terms *Assets/Liabilities Influenced*: - Inventory - Accounts Payable

What are three types of inventory that a manufacturing firm has?

*Raw material:* - Production starting point *Work-in-progress:* *Finished goods* - Ready to ship or sell One firm's "raw material" = another's "finished good"

What are two extensions to the Economic Order Quantity (EOQ) Model?

*Safety stocks:* - Minimum level of inventory kept on hand - Increases carrying costs *Reorder points:* Inventory level at which you place an order to account for delivery time

What are two examples of temporary cash surpluses?

*Seasonal or cyclical activities:* + Buy marketable securities with seasonal surpluses + Convert back to cash when deficits occur *Planned or possible expenditures:* + Accumulate marketable securities in anticipation of upcoming expenses

What are two types of offers that use the *Nontraditional Cash Offer* method for issuing new securities?

*Shelf Cash Offer*: Qualifying companies can authorize all the shares they expect to sell over a two-year period and sell them when needed. *Competitive Firm Cash Offer*: Company can elect to award the underwriting contract through a public auction instead of negotiation.

What are two shortage costs of inventory?

*Shortage costs:* - Restocking costs - Lost sales or lost customers *Shortage Costs:* Costs that fall with increases in the level of investment in current assets

What are two kinds of commercial drafts?

*Sight draft:* Immediate payment required *Time draft:* - Not immediate

Seasonal Cash Demands (slide)

*Time 1:* A surplus cash position exists. Seasonal demand for current assets is low. The surplus is invested in short-term marketable securities. *Time 2:* A deficit cash position exists. Season demand for current assets is high. The financial deficit is financed by selling marketable securities and by bank borrowing.

What are the four aspects of the Economic Order Quantity (EOQ) Model?

*Total carrying cost:* (Q/2)(CC) (Average inventory) x (Carrying cost per unit) *Total restocking cost:* F(T/Q) (Fixed cost per order) x (Number of orders) *Total Cost:* (Q/2)(CC) + F(T/Q) Total carrying cost + Total restocking cost The Minimum Cost Point is: Q* (Q*/2)(CC) = F(T/Q*) when Carrying costs = Restocking costs

What are five long-term solvency, or financial leverage, ratios?

*Total debt ratio = (Total assets - Total equity) / Total assets* The debt ratio is a financial ratio that measures the extent of a company's leverage. The debt ratio is defined as the ratio of total debt to total assets, expressed as a decimal or percentage. It can be interpreted as the proportion of a company's assets that are financed by debt. *Debt-equity ratio = Total debt / Total equity* Debt/Equity (D/E) Ratio, calculated by dividing a company's total liabilities by its stockholders' equity, is a debt ratio used to measure a company's financial leverage. The D/E ratio indicates how much debt a company is using to finance its assets relative to the value of shareholders' equity. *Equity multiplier = Total assets / Total equity* is a measure of financial leverage. Companies finance their operations with equity or debt, so a higher equity multiplier indicates that a larger portion of asset financing is attributed to debt. The equity multiplier is therefore a variation of the debt ratio, in which the definition of debt financing includes all liabilities. Time Interest earned ratio = EBIT / Interest Cash coverage ratio = (EBIT + Depreciation) / Interest

What are five long-term solvency, or financial leverage, ratios?

*Total debt ratio = (Total assets - Total equity) / Total assets* The debt ratio is a financial ratio that measures the extent of a company's leverage. The debt ratio is defined as the ratio of total debt to total assets, expressed as a decimal or percentage. It can be interpreted as the proportion of a company's assets that are financed by debt. It is calculated by dividing total liabilities by total assets, with higher debt ratios indicating higher degrees of debt financing. Whether or not a debt ratio is good depends on the context within which it is being analyzed. From a pure risk perspective, lower ratios (0.4 or lower) are considered better debt ratios. Since the interest on a debt must be paid regardless of business profitability, too much debt may compromise the entire operation if cash flow dries up. Companies unable to service their own debt may be forced to sell off assets or declare bankruptcy. A higher debt ratio (0.6 or higher) makes it more difficult to borrow money. Lenders often have debt ratio limits and do not extend further credit to firms that are over-leveraged. Of course, there are other factors as well, such as credit worthiness, payment history and professional relationships. On the other hand, investors rarely want to purchase the stock of a company with extremely low debt ratios. A debt ratio of zero would indicate that the firm does not finance increased operations through borrowing at all, which limits the total return that can be realized and passed on to shareholders. A debt ratio greater than 100% tells you that a company has more debt than assets. Meanwhile, a debt ratio less than 100% indicates that a company has more assets than debt. Used in conjunction with other measures of financial health, the debt ratio can help investors determine a company's risk level. *Debt-equity ratio = Total debt / Total equity* Debt/Equity (D/E) Ratio, calculated by dividing a company's total liabilities by its stockholders' equity, is a debt ratio used to measure a company's financial leverage. The D/E ratio indicates how much debt a company is using to finance its assets relative to the value of shareholders' equity. *Equity multiplier = Total assets / Total equity* An equity multiplier measures a company's financial leverage by using a ratio of the company's total assets to its stockholders' equity (also known as shareholders' equity). Generally, a lower equity multiplier indicates a company has lower financial leverage. It is better to have a low equity multiplier, because that means a company needs to use less debt to finance its assets. *Time Interest earned ratio = EBIT / Interest* The times interest earned ratio measures the ability of an organization to pay its debt obligations. The ratio is commonly used by lenders to ascertain whether a prospective borrower can afford to take on any additional debt. The ratio is calculated by comparing the earnings of a business that are available for use in paying down the interest expense on debt, divided by the amount of interest expense. Generally, an interest coverage ratio of at least 2 is considered the minimum acceptable amount for a company that has solid, consistent revenues, such as an energy company. *Cash Coverage Ratio = (EBIT + Depreciation) / Interest* The cash ratio or cash coverage ratio is a liquidity ratio that measures a firm's ability to pay off its current liabilities with only cash and cash equivalents. The cash ratio is much more restrictive than the current ratio or quick ratio because no other current assets can be used to pay off current debt-only cash. To show a sufficient ability to pay, the ratio should be substantially greater than 1:1.

What is the trade off regarding holding cash or marketable securities?

*Trade-off*: Opportunity Cost of Holding Cash vs. Transaction Cost of Converting Marketable Securities to Cash

What are four duties of underwriting services?

*Underwriting services*: - Formulate method to issue securities - Price the securities - Sell the securities - Price stabilization by lead underwriter in the aftermarket

Calculate the cost of equity using the Dividend Growth Model (DGM) and the Security Market Line (SML) approach using the data below. Data: Beta = 1.5 Market risk premium = 9% Current risk-free rate = 6%. Analysts' estimates of growth = 6% per year Last dividend = $2. Currently stock price =$15.65

*Using Security Market Line:* Return on Equity = 6% + 1.5(9%) = 19.5% *Using Dividend Growth Model:* Return on Equity = [2(1.06) / 15.65] + .06 = 19.55%

What are two ways you can control disbursements?

*Zero-balance account*: A disbursement account in which the firm maintains zero balance, transferring funds in from a master account only as needed to cover checks presented for payment. *Controlled disbursement account*: A disbursement practice under which the firm transfers an amount to a disbursing account that is sufficient to cover demands for payment.

What are three financial institutions?

+ Banks - commercial and investment, credit unions, savings and loans + Insurance companies + Brokerage firms

What are three aspects of international finance?

+ May allow you to work in other countries or at least travel on a regular basis + Need to be familiar with exchange rates and political risk + Need to understand the customs of other countries; speaking a foreign language fluently is also helpful

What are five aspects of the Green Shoe Provision?

- "Overallotment Option" - Allows syndicate to purchase an additional 15% of the issue from the issuer - Allows the issue to be oversubscribed - Provides some protection for the lead underwriter as they perform their price stabilization function - In all IPO and SEO offerings but not in ordinary debt offerings

What are three things to consider when choosing the best short-term financing policy?

- *Cash Reserves* (reduces probability of financial distress, however zero present value) - *Maturity Hedging* (matching maturities of assets and liabilities) - *Relative Interest Rates* (short-term interest rates lower than long-term interest rates, therefore long-term borrowing is more expensive

What three reasons for holding cash according to John Maynard Keynes? i.e What are three reason why liquidity is important?

- *Speculative Motive*: Take advantage of unexpected opportunities - *Precautionary Motive*: In case of emergencies - *Transaction Motive*: To pay day-to-day bills

What are two ways firms determine creditworthiness?

- 5 Cs of Credit - Credit Scoring

Normal Distribution

- A symmetric frequency distribution - The "bell-shaped curve" - Completely described by the mean and variance Does a normal distribution describe asset returns?

What is arbitrage?

- A violation of the "Law of One Price" - Arbitrage: + A positive cash flow + No risk - Triangle Arbitrage + Moves through 3 exchange rates

Accounting regulations include what two requirements regarding Translation Exposure?

- All cash flows be converted at the prevailing exchange rates - Currency gains and losses accumulated in a special account within shareholders' equity

Illustration of Irrelevance Wharton Corporation (part 1)

- All equity firm with 100 shares outstanding - Investors require a 10% return. - Expected cash flow = $10,000 each year - Plans to dissolve firm in 2 years Firm can either: A. Pay out dividends of $10,000 per year for each of the next two years ($100 per share) B. Pay $11,000 this year, raising the other $1,000 by issuing stock (or bonds), then pay an amount in year 2 sufficient to provide new shareholders with a 10% return

What are three aspects of ratio analysis?

- Allow for better comparison through time or between companies - Used both internally and externally - For each ratio, ask yourself: + What the ratio is trying to measure + Why that information is important

What is the process for controlled disbursement accounts?

- Almost all payments that must be made in a given day are known in the morning. With a controlled disbursement account, the bank informs the firm of the day's total, and the firm transfer (usually by wire) the amount needed.

How do you determine the weights for WACC?

- Always use the target weights, if possible + If not available, use market values

What are the annual interest tax shields and the present value of the annual interest tax sheilds of the above Case II Example?

- Annual interest tax shield + Tax rate times interest payment + $1,000 in 8% debt = $80 in interest expense + Annual tax shield = .30($80) = $24 - Present value of annual interest tax shield + Assume perpetual debt + PV = $24 / .08 = $300 + PV = D(RD)(TC) / RD = D*TC = $1,000(.30) = $300

Case III: With Bankruptcy Costs

- As Debt-Equity Ratio increases, The probability of bankruptcy increases - As the probability of bankruptcy increases, the expected bankruptcy costs increase At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy costs At this point, the value of the firm will start to decrease and the Weighted Average Cost of Capital (WACC) will start to increase as more debt is added

What are the three important aspects of the Balance Sheet?

- Assets + Left-hand side (or upper portion) + In order of decreasing liquidity - Liabilities and Owners' Equity + Right-hand side (or lower portion) + In ascending order of when due to be paid

Geometric Average

- Average compound return per period over multiple periods - Answers the question: "What was your average compound return per year over a particular period?"

What are two types of long-term debt?

- Bonds - Private issues

What are four aspects of financial distress?

