Finance Notes 1/14/2014 4:37:00 PM

What is a corporation?
A distinct permanent legal entity. A corporations owners are called
shareholders or stockholders. The share holders do not directly own
the businesss real assets (factories, oil wells, stores etc. ) they
have an indirect ownership via financial assetsthe shares of the
corporation
Shareholders cannot be legally responsible for the corporations
debts.

Goal: maximum value vs. profits:
Short falls of profits: short term focus. Which years do we maximize?
Save money this year but cutting money on training of staff. This is not as
effective.
Profit can be ambiguous due to GAAP (generally accepted
accounting principals. )
Goals of the corporation:
Profit maximization?
This goal ignores:
o Timing of returns
o Which years profits?
o Profits are ambiguous: GAAP
o Risk
o How certain are the profits
Financial Management decisions:
Investment decision
o What assets should our firm invest in?
Financing decision:
o How should we raise funds?
o How should the firm raise the money that it needs for its
investments and operations?
Capital structure: the mix of long term debt and equity financing
o (capital is funds from long term debts or equity financing)
a corporation is its own legal entity separate from its owners. A sole
proprietorship and partnership are with the owners.
Why are most large organizations public corporations?
gives access to potential investors and people are willing to take
risk because of limited liability.
Opportunity cost of capital:
The cost of capital is the expected rate of return that investors demand for
alternative investments at the same level of risk

The minimum acceptable rate of return on a firms capital investments.
A firm must generate this rate of return if it is to maintain the
current market prices of its securities.
Earning more than the cost of capital on investments creates vaiue
for shareholders (problem 26 page 28.)
10 years, 6% return guarantee. What is the cost of capital?

Chapter 2
Financial market:
Your buyers are the investors who are buying stocks or bonds and the sellers
are the companies that have the stock or bonds.
What is a (financial) market?
A pace where a multitude of willing buyers and willing sellers meet
in order to create voluntary exchanges of value.
In a financial market, who are the buyers?
o The sellers
o What is being exchanged?
Purpose of financial markets:
o To allocate funding among organizations that need it.
o
o Financial markets:
Stock markets
Fixed-income markets
Money markets
Markets for commodities, foregn exhchange, dervatives
o Corporations
Investmets in real assets
o Financial instituitions
Banks
Insurance companies
Financial intermediaries
Mutual funds
Pension funds
o Investors worldwide
o
Financing desions:
o What sources sof funds should the firm use?
o Capital markets?
o Money markets?
o Within capital markets there are primary markets and
secondary markets:
Primary: IPOs, seasoned offerings
IPO company opens stock to the public for the first time
Seasoned: when its been opened several times and its
opening it up again when they need something.
OTC markets vs. exchanges:
Most famous is the NYSE thats an exchange.
NASDAQ is an OTC Market. (internet)
Financial intermediaries: (mutual fund)
Bank of America Windsor fund investors
Firm raising capital (Sells shares)| widsor fund: invets in securities:
o Money markets securities
o Bonds
o Stocks they issue shares to the investors
Intermediaries of any kind exist only when they add value. What
kinds of value do mutual funds provide
Financial intermediaries
Mutual funds
o An investment company that pools the savings of amny
investors and onvests in a portfolio of securities
o
Hedge funds: aimed towards billionaires and the wealthy
o A private investment pool, open only to wealthy or
institutional investors, that is only lifthly regulated and
therefore can purse mre speculative policies than mutual
funds
Pension fund
o Fund set up by an employer to provide for employees
retirement
o *** intermediaries only exist when they have value.
Financial institutions are financial intermediaries that provide more services
that sampling pooling and investing savings.
Commercial bank
Investment bank
Insurance company (life)
Function of financial markets:
Transporting cash across time
Risk transfer and diversification
Liquidity
Payment mechanism
Provide information:
o Commodity prices
o Interest rates
o Company value: stock prices
o Managers use information from financial markets to estimate
the opportunity cost of capital
Its the return that investors demand for alternative
investments at the same level of risk
Chapter 3: accounting and finance
Tax effects:
Taxes and cash flows can be changed by the use of debt
Firm A pays part of its profits as debt interest. Firm B does not.
o Firm A:
o EBIT 100
o Interest: 40
o Pretax income: 60
o Taxes (35%) 21
o Net income: 39
o
o Firm B:
o EBIT: 100
o Interest: 0
o Pre tax income: 100
o Taxes (35%) 35
o Net income: 65
Taxes have a major impact on financial decisions
o Marginal tax rate: is the tax that the individual (or
corporation) will pay on the next additional dollar of income.
o Average tax rate: is the total tax bill divided by the total
taxable income.
o Example: if a firm has a taxable income of $110,00 what is its
marginal tax rate?
Pay 34% for the first range then add the 5% surtax
=39%
Tax income: $335,000
Marginal tax rate = 34% (335,000-75,000=260,000)
Average tax rate: first (50,000*15%) + (25,000*25%) + (260,000*34%) +
235,000*5%) = 34% (know how to calculate marginal tax rate and average
tax rate.)

