Exam 1
Shareholders equity =
(Current assets + net fixed assets) - (current liabilities + long term debt)
Clarke Incorporated purchased $145,000 in new equipment and sold equipment with a net book value of $68,400 during the year. What is the amount of net capital spending if the depreciation was $38,000?
145,000 - 68,400 = 76,600
Determine common stock's accounting value:
According to the accounting identity, stockholders' equity (common stock) = assets - liabilities. If a balance sheet has a total of $3,150 million in assets and liabilities of $1,800 million, its common stock value will be $1,350 million (=3,150 - 1,800).
Agency problem and its costs:
Agency problem refers to non-congruence of interest of two parties when one is the principal and the other is an agent. This misalignment leads to different goals and a potential breakdown of the team. Shareholders are the principals and managers are the agents in a corporation. The misalignment of incentives leads to monitoring costs and on-job-consumption by managers diverting shareholders' assets.
Cash flow to creditors
interest paid - long term debt
Finance and interactions with other departments
look at pic on canvas
Advantages of a corporation
• Ownership can be readily transferred• Life of corporation is unlimited• Limited liability for stockholders
Debt:
Any amount owed to a provider of resources or services is known as debt. It is a fixed claim which has to be paid off by a specified date.
Which one of the following is an agency cost?
Hiring outside accountants to audit the company's financial statements
TOTAL ASSETS
Net Fixed Assets, Net Working Capital (=CA - CL), Intangible Assets
Current assets:
These are assets that are required for business operations and are usually converted into cash within a year or one operating cycle, whichever is greater. It includes cash, accounts receivables, notes receivables, inventories etc.
Claims on assets:
These are claims that outsiders have on the assets of a firm given to them in exchange for services or resources provided by the outsiders to the firm. These claims are also known as liabilities of a firm.
Accounting values:
These are historical values for which assets are acquired or liabilities recognized. For example land may be acquired for $100 million and it will always be recorded in the books at its acquisition or accounting value, i.e., $100 million.
Current liabilities:
These liabilities have a span of less than a year.
Impact of TCJA of 2017
This Act cut the corporate tax rate to a flat rate of 21%. It did not change the tax rate for other types of taxable entities, such as, partnerships, LLCs etc.
What is Corporate Finance
This involves choosing lines of business, making strategic and long-term investment decisions (left hand side of the balance sheet), structuring the financing (right hand side of the balance sheet) as well as managing the day to operations of the company, i.e., its net working capital (current assets and current liabilities).
Long-term investment decisions
This is also known as capital budgeting which impacts the long-term assets on a balance sheet. The company identifies profitable projects to invest in to increase its value to shareholders.
Financing:
This is also known as capital structure and refers to the split between trade payables, short-term debt, long-term debt and shareholders' equity. This is essentially the right hand side of the balance sheet.
Fixed cost:
This is the cost that does not vary, or is fixed, in the short run, and includes rent, overhead etc.
Variable cost:
This is the cost that varies directly with production in the short run. They include raw materials, labor and utilities.
Average tax rate:
This is the total tax paid divided by total income.
Market value =
cash
End of year equity
Beginning of year equity+Net income-Dividends
Free cash flow for the year =
Cash flow to creditors = interest paid - long term debt
cash flow to creditors
Interest- (long term debt at year end - long term debt at beginning)
Operating profit:
Operating profit (EBIT) = Gross profit - period costs (SGA)
Disadvantages of Sole Proprietorship
Owner has unlimited liability for business debts• All business income is taxed as personal income• Life of sole proprietorship is limited to owner's life span• Amount of equity that can be raised is limited to the amount of the proprietor's personal wealth• Ownership may be difficult to transfer
Cash accounting:
Under cash accounting, all inflows (sales and revenue) are recorded when received in cash and all expenses are also recorded when paid in cash. This is a simple form of accounting which does not serve large corporations as it does not follow the matching principle. Under cash basis of accounting, a business would not record revenue for a sale made on credit since only the receipt of cash would trigger revenue and expense recognition by assumption.
CFO (cash flow from operations)
(Sales- Taxes-costs)- Net capital spending- (net working capital). [if decrease then it is negative)
taxable income=
(retained earnings + dividend)/1-tax rate
Johnston & Chu started the year with $650,000 in the common stock account and $1,318,407 in the additional paid-in surplus account. The end of the year balance sheet showed $720,000 and $1,299,310 in the same two accounts, respectively. What is the cash flow to stockholders if the firm paid $68,500 in dividends.
