Chapters For Exam

C1. The Function and Goals of FM 1.1. THE FIELD OF FINANCE Finance is the art and science of managing money. Finance applies the disciplines of economics and accounting to various problems in the firm. There are two major areas in finance. One of the areas is the provision of financial services to individuals, businesses, nonprofit organizations and government. Financial management is the second of these two major areas. A financial manager manages the financial affairs of any type of business, whether financial or nonfinancial, private or public, profit or nonprofit. 1.2. THE FINANCIAL MANAGER’S RESPONSIBILITIES The main responsibilities of financial manager include: Financial Analysis and Planning – This involves organizing and using accounting data to monitor the firm’s financial conditions. It also involves evaluating the need for capital expenditures and determining what additional financing is needed. Managing the firm’s asset structure – This involves managing the firm’s cash, marketable securities portfolio, accounts receivable, inventory, equipment and physical plant. Managing the firm’s financial structure – This involves decisions on how assets are financed, use of short-term versus long-term debt, leasing and use of debt versus equity. 1.3. THE ORGANIZATION OF THE FINANCE FUNCTION Accounting departments typically handle the finance functions in small firms. In the large firms, there is typically a Vice President Finance, or Chief Financial Officer (CFO) who reports directly to the President (CEO). Typically, the treasure and the controller will report to the Vice President Finance. The treasure is normally responsible for handling financial planning and fund raising, managing cash, capital budgeting analysis, credit and collections and investing of excess funds. The controller normally is responsible for all accounting activities, including tax management, data processing and cost and financial accounting. 1.4. GOALS OF THE FIRM The board goal of the firm should be to attempt to maximize the wealth of the firm’s present shareholders, as measured by the long run share price. Wealth maximization is superior to profit maximization because profit maximization does not recognize the risk/return tradeoff, the contribution of dividends to shareholders wealth or the problems in measuring “profit”. Sometimes managers seek to maximize their wealth and perquisites rather than shareholder wealth. This is called “agency” problem. Managers are the agents of the stockholders. Various incentives, such as stock options and bonuses, are used to insure that managers operate in the interests of stockholders. Wealth maximization is not inconsistent with social responsibility. Social responsibility will be broadly defined as quality product and service to its customers, concern for employees and community concern. Because of competitive pressure, government regulation may be needed to protect the responsible firms from the irresponsible firms. Pension funds and mutual funds with a concern about social issues are increasingly having an impact on firms in their role as large shareholders. C2. Business Organization and the Financial Environment 2.1- BASIC FORMS OF BUSINESS ORGANIZATION There are 3 type of organization: PROPITERSHIP It is a business by one person & about 75% of all business in the U.S are proprietorship. ADVANTAGES:

•Low cost & ease of information. •Decisions do not require consent of others. •Sometime income tax will be advantage. DISADVANTAGES:

•Unlimited liability. •Difficulty in raising large amount of capital. •Life of the business is limited to the life of individual. PARTNERSHIP It is a business owned by 2 or more.About 9% of all business firm in the U.S are partnership. ADVANTAGES:

•Can raise more capital than proprietorship. •Can attract talent easier than proprietorship. •Sometime income tax will be advantage. DISADVANTAGES:

•Unlimited liability for each partner. •Life of the business is limited. •Difficulty in raising a large amount of capital.

CORPORATION It is a legal entity created by state & is separate & distinct from its owner. Corporation comprise 16% of all business in the U.S but receive 88% of business receipts 78% of net profits. ADVANTAGES:

•Limited liability. •Ability to raise large amount of money. DISADVANTAGES:

•Time & cost of organizing. •Double taxation may be disadvantage. 2.2-THE FEDERAL INCOME TAX SYSTEM A corporate must pay federal income tax on its corporate income.The following table shows the tax rate for corporate income. AVERAGE TAX RATE:

• An individual or company taxes divided by its taxable income. Average tax rate=tax liability/pretax income MARGINAL TAX RATE:

•The tax rate at which additional income is taxed. There are 4 types brackets with rates of 15%,28%,33% & 28%.The size of the tax brackets varies with single or family status. 2.3-FINANCIAL INSTITUTIONS Are intermediaries that channel the saving of individual, businesses and government into Loans or Investments. The major financial institutions are following: •Commercial banks. •Mutual saving banks. •Savings and loan. •Credits Unions. •Life insurance company. •Pension funds. •Mutual funds. 2.4-FINANCIAL MARKET Provide the form with savers & users of funds a brought together. There are many financial markets such as,

