NOTES OF FINANCE
finance
The art and science of managing
money.
• Finance is the study of how and
under what terms savings
(money) are allocated between
lenders and borrowers.
– Finance is distinct from
economics in that it
addresses not only how
resources are allocated
but also under what terms
and through what
channels
managerial finance
Concerns the duties of the financial
manager in the business
firm
stockholders
The owners of a corporation,
whose ownership, or equity, is
evidenced by either common
stock or preferred stock.
common stock
The purest and most basic form
of corporate ownership.
preferred stock
A special form of ownership
having a fixed periodic dividend
that must be paid prior to
payment of any common stock
dividends.
dividends
Periodic distributions of earnings
to the stockholders of a firm.
board of directors
Group elected by the firm’s
stockholders and having ultimate
authority to guide corporate
affairs and make general policy.
accrual basis
In preparation of financial
statements, recognizes revenue
at the time of sale and recognizes
expenses when they are
incurred.
cash basis
Recognizes revenues and
expenses only with respect to
actual inflows and outflows of
cash.
stakeholders
Groups such as employees,
customers, suppliers, creditors,
owners, and others who have a
direct economic link to the firm
financial markets
Forums in which suppliers of
funds and demanders of funds
can transact business directly.
primary market
Financial market in which
securities are initially issued; the
only market in which the issuer
is directly involved in the
transaction.
secondary market
Financial market in which
preowned securities (those that
are not new issues) are traded.
money market
A financial relationship created
between suppliers and
demanders of short-term funds.
capital market
A market that enables suppliers
and demanders of long-term
funds to make transactions.
efficient market
A market that allocates funds to
their most productive uses as a
result of competition among
wealth-maximizing investors that
determines and publicizes prices
that are believed to be close to
their true value.
capital gain
The amount by which the sale
price of an asset exceeds the
asset’s initial purchase price
CHAPTER NO.2
income statement
Provides a financial summary of
the firm’s operating results
during a specified period.
balance sheet
Summary statement of the firm’s
financial position at a given point
in time.
statement of cash flows
Provides a summary of the firm’s
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operating, investment, and
financing cash flows and
reconciles them with changes in
its cash and marketable securities
during the period.
notes to the financial statements
Footnotes detailing information
on the accounting policies,
procedures, calculations, and
transactions underlying entries
in the financial statements.
current assets
Short-term assets, expected to
be converted into cash within 1
year or less.
current liabilities
Short-term liabilities, expected
to be paid within 1 year or less
time-series analysis
Evaluation of the firm’s financial
performance over time using
financial ratio analysis.
. liquidity
A firm’s ability to satisfy its
short-term obligations as they
come due
---current ratio
--quick (acid-test) ratio
activity ratios
Measure the speed with which
various accounts are converted
into sales or cash—inflows or
outflows
--inventory turnover
--average collection period
--average payment period
---total asset turnover
Indicates the efficiency with
which the firm uses its assets to
generate sales.
financial leverage
The magnification of risk and
return introduced through the use
of fixed-cost financing, such as
debt and preferred stock.
coverage ratios
Ratios that measure the firm’s
ability to pay certain fixed
charges
debt ratio
Measures the proportion of total
assets financed by the firm’s
creditors
times interest earned ratio
Measures the firm’s ability to
make contractual interest
payments; sometimes called the
interest coverage ratio.
fixed-payment coverage ratio
Measures the firm’s ability to
meet all fixed-payment
obligations.
gross profit margin
Measures the percentage of each
sales dollar remaining after the
firm has paid for its goods.
operating profit margin
Measures the percentage of each
sales dollar remaining after all
costs and expenses other than
interest, taxes, and preferred
stock dividends are deducted;
the “pure profits” earned on each
sales dollar.
net profit margin
Measures the percentage of each
sales dollar remaining after all
costs and expenses, including
interest, taxes, and preferred
stock dividends, have been
deducted
return on total assets (ROA)
Measures the overall effectiveness
of management in generating
profits with its available
assets; also called the return on
investment (ROI).
return on common equity (ROE)
Measures the return earned on
the common stockholders’
investment in the firm.
market ratios
Relate a firm’s market value, as
measured by its current share
price, to certain accounting
values.
price/earnings (P/E) ratio
Measures the amount that
investors are willing to pay for
each dollar of a firm’s earnings;
the higher the P/E ratio, the
greater is investor confidence
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DuPont system of analysis
System used to dissect the firm’s
financial statements and to
assess its financial condition.
