Test Topic 1: Intro to Corporate Finance, Financial Statements, Cash Flow & Taxes

(Ch.1&2)
Financial Manager
- Financial managers try to answer some or all of these questions
- Top financial manager = Chief Financial Officer (CFO)
- Treasurer – oversees cash management, capital expenditures and financial
planning
- Controller – oversees taxes, cost accounting, financial accounting and data
processing
Financial Management Decisions
- Capital Budgeting
- What long-term investments or projects should the business take on?
- The financial manager tries to identify investment opportunities that are worth
more to the firm than they will cost to acquire
- Financial managers must be concerned not only with how much cash they expect
to receive, but also with when they expect to receive it and how likely they are to
receive it.
- Evaluating the size, timing, and risk of future cash flows is the essence of
capital budgeting
- Capital Structure
- A firm’s capital structure (or financial structure) refers to the specific mixture of
short-term debt, long-term debt, and equity the firm uses to finance its operations
- How should we pay for our assets?
- Should we use debt or equity?
Forms of Business Organization
- Three major organizations in Canada
- Sole Proprietorship
- Is a business owned by one person
- Advantages lie in: simplest/easiest type of business to start, least regulated form
of organization, owners keep all the profits
- Disadvantages lie in: owner has unlimited liability, all business income taxed as
personal income, equity limited to the proprietor’s personal wealth (limited & lost
opportunities), difficult to transfer ownership
- Partnership
- Two or more owners that share in gains or losses and have unlimited liability
- Limited partnership
- one or more general partners has unlimited liability and runs the business
for one or more limited partners who do not actively participate in the
business
- Similar advantages and disadvantages to a sole proprietorship
- Corporation (joint stock companies, public limited companies and limited liability
companies)
- Co-operative organizations
- Income trust organizations
Corporation
- A business created as a distinct legal entity owned by one or more individuals or entities
- Advantages
- Limited liability • Unlimited life • Separation of ownership and management •
Transfer of ownership is easy • Easier to raise capital
- Disadvantages
- Separation of ownership and management
- Double taxation (income is taxed at the corporate rate and then dividends are
taxed at the personal rate)
Goal of Financial Management
- Primary Goals
- Maximize shareholder wealth
- Maximize share price
- Maximize firm value
Social Responsibility and Ethical Investing
- Investors are increasingly demanding that corporations behave responsibly
- Issues include how a corporation treats the community in which it operates, their
customers, corporate governance, their employees, the environment and human rights
- Controversial business activities include alcohol, gaming, genetic engineering, nuclear
power, pornography, tobacco and weapons
The Agency Problem and Control of the Corporation
- Agency Relationship
- Principal hires an agent to represent their interests
- Stockholders (principals) hire managers (agents) to run the company
- Agency Problem
- Conflicts of interest can exist between the principal and the agent
Managing Managers
- Managerial compensation
- Incentives can be used to align management and stockholder interests
- The incentives need to be structured carefully to make sure that they achieve
their goal
The Role of Financial Markets in Corporate Finance
- Cash flows to and from the firm

- Money vs. capital markets

- Money Markets (MM)
- Short-term debt securities of many varieties are present in money
markets, these securities are often called MM instruments and are IOU’s
- The MM is a dealer market, generally dealers buy and sell something for
themselves
- The largest MM dealers are chartered banks and investment dealers
- Capital Markets (CM)
- Long-term debt and shares of stock are present in CMs, Ex: Toronto
Stock exchange
- Primary vs. secondary markets
Statement of Financial Position
- The statement of financial position is a snapshot of the firm’s assets and liabilities at a
given point in time
- Assets are listed in order of liquidity
- Ease of conversion to cash without significant loss of value
- Statement of Financial Position Identity
- Assets = Liabilities + Stockholders’ Equity
- Total Value of Assets
- Current assets + Fixed Assets (Tangible and Intangible)
- Total Value of the firm to investors
- Current Liabilities, Long-Term Debt, Shareholders equity
Liquidity
- Ability to convert to cash quickly without a significant loss in value
- Liquid firms are less likely to experience financial distress
- However, liquid assets earn a lower return
- Tradeoff between liquid and illiquid assets
Net Working Capital
- Current Assets - Current Liabilities = Net Working Capital
- Positive when the cash that will be received over the next 12 months exceeds the cash
that will be paid out
- Usually positive in a healthy firm
Value versus Cost
- The statement of financial position provides the book value of the assets, liabilities and
equity
- Market value is the price at which the assets, liabilities or equity can actually be bought
or sold
- Market value and book value are often very different
- One reason is the passage of time
International Financial reporting standards (IFRS)
- IFRS allows companies to use the historical cost method
- Also allows use of the revaluation (fair value) method
- All items in an asset class should be revalued simultaneously
- Revaluation should be performed with regularity
Statement of Comprehensive Income
- The statement of comprehensive income is more like a video of the firm’s operations for
a specified period of time
- generally report revenues first and then deduct any expenses for the period
- Matching principle – IFRS say to show revenue when it accrues and match the
expenses required to generate the revenue
Transparency in corporations
- Financial statements are catalogued to be transparent because corporations are
transparent
- Shareholders need to be able to interpret the company’s statements, transparency helps
with interpretation
Statement of Cash Flows
- Cash flow is one of the most important pieces of information that a financial manager
can derive from financial statements
- It shows how cash is generated from utilizing assets and how it is paid to those that
finance the purchase of the assets
Cash Flow From Assets
- Cash Flow From Assets (CFFA) = Cash Flow to Bondholders + Cash Flow to
Shareholders
- Cash Flow From Assets (CFFA) = Operating Cash Flow – Net Capital Spending –
Changes in NWC
Cash Flow Summary
- Cash flow from assets = Cash flow to creditors + Cash flow to shareholders
- Cash flow from assets = Operating cash flow - Net capital spending - additions to net
working capital
- Operating Cash Flow = Earnings before interest and taxes + Depreciation - Taxes
 - Net Capital Spending = Ending net fixed assets + Depreciation - Beginning net fixed
assets
- Additions to Net working capital (NWC) = Ending NWC - Beginning NWC
- Ending NWC = 2017 Current Assets - 2017 Current Liabilities
- Beginning NWC = 2016 Current Assets - 2016 Current Liabilities
- Cash flow to creditors/bondholders = Interest paid - Net new borrowing
- Net new borrowing = 2017 long-term debt - 2016 long-term debt
- Cash flow to shareholders = Dividends paid - Net new equity raised
- Net new equity = 2017 comm shares - 2016 common shares
Taxes
- Individual vs corporate taxes
- Marginal vs average tax rates
- Marginal – the percentage paid on the next dollar earned
- Average – the percentage of your income that goes to pay taxes (tax bill / taxable
income)
Capital Cost Allowance (CCA)
- CCA is depreciation for tax purposes
- CCA is deducted before taxes and acts as a tax shield
- Every capital asset is assigned to a specific asset class by the government
- Every asset class is given a depreciation method and rate
- Half-year Rule – In the first year, only half of the asset’s cost can be used for CCA
purposes

