Accounting/Finance Quiz 3
Market Value of Total Equity
Stock Price x Number of Shares Outstanding
Price Earnings Ratio
(Market Price of Stock)/(Income)
Market-to-Book Ratio
(Market Value of Firm: # of shares outstanding x market price)/(Balance Sheet Equity) -If this value is greater than 1, it means the stock is overvalued. -If this value is less than 1, it means the stock is undervalued.
Component Percentages on the Income Statement and Balance Sheet
-Component Percentages express each item on the Income Statement and Balance Sheet as a percentage of a single base amount: -Income Statement values expressed as percentage of Net Sales -Balance Sheet values expressed as percentage of Total Assets
Dividend Discount Model
-Computation of today's stock price which states that share values equal the PV of all expected future dividends. P(0)=[(Div1)/(1+r)^1]+[(Div2)/(1+r)^2]....+[(Div(H)+P(H))/(1+r)^H]-->Last part of this equation is the most important Where H=Time horizon for your investment, r=expected return (Includes capital appreciation [the capital you gain from selling stock at more than you paid for it])
Market Risk/Systematic Risk
-Economy-wide sources of risk that affect the overall stock market. -Cannot be entirely eliminated through diversification-->Ex. If a natural disaster occurs (ex. of Market Risk), then at least some of your diverse investments will be affected and the losses incurred/inflicted.
Effective Annual Interest Rate vs. Annual Percentage Rate
-Effective Annual Interest Rate: Interest rate that is annualized using compound interest-->Ex. Given a monthly rate of 1%, EAR=[(1+.01)^12]-1 -Annual Percentage Rate: Interest rate that is annualized using simple interest--Ex. Given a monthly rate of 1%, APR=0.1 x 12
Net-Present Value (NPV)
-NPV= Present Value of Future Cash Flows- Required Investment Today -NPV= C(o) + (C(1)/(1+r)) -Where C(o) is the value of investment made today; Where C(1) is the amount of the Future Cash Flow-->C(o) is usually a NEGATIVE number because it represents investment made today which is usually a cash outflow. -Accept investments that have POSITIVE NPV-->Cost of Capital (r) such that NPV=0 is the point at which the investment in the project is not worth it.
Perpetuity
-Perpetuity: Financial concept in which a cash flow is theoretically received forever -PV of Cash Flow= (Cash Flow)/(Discount Rate)-->PV(o)=[C(1)]/r
Rate of Return Rule
-Rate of Return Rule: Accept investments that offer rates of return in EXCESS of their opportunity cost of capital where Return= (Profit)/(Investment) -Ex. If I invest $370,000 today in a building and sell it for $420,000 next year (not a PV value), then my return on investment will be ($420,000-$370,000)/($370,000)= 13.5%-->With this Return on Investment established, I now know that I should NOT accept any investments which offer a return of LESS than 13.5%
Dupont Decomposition
-Return on Equity= Net Profit Margin x Total Asset Turnover x Financial Leverage -ROE=(Net Income/Net Sales) x (Net Sales/Average Total Assets) x (Average Total Assets/Average Stockholder's Equity)
Standard Deviation
A measure of volatility/a measure of riskiness of the given investment. Standard Deviation: The square root of the variance.
Variance
A measure of volatility/a measure of riskiness of the given investment. -Variance: The Average value of squared deviations from the mean.
Accounts Payable Turnover
Accounts Payable Turnover= (Cost of Goods Sold)/(Average Accounts Payable) -This ratio measures how quickly the company pays its Accounts Payable -Accounts Payable Turnover is a test of LIQUIDITY.
Annuity
Annuity: An asset that pays a fixed sum each year for a specified number of years. -Present Value of an Annuity= C[(1/r)-(1/(r(1+r)^t))] OR (C/r)-(C/r)(1/(1+r)^t)-->Where C is the value of the fixed sum being received/paid each period of the annuity contract. -Can determine whether an annuity is worth investing in by calculating the NPV of the investment using the given opportunity cost of capital.
Asset Turnover Ratio
Asset Turnover= (Net Sales)/(Average Total Assets)
Average Age of Payables
Average Age of Payables= (365)/(Accounts Payable Turnover Ratio) -This ratio measures the average number of days it takes for a company to pay its suppliers. -Average Age of Payables is a test of LIQUIDITY.