DuPont formula
Multiplies the firm’s net profit
margin by its total asset turnover
to calculate the firm’s return on
total assets (ROA).
CHAPTER 3
Cash Flow and Financial Planning
depreciation
The systematic charging of a
portion of the costs of fixed
assets against annual revenues
over time.
operating cash flow (OCF)
The cash flow a firm generates
from its normal operations;
calculated as EBIT_taxes_
depreciation.
CHAPTER 4
Time Value of Money
compound interest
Interest that is earned on a given
deposit and has become part of
the principal at the end of a
specified period.
principal
The amount of money on which
interest is paid.
future value
The value of a present amount at
a future date, found by applying
compound interest over a
specified period of time.
present value
The current dollar value of a
future amount—the amount of
money that would have to be
invested today at a given interest
rate over a specified period to
equal the future amount
annuity
A stream of equal periodic cash
flows, over a specified time
period. These cash flows can be
inflows of returns earned on
investments or outflows of funds
invested to earn future returns
ordinary annuity
An annuity for which the cash
flow occurs at the end of each
period.
annuity due
An annuity for which the cash
flow occurs at the beginning of
each period
perpetuity
An annuity with an infinite life,
providing continual annual cash
flow.
loan amortization
The determination of the equal
periodic loan payments
necessary to provide a lender
with a specified interest return
and to repay the loan principal
over a specified period.
CHAPTER 5
Risk and Return
portfolio
A collection, or group, of assets
risk
The chance of financial loss or,
more formally, the variability of
returns associated with a given
asset
return
The total gain or loss experienced
on an investment over a
given period of time; calculated
by dividing the asset’s cash
distributions during the period,
plus change in value, by its
beginning-of-period investment
value
risk-indifferent
The attitude toward risk in which
no change in return would be
required for an increase in risk
risk-averse
The attitude toward risk in which
an increased return would be
required for an increase in risk.
risk-seeking
The attitude toward risk in which
a decreased return would be
accepted for an increase in risk
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Risk Assessment
sensitivity analysis
An approach for assessing risk
that uses several possible-return
estimates to obtain a sense of the
variability among outcomes.
range
A measure of an asset’s risk,
which is found by subtracting the
pessimistic (worst) outcome from
the optimistic (best) outcome
Risk Measurement
standard deviation (_k)
The most common statistical
indicator of an asset’s risk; it
measures the dispersion around
the expected value
expected value of a return (k_)
The most likely return on a given
asset.
coefficient of variation (CV)
A measure of relative dispersion
that is useful in comparing the
risks of assets with differing
expected returns.
efficient portfolio
A portfolio that maximizes return
for a given level of risk or
minimizes risk for a given level
of return
correlation
A statistical measure of the
relationship between any two
series of numbers representing
data of any kind.
correlation coefficient
A measure of the degree of
correlation between two series.
+1 TO -1 RANGE
capital asset pricing model
(CAPM)
The basic theory that links risk
and return for all assets
diversifiable risk
The portion of an asset’s risk that
is attributable to firm-specific,
random causes; can be eliminated
through diversification.
Also called unsystematic risk.
nondiversifiable risk
The relevant portion of an asset’s
risk attributable to market
factors that affect all firms;
cannot be eliminated through
diversification. Also called
systematic risk.
beta coefficient (b)
A relative measure of nondiversifiable
risk. An index of the
degree of movement of an asset’s
return in response to a change in
the market return
market return
The return on the market portfolio
of all traded securities
kj_RF_[bj_(km_RF)]
security market line (SML)
The depiction of the capital
asset pricing model (CAPM) as a
graph that reflects the required
return in the marketplace for
each level of nondiversifiable
risk (beta).
CHAPTER 6
Interest Rates and Bond Valuation
interest rate
The compensation paid by the
borrower of funds to the lender;
from the borrower’s point of
view, the cost of borrowing
funds.
required return
The cost of funds obtained by
selling an ownership interest; it
reflects the funds supplier’s level
of expected return
real rate of interest
The rate that creates an equilibrium
between the supply of
savings and the demand for
investment funds in a perfect
world, without inflation, where
funds suppliers and demanders
are indifferent to the term of
loans or investments and have no
liquidity preference, and where
all outcomes are certain
nominal rate of interest
The actual rate of interest
charged by the supplier of funds
and paid by the demander.
yield to maturity
Annual rate of return earned on a
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debt security purchased on a
given day and held to maturity.