- Business failure: business terminated with a loss to creditors - Legal bankruptcy: petition filed in federal court for bankruptcy - Technical insolvency: firm unable to meet debt obligations - Accounting insolvency: book value of equity is negative

What are three kinds of financial management decisions?

- Capital budgeting + What long-term investments or projects should the business take on? - Capital structure + How should we pay for our assets? + Should we use debt or equity? - Working capital management + How do we manage the day-to-day finances of the firm?

What is Capital restructuring?

- Capital restructuring = changing the amount of leverage without changing the firm's assets + Increase leverage by issuing debt (increasing debt) and repurchasing outstanding shares (reducing equity) + Decrease leverage by issuing new shares (increasing equity) and retiring outstanding debt (decreasing debt) Financial Leverage Debt-to-Equity Ratio = Total Debt / Total Equity e.g. Debt = 10m Equity = 5m Financial Leverage = 10/5 = 2 Company buyback 3m Financial Leverage = 10 / (5 - 3) = 10 / 2 = 5 Company buyback increases financial leverage or the use of debt in the capital structure

What the three special cases of Capital Structure Theory?

- Case I: Assumptions + No corporate or personal taxes No bankruptcy costs - Case II: Assumptions + Corporate taxes, but no personal taxes No bankruptcy costs - Case III: Assumptions Corporate taxes, but no personal taxes Bankruptcy costs

What conclusions can we take away from Cases I, II, and III?

- Case I: No Taxes or Bankruptcy Costs + No optimal capital structure - Case II: Corporate Taxes but No Bankruptcy Costs + Optimal capital structure = 100% debt + Each additional dollar of debt increases the cash flow of the firm - Case III: Corporate Taxes and Bankruptcy Costs + Optimal capital structure is part debt and part equity + Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs

What are the three cash cycle equations?

- Cash Cycle - Accounts payable period - Payables turnover

What are financial markets?

- Cash flows to the firm - Primary vs. secondary markets + Dealer vs. auction markets + Listed vs. over-the-counter securities * NYSE * NASDAQ

What are four additional aspects of Dividends & Repurchases?

- Changes in the dividend signal management's view concerning the firm's future prospects - Stock repurchases signal that management believes the current stock price is low (Buyback increases EPS - Earnings Per Share) - Tender offers send a more positive signal than open market repurchases because the company is stating a specific stock price - Stock prices often increase when repurchases are announced

What are four aspects of political risk?

- Changes in value due to political actions in the foreign country - Investment in countries that have unstable governments should require higher returns - Extent of political risk depends on the nature of the business: + The more dependent the business is on other operations within the firm, the less valuable it is to others + Natural resource development can be very valuable to others, especially if much of the ground work has already been done - Local financing can often reduce political risk

What are three aspects of inventory management?

- Classify inventory by cost, demand, and need + Maintain larger quantities of items that have substantial shortage costs + Maintain smaller quantities of expensive items + Maintain a substantial supply of less expensive basic materials

What are two kinds of standardized financial statements?

- Common-Size Balance Sheets - Common-Size Income Statements

What are two things standardized statements are useful for?

- Comparing financial information year-to-year - Comparing companies of different sizes, particularly within the same industry

What are six problems with financial analysis?

- Conglomerates + No readily available comparables - Global competitors - Different accounting procedures - Different fiscal year ends - Differences in capital structure - Seasonal variations and one-time events

What is the subjective approach?

- Consider the project's risk relative to the firm overall + If the project is riskier than the firm, use a discount rate greater than the WACC + If the project is less risky than the firm, use a discount rate less than the WACC Discount Rate: Current Worth of a Future Sum of Money o Stream of Cash Flow given a Specified Rate of Return

What is the subjective approach?

- Consider the project's risk relative to the firm overall + If the project is riskier than the firm, use a discount rate greater than the WACC + If the project is less risky than the firm, use a discount rate less than the WACC Discount Rate: Current Worth of a Future Sum of Money or Stream of Cash Flow given a Specified Rate of Return

What are two types of inventory costs?

- Cost of carrying too much inventory - Cost of not carrying enough inventory

What are shortage costs?

- Costs that fall with increases in the level of investment in current assets - *Order costs*: The cost of ordering additional inventory or transferring cash - *Stock-out costs*: The cost of lost sales due to lack of inventory, including lost customers

What are carrying costs?

- Costs that rise with the increases in the level of investment in current assets - Opportunity cost of owning current assets versus long-term assets that pay higher returns - Cost of storing larger amounts of inventory

What are three aspects of Terms of Sale?

- Credit period (usually 30-120 days) - Cash discount and discount period - Type of credit instrument

What are three aspects of lockboxes?

- Customer checks mailed to a P.O box - Local bank picks up checks several times each day + Lockbox maintained by local bank + Checks deposited to firm's account - Firms may have many lockbox arrangements around the country + Funds end up in multiple accounts

What are five uses of cash?

- Decrease long-term debt - Decrease equity - Decrease current liabilities - Increase current assets - Increase fixed assets

What are four aspects of a collection policy?

- Delinquency letter - Telephone call - Collection agency - Legal action

What are the two aspects of Bankruptcy Costs?

- Direct costs + Legal and administrative costs * Enron = $1 billion; WorldCom = $600 million + Bondholders incur additional losses + Disincentive to debt financing - Financial distress + Significant problems meeting debt obligations + Most firms that experience financial distress do not ultimately file for bankruptcy

What are Stock Dividends?

- Distribute additional shares of stock instead of cash - Increases the number of outstanding shares

What are the three major methods for determining the cost of equity?

- Dividend growth Model - SML (Security Market Line).. - The graphical representation of Capital Asset Pricing Model (CAPM)

What are two reasons why the dividend policy may not matter?

- Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the firm - In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future

What was the Sarbanes-Oxley Act driven by?

- Driven by corporate scandals + Enron, Tyco, WorldCom, Adelphia

What are three aspects of the Partial Adjustment Phenomenon?

- During SEC registration, a company will set a "file price range" - Just before the IPO, the final price is determined + The final price can be below, inside, or above the file price range - Historically, IPOs with a final price above the file range have been far more underpriced than those with a final price below or inside the file range

What four common misconceptions about the Efficient Market Hypothesis?

- EMH does not mean that you can't make money - EMH does mean that: + On average, you will earn a return appropriate for the risk undertaken + There is no bias in prices that can be exploited to earn excess returns + Market efficiency will not protect you from wrong choices if you do not diversify - you still don't want to put all your eggs in one basket

What are two advantages to using private issues over public issues?

- Easier to renegotiate than public issues - Lower costs than public issues + No SEC registration

What are four advantages of a sole proprietorship?

- Easiest to start - Least regulated - Single owner keeps all of the profits - Taxed once as personal income

What is the end result of the income statement?

- End result = Net Income = "Bottom Line" + Dividends paid to shareholders + Addition to retained earnings

What are two ways in which firms can manage exchange rate risk from short-run exposure?

- Enter into a forward agreement to guarantee the exchange rate - Use foreign currency options to lock in exchange rates if they move against you, but benefit from rates if they move in your favor

What are stock splits?

- Essentially the same as a stock dividend except expressed as a ratio + For example, a 2-for-1 stock split is the same as a 100% stock dividend - Stock price is reduced when the stock splits - Common explanation for split is to return price to a "more desirable trading range"

Euros and British pounds normally quoted as ______ quotations

- Euros and British pounds normally quoted as direct quotations + "The pound is selling at 1.5649 USD" - All other currencies quoted as indirect

Risk Premium

- Excess return on a risky asset over the risk-free rate - Reward for bearing risk

Noncash Items

- Expenses charged against revenue that do not affect cash flow - Depreciation = most important

What are two advantages of the Security Market Line approach?

- Explicitly adjusts for systematic risk - Applicable to all companies, as long as beta is available

What are five aspects of choosing a venture capitalist?

- Financial strength - Compatible management style - Obtain and check references - Contacts - Exit strategy

What is the Pure Play Approach?

- Find one or more companies that specialize in the product or service being considered - Compute the beta (the measure of systematic risk or volatility) for each company - Take an average - Use that beta along with the Capital Asset Pricing Model (CAPM) to find the appropriate return for a project of that risk - Pure play companies can be difficult to find

What are three aspects of zero balance accounts?

- Firm maintains + A master bank account + Several sub accounts - Bank automatically transfers funds from main account to subaccount as checks presented for payment - Requires safety stock buffer in main account only

How do time and costs relate to financial statements?

- Fixed or variable costs + Fixed - must be paid no matter what (e.g. property taxes) + Variable - can change (e.g. wages and payments to suppliers) In the long run, all costs are variable. - Not obvious on income statement

Funding for Venture Capital Stage Financing is provided in several ______________ .

- Funding for Venture Capital Stage Financing is provided in several stages - Contingent upon specified goals at each stage

What are two key issues of credit management?

- Granting credit increases sales - Costs of granting credit + Chance that customers won't pay + Financing receivables

What are three advantages to a restrictive financial policy?

- Higher returns on long term assets - Lower carrying costs - Short-Term liabilities can be decreased more easily in case of economic downturn

What are three key concepts and skills from Chapter 17: Working Capital Management?

- How firms manage cash and various collection, concentration, and disbursement techniques - How to manage receivables, and the basic components of credit policy - Various inventory types, different inventory management systems, and what determines the optimal inventory level

Where can you go on the web to see how recent IPOs have performed?

- How have recent IPOs performed? - Click on the Web surfer to go to Hoovers.com's "IPO Central" + Use the "IPO Calendar" to determine how many companies went public during the last week + Use "IPO Performance" to determine how companies that went public three months ago have performed. What about six months ago?

How would you work the web to determine the volatility of mutual funds?

- How volatile are mutual funds? - Morningstar provides information on mutual funds, including volatility (standard deviation) - Click on the Web surfer to go to the Morningstar site + Pick a fund, such as the Fidelity Magellan (FMAGX) + Enter the ticker in the "Stock/Fund" box, click on the "Go" button, and then click on "Ratings & Risk"

What are four aspects of IPO Underpricing?

- IPO pricing = very difficult No current market price available - Dutch Auctions designed to eliminate first day IPO price "pop" - Underpricing causes the issuer to "leave money on the table" - Degree of underpricing varies over time

How does a cash budget work?

- Identify sales and cash collections - Identify various cash outflows - Subtract outflows from inflows and determine investing and financing needs - Inflow - Outflow = Determine Investing and Financing Needs

Break-Even EBIT

- If we expect EBIT to be greater than the break-even point, then leverage is beneficial to our stockholders - If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders

What is Translation Exposure?

- Income from foreign operations translated back to U.S. dollars for accounting, even if foreign currency not actually converted: + If gains/losses flowed through directly to the income statement it could lead to significant Earnings Per Share (EPS) volatility

What are five sources of cash?

- Increase long-term debt - Increase equity - Increase current liabilities - Decrease current assets - Decrease fixed assets

What are the two kinds of international finance swaps?

- Interest Rate Swap - Currency Swap

What are the aspects of Case II: Corporate Taxes?

- Interest on debt is tax deductible - When a firm adds debt, it reduces taxes, all else equal - The reduction in taxes increases the cash flow of the firm - The reduction in taxes reduces net income

What are two reasons why we evaluate financial statements?