Average Age of Receivables
Average Age of Receivables= (365)/(Receivable Turnover Ratio) -This ratio measures the average number of days it takes to collect receivables. -Average Age of Receivables is a test of LIQUIDITY.
Average Days' Supply in Inventory
Average Days' Supply in Inventory= (365)/(Inventory Turnover Ratio) -This ratio measures the average number of days it takes to sell the inventory. -Average Days' Supply in Inventory is a test of LIQUIDITY.
C(Interest)
C(Interest)= Face Value x Coupon Rate x 1/2
C(Principal)
C(Principal)=Face Value of the Bond
Cash Coverage
Cash Coverage= (Cash Flow from Operating Activities Before Interest and Taxes Paid)/(Interest Paid) -This ratio compares the cash generated with the cash obligations of the period -Cash Coverage is a test of SOLVENCY.
Cash Ratio
Cash Ratio= (Cash+Cash Equivalents)/(Current Liabilities) -This ratio measures the adequacy of available cash -Cash Ratio is a test of LIQUIDITY
Current Ratio
Current Ratio= (Current Assets)/(Current Liabilities) -This ratio measures the ability of the company to pay current debts as they come due. -Current Ratio is a test of LIQUIDITY
Debt-to-Equity Ratio
Debt-to-Equity= (Total Liabilities)/(Stockholder's Equity) -This ratio measures the amount of liabilities that exist for each $1 invested by the owners. -Debt-to-Equity ratio is a test of SOLVENCY.
Discount Factor
Discount Factor=1/(1+r)^t -Discount Factor is the Present Value of $1!
Tools to Estimate "r" for Valuing Common Stocks: Dividend Yield
Dividend Yield= (Div1)/(P(0)) Where Div1= Dividend Payment; Where P(0)= Initial Investment
Dividend Yield Ratio
Dividends Yield= (Dividends per share)/(Market price per share) -Used to evaluate the amount of dividends received -This ratio is often used to compare the dividend-paying performance of different investment activities. -Dividend Yield Ratio is a MARKET TEST.
Earnings per Share (EPS)
Earnings per Share=(Net Income)/(Average Number of Outstanding Shares for the Period) -If there are preferred dividends, the amount is subtracted from Net Income -Can help judge company performance over time but not as useful for comparing companies.
Equivalent Annual Annuity
Equivalent Annual Annuity=(PV of Cash Flows)/(Annuity Factor)
Future Value of an Annuity
FV of Annuity= C x [(((1+r)^t)-1)/r)]-->Where C is the fixed sum paid/received each period of the annuity.
Financial Leverage Percentage
Financial Leverage %= Return on Equity - Return on Assets -Financial Leverage % is a test of PROFITABILITY -Financial Leverage is the advantage or disadvantage that occurs as a result of earning a return on assets greater than that on debt-->This accrues to the stockholder as the FL%-->The return difference between assets and the "levered" equity. -Each dollar raised as debt increases the effect of leverage because it substitutes for a dollar of equity.
Financial Leverage
Financial Leverage= (Average Total Assets)/(Average Stockholder's Equity) -Ideally, Financial Leverage will be greater than 1, but you don't want it to be too high as this could indicate that too much of your asset value is financed by debt which can be risky-->Excess debt can lead to eventual bankruptcy.
