Finance Objectives: Exam 1

Explain what an efficient market is and why market efficiency is important to financial managers.

An efficient market is a market where security prices reflect the knowledge and expectations of all investors. Public markets, for example, are more efficient than private markets because issuers of public securities are required to disclose a great deal of info about these securities to investors and investors are constantly evaluating the prospects for these securities and acting on the conclusions from their analyses by trading them. Market efficiency is important to investors because it assures them that the securities they buy are priced close to their true value.

Explain what benchmarks are, describe how they are prepared, and discuss why they are important in financial statement analysis.

Benchmarks are used to provide a standard for evaluating the financial performance of a firm. In financial statement analysis, a number of benchmarks are used. Most often, benchmark comparisons involve competitors that are roughly the same size and that offer a similar range of products. Another form of benchmarking is time-trend analysis, which compares a firm's current financial ratios against the same ratios from past years. Time-trend analysis tells us whether a ratio has increased, decreased, or remained the same over time.

Discuss how financial ratios facilitate financial analysis and be able to compute and use them to analyze a firm's performance.

Financial ratios are used in financial analysis because they eliminate problems caused by comparing two or more companies of different size, or when looking at the same company over time as the size changes. Financial ratios can be divided into 5 categories 1. liquidity ratios measure the ability of a co to cover its current bills 2. efficiency ratios tell how efficiently the firm uses its assets 3. leverage ratios tell how much debt a firm has in its capital structure and whether the firm can meet its long-term financial obligations 4. profitability ratios focus on the firm's earnings 5. market value indicators look at a company based on market data as opposed to historical data used in financial statements.

Explain the three perspectives from which financial statements can be viewed

Financial statements can be viewed from the owners', managers', or creditors' perspective. All three groups are ultimately interested in a firm's profitability, but each group takes a different view. Stockholders want to know how much cash they can expect to receive for their stock, what their return on investment will be, and how much their stock is worth in the market. Managers are concerned with maximizing the firm's long-term value through a series of day-to-day management decisions; thus, they need to see the impact of their decisions on the financial statements to confirm that things are going as planned. Creditors are concerned with how much debt the firm is using and whether the firm will have enough cash to meet its debt obligations.

Discuss generally accepted accounting principles (GAAP) and their importance to the economy.

GAAP are a set of authoritative guidelines that define accounting practices at a particular point in time. The principles determine the rules for how a company maintains its accounting system and how it prepares financial statements. Accounting standards are important because without them each firm could develop its own unique accounting practices. This would make it difficult for anyone to monitor the firm's true performance or compare the performance of different firms. The result would be a loss of confidence in the accounting system and the financial reports it produces. Fundamental accounting principles include the transactions are arm's-length, the cost principle, the realization principle, the matching principle, and the going concern assumption.

Compute the nominal and the real rates of interest, differentiating between them.

The real rate of interest is the interest rate that would exist in the absence of inflation. It is determined by the interaction of (1) the rate of return that businesses can expect to earn on capital projects and (2) individuals' time preference for consumption. The interest rate we observe in the marketplace is called the nominal rate of interest and is composed of two parts: the real rate of interest and the expected rate of inflation.

Explain the balance sheet identity and why a balance sheet must balance.

A balance sheet provides a summary of a firm's financial position at a particular point in time. It identifies the current assets that a firm has and the productive assets that it uses to generate income, as well as the sources of funding from creditors (liabilities) and owners (stockholders' equity) that were used to buy the assets. The balance sheet identity is: Total assets= Total liabilities + Total Stockholders' equity. Stockholders' equity represents ownership in the firm and is the residual claim of the owners after all other obligations to creditors, employees, and vendors have been paid. The balance sheet must always balance because the owners get what is left over after all creditors have been paid- that is Total stockholders' equity= total assets- Total liabilities

Identify the basic equation for the income statement and the information it provides.

An income statement presents a firm's profit or loss for a period of time, usually a month, quarter, or year. The income statement identifies the major sources of revenues generated by the firm and the corresponding expenses needed to generate those revenues. The equation for the income statement is Net income= Revenue - Expenses. If revenues exceed expenses, the firm generates a net profit for the period. If expenses exceed revenues, the firm generates a net loss. Net profit or net income is the most comprehensive accounting measure of a firm's performance.

Discuss why the concept of compounding is not restricted to money.

Any number of changes that are observed over time in physical and social sciences follow a compound growth rate pattern.

Describe how market-value balance sheets differ from book-value balance sheets.

Book value is the amount a firm paid for its assets at the time of purchase. The current market value of an asset is the amount that a firm would receive for the asset if it were sold on the open market (not in a forced liquidation). Most managers and investors are more concerned about what a firm's assets can earn in the future than about what the assets cost in the past. Thus, marked-to-market balance sheets are not commonly used is that it is difficult to estimate market values for some assets and liabilities

How are many large firms organized in the U.S? And identify the strengths and weaknesses of this organization.