- Internal uses + Performance evaluation - compensation and comparison between divisions + Planning for the future - guide in estimating future cash flows - External uses + Creditors + Suppliers + Customers + Stockholders

What are five aspects of Firm Commitment Underwriting?

- Issuer sells entire issue to underwriting syndicate - Syndicate resells issue to the public - Underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold - Syndicate bears the risk of not being able to sell the entire issue for more than the cost - Most common type of underwriting in the United States

What are the four key concepts and skills of Chapter 12: Cost of Capital?

- Know how to determine: + A firm's cost of equity capital + A firm's cost of debt + A firm's overall cost of capital - Understand pitfalls of overall cost of capital and how to manage them

What are six aspects of a flexible short-term financial policy?

- Large amounts of cash and marketable securities (financial instruments that can be sold or redeemed within one year) (assets) - Large amounts of inventory - Liberal credit policies (large accounts receivable) - Relatively low levels of short-term liabilities - Flexible (conservative) policy has less short-term debt and more long-term debt - *High Liquidity* The debt in the short term liabilities account is usually made up of short-term bank loans taken out by a company, or of commercial paper, among other types.

What are three aspects of managing exchange rate risk?

- Large multinational firms may need to manage the exchange rate risk associated with several different currencies - The firm needs to consider its net exposure to currency risk instead of just looking at each currency separately - Hedging individual currencies could be expensive and may actually increase exposure

What are five indirect bankruptcy costs?

- Larger than direct costs, but more difficult to measure and estimate - Stockholders wish to avoid a formal bankruptcy - Bondholders want to keep existing assets intact so they can at least receive that money - Assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business - Lost sales, interrupted operations, and loss of valuable employees, low morale, inability to purchase goods on credit

What are three aspects of Foreign Exchange Trading? (FOREX Trading)

- Largest financial market in the world - Trading = 24/7 over-the-counter - Most trading in USD, £, ¥, and €

What are two disadvantages to a restrictive financial policy?

- Less liquidity for emergencies - Higher storage costs

Small stock dividend

- Less than 20 to 25% - If you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 shares

What are three effects of financial leverage?

- Leverage amplifies the variation in both Earnings Per Share (EPS) and Return on Equity (ROE) - We will ignore the effect of taxes at this stage - What happens to EPS and ROE when we issue debt and buy back shares of stock? - The variability in both ROE and EPS increases when financial leverage is increased. ROE = Net Income / Shareholder's Equity

What are five advantages of a corporation?

- Limited liability - Unlimited life - Separation of ownership and management - Transfer of ownership is easy - Easier to raise capital

What are four disadvantages of a sole proprietorship?

- Limited to life of owner - Equity capital limited to owner's personal wealth - Unlimited liability - Difficult to sell ownership interest

What are four kinds of unsecured loans that use short-term borrowing?

- Line of Credit - Committed - Non-Commited - Resolving Credit

What are two disadvantages to a flexible financial policy?

- Liquid Securities = Lower Return - Financing Short-Term Assets with Long-Term Debt risky

What are the five categories of financial ratios?

- Liquidity ratios or Short-term solvency - Financial leverage ratios or Long-term solvency ratios - Asset management or Turnover ratios - Profitability ratios - Market value ratios

What are six aspects of a restrictive short-term financial policy?

- Low cash and marketable security balances (financial instruments that can be sold or redeemed within one year) (assets) - Low inventory levels - Little or no credit sales (low accounts receivable) - Relatively high levels of short-term liabilities -Restrictive (aggressive) policy has more short-term debt and less long-term debt - *Low Liquidity* The debt in the short term liabilities account is usually made up of short-term bank loans taken out by a company, or of commercial paper, among other types.

Do Managers Act in the Shareholders' Interests?

- Managerial compensation + Incentives can be used to align management and stockholder interests + Incentives need to be carefully structured to insure that they achieve their goal - Corporate control + Threat of a takeover may result in better management Other stakeholders

What are the two different kinds of tax rates?

- Marginal Tax Rates - Average Tax Rates

What are three factors that influence a company's Weighted Average Cost of Capital (WACC)?

- Market conditions, especially interest rates, tax rates and the market risk premium - The firm's capital structure and dividend policy - The firm's investment policy + Firms with riskier projects generally have a higher WACC

Why are four areas of finance?

- Marketing + Budgets, marketing research, marketing financial products - Accounting + Dual accounting and finance function, preparation of financial statements - Management + Strategic thinking, job performance, profitability - Personal finance + Budgeting, retirement planning, college planning, day-to-day cash flow issues

What are the four characteristics of short term securities?

- Maturity - Default Risk - Marketability - Taxability

What are two ways in which firms can maximize shareholder wealth?

- Maximizing firm value - Minimizing Weighted Average Cost of Capital (WACC)

What are three ways in which firms can manage exchange rate risk from long-run exposure?

- More difficult to hedge - Try to match long-run inflows and outflows in the currency - Borrowing in the foreign country may mitigate some of the problems

What are three disadvantages of the Security Market Line approach?

- Must estimate the *expected* market risk premium, which does vary over time - Must estimate beta, which also varies over time - Relies on the past to predict the future, which is not always reliable

What are two other aspects of the balance sheet?

- Net working capital + Current Assets minus Current Liabilities + Usually positive for a healthy firm - Liquidity + Speed and ease of conversion to cash without significant loss of value + Valuable in avoiding financial distress

IPO Cost - Example (part 2)

- Next, we can calculate the direct costs. Part of the direct costs are given in the problem, but the company also had to pay the underwriters. The stock was offered at $34.40 per share, and the company received $32 per share. The difference, which is the underwriters' spread, is also a direct cost. - Total direct costs = $905,000 + ($34.40 - 32)(4,100,000 shares) = $10,745,000 - We are given part of the indirect costs, but the underpricing is another indirect cost. - Total indirect costs = $250,000 + ($41 - 34.40)(4,100,000 shares) = $27,310,000

What are three advantages to a flexible financial policy?

- No difficulty meeting short-term obligations - Cash available for emergencies - Lower storage costs

What there three requirements that need to be met for Absolute PPP to hold?

- No transaction costs - No barriers to trade (no taxes, tariffs, etc.) - No difference in the commodity between locations

What are three aspects of Lockup Agreements?

- Not legally required but common - Restricts insiders from selling IPO shares for a specified time period + Common lockup period = 180 days - Stock price tends to drop when the lockup period expires due to market anticipation of additional shares hitting the Street

What are four disadvantages of the dividend growth model?

- Only applicable to companies currently paying dividends - Not applicable if dividends aren't growing at a reasonably constant rate - Extremely sensitive to the estimated growth rate - Does not explicitly consider risk

What are the three components of Cash Flow from Assets?

- Operating Cash Flow - Capital Spending - Change in Net Working Capital

What are the five Operating Cycle equations?

- Operating Cycle - Inventory Period - Inventory Turnover - Accounts Receivable Period / Average Collection Period - Accounts Receivable Turnover

Line of Credit *Short-Term Borrowing Unsecured Loans*

- Prearranged agreement with a bank that allows the firm to borrow up to a certain amount on a short-term basis - May require a "Cleanup period"

Cost of Preferred Stock

- Preferred pays a constant dividend every period - Dividends expected to be paid forever - Preferred stock is a perpetuity

What are three aspects of a strong form efficient market?

- Prices reflect *all information*, including public and private - If true, then investors can not earn abnormal returns regardless of the information they possess - Empirical evidence indicates that markets are *NOT* strong form efficient + *Insiders* can earn abnormal returns (may be illegal)

What are three aspects of a weak form efficient market?

- Prices reflect *all past market information* such as price and volume - If true, then investors cannot earn abnormal returns by trading on market information - Implies that technical analysis will not lead to abnormal returns - Empirical evidence indicates that markets are generally weak form efficient

What are three aspects of a semi-strong form efficient market?

- Prices reflect all *publicly available information* including trading information, annual reports, press releases, etc. - If true, then investors cannot earn abnormal returns by trading on public information - Implies that fundamental analysis will not lead to abnormal returns

What is a cash budget?

- Primary tool in short-run financial planning + Identify short-term needs and opportunities + Identify when short-term financing may be required

What is an agency relationship?

- Principal hires an agent to represent its interests - Stockholders (principals) hire managers (agents) to run the company

What is Venture Capital? "Private Equity"

- Private financing for new, high risk businesses in exchange for stock + Individual investors + Venture capital firms - Usually involves active participation by Venture Capital (VC) - Ultimate goal: take company public + the VC will benefit from the capital raised in the IPO - Hard to find - Expensive

What are the four determinants of growth for a company?

- Profit margin: + operating efficiency - Total asset turnover: + asset use efficiency - Financial leverage + choice of optimal debt ratio - Dividend policy + choice of how much to pay to shareholders versus reinvesting in the firm

What are the two methods of issuing securities to the public?

- Public Issue - Private Issue

What is Relative Purchasing Power Parity?

- Quantifies inflation-exchange rate relationship - Provides information about what causes changes in exchange rates - Exchange rates depend on relative inflation between countries E(St ) = S0[1 + (hFC - hUS)]^t Expected Exchange Rate at Time t = Current Spot Exchange [1 + (Inflation Rate in Foreign Country - Inflation Rate in the U.S.]^time t S0 = Current spot exchange rate E(ST) = Expected exchange rate at time t hUS = Inflation rate in the U.S. hFC = Inflation rate in foreign country

London Interbank Offer Rate (LIBOR)

- Rate international banks charge each other for loans of Eurodollars overnight in the London market - Frequently used as a benchmark rate for money market instruments

Risk-Free Rate

- Rate of return on a riskless investment - Treasury Bills are considered risk-free

GAAP Matching Principle

- Recognize revenue when it is fully earned - Match expenses required to generate revenue to the period of recognition

What are five aspects of a public issue?

- Registration with SEC required - General cash offer: Offered to general public - Rights offer: Offered only to current shareholders - Initial Public Offering (IPO): Unseasoned new issue - Seasoned Equity Offering (SEO)

What are the four kinds of cash dividends?

- Regular Cash Dividend - Extra Cash Dividend - Special Cash Dividend - Liquidating Dividend

What are the two main differences between a repurchase and a cash dividend?

- Repurchase returns cash from the firm to the stockholders - Same as cash dividend in the absence of taxes and transactions costs

Arithmetic Average

- Return earned in an average period over multiple periods - Answers the question: "What was your return in an average year over a particular period?"

What are reserve stock splits?

- Reverse Split reduces number of shares outstanding + For example, a 1-for-5 stock split replaces every 5 shares of stock with one share

What are four aspects of shelf registration?

- SEC Rule 415 - Permits firm to register a large issue with the SEC and sell it in small portions - Reduces flotation costs - Allows company more flexibility to raise money quickly

American Depositary Receipt (ADR)

- Security issued in the U.S. representing shares of a foreign stock - Can be traded in the U.S.

What are two disadvantages of a corporation?

- Separation of ownership and management (agency problem) - Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate, while dividends paid are not tax deductible)

What are three important questions that are answered by an Investment Banker?