17,597
For the past year, Pellicier Inc had depreciation of $2,419, beginning total assets of $23,616, and ending total assets of $21,878. Current assets decreased by $1,356. What was the amount of net capital spending for the year?
21,878 - 23,616 + 1356 + 2419 = 2037
Villacana Lighting has beginning LT debt of $682,400 and ending LT debt of $697,413. Current liabilities increased by $18,915 during the year. What was the cash flow to creditors if the firm paid $34,215 in interest during the year.
34,215 - (697,413 - 682400) = $19,202
The operating cash flow is computed as shown below:
= Sales - cost of goods sold - administrative and selling expenses
. The net income / loss is computed as follows:
= Sales - cost of goods sold - administrative and selling expenses - depreciation - interest expense
Partnership
A business in which two or more persons combine their assets and skills
Sole Proprietorship
A business owned by one person: least regulated, owner keeps all profits
Double taxation and dividends:
A corporation can deduct interest payments as an expense so only recipients of interest pay taxes on their interest income. Hence, interest income is taxed only once. On the other hand, corporations cannot deduct dividends paid to shareholders as an expense for income tax calculation. The corporation pays taxes and then pays dividends from after-tax or net income. So dividends are already taxed at the corporation level. Shareholders, who receive dividends, also report dividends as taxable income in the US and pay taxes to the IRS on that income. Hence, dividends are taxed twice. This is known as double taxation and is one of the reasons which makes equity a costly source of funds.
Working Capital Management
A day-to-day activity that ensures the firm has sufficient resources to continue its operations and avoid costly interruptions. How much cash and inventory should we keep on hand? Should we sell credit? How will we obtain any needed short-term financing?
LLC
A hybrid form of partnership and corporation that provides limited personal liability to the owners of a business.
Which of the following actions would be considered an agency problem?
A manager in a corporation makes online personal travel arrangements during work hours
Assets:
An asset is what a firm owns including claims it has against other parties. For example, plant, equipment, land, inventories, accounts receivables, patents etc. are all examples of assets.
Intangible assets:
Assets which are not physical and include goodwill, patents, franchise rights and trademarks.
Straight line depreciation:
Assets which are of long-term nature and their use spans several accounting periods or operating cycles are also known as fixed assets, long-lived assets, tangible assets or plant assets. Their use is allocated to accounting periods - known as depreciation which is based on expected useful lives and cost of acquisition. Straight line depreciation = (Acquisition cost - Expected salvage value) / Useful life. If a fixed asset is acquired for $100,000 and has a salvage value of $20,000 with ten years of useful life, according to the straight line method, its annual depreciation will be, Annual depreciationstraight-line = (100,000 - 20,000) / 10 = 80,000 / 10 = $8,000
Cashflow to creditors:
Cashflow to creditors = Interest paid - Net new borrowing
Cashflow to shareholders:
Cashflow to shareholders = Dividend paid - Net new equity raised
Net Working Capital =
Current Assets (CA) - Current Liabilities (CL)
Impact of depreciation on income statement and cashflows:
Depreciation reduces the income for a corporation but has no impact on its cashflow as it is not a cash expense but only an allocation of a previously acquired asset. In order to calculate cashflow, depreciation is added back to income.
Impact of depreciation on the balance sheet:
Depreciation reduces the value of a fixed asset on the balance sheet. It is an estimated non-cash expense which is also recognized in the income statement. Since long-term assets are useful for several years, cash is paid out at the time of their purchase. Over the years, their use causes wear and tear which is recognized as depreciation. Depreciation is an allocation item. Allocation may be based on straight line or an accelerated method.
Disadvantages of a corporation
Double taxation: meaning corporate profits are taxed twice, first at the corporate level when they are earned and again at the personal level when they are paid out
Operating cashflow:
EBIT + Depreciation - Taxes, (interest is not subtracted here as it is paid out to creditors later, but taxes are calculated net of interest. This can be confusing so be careful.)
EBITDA:
Earnings before interest, taxes, depreciation and amortization = EBITDA = EBIT + Depreciation & amortization. Amortization refers to write-off of intangibles.
Financial leverage:
Financial leverage refers to the percentage of debt used in a firm's capital structure. If a firm has $100 million in debt while its total sssets equal $500 million, it will be said to have 20% debt (100/500 = 0.20). Financial leverage may also refer to the ratio of debt to equity. In this case, equity would be $400 million (=500-100) and financial leverage will be 0.25 (=100/400). Pay attention to what is being reported, i.e., debt as a percent of total capital or debt as a percent of shareholders' equity.