C-corporations Strength: Easy to raise money, capital. Disadvantage: Double Taxation

Identify the cash flow to a firm's investors using its financial statements.

Cash flow to investors is the cash flow that a firm generates in a given period )cash receipts less cash payments and investments), excluding cash inflows from new equity sales or long-term debt issues. Cash flow to investors is the cash flow in a given period that is used to meet the firm's obligations to its debt holders and that is distributed to its equity investors, which in turn defines the value of their investments in the firm over time. The cash flow to investors is calculated as the cash flow to investors from operating activity, minus the cash flow invested in net working capital, minus the cash flow invested in long-term assets.

Understand the calculation of cash flows from operating, investing, and financing activities required in the statement of cash flows.

Cash flows from operating activities in the statement of cash flows are the net cash flows that are related to a firm's principal business activities. The most important items are the firm's net income, depreciation and amortization expense, and working capital accounts (other than cash and short-term debt obligations, which are classified elsewhere). Cash flows from long-term investing activities relate to the buying and selling of long-term assets. Cash flows from financing occur when cash is obtained from or repaid to creditors or owners (stockholders). Typical financing activities involve cash received from the issuance of common or preferred stock, as well as cash from bank loans, other notes payable, and long-term debt. Cash payments of dividends to stockholders and cash purchases of treasury stock reduce a company's cash position.

Describe common-size financial statements, explain why they are used, and be able to prepare and use them to analyze the historical performance of a firm.

Common-size financial statements are financial statements in which each number has been scaled by a common measure of firm size; balance sheets are expressed as a percentage of total assets, and income statements are expressed as a percentage of net sales. Common-size financial statements make it easier to evaluate changes in a firm's performance and financial condition over time. They are also useful when comparing firms that are significantly different in size.

Discuss direct financing and the important role that investment banks play in this process.

Direct markets are wholesale markets where lender-savers and borrower-spenders deal directly with one another. For example, corporations sell securities, such as stocks and bonds, directly to investors in exchange for money, which they use to invest in their businesses. Investment banks are important in the direct markets because they help borrower-spenders sell their new security issues. The services provided by investment bankers include origination, underwriting, and distribution.

Explain why ethics is an appropriate topic in the study of corporate finance.

If we lived in a world without ethical norms, we would soon discover that it would be difficult to do business. As a practical matter, the law and market forces provide important incentives that foster ethical behavior in the business community, but they are not enough to ensure ethical behavior. An ethical culture is also needed. In an ethical culture, people have a set of moral principles- a moral compass- that helps them identify ethical issues and make ethical judgments without being told what to do.

Describe the typical organization of the financial function in a large corporation

In a large corporation, the financial manager generally has the rank of vice president and goes by the title of chief financial officer. The CFO reports directly to the firm's CEO. Positions reporting directly to the CFO generally include the treasurer, the risk manager, the controller, and the internal auditor. The audit committee of the board of directors is also important in the financial function. The committee hires the external auditor for the firm, and the internal auditor, external auditor, and compliance and ethics director all report to the audit committee.

Discuss how agency conflicts affect the goal of maximizing the stockholder value

In most large corporations, there is a significant degree of separation between management and ownership. As a result, stockholders have little control over corporate managers, and management may thus be tempted to pursue its own self-interest rather than maximizing the value of the owners' stock. The resulting conflicts give rise to agency costs. Ways of reducing agency costs include developing compensation agreements that link employee compensation to the firm's performance and having independent boards of directors monitor management.

Explain why maximizing the value of the firm's stock is the appropriate goal for management.

Maximizing the firm's stock value is an appropriate goal because it forces management to focus on decisions that will generate the greatest amount of wealth for stockholders. Since the value of a share of stock (or any asset) is determined by its cash flows, management's decisions must consider the size of the cash flow (larger is better), the timing of the cash flow (sooner is better), and the riskiness of the cash flow (given equal returns, lower risk is better).

Explain how financial institutions serve the needs of consumers and small businesses.

One problem with direct financing is that it takes place in a wholesale market. Most consumers and small businesses do not have the skills, financing requirements, or money to transact in this market. In contrast, a large portion of the indirect market focuses on providing financial services to consumers and small businesses. For example, commercial banks collect money from consumers in small dollar amounts through selling them checking accounts, savings accounts, and consumer CDs. They then aggregate the funds and make loans in larger amounts to consumers and businesses. The financial services bought or sold by financial institutions are tailor-made to fit the needs of the markets they serve.

Describe the primary, secondary, and money markets, explaining the special importance of secondary and money markets to business organizations.

Primary markets are markets in which new securities are sold for the first time. Secondary markets are markets for securities that were previously issued. Not all securities have active secondary markets. Active secondary markets are important because they enable investors to convert securities easily to cash. Business firms whose securities are traded in secondary markets are able to issue new securities at a lower cost than they otherwise could because investors are willing to pay a higher price for securities that have active secondary markets. Large corporations use money markets to adjust their liquidity because cash inflows and outflows are rarely perfectly synchronized. Thus, on one hand, if cash expenditures exceed cash receipts, a firm can borrow short-term in the money markets. If that firm holds a portfolio of money market instruments, it can sell some of these securities for cash. On the other hand, if cash receipts exceed expenditures, the firm can temporarily invest the funds in short-term money market instruments. Businesses are willing to invest large amounts of idle cash in money market instruments because of their high liquidity and their low default risk.