- Should we issue securities to fund our company? - Public or Private? Domestic or Foreign ? - How will we manage the everyday risks of being a public entity?

How can you slow down disbursement float?

- Slowing down payments can increase disbursement float + Mail checks from distant bank or post office + May not be ethical or optimal

What was earnings management do?

- Smoothing earnings - GAAP leaves "wiggle room" - Global standardization of accounting + GAAP versus IFRS

Foreign bonds

- Sold by foreign borrower - Denominated in currency of the country of issue

What are two aspects of a private issue?

- Sold to fewer than 35 investors - SEC registration not required

What is the efficient market hypothesis?

- Stock prices are in equilibrium - Stocks are "fairly" priced - Informational efficiency - If true, you should not be able to earn "abnormal" or "excess" returns - Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market

What are three job opportunities in investment banking?

- Stockbroker or financial advisor - Portfolio manager - Security analyst

What are three forms of market efficiency?

- Strong-form Efficient Market: + Information = Public or private + *"Inside information" is of little use* - Semistrong-form Efficient Market: + Information = publicly available information + *Fundamental analysis is of little use* - Weak-form Efficient Market: + Information = past prices and volume data + *Technical analysis is of little use*

What are four patterns regarding the cost of issuing securities?

- Substantial economies of scale (A proportionate saving in costs gained by an increased level of production) - Costs of selling debt is less than the cost of issuing equity - IPO costs are greater than SEO costs - Straight bonds are more costly to issue than Convertible bonds

Proposition II: the systematic risk of the stock depends on what two factors?

- Systematic risk of the assets, RA, (business risk) - Level of leverage, D/E, (financial risk)

What are three components of credit policy?

- Terms of Sale - Credit Analysis - Collection Policy

IPO Cost - Example (part 1)

- The Faulk Co. has just gone public under a firm commitment agreement. Faulk received $32 for each of the 4.1 million shares sold. The initial offering price was $34.40 per share, and the stock rose to $41 per share in the first few minutes of trading. Faulk paid $905,000 in legal and other direct costs and $250,000 in indirect costs. What was the flotation cost as a percentage of funds raised? - The net amount raised is the number of shares offered times the price received by the company, minus the costs associated with the offer, so: - Net amount raised = (4,100,000 shares)($32) - 905,000 - 250,000 = $130,045,000

What website can be used to make ratio analysis simpler?

- The Internet makes ratio analysis much easier than it has been in the past - Click on the Web surfer to go to www.reuters.com + Choose a company and enter its ticker symbol + Click on "Financial Results" and "Key Ratios" to compare the firm to its industry and the S&P 500 for various ratio categories + Change the ratio category using the links to the left of the chart.

What happened during the Great Recession?

- The S&P 500 lost 50% of its value from November 2007 through March 2009 + On the other hand, long-term Treasuries gained 40% during 2008 - A Global Phenomenon - Volatile in both directions + The S&P 500 doubled in value from March 2009 through February 2011

Which is better: Arithmetic or Geometric Mean?

- The arithmetic average is overly optimistic for long horizons - The geometric average is overly pessimistic for short horizons - Depends on the planning period under consideration + 15 - 20 years or less: use arithmetic + 20 - 40 years or so: split the difference between them + 40 + years: use the geometric

What is the cost of equity?

- The cost of equity is the return required by equity investors given the risk of the cash flows from the firm

What is the cost to a firm for capital funding?

- The cost to a firm for capital funding = the return to the providers of those funds - The return earned on assets depends on the risk of those assets - A firm's cost of capital indicates how the market views the risk of the firm's assets - A firm must earn at least the required return to compensate investors for the financing they have provided - The required return is the same as the appropriate discount rate

What are four key concepts and skills of Chapter 2?

- The difference between book value and market value - The difference between accounting income and cash flow - The difference between average and marginal tax rates - How to determine a firm's cash flow from its financial statements

What are three aspects of cross rates?

- The exchange rate between any two currencies not involving U.S. dollars - Usually calculated from direct or indirect rates - Based on U.S. dollar exchange rates

Forward rate (F)

- The exchange rate specified today in a forward contract to exchange currency at some future date - Normally reported as indirect quotations

What does the income statement measure?

- The income statement measures performance over a specified period of time (period, quarter, year). - Report revenues first and then deduct any expenses for the period

Exchange Rate

- The price of one country's currency in terms of another + Most currency quoted in terms of dollars (i.e. direct quote)

What is Economic Order Quantity (EOQ) model?

- The restocking quantity that minimizes the total inventory costs. - EOQ = Economic Order Quantity - EOQ minimizes total inventory cost - Q = inventory quantity in each order - Q/2 = Average inventory T = firm's total unit sales per year - T/Q = number of orders per year - CC = Inventory carrying cost per unit - F = Fixed cost per order

What is Exchange Rate Risk?

- The risk that the value of a cash flow in one currency translated from another currency will decline due to a change in exchange rates. - A natural consequence of international operations in a world where relative currency values move up and down.

What is Capital Structure Theory?

- The value of the firm is determined by the cash flows to the firm and the risk of the firm's assets - Modigliani and Miller + M&M Proposition I: The Pie Model + M&M Proposition II: Weighted Average Cost of Capital (WACC) - Changing firm value + Change the risk of the cash flows + Change the cash flows

What is M&M Proposition I? (The Pie Model)

- The value of the firm is independent of its capital structure - The value of the firm is NOT affected by changes in the capital structure - The cash flows of the firm do not change; therefore, value doesn't change - The size of the pie is the same for both firms because the value of the assets are the same. - The size doesn't depend on how it is sliced.

What are two key lessons from capital market history?

- There is a reward for bearing risk - The greater the potential reward, the greater the risk This is known as a risk-return tradeoff

What are the two kinds of Bench marking?

- Time-Trend Analysis + How the firm's performance is changing through time + Internal and external uses - Peer Group Analysis + Compare to similar companies or within industries + SIC and NAICS codes

IPO Cost - Example (part 3)

- Total costs = $10,745,000 + 27,310,000 = $38,055,000 - The flotation costs as a percentage of the amount raised is the total cost divided by the amount raised, or: - Flotation cost percentage = $38,055,000 / $130,045,000 - *Flotation cost percentage = .2926, or 29.26%*

What are four advantages to a partnership?

- Two or more owners - More capital available - Relatively easy to start - Income taxed once as personal income

What are four aspects of Best Efforts Underwriting?

- Underwriter makes "best effort" to sell the securities at an agreed-upon offering price - Issuing company bears the risk of the issue not being sold - Offer may be pulled if not enough interest at the offer price + Company does not get the capital and they have still incurred substantial flotation costs - Not as common as it used to be

What are two reasons that IPOs are usually underpriced?

- Underwriters want offerings to sell out + Reputation for successful IPOs is critical + Underpricing = insurance for underwriters + Oversubscription & allotment + "Winner's Curse" - Smaller, riskier IPOs underprice to attract investors

What are four disadvantages to a partnership?

- Unlimited liability + General partnership + Limited partnership - Partnership dissolves when one partner dies or wishes to sell - Difficult to transfer ownership

What is Weighted Average Cost of Capital (WACC)?

- Use the individual costs of capital to compute a weighted "average" cost of capital for the firm - This "average" equals the required return on the firm's assets, based on the market's perception of the risk of those assets - The WACC is the overall return the firm must earn on its existing assets to maintain the value of its stock. - The weights are determined by how much of each type of financing is used

What is Weighted Average Cost of Capital (WACC)?

- Use the individual costs of capital to compute a weighted "average" cost of capital for the firm - This "average" equals the required return on the firm's assets, based on the market's perception of the risk of those assets - The weights are determined by how much of each type of financing is used

What are two ways to monitor receivables?

- Watch average collection period relative to firm's credit terms - Use aging schedule to monitor percentage of overdue payments

What are three important questions that are answered using finance?

- What long-term investments should the firm take on? - Where will we get the long-term financing to pay for the investments? - How will we manage the everyday financial activities of the firm?

What are three aspects of a commercial draft?

- When draft presented, buyer "accepts" it + Indicates promise to pay + "Trade acceptance" - Seller may keep or sell acceptance - *Banker's acceptance* - Bank Guarantees Payment

Calculating Total Dollar and Total Percent Returns

- You invest in a stock with a share price of $25. - After one year, the stock price per share is $35 - Each share paid a $2 dividend - What was your total return?

What are three aspects of Collection and Disbursement Times?

1. *Mailing Time*: The part of the collection and disbursement process during which checks are trapped in the portal system. 2. *Processing Delay*: The time it takes the receiver of a check to process the payment and deposit it in a bank for collection. 3. *Availability Delay*: Refers to the time required to clear a check though the banking system. + To speed collections, decrease one or more. + To slow disbursements, increase one or more.

What are five conclusions we can draw from dividends?

1. Aggregate dividend and stock repurchases are massive and have increased steadily. 2. Dividends heavily concentrated among a small number of large firms 3. Managers very reluctant to cut dividends 4. Managers smooth dividends, raising them slowly as earnings grow. 5. Stock prices react to unanticipated changes in dividends

What are four pros of paying dividends?

1. Cash dividends underscore good results and provide support to stock price 2. Dividends may attract institutional investors 3. Stock price usually increases with a new or increased dividend 4. Dividends absorb excess cash and may reduce agency costs (costs of disagreement between shareholders and business managers)

What are the two methods for calculating the cost of debt?

1. Compute the yield to maturity on existing debt 2. Use estimates of current rates based on the bond rating expected on new debt

What are the five basic areas of finance?

1. Corporate finance = Business Finance 2. Investments 3. Financial institutions 4. International finance 5. Investment Banking

What is the chronology for dividend payments?

1. Declaration Date: + Board declares the dividend and it becomes a liability of the firm. 2. Ex-dividend Date: + Occurs two business days before date of record + If you buy stock on or after this date, you will not receive the upcoming dividend + Stock price generally drops by approximately the amount of the dividend 3. Date of Record: + holders of record are determined, and they will receive the dividend payment 4. Date of Payment: Checks are mailed

What are three cons to paying dividends?

1. Dividends are taxed to recipients 2. Dividends can reduce internal sources of funding + May force firm to forgo positive (Net Present Value) NPV projects + May require external financing 3. Once established, dividends cuts are hard to make without adversely affecting a firm's stock price.

What are three aspects of a flexible short-term financial policy?

1. Keeping large balances of cash and marketable securities (debts that can be sold or redeemed within a year) 2. Making large investments in inventory 3.Granting liberal credit terms, which results in a high level of accounts recievable

What are three aspects of a restrictive short-term financial policy?

1. Keeping low cash balances and little investment in marketable securties (debts that can be sold or redeemed within a year) 2. Making small investments in inventory 3. Allowing few or no credit sales, thereby minimizing accounts recievable

What are six steps of selling securities to the public?

1. Management obtains permission from the Board of Directors. 2. Firm files a registration statement with the SEC. 3. The SEC examines the registration during a 20-day waiting period. 4. Securities may not be sold during the waiting period. 5. A preliminary prospectus, called a red herring, is distributed during the waiting period + If problems, the company amends the registration, and the waiting period starts over 6. Price per share determined on the effective date of the registration and the selling effort begins

What are the six main cots of issuing securities?