From the stockholders' point of view, what is a good financial management decision?
Goal of financial management is to maximize the current value per share of the existing stock
Gross profit:
Gross profit = Revenue - Product costs
Which one of the following questions involves a capital structure decision?
How much debt should the firm incur to fund a project?
Flat tax:
If the tax rate does not change with the level of income, it is known as a flat tax rate. You may think of average tax rate as the equivalent "flat tax" rate applied to the entire taxable income.
Goal of a business
In addition to maximizing the value of firm, managers should focus on maximizing the wealth of the owners in all forms of business. This means that they should maximize the value or price of a share of stock of existing shareholders, not new shareholders unless they have already purchased the stock. If equity is illiquid then maximizing value of equity should be the target.
Income vs. cashflow:
Income refers to accounting income whereas cashflow refers actual cashflow. Recall that depreciation affects income but does not affect cashflow. It needs to be added back to income to estimate cashflow. The following relationships will help you understand the cash flow identity.
Which one of the following actions by a financial manager is most apt to create an agency problem?
Increasing current profits when doing so lowers the value of the company's equity
Sarbanes-Oxley Act
Intended to protect investors from corporate abuses. Key requirements of SOX include the following:• Section 404 requires each company's annual report to have an assessment of the company's internal control structure and financial reporting• Officers of corporation must review and sign annual reports• Annual report must list any deficient in internal controls
Interest payment:
Interest payment is reported below EBIT to calculate profit before taxes or taxable profit. If one is given total debt and the interest rate, then Interest payment = Debt outstanding x Interest rate For example, if a corporation has $50 million debt outstanding throughout the year, borrowed at 6%, the interest amount will be, Interest - 50,000,000 x 0.06 = $3,000,000
Equity:
It represents the funds invested by the owners of a firm and reinvested earnings, net of dividends received by the owners.
Constraints preventing maximization of shareholder wealth:
Lack of liquidity of shareholder equity (non-traded) makes value measurement difficult.
Listing of liabilities on a balance sheet:
Liabilities on a balance sheet are listed in the increasing order of their term to maturity. Shortest maturity obligations (such as current liabilities) are listed first followed by long-term debt. Shareholders' equity is listed in the end as it does not have a maturity date and is expected to last through the life of the business.
Long-term liabilities:
Liabilities that are due in more than a year are referred to as long-term liabilities.
Definition of liquidity:
Liquidity refers to the speed with which assets of a firm can be converted into cash as fair value. Assets are listed on the balance sheet in the order of their decreasing liquidity.
TOTAL LIABILITIES & SHAREHOLDER EQUITY
Long-term Debt Shareholder Equity Paid-in Capital Retained Earnings
Decision making and marginal taxes:
Most decisions have an incremental impact. They build on already existing projects or cashflows. For example, if a firm is earning $100 million a year already, and product or market expansion would increase that income to $120 million a year, additional taxes will only apply to the incremental net income, i.e., $20 million. The existing income will continue to be taxed at the existing tax rate. Hence, only marginal tax rate as applied to the $20 million incremental income is relevant to the decision to expand or not.
Net income:
Net income or net profit = Operating profit - Interest - Taxes
Definition and calculation of net working capital:
Net working capital simply refers to the difference between current assets and current liabilities, i.e., Net working capital (NWC) = Current assets - Current liabilities
Market values:
Over time, asset values fluctuate in the market. If land, that was previously acquired for $100 million, has appreciated to $140 million, it will still be recorded in the accounting books at $100 million but its market value will be $140 million. If one restates the balance sheet ro reflect market values, land revaluation will add $40 million (=140 - 100) to owner's equity due to land appreciation alone, ignoring other changes. Market values may go up or go down.
Product vs. period costs:
Product vs. period costs: Costs are often split between product costs and period costs. Product costs are associated with the product and are variable wit the level of production, whereas, period costs are associated with the accounting period. Selling, general and administrative (SGA) costs are considered period costs and may be fixed as well as variable.
Cash flow identity:
Recall the accounting identity, Assets = Liabilities (owed to creditors) + Shareholders' equity This can be extended to cashflows generate by the firm from the use of its assets through operations revolving around production and selling. This is known as the cashflow identity, shown below Cashflow from assets = Cashflow to creditors + Cashflow to shareholders Cashflow to creditors includes interest payments (outflows) and the net of principal repayments and fresh borrowing. The latter net figure could be positive or negative, i.e., net inflow or outflow. Cashflow to shareholders consists of dividends (outflows), share repurchases (outflows) and new equity issue (inflows).