Capital Structure & Corporate Taxes: Firm Value
Firm Value= Value of ALL equity financed firm + PV Tax Shield
Fixed Asset Turnover
Fixed Asset Turnover= (Net Sales Revenue)/(Average Net Fixed Assets) -This ratio measures a company's ability to generate sales given an investment in fixed assets. -Fixed Asset Turnover is a test of PROFITABILITY
Forward Rate
Forward Rate: The interest rate which is locked in today on a loan made in the future at a fixed time
rF: Cost of Equity
Free-Risk rate of equity (usually that on government bonds which is around 3-4%)
Future Rate
Future Rate: The spot rate that is expected in the future
Future Value of Money
Future Value= Amount of Initial Investment x (1+r)^t
Internal Rate of Return (IRR)
IRR-->NPV=0= C(o) + ((C1)/(1+IRR)) -The IRR is the value of the cost of capital (r) at which NPV=0 -FOR BONDS: Calculate Present Value of the Bond as a whole (Sum of PV of principal and interest)-->NPV=0= C(o)+ (PV Bond)/(1+IRR)
Inventory Turnover Ratio
Inventory Turnover= (Cost of Goods Sold)/(Average Inventory) -This ratio measures how quickly the company sells its inventory -Inventory Turnover is a test of LIQUIDITY
T-Bonds
Longer term borrowing of US government--Can be up to 30 years -When market yields for T-Bonds increase, the returns of the bonds decrease-->Could be earning a greater return on other bonds than the one's currently being held. -As interest rates go up, prices for the bonds go down
rM: Cost fo Equity
Market Return on investments
Net Profit Margin
Net Profit Margin= (Net Income)/(Net Sales) -This ratio tells us the percentage of each sales dollar that is income -Net Profit Margin is a measure of PROFITABILITY
Book Value
Net worth of the firm according to the balance sheet
Stock Price with Company Growth
P(0)=Steady State Value + Value of Growth OR PVGO P(0)=(EPS/r)+PVGO
Stock Price under the assumption of No Growth
P(No Growth)=(Div1)/(r)=(EPS)/(r) -EPS and Dividend are equal under no growth because a no growth company puts all its earnings out as dividends -(EPS)/(r)-->This is the "Steady State" value of the stock-->No growth of the company
Price/Earnings Ratio (P/E Ratio)
P/E= (Current Market Price per Share)/(Earnings per Share) -This ratio measures the relationship between the current market price of the stock and its EPS. -P/E is a MARKET TEST.
Present Value of a Bond (Price of a Bond for Sale)
PV (Price) of Bond w/ Face value of $1000=[C(1)/(1+r)] +[C(2)/(1+r)^2] +[C(3)/(1+r)^3].....+ [$1000+C(t)/(1+r)^t] -->Where C(1) represents the first interest payment, C(2) represents the second interest payment etc... and where $1000+C(t) represents the Principal being paid back along with the final interest payment; where r=Market Rate. -Given that Bonds pay fixed interest payments each period, C(1), C(2) etc... should all be the same amount of money.
Capital Structure & Corporate Taxes: Present Value of Tax Shield
PV Tax Shield=D x Tc Where D=Amount of debt ; Tc=Tax Rate -Tax Shield is the net benefit that a firm gets by taking on some debt instead of being financed entirely by equity. Because Debt is tax deductible and Equity is not, firms can reduce their net cash outflows to a certain ideal point by taking on debt instead of equity.
PV(Interest)
PV(Interest)= [(C(Interest)/r)] x (1-(1/(1+r)^t))
PV(Principal)
PV(Principal)= [C(Principal)/(1+r)^t]
Constant Growth Perpetuities
PV(o)= C(1)/(r-g)-->Where r=Rate of Return and g=The annual growth rate of the Cash Flow
Present Value of Multiple Cash Flows--Discounted Cash Flow (DCF) Formula
PV(o)= [C(1)/(1+r)] + [C(2)/(1+r)^2] + [C(3)/(1+r)^3].....+ [C(t)/(1+r)^t] -Deals with Multiple Cash Flows may change the way that NPV looks in regards to the desirability of the deal.
Present Value of Single Investment
PV= C/(1+r)^t -Where C is the expected future cash flow -Deals should be pursued if the Present Value of the money to be received as a result of the deal in the future is greater than the investment being made today-->If NPV is positive, then pursue the deal.
PVGO--Present Value of Growth Opportunities
PVGO=Growth value of stock-No growth value of stock -PVGO=NPV of a firm's future investments
Plowback Ratio
Plowback Ratio=100%-Payout ratio Where Payout Ratio=% of earnings paid out as dividends
Market Portfolio
Portfolio of all assets in the economy
Exchange-Traded Funds (ETFs)
Portfolios of stocks that can be bought or sold in a single trade--a bundle of stocks
Quality of Income
Quality of Income= (Cash Flow from Operating Activities)/(Net Income) -Quality of Income is a test of PROFITABILITY -Ideally, Quality of Income will be greater than 1 (100%) as this would indicate high quality income.