1. Spread 2. Other direct expenses 3. Indirect expenses 4. Abnormal returns 5. Underpricing 6. Green Shoe Option

Lockboxes and Cash Concentration (slide)

1. Statements are sent by mail to firm for receivables processing 2. Funds are transferred to concentration bank. 3. Cash manager analyzes bank balance and deposit information and makes cash allocation revision.

What are four carrying costs of keeping inventory on hand?

1. Storage and tracking costs 2. Insurance and taxes 3. Losses due to obsolescence, deterioration, or theft 4. Opportunity cost of capital for the invested amount

What are three conclusions we can take away from Trans Am Corp?

1. The effect of leverage depends on Earnings Before Interest and Taxes (EBIT) + When EBIT is higher, leverage is beneficial + When EBIT is lower, leverage is detrimental 2. Under the "Expected" scenario, leverage increases Return on Equity (ROE) and Earnings Per Share (EPS) 3. Shareholders are exposed to more risk with more leverage + ROE and EPS more sensitive to changes in EBIT

Overview of Lockbox Processing (slide)

1. The flow starts when a customer mails remittances to a post offie instead of to the corporation. 2. Several times day the bank collects the lockbox receipts from the post office. 3. The checks are then put into the company bank accounts.

What are the three main carrying costs associated with granting credit?

1. The required return on receivables. 2. The losses from bad debts. 3. The cost of managing credit and credit collections. Carrying Costs: Costs that rise with increases in the level of investment in current assets.

What are the three main carrying costs associated with granting credit?

1. The required return on receivables. 2. The losses from bad debts. 3. the cost of managing credit and credit collections. Carrying Costs: Costs that rise with increases in the level of investment in current assets.

What are four reasons for reserve stock splits?

1. Transactions costs may be less for investors 2. Liquidity might be improved 3. Too low a price not considered "respectable" 4. Exchange minimum price per share requirements

What is a current asset?

A current asset has a life of less than one year. This means that the asset will normally convert to cash within 12 months.

Cash discount

A discount given to induce prompt payment. Also sales discount.

A firm's WACC reflects the risk of an ____________ project undertaken by the firm

A firm's WACC reflects the risk of an average project undertaken by the firm + "Average" risk = the firm's current operations

A firm's WACC reflects the risk of an ____________ project undertaken by the firm

A firm's WACC reflects the risk of an average project undertaken by the firm + "Average" risk = the firm's current operations Weighted Average Cost of Capital (WACC) - The weighted average of the cost of equity and the aftertax cost of debt.

Cash Flow to Creditors

A firm's interest payments to creditors less net new borrowing

What are fixed assets?

A fixed asset is one that has a relatively long life. Fixed assets can be *tangible*, such as a truck or a computer, or *intangible* such as trademark or patent.

What is a syndicate?

A group of investment bankers that market the securities and share the risk associated with selling the issue

What is a corporation?

A legal "person" distinct from owners and a resident of a state

Commercial Draft (Bill of Exchange)

A note issued by one party that orders another party to pay a specified sum on a specified date.

What are Seasoned Equity Offerings?

A seasoned equity offering or secondary equity offering (SEO) or capital increase is a new equity issue by an already publicly traded company.

Balance Sheet

A snapshot of the firm's assets and liabilities at a given point in time ("as of ...")

Cost of Equity (Re)

A. Dividend Growth Model Approach (DGM) Re = (D1 / P0) + g Cost of Equity = (Expected Dividend in One Period/ Current Stock Price) + Dividend Growth Rate B. Securities Market Line Approach (SML) Re = Rf + Be x (Rm - Rf) Cost of Equity = Risk Free Rate + The Systematic Risk of the Equity x (Expected Return on the Overall Market - Risk Free Rate)

How does cash flow between the firm and the financial markets?

A. Firm issues securities to raise cash B. Firm invests in assets C. Firm's operations generate cash flow. D. Cash is paid to government as taxes. Other stakeholders may receive cash. E. Reinvested cash flows are plowed back into the firm. F. Cash is paid out to investors in the form of interest and dividends.

Cost of Debt (Rd)

A. For a firm with publicly held debt, the cost of debt can be measured as the yield to maturity on the outstanding debt. The coupon rate is irrelevant. B. If the firm has no publicly held debt, then the cost of debt can be measured as the yield to maturity on similarly rated bonds.

M&M Summary: The No-Tax Case

A. Proposition I: The value of the leveraged firm (VL) is equal to the value of the unleveraged firm firm (VU) VL = VU B. Implications of Proposition I: 1. A firm's capital structure is irrelevant. 2. A firm's weighted average cost of capital, WACC, is the same no matter what mixture of debt and equity is used to finance the firm. C. Proposition II: The cost of equity, Re, is: Re = Ra + (Ra - R0) x D/E Cost of Equity = Required Return on the Firms Assets + (Required Return on the Firms Assets - The Cost of Debt) x The Debt-Equity Ratio RA = WACC D. Implications of Proposition II: 1. The cost of equity rises as the firm increases its use of debt financing. 2. The risk of equity depends on two things: the riskiness of the firm's operations (business risk) and the degree of financial leverage (financial risk). Business risk determines Required Return on Assets (RA), and financial risk is determined by the Debt Equity Ratio (D/E).

Weighted Average Cost of Capital (WACC)

A. The Firm's WACC is the overall required return on the firm as a whole. It is the appropriate discount rate to use for cash flows similar in risk to the overall firm. B. The WACC is calculated as: WACC = (E/V) x Re + (D/V) x Rd x (1 - Tc) Weighted Average Cost of Capital = Percentage Financed with Equity x Cost of Equity + Percentage Financed with Debt x Cost of Debt x (1 - Corporate Tax Rate) Tc = Corporate Tax Rate D = Market Value of the Firm's Debt E = Market Value of the Firm's Equity V = D + E E/V = Percentage of the Firm's Financing (in Market Value Terms) that is Equity D/V = Percentage of the Firm's Financing (in Market Value Terms) that is Debt

Optimal Capital Structure

According to the static theory, the gain from the tax shield on the debt is offset by financial distress costs. An optimal capital structure exists that just balances the additional leverage against the added financial distress costs.

What is the equation for the Accounts Payable Period?

Accounts payable period = 365/Payables Turnover

What is the equation for Accounts Receivable Period? aka Average Collection Period

Accounts receivable period = 365/Receivables turnover aka Average Collection Period

What is the equation for Accounts Receivable Turnover?

Accounts receivable turnover = Credit sales/Average accounts receivable

What are Temporary Current Assets?

Additional current assets added when sales are expected to increase on a seasonal basis

Adjusting for risk ________________ the decisions

Adjusting for risk changes the decisions

Currency Swap

Agreement to deliver one currency in exchange for another

What are Common-Size Balance Sheets?

All accounts = percent of total assets (%TA)

What are Common-Size Income Statements?

All line items = percent of sales or revenue (%SLS)

International Corporate Forms

All of these forms feature public ownership and limited liability

International Finance

An area of specialization within each of the areas discussed so far

An indirect quotation is the reciprocal of a ______ quotation

An indirect quotation is the reciprocal of a direct quotation - Direct Quotation = 1/Indirect Quotation

What is the accounting equation?

Assets = Liabilities + Stockholders' Equity aka the Balance Sheet identity

What is the average for total direct costs of issuing securities?

Average total direct costs ≈ 10.4% + Largest direct cost, gross spread average ≈ 7.2% + Direct costs very large, especially for issues greater than $10 million (25.22%)

What is Default Risk? *Characteristics of Short-Term Securities*

Avoid investing in marketable securities with significant default risk

Bankruptcy can be expensive and ________.

Bankruptcy can be expensive and slow. - Prepacks: pre-packaged filings - Cram-downs: court-ordered plan acceptance - Section 363: auction-like bankruptcy - Workouts: negotiated extensions or payments

What are credit instruments?

Basic evidence of indebtedness

Eurobond

Bond issued in multiple countries but denominated in the issuer's home currency

What is a compromise policy?

Borrow short-term to meet peak needs, and maintain a cash reserve for emergencies

Gilts

British and Irish government securities

What is a sole proprietorship?

Business owned by one person

What is a partnership?

Business owned by two or more persons

Capital Gains Yield

CGY = Pt+1 - Pt / Pt (Stock Price After First Period - Initial Stock Price)/Initial Stock Price % Return = Dividend Yield + Capital Gains Yield % Return = Dt+1 + Pt+1 - Pt / Pt

Capital Spending

Capital spending refers to the net spending on fixed assets (purchases of fixed assets less sales of fixed assets).

What is capital structure?

Capital structure = percent of debt and equity used to fund the firm's assets + "Leverage" = use of debt in capital structure + Debt to Equity Ratio = Total Debt / Total Equity

Observed Capital Structures Capital structure differs by ____________.

Capital structure differs by industries. - Differences according to Cost of Capital 2010 Yearbook by Ibbotson Associates, Inc. + Lowest levels of debt * Computer equipment = 9.09% * Drugs = 7.80% debt + Highest levels of debt * Pay television = 63.56% * Airlines = 63.92% debt

Covered Interest Arbitrage

Capitalizing on the interest rate differential between two countries while covering exchange rate risk with a forward contract.

Carrying costs = 20-___% of inventory value per year

Carrying costs = 20-40% of inventory value per year

What are the carrying costs of a credit policy?

Carrying costs: - Required return on receivables - Losses from bad debts - Cost of managing credit & collections Carrying Costs: Costs that rise with increases in the level of investment in current assets.

The Capital Structure Question

Case I: With no taxes or bankruptcy costs, the value of the firm and its weighted average cost of capital are not affected by capital structures. Case II: With corporate taxes and no bankruptcy costs, the value of the firm increases and the weighted average cost of capital decreases as the amount of debt goes up. Case III: With corporate taxes and bankruptcy costs, the value of the leveraged firm, VL, reaches a a maximum at D*, the optimal amount of borrowing. At the same time, the weighted average cost of capital (WACC) is minimized at D*/E* (Debt-Equity Ratio*)

What is the equation to determine Cash Flow From Assets?

Cash Flow From Assets = Operating Cash Flow - Net Capital Spending - Change in net working capital (NWC) Operating cash flow = Earnings before interest and taxes (EBIT) + Depreciation - Taxes Net Capital Spending = Ending net fixed assets - Beginning net fixed assets + Depreciation Change in Net Working Capital (NWC) = Ending NWC - Beginning NWC

What is the equation to determine Cash Flow From Assets?

Cash Flow From Assets = Operating Cash Flow - Net Capital Spending - Change in net working capital (NWC) Operating cash flow = Earnings before interest and taxes (EBIT) + Depreciation - Taxes Net Capital Spending = Ending net fixed assets - Beginning net fixed assets + Depreciation Change it Net Working Capital (NWC) = Ending NWC - Beginning NWC

What is the cash flow identity?

Cash Flow From Assets = Cash Flow to Creditors (Bondholders) + Cash Flow to Stockholders (Owners)

What is the equation for Cash Cycle?

Cash cycle = Operating Cycle - Accounts Payable Period

What is the equation for the Cash Cycle?