What is an agency relationship?
Relationship between stockholders and management is called an agency relationship• Exists when someone (the principal) hires another (the agent) to represent his or her interests
Which of the following actions would be most likely to decrease agency costs for the firm?
Reward high performing employees with shares of stock
Partnership advantages and disadvantages
Same as proprietership
Which one of the following questions involves a capital budgeting decision?
Should the firm purchase a new machine for the production line?
Which one of the following is a working capital management decision?
Should the firm require immediate payment from customers or offer credit terms?
Tax expense for different forms of business:
Similar to the tax table example above, apply the relevant marginal tax rate from the relevant tax table for the business organization, to the taxable income in multiple steps to get its total tax expense.
Goal of a corporation:
Since the ownership and control are separated in a corporation, managers and shareholders have an agency conflict. Shareholders want the managers to maximize the value of the firm.
Total liabiltiies and equity=
Stockholders equity+Total liabilities
Provisions of Sarbanes-Oxley Act:
The Sarbanes-Oxley Act was designed to prevent management from misreporting and misrepresenting the earnings and financial condition of the firm to stockholders and stakeholders. It is also meant to prevent the abuse of corporate assets by managers, while prohibiting personal loans from the corporation to managers. Furthermore, it requires that corporate accounts are subject to internal control procedures, independent of the management, preferably overseen by the board of directors. The senior officers of a public corporation are required to sign the annual reports vouching for their accuracy and fair representation of the financial position of the company under the threat of prosecution and potential incarceration with penalties.
Accounting identity
The accounting identity presents the concept behind double-entry accounting system and the presentation of the balance sheet of a business. Simply put, Assets = Liabilities + Shareholders' Equity Generally speaking, the value of the assets a corporation and its liabilities may vary, so, shareholders' equity is calculated as the residual amount, i.e., Shareholders' Equity = Assets - Liabilities. Liabilities refer to external liabilities representing claims outsiders have on the assets of a company.
Accounting identity:
The accounting identity presents the concept behind double-entry accounting system and the presentation of the balance sheet of a business. Simply put, Assets = Liabilities + Shareholders' Equity Generally speaking, the value of the assets a corporation and its liabilities may vary, so, shareholders' equity is calculated as the residual amount, i.e., Shareholders' Equity = Assets - Liabilities. Liabilities refer to external liabilities representing claims outsiders have on the assets of a company.
Listing of assets on a balance sheet:
The assets are listed in the order of liquidity on a balance sheer. The most liquid assets (also known as current assets) are listed first, followed by fixed assets such as, land buildings and equipment. Intangible assets such as patents, copyrights etc. are listed in the end as they are the least liquid. Current assets are listed in the order of cash, marketable securities, accounts receivable and inventories because cash is the most liquid asset and inventories are the least liquid even though both are short-term assets.
Finance reporting structure
The finance function is typically split into parallel paths: (1) Controllership, and (2) Treasury Functions. Both report to the Chief Financial Officer (CFO). The Controller supervises the accounting systems and reporting, taxation and costing, along with internal controls, whereas, the Treasurer interfaces with the external world raising capital and managing banking relationships. (S)he also manages cash and supervises capital expenditures, relying on accounting information generated by the Controller's department. The two divisions work closely with one another.
Matching principle of GAAP:
The matching principle requires that period expenses be matched with period revenues. Recognition of revenues and expenses plays an important part in determining the reported income for a period.
What is capital budgeting?
The process of planning and managing a firm's long-term investments. Financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire. Value of cash flow generated by an asset exceeds cost of asset. Evaluating the size, timing, and risk, of future cash flows is the essence of capital budgeting.
Long-term assets:
These include property, plant and equipment and are assets which are of long-term nature and their use spans several accounting periods or operating cycles. They are also known as fixed assets, long-lived assets, tangible assets or plant assets. Their use is allocated to accounting periods - known as depreciation which is based on expected useful lives and cost of acquisition.
Operating section of an income statement:
This is related to the operations of a company, such as revenue and cost of goods sold and depreciation. EBIT is also known as operating profit or income.
Marginal tax rate:
This is the tax rate based on the income bracket in the tax table.