CHAPTER 7
Stock Valuation
capital
The long-term funds of a firm; all
items on the right-hand side of
the firm’s balance sheet, excluding
current liabilities.
debt capital
All long-term borrowing incurred
by a firm, including bonds.
equity capital
The long-term funds provided by
the firm’s owners, the stockholders
par value (stock)
A relatively useless value for a
stock established for legal purposes
in the firm’s corporate
charter.
authorized shares
The number of shares of common
stock that a firm’s corporate
charter allows it to issue.
outstanding shares
The number of shares of common
stock held by the public.
issued shares
The number of shares of common
stock that have been put into
circulation; the sum of outstanding
shares and treasury stock.
treasury stock
The number of shares of outstanding
stock that have been
repurchased by the firm
venture capital
Privately raised external equity
capital used to fund early-stage
firms with attractive growth
prospects.
initial public offering (IPO)
The first public sale of a firm’s
Stock
prospectus
A portion of a security registration
statement that describes the
key aspects of the issue, the
issuer, and its management and
financial position.
underwriting
The role of the investment banker
in bearing the risk of reselling, at
a profit, the securities purchased
from an issuing corporation at an
agreed-on price
zero-growth model
An approach to dividend
valuation that assumes a
constant, nongrowing dividend
stream.
constant-growth model
A widely cited dividend
valuation approach that assumes
that dividends will grow at a
constant rate, but a rate that is
less than the required return
variable-growth model
A dividend valuation approach
that allows for a change in the
dividend growth rate.
CHAPTER 8
Capital Budgeting Cash Flows
book value
The strict accounting value of an
asset, calculated by subtracting
its accumulated depreciation
from its installed cost.
net working capital
The amount by which a firm’s
current assets exceed its current
liabilities.
CHAPTER 9
Capital Budgeting Techniques
payback period
The amount of time required for a
firm to recover its initial investment
in a project, as calculated
from cash inflows.
net present value (NPV)
A sophisticated capital budgeting
technique; found by subtracting
a project’s initial investment
from the present value of its cash
inflows discounted at a rate
equal to the firm’s cost of capital
NPV= Present value of cash
inflows_Initial investment
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internal rate of return (IRR)
A sophisticated capital
budgeting technique; the
discount rate that equates the
NPV of an investment opportunity
with $0 (because the present
value of cash inflows equals the
initial investment); it is the
compound annual rate of return
that the firm will earn if it invests
in the project and receives the
given cash inflows.
CHAPTER 11
The Cost of Capital
cost of capital
The rate of return that a firm must
earn on the projects in which it
invests to maintain its market
value and attract funds
business risk
The risk to the firm of being
unable to cover operating costs
financial risk
The risk to the firm of being
unable to cover required
financial obligations (interest,
lease payments, preferred stock
dividends
target capital structure
The desired optimal mix of debt
and equity financing that most
firms attempt to maintain
cost of long-term debt, ki
The after-tax cost today of
raising long-term funds through
borrowing.
net proceeds
Funds actually received from the
sale of a security.
flotation costs
The total costs of issuing and
selling a security
weighted marginal cost
of capital (WMCC)
The firm’s weighted average cost
of capital (WACC) associated
with its next dollar of total new
financing
break point
The level of total new financing
at which the cost of one of the
financing components rises,
thereby causing an upward shift
in the weighted marginal cost of
capital (WMCC).
CHAPTER 12
Leverage and Capital Structure
breakeven analysis
Indicates the level of operations
necessary to cover all operating
costs and the profitability associated
with various levels of sales.
operating leverage
The potential use of fixed operating
costs to magnify the effects
of changes in sales on the firm’s
earnings before interest and
taxes
degree of operating leverage
(DOL)
The numerical measure of the
firm’s operating leverage.
Percentage change in EBIT
___
Percentage change in sales
financial leverage
The potential use of fixed
financial costs to magnify the
effects of changes in earnings
before interest and taxes on the
firm’s earnings per share.
degree of financial leverage
(DFL)
The numerical measure of the
firm’s financial leverage.
Percentage change in EPS
___
Percentage change in EBIT
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total leverage
The potential use of fixed costs,
both operating and financial, to
magnify the effect of changes in
sales on the firm’s earnings per
share
degree of total leverage (DTL)
The numerical measure of the
firm’s total leverage.
