Corporate Finance Quiz 1
What are the 5 uses of free cash flow?
1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock. 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)
How to solve for Free Cash Flow
1. Solve for NOPAT (Net Income) 2. Solve for Net Op Working Capital for each year 3. Add Op Long term assets to Net Op Working Cap to solve for Total Net Op Capital 4. Find difference of Total Net Op Capital of each year to find Net Investment in Operating Capital FCF = NOPAT - Net Investment in Op Capital
What is a firm's fundamental (intrinsic) value? What might cause a firm's intrinsic value to be different than its market value?
A firm's fundamental, or intrinsic, value is the present value of its free cash flows when discounted at the weighted average cost of capital. If the market price reflects all relevant information, then the observed price is also the intrinsic price.
Advantages/Dis of Sole Propritership
Advantages: ease and low cost of formation Disadvantages: difficulty in obtaining large sums of capital; unlimited personal liability for business debts; limited life
Advantages/Dis of Partnership
Advantages: ease and low cost of formation Disadvantages: unlimited liability, limited life, difficulty of transferring ownership, difficulty raising large amounts of capital
Advantages/Dis of Corporation
Advantages: limited liability, indefinite life, ease of ownership transfer, and access to capital markets Disadvantages: double taxation of earnings; requirements to file state and federal reports for registration, which are expensive, complex and time-consuming
Is an IPO an example of a primary or secondary market interaction?
An initial public offering is a stock issue in which privately held firms go public. A primary market is the market in which corporations raise capital by issuing new securities. Therefore, an IPO would be an example of a primary market transaction.
WACC is affected by:
Capital structure Interest rates Risk of the firm Investors overall attitude toward risk
Net Op Working Capital
Current operating Assets - Current operating Liabilities
Economic Value Added (EVA) formula
EVA = NOPAT - (WACC)*(Capital)
Company X makes an investment that will help reduce costs long term. What happens to the earnings per share this year? What happens to its intrinsic value and stock price?
Earnings per share: decline; due to the cost of the investment made in the current year and no significant performance impact in the short run Stock price: increase; due to the significant cost savings expected in the future.
Free Cash Flow Formula
FCF = Sales revenues-Op costs-Op taxes-Required investments in operating capital
What economic conditions affect the cost of money?
Federal Reserve policies Budget deficits/surpluses Level of business activity (recession or boom) International trade deficits/surpluses
Market Value Added (MVA)
MVA = Market Value of the firm - Book Value of the Firm
Market Value
Market Value = (#shares stock)*(price per share) + Value of Debt
Formula for Net Income
Net Income = (1-tax rate)*EBT
What four factors affect the cost of money?
Production opportunities Time preferences for consumption Risk Expected inflation
Return on Invested Capital (ROIC)
ROIC = NOPAT/Operating Capital
What are the three principal forms of business organization?
Sole proprietorship Partnership Corporation
What is operating capital and why is it important?
The amount of interest bearing debt, preferred stock, and common equity used to acquire the company's net operating assets. Without this capital a firm cannot exist, as there is no source of funds with which to finance operations.
Book Value
Total Common Equity + Value of Debt
Weighted Average Cost of Capital (WACC)
average rate of return required by all of the company's investors
Income statement is thought of as
report of operations over a period of time
Balance sheet is thought of as
snapshot of firm at a specific point in time