Cash cycle = operating cycle - accounts payable period Accounts payable period = time between receipt of inventory and payment for it

What are two tax effects of Cash Dividends?

Cash dividends: - No investor control over timing or size - Taxed as ordinary income

What is the equation to determine cash flow to stockholders (owners)?

Cash flow to stockholders = Dividends paid - Net new equity raised

Operating Cash Flow

Cash generated from a firm's normal business activities.

Regular Cash Dividend

Cash payments made directly to stockholders, usually each quarter

What are financial institutions?

Companies that specialize in financial matters

What is a stock repurchase?

Company buys back shares of its own stock: - Open market: company buys its own stock in the open market (at market price) - Tender offer: company states a purchase price and a desired number of shares to be bought (almost always at a premium to the market price) Targeted repurchase: Firm repurchases shares from specific individual shareholders

What are the repercussions of the Sarbanes Oxley Act?

Compliance very costly Firms driven to: - Go public outside the U.S. - Go private ("go dark")

Homemade Leverage & ROE

Conclusion: - Any stockholder who prefers leverage can create their own "homemade" and replicate the payoffs - Trans Am's capital structure is irrelevant to shareholders

Terms of Sale

Conditions under which a firm sells its goods and services for cash and credit

What is the agency problem?

Conflict of interest between principal and agent

What is Taxibility? *Characteristics of Short-Term Securities*

Consider different tax characteristics when making a decision

Chapter 12

Cost of Capital

shortage costs

Costs that fall with increases in the level of investment in current assets

carrying costs

Costs that rise with the increases in the level of investment in current assets

Net Working Capital (NWC)

Current assets Minus Current Liabilities Current Assets: Cash and other assets that are expected to be converted to cash within a year. Current Liabilities: Current liabilities are a company's debts or obligations that are due within one year or within a normal operating cycle.

Dealer vs. Auction Markets

Dealers buy and sell for themselves, at their own risk. Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Most trading in debt securities takes place over the counter. Auction markets differ from dealer markets in two ways. First, an auction market, or exchange, has a physical location (like Wall Street). Second, in a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role.

How would Perishable goods with low collateral value effect a credit period?

Decrease Credit Period

How would high credit risk effect a credit period?

Decrease Credit Period

How would low cost, low profitability, and high standardization effect a credit period? (standardization in cost)

Decrease Credit Period

How would small account size effect a credit period?

Decrease Credit Period

What are three factors favoring a high payout?

Desire for current income: - Individuals in low tax brackets - Groups that are prohibited from spending principal (trusts and endowments) Uncertainty resolution: - No guarantee that the higher future dividends will materialize Taxes: - Dividend exclusion for corporations - Dividends versus capital gains irrelevant to tax-exempt investors

What is float?

Difference between cash balance recorded in the cash account and the cash balance recorded at the bank The difference between book cash and bank cash, representing the net effect of checks in the process of clearing.

What is a spread?

Difference between what the syndicate pays the company and what the security sells for in the market

What is a spread?

Difference between what the syndicate pays the company and what thesecurity sells for in the market

Different divisions/projects may have ____________ risks

Different divisions/projects may have different risks + The division's or project's WACC should be adjusted to reflect the appropriate risk and capital structure

Is disbursement float desirable or undesirable?

Disbursement float is desirable. Disbursement float is when your available bank balance is greater than your book balance, and is usually caused by writing checks.

What is credit analysis?

Distinguishing between "good" customers that will pay and "bad" customers that will default

Dividend Yield

Dividend Yield = Annual Dividend / Stock Price x 100 or Dividend yield = Dividend x Dividends per year / Stock price x 100 DY = Dt + 1 / Pt

Internal and Sustainable Growth Payout and Retention Ratios

Dividend payout ratio ("1 - b") = (Yearly Dividends Per Share / Earnings Per Share) = DPS / EPS = Cash dividends / Net income Retention ratio ("b") = (Net Income - Dividends) / Net Income = (EPS - DPS) / EPS = (Addition to Retained Earnings) / Net income

Chapter 14

Dividends and Dividend Policy

Cash Flow to Stockholders

Dividends paid out by a firm less net new equity raised

Eurodollars

Dollar-denominated deposits in banks outside the U.S. banking system

THE

END :)

What is Marketability? *Characteristics of Short-Term Securities*

Ease of converting to cash otherwise known as Liquidity

What is one advantage of the Dividend Growth Model?

Easy to Understand and Use

What is a collection policy?

Effort expended on collecting receivables

Exchanges facilitate the flow of ____________.

Exchanges facilitate the flow of capital. - Extremely important to developing countries - *Differences:* + Market Structure + Regulation + Trading rules

Change in Net Working Capital (NWC)

Finally, the change in net working capital is the amount spent on net working capital. It is measured as the change in net working capital over the period being examined and represents the net increase or decrease in current assets over current liabilities. Change in NWC = Ending NWC - Beginning NWC Remember: Net Working Capital (NWC) = Currents Assets - Current Liabilities

Financial Managers use capital structure theory to help determine the mix of debt & equity at which the weighted average cost of capital is ________.

Financial Managers use capital structure theory to help determine the mix of debt & equity at which the weighted average cost of capital is lowest.

Chapter 2

Financial Statements, Taxes, and Cash Flow

What are money market securities?

Financial instruments with original maturity of less than or equal to one year

What is the inventory management objective?

Find the optimal trade-off between carrying too much inventory versus not enough

How do you find the implied interest rate when customers do not take the discount?

Finding the implied interest rate when customers do not take the discount: - Credit terms of 2/10 net 45 and $500 loan + $10 interest (= .02*500) + Period rate = 10 / 490 = 2.0408% + Period = (45 - 10) = 35 days + 365 / 35 = 10.4286 periods per year - EAR = (1.020408)10.4286 - 1 = 23.45% - The company benefits when customers choose to forgo discounts

What is Maturity? *Characteristics of Short-Term Securities*

Firms often limit the maturity of short-term investments to 90 days to avoid loss of principal due to changing interest rates

What is the first stage of venture capital stage financing?

First stage: - "Ground floor" or "Seed money" - Fund prototype and manufacturing plan

Floatation Costs

Floatation costs are incurred by a publicly traded company when it issues new securities, and includes expenses such as underwriting fees, legal fees and registration fees.

Floatation Costs

Flotation costs are incurred by a publicly traded company when it issues new securities, and includes expenses such as underwriting fees, legal fees and registration fees.

Eastman Chemical: Cost of Debt (slide 9)

For Eastman, the cost of debt is similar when using either book values or market values.

Underpricing

For initial public offerings, losses arise from selling the stock below the true value.

Committed *Short-Term Borrowing Unsecured Loans*

Formal legal arrangement that may require a commitment fee and generally has a floating interest rate

Which is greater: the geometric or compound average?

Geometric average < arithmetic average unless all the returns are equal

How do you estimate the weights of WACC?

Given: - Stock price = $50; 3m shares common stock - $25m preferred stock - $75m debt - 40% Tax rate Component Costs: - Firm's Cost of Equity (RE) = 14% - Firm's Cost of Preferred Stock (RP) = 9% - Firm's Cost of Debt (RD) = 10% Component Values: - Value of Equity (VE) = $50 x (3 m) = $150m - Value of Preferred Stock (VP) = $25m - Value of Debt (VD) = $75m - Total Value of Financing (VF) = $150+$25+$75=$250m Component Weights: Percent Financed with Equity (E/V) = $150/$250 = 0.6 (60%) Percent Financed with Preferred Stock (P/V) = $25/$250 = 0.1 (10%) Percent Financed with Debt (D/V) = $75/$250 = 0.3 (30%) WACC = 0.6(14%) + 0.1(9%) + 0.3(10%)(1-.40) WACC = 8.4% + 0.9% + 1.8% = 11.1% WACC = (E/V) x Re + (P/V) x Rp + (D/V) x Rd x (1-Tc) Weighted Average Cost of Capital = Percent of Common Equity in Capital Structure x Firm's Cost of Equity + Percent of Preferred Stock in Capital Structure x Firm's Cost of Preferred Stock + Percentage of Debt in Capital Structure x Firm's of Cost of Debt x (1 - Firm's Corporate Tax Rate)

Credit Cost Curve

Graphical representation of the sum of the carrying costs and the opportunity costs of a credit policy.

What are the key concepts and skills of chapter 1: introduction to financial management?

Have a good understanding of: - The basic types of financial management decisions and the role of the financial manager - The goal of financial management - The financial implications of the different forms of business organization - The conflicts of interest that can arise between owners and managers

Cash Flow

How cash is generated from utilizing assets and how it is paid to those who finance the asset purchase The accounting Statement of Cash Flows does *not* provide the same information that we are interested in here One of the most important pieces of information that can be derived from financial statements

What does the internal growth rate measure?

How much the firm can grow assets using retained earnings as the only source of financing

What was the internal growth rate measure?

How much the firm can grow assets using retained earnings as the only source of financing

What does the sustainable growth rate measure?

How much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.

Divisional Risk & the Cost of Capital

If a firm uses its Weighted Average Cost of Capital (WACC) to make accept-reject decisions for all types of projects, it will have a tendency toward incorrectly accepting risky projects and incorrectly rejecting less risky projects.

What are two things that happen is there is a restrictive credit policy in place?

If restrictive credit policy: - Carrying costs low - Credit shortage = opportunity costs Carrying Costs: Costs that rise with increases in the level of investment in current assets.

Cross-rate

Implicit exchange rate between two currencies when both are quoted in a third (usually dollars) currency

Abnormal Returns

In a seasoned issue of stock, the price of the existing stock drops on average by 3 percent upon the announcement of the issue. This drop is called the abnormal return.

NASD Automated Quotations system (NASDAQ)

In addition to the stock exchanges, there is a large OTC market for stocks. In 1971, the National Association of Securities Dealers (NASD) made available to dealers and brokers an electronic quotation system called NASDAQ (NASD Automated Quotations system, pronounced "naz-dak"). There are more companies listed on NASDAQ than there are on NYSE, but they tend to be much smaller in size and trade less actively. There are exceptions, of course. Both Microsoft and Intel trade OTC, for example. Nonetheless, the total value of NASDAQ stocks is significantly less than the total value of NYSE stocks.

How would competition effect a credit period?

Increase Credit Period

How would low consumer demand effect a credit period?

Increase Credit Period

Extra Cash Dividend

Indication that the "extra" amount may not be repeated in the future

Non-Committed Credit Line *Short-Term Borrowing Unsecured Loans*

Informal agreement with a bank that is similar to credit card debt for individuals

Sarbanes-Oxley Act (SarBox, 2002)

Intended to strengthen protection against accounting fraud and financial malpractice

Chapter 18

International Aspects of Financial Planning

Chapter 1

Introduction to Financial Management

Inventory is a _______ percentage of firm assets

Inventory is a large percentage of firm assets

What is the equation for Invention Period?

Inventory period = 365/Inventory turnover

What is the equation for Inventory Turnover?

Inventory turnover = COGS/Average Inventory COGS = Cost of Goods Sold

How do dividends payouts effect clientele?