What is a balance sheet?
Tells assets, liabilities and equity of a company for a specific date.
A financial statement that shows the value of the firms asstes and
liabilities (from an accounting perspective) at a particular point in
time.
A tabular representation of the accounting equation:
assets=liabilities + shareholders equity.
Balance sheet:
Assets:
Cash
Marketable securities
Accounts receivable
Inventories
Prepaid expenses
Fixed assets
Machinery and equipment
Buildings and land *
Other assets
Investments and patents

Liabilities: debt and equity:
Current liabilities
Accounts payable
Accrued expenses
Short term notes
Long term liabilities
Ling term notes
Mortgages
Equity
Preferred stock
o Common stock par value*
o paid in capital *
o retained earnings. *
o **book value or net worth
market value and book value are different.*
book value vs. market value:
o GAAP
o Book value
Value of assets or liabilities according to the balanve
sheet
Values recorded at their historical cost adjusted for
depreciation
o Market value:
The value of assets or liabilities were they to be resold
in the market today.
Market price per share of common stock times the
number of outstanding shares.
The income statement:
Documents revenues and expenses
Rev-expenses=net income
o a financial statement that gives operating results for a specific
period
the statement of cash flows: a financial statement that shows the
firms cash receipts and cash payments over a period of time. la
Study Guide Chapter 1-3 1/14/2014 4:37:00 PM
Is limited liability always an advantage for a corporation and its shareholders
Yes
Large corporations would not be able to obtain financing from
thousands of share holder if the shareholders were not protected by
the fact that the corporation is a distinct legal entity.
Lenders do not view limited liability as an advantage to them.
In some situations lenders are not wiling to lend to a corporation
without personal guarantees from shareholders, promising
repayment of loan where the corporation does not have the
financial resources to repay the loan.
Typically involve small corporations, with few shareholdersthey
often obtain debt financing only if the shareholders provide these
personal guarantees.
Which of the following are real assets and which are financial?
Share of stock------financial asset
A personal IOU-----Financial asset
A trademark--------Real asset
A truck--------------Real Asset
Undeveloped Land-Real asset
The balance of a firms checking account------financial asset
An experienced and hardworking sales force-real asset
A bank loan agreement----Financial asset

Statements that describe the treasurer, not the controller:
Monitors capital expenditures to make sure they are not
misappropriated.
Responsible for investing the firms spare cash
Responsible for arranging any issue of common stock
Responsible for the companys tax affairs.
Financing for public corporations must flow through financial markets: False
Financing for private corporations must flow through financial
intermediaries: False
The sale of policies is a source of financing for insurance companies: False
Almost all foreign exchange trading occurs on the floor of the FOREX
exchanges in NY and London: False
The opportunity cost of capital is the capital outlay required to undertake a
real investment opportunity. False
The cost of capital is the interest rate paid on borrowing from a bank or
other financial institution: False