Cashflow from assets:
This puts together operating cashflow and the following two items Net capital spending = Ending net fixed assets - Beginning net fixed assets + Depreciation Change in net working capital (NWC) = Ending NWC - Beginning NWC Cashflow from assets = Operating cashflow - Net capital spending - Change in NWC = EBIT + Depreciation - Taxes - (Ending net fixed assets - Beginning net fixed assets + Depreciation) - (Ending NWC - Beginning NWC) = EBIT - Taxes - Ending fixed assets + Beginning net fixed assets - Ending NWC + Beginning NWC [Note that depreciation cancels out and other signs reverse in the substitution made above to simply the calculation.]
Net working capital:
This refers to the difference between the current assets and current liabilities of a corporation. These are discussed in detail later. So, a typical balance sheet can be recast as follows:
Non-operating section of an income statement:
This refers to the items below EBIT, which are related to interest payments and tax expense.
Identify mechanisms employed to control agency costs:
Top management compensation can be tied to firm performance. Employees can be offered performance bonuses, stock options and restricted stock units (RSUs) so they benefit from better corporate performance along with the shareholders, thus aligning their interests.
Total Assets =
Total Liabilities + Stockholders Equity
Total assets=
Total liabilties and equity
Accrual accounting:
Under accrual accounting, revenue is recognized even though cash is not yet received. The revenue account is credited by the amount of the sale and an accounts receivable (balance sheet) account is debited for an equal amount. The goal of accrual accounting is to record revenues and expenses in the period in which they occur rather than the period in which related cash is received or disbursed. This is known as the matching rule. Accruals and deferrals impact both income statement and the balance sheet. If revenue is accrued (cash received after a sale is completed) it gives rise to recognition in the income statement as well as an asset (accounts receivable). If revenue is deferred (cash is received before revenue is earned) it does not impact the income statement but creates a liability (unearned revenue). If an expense is accrued (cash is paid after an expense has been incurred) it gives rise to recognition in the income statement as well as a liability (such as rent or accounts payable). If the expense item is deferred (cash is paid before the expense is recognized) it does not impact the income statement but creates an asset(such as, prepaid insurance or subscription). In short,
Difference between stockholders and stakeholders:
While shareholders have a direct and formal claim on the earnings and assets of the firm and control the board of directors, there are others who also have a claim on a firm's cash flows. They may also include outsiders. Stakeholders are comprised of employees, customers, suppliers, creditors, regulators, and the government who may have a competing claim against shareholders in the form of taxes. In recent years, environmentalists have also claimed to be stakeholders who are concerned about the impact of a corporation's actions on the environment and the sustainability of its operations without degradation of the environment. You will study more about externalities later in the course under project analysis and evaluation.
Corporation
a business created as a distinct legal entity composed of one or more individuals or entities• Legal "person," separate and distinct from its owners with many of the rights, duties, and privileges of an actual person• Stockholders and managers are usually separate groups
A partner in a firm knows that the maximum financial loss he or she will experience is the amount he or she invested in the firm. The partner is called a ______ partner.
limited
Earnings Per Share (EPS)
net income/number of shares
Book Value =
net working capital + current liabilites + net fixed assets
Limited partnership
one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business. Limited partner's liability for business debts is limited to the amount that the partner contributes. (common in real estate).
General Partnership
partners share in gains or losses, and all have unlimited liability for all partnership debts. The way partnership gains and losses are divided is partnership agreement (oral or written)
Financial managers should primarily focus on the interests of:
shareholders
Working Capital
short term assets (inventory), short-term liabilities (money owed to suppliers).
Capital Structure
the specific mixture of long-term debt and equity the firm uses to finance its operations. The financial manager has two concerns in this area: how much should the firm borrow (what mixture of debt and equity is best) and, what are the least expensive sources of funds for the firm. What percentage of the firm's cash flow goes to creditors and what percentage goes to shareholders. Decide how and where to raise money.
Financial Management function
top officer (CFO), VP: coordinates activities of the treasurer and controller, controller: cost and financial accounting, tax payments, MIS. Treasurer: managing firm's credit and cash, financial planning, capital expenditures.
Dividend per share
total annual dividends / total number of issued shares
Advantages of Sole Proprietorship
• Simplest type of business to start• Least regulated form of organization• Owner keeps all the profits
Primary disadvantages of sole proprietorships and partnerships are the following, which add up to a single, central problem of the inability to raise cash for investment:
• Unlimited liability for business debts on the part of the owners• Limited life of the business• Difficulty of transferring ownership