Investor preference: - Some investors prefer low dividend payouts - Some investors prefer high payouts - Investors will buy stock in companies that meet their dividend preferences What do you think will happen if a firm changes its policy from a high payout to a low payout? ... or vice versa?

What is Interest Rate Parity? (IRP)

Investors should expect to earn the same return on similar-risk securities in all countries

Are issue costs greater for equity or for debt?

Issue costs for equity, direct and indirect, are significantly more than for debt.

Chapter 13

Leverage and Capital Structure

What is Long-Run Exposure?

Long-run fluctuations from unanticipated changes in relative economic conditions.

Graph of M&M Proposition II with Taxes

M&M Proposition I with taxes implies that firm's Weighted Average Cost of Capital (WACC) decreases as the firm relies more heavily on debt financing. M&M Proposition II with taxes implies that a firm's cost of equity (Re) rises as the firm relies more heavily on debt financing.

What two aspects of float are management most concerned with?

Management are most concerned with Net Float and Available Bank Balance.

What is most prevalent aspect of the agency problem?

Management goals and agency costs

What is the primary goal of financial managers?

Maximize stockholder wealth

What should be the goal of a corporation?

Maximize the market value of the existing owners' equity

Eurocurrency

Money deposited in a financial center outside the country of the currency involved

Large stock dividend

More than 20 to 25%

Is the cost of debt the same as the coupon rate?

NO. The cost of debt is NOT the coupon rate

What is the income statement equation?

Net Income = Revenue - Expenses

What are three variations of the balance sheet identity equation? (aka the Accounting Equation)

Net Working Capital + Fixed Assets = Long Term Debt + Equity Net Working Capital = (Cash + Other Current Assets) - Current Liabilities Cash = Long Term Debt + Equity + Current Liabilities - Current Assets Other Than Cash - Fixed Assets

Net Capital Spending (NCS)

Net capital spending is the amount that a firm spends on acquiring fixed assets during the year. It is defined as: Net capital spending = Fixed assets at the end of the year - Fixed assets at the beginning of the year + Depreciation.

Does Absolute PPP usually hold in practice?

No. Absolute PPP rarely holds in practice Usually only for uniform, traded goods

Resolving Credit Agreement *Short-Term Borrowing Unsecured Loans*

Non-committed agreement with a longer time between evaluations

What are the capital structure weights?

Notation: E = Market Value of Equity = Number of Outstanding Shares x Price Per Share D = Market Value of Debt = Number of Outstanding Bonds x Bond Price V = Market value of the Firm = Market Value of Debt + Market Value of Equity (D + E) Weights: E/V = Percent Financed with Equity D/V = Percent Financed with Debt

Number of exchanges in foreign countries continues to increase, as does the ____________ on those exchanges

Number of exchanges in foreign countries continues to increase, as does the liquidity on those exchanges

How can financial managers achieve the primary goal of maximizing stockholder wealth?

Objective: Choose the capital structure that will minimize WACC and maximize stockholder wealth

How do you estimate the dividend growth rate?

One method for estimating the growth rate is to use the historical average

What is a Commercial Draft?

One way to obtain a credit commitment from a customer before the goods are delivered is to arrange a commercial draft. Typically, the firm draws up a commercial draft of calling the customer to pay a specific amount by a specified date. The draft is then sent tot the customer's bank with shipping invoices.

What is the equation used to determine cash flow from assets? (CFFA)

Operating Cash Flow (OCF) - Net Capital Spending (NCS) - Changes in NWC (ΔNWC)= Cash Flow From Assets (CFFA) Cash Flow to Creditors (CF/CR) + Cash Flow to Stockholders (CF/SH) = Cash Flow From Assets (CFFA)

Operating Cash Flow (OCF)

Operating cash flow refers to the cash flow that results from the firm's day-to-day activities of producing and selling. Expenses associated with the firm's financing of its assets are not included because they are not operating expenses.

What is the equation for an Operating Cycle?

Operating cycle = Inventory period + Accounts receivable period

Treasurer

Oversees cash management, credit management, capital expenditures, and financial planning

Controller

Oversees taxes, cost accounting, financial accounting, and data processing

The Dividend Growth Model

P0 = D1 / RE - g Current Market Value of the Security = The Next Year's Dividend / (The Required Return on Common Equity - The Firm's Expected Constant Growth Rate for Dividends) or RE = D1/P0 + g The Required Return on Common Equity = (The Next Year's Dividend / Current Market Value of the Security) + The Firm's Expected Growth Rate for Dividends RE = The Required Return on Common Equity D1 = The Next Year's Dividend P0 = Current Market Value of the Security g = The Firm's Expected Growth Rate for Dividends

What is payables turnover?

Payables turnover = COGS/Average account payable COGS = Cost of Goods Sold

Marginal tax rate

Percentage tax paid on the next dollar earned

How do you calculate the cost of Preferred Stock?

Preferred annual dividend = $10 Current stock price = $111.10 RP = D/P0 Cost of Preferred Stock = Preferred Annual Dividend / Current Stock Price RP = 10 / 111.10 = 9%

Absolute Purchasing Power Parity

Price of an item is the same regardless of the currency used to purchase it or where it is selling: Puk = S0 x Pus Price of UK goods = Spot Rate x Price of US goods P = Price of Goods S0 = Spot Rate

What are Private Issues?

Private issues: *Term loans:* - Direct business loans from commercial banks, insurance companies, etc. - Maturities 1 - 5 years - Repayable during the life of the loan *Private placements*: Similar to term loans with longer maturity

What is Cash Concentration?

Procedure to gather funds into firm's main accounts - Reduces mailing and processing times

Collection Policy

Procedures followed by a firm in collecting accounts receivable

What is Credit Analysis?

Process of deciding which customers receive credit

What are the five main steps of the Bankruptcy Process for Reorganization?

Process: - Petition filed by firm or creditors - Usually, firm continues operation as "debtor-in-possession" - Firm submits reorganization plan - If accepted by classes of creditors, then confirmed by court - Firm makes payments to creditors and operates under plan for some fixed time Chapter 11 of the Federal Bankruptcy Reform Act of 1978

What are the four main steps of the Bankruptcy Process for Liquidaton?

Process: - Petition filed in federal court - Trustee elected by creditors to take over firm's assets - Trustee attempts to sell assets - Proceeds distributed according to the absolute priority rule (APR) Chapter 7 of the Federal Bankruptcy Reform Act of 1978

What is M&M Proposition II? (The Cost of Equity and Leverage)

Proposition II: - The Weighted Average Cost of Capital (WACC) is the firm is NOT affected by capital structure - The WACC is not affected by the Debt/Equity Ratio. Its the same no matter what the ratio is. - The change in capital structure weights (E/V and D/V) is exactly offset by the change in cost of equity (Re), so the WACC stays the same. - A firm's cost of equity capital is positive linear function of its capital structure. - As the firm raises its debt equity ratio, the increase in leverage raises the risk of the equity, and therefore the required return, cost of equity. (Re) - The cost of equity depends on three things: the required rate of return on the firm's assets (Ra), the firms cost of debt (Rd) and the firm's debt-equity ratio (D/E)

What are Bonds?

Public issue of long-term debt

Publicly traded companies must file regular reports with the _______ and ____________ Commission

Publicly traded companies must file regular reports with the Securities and Exchange Commission These reports are usually filed electronically and can be searched at the SEC public site called EDGAR Click on the web surfer, pick a company, and see what you can find!

Chapter 15

Raising Capital

Why do we use benchmarking?

Ratios need to be compared to something

Your company is expected to pay a dividend of $4.40 per share next year. (D1) Dividends have grown at a steady rate of 5.1% per year and the market expects that to continue. (g) The current stock price is $50. (P0) What is the cost of equity?

Re = (4.40/50) + .051 = .139

Company's equity beta = 1.2 Current risk-free rate = 7% Expected market risk premium = 6% What is the cost of equity capital? *Security Market Line Approach*

Re = 7 + 1.2(6) = 14.2% Return on Equity = Risk Free Rate + Company's Equity Beta (Market Risk Premium)

What are three tax effects of Stock Repurchases?

Repurchase: - Allows investors to decide if they want a current cash flow - Taxed only if: + They choose to sell AND + They reap a capital gain on that sale - Gain may qualify as lower taxed capital gains if shares owned more than one year.

What is the Dupont Identity?

Return on Equity = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Total Equity) Return on Equity = Profit Margin x Total Asset Turnover x Equity Multiplier Total Asset Turnover = Asset Use Equity Multiplier = Firm's Leverage ROE = PM x TAT x EM

What is the basic formula for return on equity?

Return on Equity = Net Income / Total Equity ROE = NI / TE

What was each part of the DuPont Indentity Measure?

Return on Equity = Profit Margin x Total Asset Turnover x Equity Multiplier ROE = PM * TAT * EM - Profit margin + Measures firm's operating efficiency + How well does it control costs - Total asset turnover + Measures the firm's asset use efficiency + How well does it manage its assets - Equity multiplier + Measures the firm's financial leverage Equity multiplier = (Total Assets / Total Equity) or (1 + Debt / Equity) (1 + Debt Equity Ratio) EM = TA / TE = 1 + D/E ratio

What is Short-Run Exposure?

Risk from day-to-day fluctuations in exchange rates and the fact that companies have contracts to buy and sell goods in the short-run at fixed prices

Risk

Risk is measured by the dispersion, spread, or volatility of returns

Standard deviation

SD(R) or σ + Square root of the variance + Sometimes called volatility + Same "units" as the average

What is the second stage of venture capital financing?

Second Stage: - Mezzanine" financing - Begin manufacturing, marketing & distribution

What is the equation for determine shareholder's equity?

Shareholders' Equity = Assets - Liabilities

Chapter 16

Short-Term Financial Planning

Special Cash Dividend

Similar to extra dividend, but definitely won't be repeated

Chapter 10

Some Lessons from Capital Market History

Liquidating Dividend

Some or all of the business has been sold

Lockboxes

Special post office boxes set up to intercept and speed up accounts receivable collections

Stock prices tend to decline when new __________ is issued

Stock prices tend to decline when new equity is issued

Listed Securities

Stocks that trade on an organized exchange (or market) are said to be listed on that exchange. In order to be listed, firms must meet certain minimum criteria concerning, for example, asset size and number of shareholders. These criteria differ for different exchanges.

Suppose the exchange rate goes from 7.45 Kronas per USD to 12 Kronas per USD. A USD now buys more Kronas, so: The USD is ____________ (strengthening) The Krona is ____________ (weakening)

Suppose the exchange rate goes from 7.45 Kronas per USD to 12 Kronas per USD. A USD now buys more Kronas, so: The USD is *appreciating* (strengthening) The Krona is *depreciating* (weakening)

What is the equation for Sustainable Growth Rate?

Sustainable Growth Rate = (Return on Equity x Retention Ratio) / (1 - Return on Equity) x Retention Ratio (ROE x b) / ((1 - ROE) x b)

What are the three factors favoring a low payout?

Taxes: - Individuals in upper income tax brackets might prefer lower dividend payouts, with their immediate tax consequences, in favor of higher capital gains Flotation costs: - Low payouts can decrease the amount of capital that needs to be raised, thereby lowering flotation costs Dividend restrictions: - Debt covenants may limit the percentage of income that can be paid out as dividends

What are two other additional managerial recommendations?