Percentage change in EPS
___
Percentage change in sales
DTL=DOL-DFL
CHAPTER 13
Dividend Policy
retained earnings
Earnings not distributed to
owners as dividends; a form of
internal financing.
dividend reinvestment plans
(DRIPs)
Plans that enable stockholders to
use dividends received on the
firm’s stock to acquire additional
shares—even fractional
shares—at little or no transaction
cost
dividend policy
The firm’s plan of action to be
followed whenever a dividend
decision is made.
dividend payout ratio
Indicates the percentage of each
dollar earned that is distributed
to the owners in the form of cash.
It is calculated by dividing the
firm’s cash dividend per share by
its earnings per share.
CHAPTER 14
Working Capital and Current Assets
Management
working capital
Current assets, which represent
the portion of investment that
circulates from one form to
another in the ordinary conduct
of business.
net working capital
The difference between the
firm’s current assets and its
current liabilities; can be
positive or negative.
operating cycle (OC)
The time from the beginning of
the production process to the
collection of cash from the sale
of the finished product.
OC= AAI + ACP
cash conversion cycle (CCC)
The amount of time a firm’s
resources are tied up; calculated
by subtracting the average
payment period from the operating
cycle.
CCC= AAI + ACP-APP
Five C’s of Credit
One popular credit selection technique
is the five C’s of credit, which provides a
framework for in-depth credit analysis.
Because of the time and expense
involved, this credit selection method is
used for large-dollar credit requests.
The
five C’s are
1. Character: The applicant’s record of
meeting past obligations.
2. Capacity: The applicant’s ability to
repay the requested credit, as judged in
terms of financial statement analysis
focused on cash flows available to repay
debt obligations.
3. Capital: The applicant’s debt relative
to equity.
4. Collateral: The amount of assets the
applicant has available for use in
securing the credit. The larger the
amount of available assets, the greater
the chance that a firm will recover funds
if the applicant defaults.
5. Conditions: Current general and
industry-specific economic conditions,
and any unique conditions surrounding
a specific transaction.
float
Funds that have been sent by the
payer but are not yet usable
spontaneous liabilities
Financing that arises from the
normal course of business; the
two major short-term sources of
such liabilities are accounts
payable and accruals.
accruals
Liabilities for services received
for which payment has yet to be
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made.
effective annual rate for a discount
loan
letter of credit
A letter written by a company’s
bank to the company’s foreign
supplier, stating that the bank
guarantees payment of an
invoiced amount if all the
underlying agreements are met.
hybrid security
A form of debt or equity financing
that possesses characteristics of
both debt and equity financing.
derivative security
A security that is neither debt nor
equity but derives its value from
an underlying asset that is often
another security; called ”derivatives,”
for short.
option
An instrument that provides its
holder with an opportunity to
purchase or sell a specified
asset at a stated price on or
before a set expiration date.
call option
An option to purchase a specified
number of shares of a stock
(typically 100) on or before a
specified future date at a stated
price
striking price
The price at which the holder of
a call option can buy (or the
holder of a put option can sell) a
specified amount of stock at any
time prior to the option’s expiration
date.
put option
An option to sell a specified
number of shares of a stock
(typically 100) on or before a
specified future date at a stated
price.
hedging
Offsetting or protecting against
the risk of adverse price
movements
merger
The combination of two or more
firms, in which the resulting firm
maintains the identity of one of
the firms, usually the larger.
consolidation
The combination of two or more
firms to form a completely new
corporation.
holding company
A corporation that has voting
control of one or more other
corporations.
subsidiaries
The companies controlled by a
holding company.
acquiring company
The firm in a merger transaction
that attempts to acquire another
firm
technical insolvency
Business failure that occurs
when a firm is unable to pay its
liabilities as they come due.
bankruptcy
Business failure that occurs
when the stated value of a firm’s
liabilities exceeds the fair
market value of its assets.
World Trade Organization (WTO)
International body that polices
world trading practices and
mediates disputes between
member countries.
joint venture
A partnership under which the
participants have contractually
agreed to contribute specified
amounts of money and expertise
in exchange for stated proportions
of ownership and profit
nominal interest rate
In the international context, the
stated interest rate charged on
financing when only the MNC
parent’s currency is involved.
effective interest rate
In the international context, the
rate equal to the nominal rate
plus (or minus) any forecast
appreciation (or depreciation) of
a foreign currency relative to the
currency of the MNC parent