•Money Market. •Capital Market. •Primary Market. •Secondary Market. •Futures Market. •Foreign Exchange Market. 2.4-INTEREST RATES & REQUIRED RETURN Is the interest rate which would prevail in the absence of risk & inflationary expectations. ACTUAL OR NOMINAL RATE OF INTEREST: Is the rate paid in the market, equal to the real interest rate plus risk adjustment plus inflation adjustment plus liquidity preference. RISK PREMIUM Investor & lenders require a higher rate of return for assuming risk is called a risk premium. There are 3 elements of risk premium

•Default risk. •Maturity risk. •Marketability risk. DEFAULT RISK: The risk that a loan or investment will not be repaid. MATURITY RISK: When interest rates rise bond price fall. The greater the years to maturity, the greater the change in price. MARKETABILITY RISK: The more highly, marketable the issue the lower the risk. C3. Financial Statements, Depreciation, and Cash Flow Financial Statements, Depreciation and Cash Flow Contents Income Statement Balance Sheet

Analyzing the Firm’s Funds Flow Depreciation ACRS

Income Statement Earnings after taxes may be paid as dividends to stockholders in the firm. Earnings after taxes may be reinvested in the firm; they are called retained earnings. Balance Sheet Statement of Financial Position:  what a firm owns (assets)  how these assets were financed through borrowing (liabilities)  owner money (equity) What is the difference between “Income Statement” and “Balance Sheet” ? Balance Sheet Analyzing the Firm’s Funds Flow Sources and uses of funds – worksheet which explains where funds were used during any accounting period and how these funds were generated. Source of funds is: Any decrease in an asset An increase in a liability An increase is an equity account Uses of funds is: Any increase in an asset A decrease in a liability A decrease in an equity account Analyzing the Firm’s Funds Flow Depreciation Tax Reform Act provides 2 types: Accelerated Cost Recovery System (ACRS) Straight Line (SL) ACRS uses double-declining balance (200%) method using the half-year convention. 4 property classes (recovery periods) under ACRS ACRS Property classes: •3-year - Research and experiment equipment and certain special tools •5-year - Computers, typewriters, duplicating equipment, cars, light-duty trucks, qualified technological equipment and similar assets •7-year - Office furniture, fixtures, most manufacturing equipment, railroad truck, and single-purpose agricultural and horticultural structures •10-year- Equipment used in petroleum refining or in the manufacture of tobacco products and certain food products ACRS Depreciation is:  a non-cash expense ( serves as a tax shield by reducing taxable net income ) source of funds because the cash outflow occurs at the time of purchase and is then amortized over the life of the asset by including it as an expense in product pricing C4. Financial Statement Analysis 4.1-Basic Types Of Financial Ratios: There are different classifications systems for describing financial ratios.In this chapter we have used one common system which is the four categories of ratios. Ace Corporation data from chapter 3 will be used as example of calculations. Four Categories Of Ratios:

•Liquidity Ratio. •Activity Ratio. •Debt Ratio. •Profitability Ratio. 4.1.1-LIQUIDITY RATIO The most common liquidity ratios are the CURRENT RATIO and the QUICK RATIO. NETWORKING CAPITAL, while not a ratio, is a measure of liquidity. These ratios can be calculated as follows: Current ratio = current assets / current liabilities Quick ratio = current assets less inventory / current liabilities Networking Capital = current assets - current liabilities 4.1.2-ACTIVITY RATIO

•Frequently called TURNOVER ratio.

•Considered good measures of management effectiveness. Management can directly affect the inventory and accounts receivable ratios which short-term creditors will examine. Example: If a firm has difficulty paying bills when due, activity ratio affecting working capital will be closely examined. INVENTORY TURNOVER Measures the movement of how rapidly inventory can be converted into cash within a period.It is usually calculated by: Cost of goods sold / Inventory (avg Inventory) Example: Ace Corporation Inventory - $8,000,000 / $1,500,000 = 5.33 times Avg Inventory - $8,000,000 / $1,000,000 = 6.15 times ACCOUNTS RECEIVABLE TURNOVER