Chapter 4 1/14/2014 4:37:00 PM
Chapter 4: measuring corporate performance
Who would be interested in measuring the financial performance of a
corporation?
Investors
Creditors
Suppliers
Stock price (stock brokers)
Measuring financial performance
Value and value added
Market capitalization:
o Total market value of equity, equal to share price times
number of shares outstanding.
Market Capitalization = (#shares)x(prices per share)
o Increasing market cap: is the ultimate indicator of successful
financial performance:
o Market value added:
Market capitalization minus book value of equity.
MVA=MARKET CAPITALIZATION NET WORTH
The amount of value that management has created.
(the more positive the better)
How do we have 2 companies with similar market value, but one
has a higher to book ratio? What explains this situation?
o Book value of one is going to be lower.
o One has more demand for product than the other. If we are
comparing att&t with home depot, people are going to have
more demand for the cell phones because of the things that
go into the equipment, etc.
Economic value added EVA:
o Income to bond and stock holders minus a charge for the cost
of capital employed. Also called residual income.
o Net dollar return after deducting the cost of capital
o EVA = residualincome.
= after tax interest + Net income [cost of capital x
total capital]
shareholder value depends on the efficiency of all the
ratios.
Why do we use ratios?
o Comparability
Return on capital (ROC) some of the investments
o After tax operating income* as a percentage of long-term
capital
Return on Assets (ROA) all investments
o After tax operating income* as a percentage of total assets
Return on Equity (ROE) considers one parties investment:
shareholders
o Net income as a percentage of shareholders equity
o **after tax operating income = net income + after tax
interest.
Current ratio: current assets / current liabilities
How does this ratio measure liquidity?
Quick ratio for liquidity: cash + marketable securities + receivables
/ current liabilities (does not have inventory)
Cash ratio: cash + marketable securities/ current liabilities
How does this ratio differ from the current ratio? Why might a
financial manager prefer it?
Dupont system:
What is it and what is it used for?
Return on assets = net income + (after tax) interest / assets
ROA = Sales/ assets x Net income +(after tax) interest/ Sales
o Asset turn over^ operating profit margin^
o
Increase turn over in retailmake sure items sell rather than sitting
on the shelves.
Return on Equity:
Net income / equity
ROE = assets / equity x sales / assets x net income +
(AT) interest / sales x net income / net income + (at) interest
1/14/2014 4:37:00 PM
Return on assets= assets/equity x ROA x Net income/net income + interest
ROA=5% x 3 = 15%
ROE=2 x .15 x (20-8-8/20-8-8+8)

A=L+e
If Debt/equity =1.75 what is Assets/Equity?
A= 1.75E +E
A/E=2.75
Chapter 18:
Planning Horizon:
Long-term planning: plans that exceed the next 12 months.
Short term planning: plans for the next 12 months
The creation of pro forman (projected) financial statements for 5-10
years into the future.
Contingency planning:
Planning for the unlikely events (what if)
If you think ahead about what could go wrong, you are less likely to
panic if things do go wrong and can respond faster and more
effectively to trouble.
Considering options: opportunities to exploit the firms strengths
New business areas? New proucts?
Making timely preparations
o Financing and investment plans take time to implement
o Focing consistency:
Are corp. goals mutually consistent?
E.G., 25% growth and no external financing.
Inputs: current financial statements. Forecasts of key variables
such as sales or interst rates
Planning model: equations specifiny key relationships.
Outputs: projected financial statements. Pro formas.
Financial ratios
Sources and uses of cash.
Percentage of sales models: planning model in which sales forecasts
are the driving variables and most other variables are proportional
to sales: why are they useful?
o People use it often: its quick and easy
Balancing item:
o Vairbale that adjusts to maintain the consistency of a financial
plan. Also called the plug item.
o (basic accounting formula: change in assets=change in
liabilities+ change in owners equity
o pro forma: does the accounting formula hold the balance
sheet?
Look at net income: the sum of the profits must be equal to
Net income= div +change in RE
made profits (NI of 220), look at equity example if it is 1320,
a $100 dividend is the balancing item
if you need more financing and have a limit your debt, a
company can issue common stock to have the balance sheet
balance,
problem 12 chapter 18
500 x 1.15 = 575.00
div=.7x575=402.50 (investing 70%)
change in RE =.3x575 $172.50
REF= look at previous year, start at 2012 when looking for answers in 2013.
3000x 1.15=$3450 this is the new assets for 2013.
450-172.50 = $277.50
how much is new debt we will issue and how much is common stock?
REF=retained external financing/funding
70% of earnings are [ dividends. While 40% of earnings are
retained in the firm.]
The first stage pro forma denotes how much money the firm will
need to raise, bot not how the funds are raised.
Since divided policy is fixed and no equity will be issued, debt must
be the balancing item. Dbeet issued must be 277.50.
If debt issued in 2013 is limited to $100 and equity issued are ruled
out, then the firm must finance its remaining asset requirements
out of retained earnings. Retained earnings must be: increase in
assets-debt issued =.15 X 3,000)-100=350
Therefore dividends must be:
Net income retained earnings = 575-350 =225 = dividends.