Describe the DuPont system of analysis and be able to use it to evaluate a firm's performance and identify corrective actions that may be necessary.

The DuPont system of analysis is a diagnostic tool that uses financial ratios to assess a firm's financial strength. Once the financial ratios are calculated and the assessment is complete, management can focus on correcting the problems within the context of maximizing the firm's ROE. For analysis, the DuPont system breaks ROE into three components: net profit margin, which measures operating efficiency; total asset turnover, which measures how efficiently the firm's assets are being used and the equity multiplier, which measures financial leverage.

How are many small firms organized in the U.S? Identify the strengths and weaknesses of these organizations

Smaller companies tend to organize as sole proprietorships or partnerships. The advantages of these forms of organization include ease of formation and taxation at the personal income tax rate. The major disadvantage is the owners' unlimited personal liability. Limited liability partnerships and S-corporations provide owners of small businesses who make the business decisions with limited personal liability.

Discuss the difference between average and marginal tax rates.

The average tax rate is computed by dividing the total taxes paid by taxable income. It takes into account the taxes paid at all levels of income and will normally be lower than the marginal tax rate, which is the rate that is paid on the last dollar of income earned. However, for very high income earners, these two rates can be equal. When companies are making financial investment decisions, they use the marginal tax rate because new projects are expected to generate additional cash flows, which will be taxed at the firm's marginal tax rate.

Identify the key financial decisions facing the financial manager of any business.

The financial manager faces 3 basic decisions. 1. Capital budgeting decisions: which productive assets the firm should buy 2. Financial decisions: how the firm should finance the productive assets purchases 3. Working capital decisions: how the firm should manage its day-to-day financial activities Financial manager should make these decisions in a way that maximizes the current value of the firm's stock

Explain how the four major financial statements discussed in this chapter are related

The four financial statements discussed in the chapter are the balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows. The key financial statement that ties together the other three statements is the statement of cash flows, which summarizes changes in the balance sheet from the beginning of the year to the end. These changes reflect the info in the income statement and in the statement of retained earnings.

Explain the concept of future value, including the meaning of the terms principal, simple interest, and compound interest, and use the future value formula to make business decisions.

The future value is what the investment will be worth after earning interest for one or more periods. The principal is the amount of the investment. Simple interest is the interest paid on the original investment; the amount of simple interest remains constant from period to period. Compound interest includes not only simple interest, but also interest earned on the reinvestment of previously earned interest, the so-called interest earned on interest. For future value calculations, the higher the interest rate, the faster the investment will grow.

Explain what the time value of money is and why it is so important in the field of finance

The idea that money has a time value is one of the most fundamental concepts in the field of finance. The concept is based on the idea that most people prefer to consume goods today rather than wait to have similar goods in the future. Since money buys goods, they would rather have money today than in the future. Thus, a dollar today is worth more than a dollar received in the future. Another way of viewing the time value of money is that your money is worth more today than at some point in the future because, if you have the money now, you could invest it and earn interest. Thus, the time value of money is the opportunity cost of forgoing consumption today. Applications of the time value of money focus on the trade-off between current dollars and dollars received at some future date. This is an important element in financial decisions because most investment decisions require the comparison of cash invested today with the value of expected future cash inflows. Time value of money calculations facilitate such comparisons by accounting for both the magnitude and timing of cash flows. Investment opportunities are undertaken only when the value of future cash inflows exceeds the cost of the investment (the initial cash outflow).

Identify the major limitations in using financial statement analysis

The major limitations to financial statement and ratio analysis are the use of historical accounting data and the lack of theory to guide the decision maker. The lack of theory explains, in part, why there are so many rules of thumb. Rules of thumb are useful in that they may work under certain conditions. However, they may also lead to poor decisions if circumstances change.

Explain the concept of present value and how it relates to future value, and use the present value formula to make business decisions.

The present value is the value today of a future cash flow. Computing the present value involves discounting future cash flows back to the present at an appropriate discount rate. The process of discounting cash flows adjusts the cash flows for the time value of money. Computationally, the present value factor is the reciprocal of the future value factor, or 1/ (1 + i).

Describe the role of the financial system in the economy and the two basic ways in which money flows through the system.

The role of the financial system is to gather money from households, businesses, and governments with surplus funds to invest (lender-savers) and channel that money to households, businesses, and governments who need money (borrower-spenders). If the financial system works properly, only investment projects with high rates of return and good credit are financed and all other projects are rejected. Money flows through the financial system in two basic ways: 1. directly, through financial markets, or 2. indirectly, through financial institutions