•Helps to provide insight into how efficiently accounts receivable is being managed. •Accounts receivable is an interest-free loan from the buyer to the seller and requires financing by the buyer. Accounts Receivable Turnover is calculated as: Sales / Accounts receivable (avg accounts receivable) FIXED ASSET TURNOVER Determines if investment in fixed assets is excessive.The age of assets, depreciations policies and use of leases all impact this ratio. Equation of Fixed Asset Turnover is: Sales / Fixed Assets (avg fixed assets) Total Asset Turnover is calculated : Sales / Total Assets (avg total assets) 4.1.3-DEBT RATIO Indicates the proportion of total asset financial by a company’s creditors. A higher ratio indicates that there is larger amount of others money being used in an attempt to generate profit. Debt ratio – Total Liabilities / Total Assets DEBT TO EUITY RATIO Is a measure of financial leverage. This ratio is useful in evaluating a stock risk exposure to debt. A higher number, the more a company is at risk of defaulting on loans. This ratio is calculated as: Long-term debt / Common Stockholders equity $1,500,000 / 6,000,000 = 25% TIMES INTEREST EARNED RATIO Earnings before interest and taxes( EBIT) divided by total interest. Taking into account the data of Ace Corporation: $1,200,000 / $100,000 = 12 times FIXED PAYMENT COVERAGE RATIO Earnings before interest and taxes (EBIT) divided by the interest plus principal payments and preferred dividends adjusted to before-taxes amount. 4.1.4-PROFITABILITY RATIO These ratios are of particular interest to investor and long term creditors. Long-term debt is repaid from earnings. • Gross Profit Margin – represents the excess of sales over the cost of goods o Gross profit / Sales

•

Operating Profit Margin – Measures the percentage of each sales dollar that is left after all costs and expenses other than taxes. Operating profit (EBIT) / Sales PROFITABILITY RATIO The following four ratios compare net profit after tax to various bases.

Net Profit Margin – Net profit after taxes / Sales Return On Investment (ROI) – Net profit after tax / Total Assets Return On Equity (ROE) – Net profit after taxes / Stockholders equity

Earnings Per Share (EPS) – Net profit after tax /Common Shares 4.2-CROSS SECTION ANALYSIS Compares the firm under study with average data from the comparable firms. The data of comparable firms are available from several sources, such as:

•Robert Morris Associates. •Dun. •Bradstreet. 4.3-TREND ANALYSIS This compares the current ear financial data with previous years data. Principal methods used for Trend Analysis are:

•Comparative ratios. •Common size financial statement.

•Percentage changes. 4.4-DUPONT SYSTEM OF ANALSIS Dupont developed a system of analysis for internal operating control using control charts.It can be used or various subdivisions of a company. The form they developed for internal control purpose is: (Operating Profit / Sales) X (Sales / Operating Assets) Above equation equals the value of ROI. 4.5-LIMITATIONS OF RATIO ANALYSIS

•Ratio analysis is limited by quality of the data and by the aggregation of data. •Original cost versus market values and inflation limit ratio analysis. •Seasonal differences affect both trend and cross section analysis. •Age of firm, the point in the life cycle of the firm. •Age of the assets also affect ratio analysis. C5. Financial Planning FINANCIAL PLANNING Strategic Financial Plans - long run (e.g. 5 years) - expansions, R&D, acquisitions, etc. Operating Financial Plans - short run (the year ahead) - follow the framework of the Strategic Financial Plan Operating Financial Plan - components Budgeted (Pro Forma) Income Statement - Sales budget - Costs-of-goods-sold budget Production budget Direct materials purchase budget Direct labor cost budget Factory overhead cost budget - Operating expenses budget Budgeted (Pro Forma) Balance Sheet - Capital expenditures budget Cash budget Pro Forma statements - based upon the sales forecast Sales forecasts : external (top-down) - relationships between the firm’s sales and various economic indicators in the firm’s sales area internal (bottom-up) - individual forecasts by salespeople in the territory, aggregated at the level of sales managers into a consensus forecast Pro Forma Income Statement -starts with the sales forecast -monthly, quarterly, semiannual, etc. -data from: costs of goods sold operating expenses budget -after-tax earnings  retained earnings on the Balance Sheet The Cash Budget (1) The Cash Budget shows (as forecast): -cash that will be received/disbursed -amount and time available of excess funds for investing -amount and timing of borrowing needed -when and how borrowed funds will be repaid The Cash Budget (2) Typical format: -cash receipts -all cash sales -collection of accounts receivables -all non-operating cash receipts -cash disbursements = all cash payments -purchases