Taxes: - The tax benefit is only important if the firm has a large tax liability - Higher tax rate → greater incentive to use debt Risk of financial distress: - The greater the risk of financial distress, the less debt will be optimal for the firm - The cost of financial distress varies across firms and industries

What is Effective Annual Rate (EAR)?

The Effective Annual Rate (EAR) is the rate of interest actually earned on an investment or paid on a loan as a result of compounding the interest over a given period of time.

Green Shoe Option

The Green Shoe option gives the underwriters the right to buy additional shares at the offer price to cover over allotments.

What is book value?

The balance sheet value of the assets, liabilities, and equity.

What does the cash cycle measure?

The cash cycle measures how long we need to finance inventory and receivables

M&M Propositions I & II (slide 1)

The change in the capital structure weights [% of the firm financed by equity (E/V) and % of the firm financed by debt (D/V)] is exactly offset by the change in the cost of equity (RE), so the WACC stays the same.

What is the cost of debt?

The cost of debt = the required return on a company's debt

New York Stock Exchange (NYSE)

The equity shares of most of the large firms in the United States trade in organized auction markets. The largest such market is the New York Stock Exchange (NYSE), which accounts for more than 85 percent of all the shares traded in auction market. NYSE has the most stringent requirements of the stock markets in the United States. There are minimums on earnings, assets, and number and market value of shares outstanding.

Credit instrument

The evidence of indebtedness

Spot rate (S)

The exchange rate for an immediate trade

What are Permanent Current Assets?

The level of current assets the company retains regardless of any seasonality in sales

Cash Concentration

The practice of and procedures for moving cash from multiple banks into the firm's main accounts

Credit Analysis

The process of determining the probability that customers will or will not pay

What is the primary determinant of the spot/forward rate relationship?

The relationship between domestic and foreign interest rates.

Total Percent Return

The return on an investment measured as a percentage of the original investment Percentage Return = Dollar Return / Dollars Invested

Total Dollar Return

The return on an investment measured in dollars Dollar Return = Dividends + Capital Gains Capital Gains = Price Received - Price Paid

The right to file bankruptcy has _____________ value

The right to file bankruptcy has strategic value - Immediate "stay" on creditors - Ability to terminate labor agreements - Ability to lay off large numbers of workers - Ability to reduce wages

Spread

The spread consists of direct fees paid by the issuer to the underwriting syndicate - the difference between the price the issuer receives and the offer price.

The Ex-Dividend Day Price Drop

The stock price will fall by the amount of the divided on the ex-dividend date. (Time 0) If the dividend is $1 per share, the price will be equal to $10 - $1 = $9 on the ex-dividend date.

M&M Summary: The Tax Case

The tax case A. Proposition I with taxes: The value of the leveraged firm (VL) is equal to the value of the unleveraged firm (VU), plus the present value of the interest tax shield. VL = VU + Tc x D Value of Leveraged Firm = Value of Unleveraged Firm + Corporate Tax Rate x Amount of Debt B. Implications of Proposition I with taxes: 1. Debt financing is highly advantageous, and, and in the extreme, a firm's optimal debt structure is 100 percent debt. 2. The firm's weighted average cost of capital, WACC, decreases as the firm relies more heavily on debt financing.

Interest Tax Shield

The tax saving attained by a firm from the tax deductibility of interest expense

Primary vs. Secondary markets

The term primary market refers to the original sale of securities by governments and corporations. The secondary markets are those in which these securities are bought and sold after the original sale.

What is the Cash Cycle?

The time between payment for inventory and receipt from the sale of inventory

Cash Flow from Assets

The total cash flow to creditors and cash flow to stockholders, consisting of the following: operating cash flow, capital spending, and change in net working capital.

What is homemade leverage?

The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed

M&M Proposition I with Taxes

The value of the firm increases as total debt increases because of the interest tax shield. This is the basis of the M&M Proposition I with taxes.

Why is one reason why dividends matter?

The value of the stock is based on the present value of expected future dividends

Other Direct Expenses

These are direct costs incurred by the issuer that are not part of the compensation to underwriters. These costs include filling fees, legal fees, and taxes - all reported on the prospectus.

Indirect Expenses

These costs are not reported on the prospects and include the cost of management time spend working on the new issue.

What is the Operating Cycle?

Time required to receive inventory, sell it, and collect on the receivables generated from the sale of the inventory. Operating cycle = inventory period + accounts receivable period *Inventory Period*: - Time Inventory Sits on the Shelf *Accounts Receivable Period* - Time it takes to collect on receivables

What is Credit Management?

Trade-off between increased sales and the costs of granting credit

What is market value?

True value The price at which the assets, liabilities, or equity can actually be bought or sold.

Interest rate swap

Two parties exchange a floating-rate payment for a fixed-rate payment

What is the average Underpricing Cost for issuing securities?

Underpricing cost ≈ 19.3%

What are the key concepts and skills of Chapter 3: Working with Financial Statements?

Understand the problems and pitfalls in financial statement analysis Know: - How to standardize financial statements for comparison purposes - How to compute and interpret important financial ratios - The determinants of a firm's profitability and growth

What are the five key concepts and skills from Chapter 18: International Aspects of Financial Planning?

Understand: - How exchange rates are quoted and what they mean - The difference between spot and forward rates - Purchasing power parity and interest rate parity and the implications for changes in exchange rates - The types of exchange rate risk and how it can be managed - The impact of political risk on international business investing

What are four key concepts and skills for Chapter 10: Some Lessons from Capital Market History?

Understand: - How to calculate the return on an investment - The historical returns on various types of investments - The historical risks on various types of investments - The implications of market efficiency

What are three key concepts and skills to understand from Chapter 15: Raising Capital?

Understand: - The venture capital market and its role in financing new businesses - How securities are sold to the public, and the role of investment bankers - Initial public offerings, and the costs of going public

What are the four Key Concepts and Skills of Chapter 14: Dividends and Dividend Policy?

Understand: - Dividend types and how they are paid - The issues surrounding dividend policy decisions - The difference between cash and stock dividends - Why share repurchases are an alternative to dividends

What are the Key Concepts and Skills to understand about Chapter 13: Leverage and Capital Structure?

Understand: - The effect of financial leverage on cash flows and cost of equity - The impact of taxes and bankruptcy on capital structure choice - The basic components of the bankruptcy process

United States have the most developed ________ markets in the world

United States have the most developed capital markets in the world, but: - Foreign markets becoming more competitive - Often more willing to innovate

How do you calculate the component cost of debt?

Use the YTM on the firm's debt Interest is tax deductible, so the after-tax (AT) cost of debt is: RD,AT = RD,BT ( 1 - TC) Cost of Debt, After Taxes = Cost of Debt, Before Taxes (1 - Corporate Tax Rate) If the corporate tax rate = 40% RD,AT = 8.9% (1-.40) = 5.34%

What is the Security Market Line approach?

Uses the following information to compute the cost of equity: Risk-free rate: Rf Market risk premium: E(Rm)- Rf Systematic risk of asset: B Company's equity beta: Be Re = Rf + Be (E(Rm)-Rf) Required Return = Risk Free Rate of Return + Beta (Market Return - Risk Free Rate of Return) Return on Equity = Risk Free Rate + Systematic Risk of an Asset (Market Risk Premium)

Chief Financial Officer (CFO)

Usually the top financial manager within a firm

Variance

VAR(R) or σ2 + Common measure of return dispersion + Also called variability

How would customer type effect a credit period?

Varied

What is the formula for Weighted Average Cost of Capital?

WACC = (E/V) x Re + (P/V) x Rp + (D/V) x Rd x (1-Tc) Weighted Average Cost of Capital = Percent of Common Equity in Capital Structure x Firm's Cost of Equity + Percent of Preferred Stock in Capital Structure x Firm's Cost of Preferred Stock + Percentage of Debt in Capital Structure x Firm's of Cost of Debt x (1 - Firm's Corporate Tax Rate)

Case I - Equations

WACC = RA = (E/V) x RE + (D/V) x RD Weighted Average Cost of Capital = Risk of Firms Assets = % of the Firm Valued in Equity x Return on Equity + % of the Firm Valued in Value x Return on Debt RE = RA + (RA - RD) x (D/E) Cost of Equity Capital = Risk of Firms Assets + (Risk of Firms Assets - Risk of Firm's Debt) x (Debt/Equity Ratio) RA = the "cost" of the firm's business risk (i.e., the risk of the firm's assets) (RA - RD)(D/E) = the "cost" of the firm's financial risk (i.e., the additional return required by stockholders to compensate for the risk of leverage)

When is net working capital positive?

When current assets exceed current liabilities. This means that the cash will become available over the next 12 months exceeds that cash that must be paid over that same period. For this reason, net working capital is usually positive in a healthy firm.

When the forward rate is greater than the spot rate, the foreign currency is selling at a ______________.

When the forward rate is greater than the spot rate, the foreign currency is selling at a premium. F > S Foreign currency selling at a premium Example: Spot rate = 0.7 £/$ Forward rate = 0.6 £/$ - More dollars needed to buy pounds with the forward rate. The pound is expected to appreciate £ will buy more dollars in the future Forward rate for the pound is at a premium

When the forward rate is less than the spot rate, the foreign currency is selling at a ___________.

When the forward rate is less than the spot rate, the foreign currency is selling at a discount. F < S Foreign currency selling at a discount Example: Spot rate = 0.7 £/$ Forward rate = 0.8 £/$ Less dollars needed to buy pounds with the forward rate. - The pound is expected to depreciate - £ will buy fewer dollars in the future - Forward rate for the pound is at a discount

Compromise Financing Policy

With a compromise policy, the firm keeps a reserve of liquidity that it uses to initially finance seasonal variations in current assets needs. Short-term borrowing is used when the reserve is exhausted.

What are benefits of a zero balance account?

Without zero balance accounts, separate safety stocks must be maintained, which ties up cash unnecessarily. With zero balance cash accounts, the firm keeps a single safety stock of cash in a master account. Funds are transferred into disbursement accounts as needed.

Zero-Balance Accounts (slide)

Without zero balance accounts, separate safety stocks must be maintained, which ties up cash unnecessarily. With zero balance cash accounts, the firm keeps a single safety stock of cash in a master account. Funds are transferred into disbursement accounts as needed.

how do financial managements work with investments?

Work with financial assets such as stocks and bonds Value of financial assets, risk versus return, and asset allocation

Chapter 17

Working Capital Management

Chapter 3

Working with Financial Statements

You can find information about a company's capital structure relative to its industry and sector using the industry center or sector analysis through which website?

You can find information about a company's capital structure relative to its industry and sector using the industry center or sector analysis through Yahoo! Finance Click on the Web surfer to go to the site - Choose a company and get a quote - Perform sector and industry comparisons

Free Cash Flow

another name for cash flow from assets

Net New Equity Raised

stock sold - stock repurchased

Financial Risk

the equity risk that comes from the financial policy (i.e. capital structure) of the firm

Business Risk

the equity risk that comes from the nature of the firm's operating activities

Average tax rate

total tax bill / taxable income