Test Topic 2: Working with Financial Statements / Long-Term Financial Planning and
Corporate Growth (Ch. 3&4)
Sources and Uses of Cash
- Sources of Cash
- Cash inflow – occurs when we “sell” something
- Decrease in asset account
- Increase in liability or equity account
- Uses of Cash
- Cash outflow – occurs when we “buy” something
- Increase in asset account
- Decrease in liability or equity account
Statement of Cash Flow
- Statement that summarizes the sources and uses of cash
- Changes divided into three major categories
- Operating Activity – includes net income and changes in most current
accounts
- Investment Activity – includes changes in fixed assets
- Financing Activity – includes changes in notes payable, long-term debt
and equity accounts as well as dividends
Standardized (Common-Size) Financial Statements
- Common-Size Statements of Financial Position
 - Compute each asset as a % of total assets
- Compute each liability as a % of total liabilities
- Compute each equity line item as a % of equity
- Common-Size Statements of Comprehensive Income
- Compute each line items as a % of sales revenue
Why do we use standardized financial statements?
- Standardized statements make it easier to compare financial information, particularly as
the company grows
- They are also useful for comparing companies of different sizes, particularly within the
same industry
Ratio Analysis
- Ratios allow for better comparison through time or between companies
Categories of Financial Ratios
- Short-term solvency or liquidity ratios
- Long-term solvency or financial leverage ratios
- Asset management or turnover ratios
- Profitability ratios
- Market value ratios
Benchmarking (Relatable stats)
- Ratios are not very helpful by themselves; they need to be compared to something
- Time-Trend Analysis
- Used to see how the firm’s performance is changing through time
- Internal and external uses
- Peer Group Analysis
- Compare to similar companies or within industries
- NAICS codes, Financial Post Datagroup, and Dun & Bradstreet Canada
Using financial statement information
- Internal uses
- Performance evaluation – compensation and comparison between divisions
- Planning for the future – guide in estimating future cash flows
- External uses
- Creditors • Suppliers • Customers • Stockholders
Basic Elements of financial planning
- Investment in new assets – determined by capital budgeting decisions
- Degree of financial leverage – determined by capital structure decisions
- Cash paid to shareholders – dividend policy decisions
- Liquidity requirements – determined by net working capital decisions
Role of Financial Planning
- Examining interactions
- helps management see the interactions between decisions
- Exploring options
- gives management a systematic framework for exploring its opportunities
- Avoiding surprises
- helps management identify possible outcomes and plan accordingly
 - Ensuring Feasibility and Internal Consistency
- helps management determine if goals can be accomplished and if the various
stated (and unstated) goals of the firm are consistent with one another
- Financial Requirements
- how much financing will we need to pay for the required assets
- Plug Variable
- management decision about what type of financing will be used (makes the
Statement of Financial Position balance)
- Economic Assumptions
- explicit assumptions about the coming economic environment
Growth and External Financing
- At low growth levels, internal financing (retained earnings) may exceed the required
investment in assets
- As the growth rate increases, the internal financing will not be enough and the firm will
have to go to the capital markets for money
- Examining the relationship between growth and external financing required is a useful
tool in long-range planning
Determinants of Growth
- Profit margin
- operating efficiency
- Total asset turnover
- asset use efficiency
- Financial policy
- choice of optimal debt/equity ratio
- Dividend policy
- choice of how much to pay to shareholders versus reinvesting in the firm
Formulas
- Net working capital turnover
- Formula = Sales/Working Capital
- External Financing Needed

-
- Total Assets (Current & Fixed) - Total Equity & Liabilities
- Full Capacity Sales
- Formula: Current Sales = (Full Capacity Sales) x (% of capacity used)

Test Topic 3: Introduction to Valuation: The Time Value of Money / Discounted Cash
Flow Valuation (Ch. 5&6)
Effective EAR
- Actual FV = PV(1+r)^t
Present value of annuity (annual loan payment)
- = Annuity[1-(1+interest rate)^-time period]/rate
Test Topic 4: Stock Valuation / Bond Valuation (Ch. 7&8)

Test Topic 5: Net Present Value and Other Investment Criteria / Making Capital
Investment Decisions (Ch.8&9)

Test Topic 6: Lessons from Capital Market History / Cost of Capital (Ch.12&14)