-expenses -interests -debt

payment equipment payments -dividends The Cash Budget (3) Total Receipts – Total Disbursements = Net Cash Inflow/Outflow + Beginning Cash Balance = Ending Cash  Beginning Cash for the next period If Ending Cash – Desired Cash Level < 0  funds must be borrowed Pro Forma Balance Sheet Projected annually for the next 5 years in order to develop financial strategy Uses: -capital

C7. Time Value of Money Definition The "time value of money" is basically the concept that a dollar received today is worth more than a dollar received at some point in the future, because the dollar received today can be invested to earn interest. Future value (compund value) Future value measures what money is worth at a specified time in the future assuming a certain interest rate. Present value The current value of one or more future cash payments, discounted at some appropriate interest rate. C8. Risk and Return RISK AND RETURN RISK VARIABILITY OF RETURNS ASSOCIATED WITH A APRTICULAR ASSET TOTAL OF GAIN (LOSS) EXPERIENCED BY THE OWNER OF AN ASSET OVER A GIVEN TIME PERIOD C12. Capital Structure C14. Accounts Receivable and Inventories CREDIT MANAGEMENT Credit management involves the development and implementation of policies on: -credit standards -credit terms -collections Scope -increased sales -increased investment in AR -increased bad debts losses CREDIT ANALYSIS The five “C’s” of credit in evaluating the customer:  Character (Does the customer pay his bills?)  Capacity (Ability to pay)  Capital (Financial condition of the firm)  Collateral (Possible assets to be pledged)  Conditions (Economic conditions) Credit terms  Credit period  Cash discounts  Maximum credit line MONITORING AR Three approaches: Average collection period AR+ average daily sales Aging schedule of AR (can be affected by changing sales levels) Payments Pattern Approach (is unaffected by changes) COLLECTION POLICIES Letters Telephone calls

Personal visits Collection agencies Legal action

Size of customer, potential sales, size of outstanding receivable decide when and witch technique to use ABC INVENTORY Scope  control of finished goods “A” 70% of the inventory value 20% of the items numerically “B” 20% of the inventory investment 30% of the items  “C” 10% of the inventory value 50% of the items ECONOMIC ORDERING QUANTITY (EOQ) Scope  to minimize the total cost of inventory (order costs + carrying costs) Order costs = clerical cost of placing and receiving order (a fixed cost/order) Carrying costs = storage costs + deterioration, etc. (a variable cost, 20-30% of the value of the inventory) C15. Short-Term Financing C19. Leasing In brief A lease or tenancy is the right to use or occupy personal property or real property given by a lessor to another person (the lessee or tenant) for a fixed or indefinite period of time, whereby the lessee obtains exclusive possession of the property in return for paying the lessor a fixed or determinable consideration (payment). Types of leases Operating lease Financial lease Sale and leaseback Direct leasing Leveraged leasing Operating lease (maintenance, service lease) Short or intermediate terms Lessor (rather than lessee) responsible for maintenance, insurance and taxes related to the leased asset Cancellable contract Not fully amortized (usually) Computers, automobiles, trucks Financial lease Intermediate or long terms Lessee (rather than lessor) responsible for maintenance, insurance and taxes related to the leased asset Non-cancelable contract Fully amortized (usually) Land, buildings, aircrafts Sale and leaseback A sells an asset to B B (lessor) leases to A (lessee) A receives sales price in cash and economic use of the asset A makes periodic lease payments to B B realizes any salvage value Direct leasing A company acquires the economic use of the leased asset it did not own previously Ex: lease a computer from IBM Leveraged leasing Lessee – uses the asset and makes periodic lease payments Lessor – owns the asset which is financed in part by a long-term lender Lessor – equity participant, as well as borrower Financial statement effects Capital lease lessee acquires all of the economic benefits and risks of the leased asset the lease term is greater than 75% of the property's estimated economic life the lease contains an option to purchase the property for less than fair market value ownership of the property is transferred to the lessee at the end of the lease term

the present value of the lease payments exceeds 90% of the fair market value of the property Financial statement effects Operating lease the lessee does not acquire all the economic benefits and risks of the leased asset the lessee acquires the property for only a small portion of its useful life commonly used to acquire equipment on a short-term basis any lease that is not a capital lease is an operating lease Leasing vs. borrowing Lease the asset or purchase it and finance by borrowing? Evaluate the project using cash flow methods: NPV or IRR Decide whether finance by debt or by lease –> compare costs