Quick Ratio
Quick Ratio= (Quick Assets)/(Current Liabilities) -This ratio is like the Current Ratio but measures the company's IMMEDIATE ability to pay debts. -Quick Ratio is a test of LIQUIDITY
Tools to Estimate "r" for Valuing Common Stocks: Return on Equity (ROE)
ROE=(EPS)/(Book Equity Per Share)
Inflation: Real Discount Rate
Real Discount Rate=[(1+Nominal Discount Rate)/(1+Inflation Rate)]-1
Receivables Turnover Ratio
Receivables Turnover= (Net Credit Sales)/(Average Net Receivables) -This ratio measures how quickly a company collects its Accounts Receivable. -Receivables Turnover is a test of LIQUIDITY
Return on Assets (ROA)
Return on Assets= (Net Income+Interest Expense (1-Tax rate))/(Average Total Assets) OR (Net Income)/(Average Total Assets) -ROA is a test of PROFITABILITY
Return on Equity (ROE)
Return on Equity=(Net Income)/(Average Stockholder's Equity) -ROE is a test of PROFITABILITY -A common measure of management's performance: Indicates how much income was earned for every dollar invested by the owners. -Purchase of treasury stock can improve ROE, increase EPS, and lower the P/E ratio.
Unique Risk/Diversifiable RIsk
Risk factors affecting only a single firm--Risk that somebody takes on by only investing in that single company.
Beta OR β
Sensitivity of a stock's return to the return on the market portfolio-->Indication of how much risk we hold relative to the baseline level of market risk. -Ex. If return on a stock changes on average by 1.41% for each 1% additional change in the market return, than Beta is 1.41. -High Beta's are associated with High Values for Cost of Capital-->High risk investments because they are volatile, so they must have a high cost of capital
Spot Rate
Spot Rate: The actual interest rate today (t=0)
Diversification
Strategy designed to reduce risk by spreading the portfolio across many investments.
Risk Premium
The additional annual reward for holding stocks, because stocks are much risker investments than purchasing bonds. -Ex. Countries experiencing a great amount of inflation will normally have higher risk premiums as investing in a market with high inflation is much riskier than investing in a more stable market. -Risk Premium=(rM-rF)-->Where rM=Market Return; rF=Free-Risk Rate
Equivalent Annual Cash Flow
The cash flow per period with the same present value as the actual cash flow of the project
Intrinsic Value
The value we calculate for the stock--we expect the market price to trend towards this underlying value
Pecking Order Theory
Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient -Ex. Announcement of a stock issue drives down stock price b/c people think that managers are more likely to issue stock when stock is overpriced.
Trade-Off Theory
Theory that capital structure is based on a trade-off between tax savings and distress costs of debt
Times Interest Earned
Times Interest Earned= (Net Income + EBIT)/(Interest Expense) -This ratio indicates a margin of protection for creditors -Times Interest Earned is a test of SOLVENCY.
T-Bills
Very short-term US government borrowing of less than 3 months duration
Calculate Specific Cost of Capital: Weighted Average Cost of Capital
WACC=(1-Tc)rD(D/V)+rE(E/V) Where rD=Cost of Capital; rE=Cost of Equity; Tc=Tax Rate; D=Market value of the firm's debt; E=Market value of the firm's equity (or market cap); V=Value of the firm (D/V)+(E/V)=1 BECAUSE V=D+E
Yield to Maturity (YTM)
YTM: The IRR on an interest bearing instrument. The Law of One Price says that all interest bearing instruments must be priced to fit the term structure--Requires modifying the asset price-->Modified Price creates a new Yield called the YTM. -YTM is essentially the rate (r) at which the sum of all future cash flows from the bond (coupons and principal) is equal to the price of the bond.
Dividend Growth Rate
g=ROE x Plowback Ratio -Where ROE=(EPS)/(Book Value Per Share)-->Where Book Value Per Share=(Value of Common Equity)/(Average # of Shares Outstanding) Higher values of ROE, Plowback, or both will increase the growth rate of the company as this indicates greater reinvestment into the company for future growth or more efficient use of investments, or both.
Tools to Estimate "r" for Valuing Common Stocks: Growth Rate
r=[(Div1)/(P(0))]+g OR r=Dividend Yield + g
Calculate "r" for Stock Valuation: Return Formula
r=r(f)+(r(m)-r(f))β Where r(f)=
rE: Cost of Equity
rE=rF+β(rM-rF) Where rF=Free-Risk Rate; rM=Market Return; (rM-rF)="Risk Premium"