C21. Business Expansion and Business Failure 21.1 GLOSSARY MERGER: combination of two or more companies, with one surviving as a legal entity - horizontal/vertical, market extension, product extension, conglomerate CONSOLIDATION: neither company survives as a legal entity, with a new one being born TAKEOVER: friendly / hostile RAIDER: the entity attempting to take over a company TENDER OFFER: an offer to buy shares from shareholders CROWN JEWEL: the most valued asset owned by a target company OTHERS: - Greenmall - Golden Parachute - Maiden - Poison Pill - Shark Repellants - Stripper - White Knight 21.2 REASONS FOR MERGERS • Increase market value - Increase earnings per share - Decreasing the rate of return • Other reasons: - Operating economies - Improved management - Future growth - Diversification 21.3 FINANCIAL EVALUATION OF MERGERS • Based upon the Net Present Value formula • If positive, the acquiring company should buy target company 21.4 GLOSSARY #2 LEVERAGED BUYOUT (LBO): • the purchase of a company with debts; • cash is raised through assets; • all shareholders are bought out; LEVERAGED CASHOUT (LCO): • the shareholders keep their share; • cash is raised through increased leverage; DIVESTITURE: • SELL OFF • SPIN-OFF • EQUITY CARVE-OUT • Based on different NPV formula, a company should divest or not 21.5 BUSINESS FAILURE TECHNICAL INSOLVENCY: situation where a firm is unable to pay its bills • Business can fail with reported profits or growth • The principal cause of bankruptcy - mismanagement 21.6 VOLUNTARY SETTLEMENT • Arranged with creditors rather that legal bankruptcy proceedings • EXTENSION • COMPOSITION

• CREDITOR CONTROL • ASSIGNMENT 21.7 COURT SUPERVISED REORGANIZATION AND LIQUIDATION • Legal aspects and procedures in pages 111 and 112 21.8 BANKRUPTCY COSTS DIRECT COSTS: out-of-pocket fees associated with the bankruptcy process INDIRECT COSTS: lost efficiency and revenue as bankruptcy is anticipated by creditors, customers and employees C23. Financing Small Firms and Startups Life Cycle of The Firm Startup(experimentation stage) • Sales grow slowly

•

Sufficient equity is important • Source credit : trade credit and government agencies Rapid growth stage • Sales grow rapidly • Dangerous time for small bussiness • Requires an increasing amount of external long-term funds. Maturity Stage • Sales growth has slowed • Earnings can finance growth • Debt ratios can be improved • Liquidity can be rebuilt • Concerns switch to marketing Decline Stage • Market is saturated or changed • New products/diversification • Asset base should decline as sales decline • Funds for debt reduction and alternative investments Sources of financing for traditional small firms - Small firms • Localized market • Low capital requierments • Simple technology - Startups • Owners commit their savings(mortage on home, loans from family) • Credit source: trade credit • Direct loans and guaranteed loans (ex. SBA) Sources of financing for traditional small firms - Rapid growth stage • Trade credit • Bank loans • Owners need to reinvest their earnings • Leasing and installment buying of fixed assets • Public stock offering may be possible • Commercial finance companies • Working capital management and current liability management are momentuous Maturity stage • Seasonal loans and term loans for equipment purchases • Same sources as in the rapid growth stage Decline • Liquidation of assets->funds • External funds for diversification • Merger may be necessary Sources of financing for firms with growth potential • Use all the sources available for small firms plus additional sources ->venture capital and public offerings • Venture capital firm - An investment company that invests its shareholders' money in startups and other risky but potentially very profitable ventures. • Venture capital

- Funds made available for startup firms and small businesses with exceptional growth potential. Managerial and technical expertise are often also provided. also called risk capital. Sources of financing for firms with growth potential • Equity - Ownership interest in a corporation in the form of common stock or preferred stock. • Venture capital - Equity capital or debt and equity capital • Public offering - An offering of new securities to the investing public at a public offering price that has been agreed upon by the issuer and the investment bankers. - It’s used at startups when considerable capital is required