TERMINOLOGIES.docx

**TERMINOLOGIES** **ROLE OF FINANCIAL MANAGEMENT** **What does Financial Managers do?** 1***. Maximization of shareholder's wealth.*** [Act on behalf of the firm's owners] by making operating and investment decision, benefits exceeds cost To [deliver value to the investors] - raise funds on...

**TERMINOLOGIES** **ROLE OF FINANCIAL MANAGEMENT** **What does Financial Managers do?** 1***. Maximization of shareholder's wealth.*** [Act on behalf of the firm's owners] by making operating and investment decision, benefits exceeds cost To [deliver value to the investors] - raise funds on ongoing firm's operations, future investment opportunities **Personal** 1\. spend 2\. save 3\. invest **Business** 1\. raise money 2\. invest money 3\. reinvest profits or distribute I. **FINANCIAL RATIOS** **The Four Key Financial Statements** 1. **Income Statement** - Provides a [financial summary of the firm' operating results] during a specified period - ***Dividends Per Share*** The [dollar amount of cash distributed during the period o]n behalf of each outstanding share of common stock 2. **Balance Sheet** - summary statement of the firm's financial position at a given point in time - *Current Assets* -short-term assets, expected to be converted into cash within 1 year - *Current Liabilities* - short-term liabilities, expected to be paid within 1 year - *Long-Term Debt* - debt for which payment is not due in the current year - *Paid-in-Capital in Excess of Par* - The amount of proceeds in excess of the par value received from the original sale of common stock - *Statement of Stockholders' Equity* - Shows all equity account transactions that occurred during a given year 3. **Statement of Retained Earnings** - Reconciles the net income earned during a given year, and any cash dividends paid, with the change in retained earnings between the start and the end of that year 4. **Statement of Cash Flows** - Provides a summary of the firm's operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the period. **Interest Parties** - Shareholders - Creditors - Management **Types of Ratio Comparisons** 1. **Cross-Sectional Analysis** - Comparison of different firms' financial ratios at the same point in time; involves comparing the firm's ratios with those of other firms in its industry or with industry averages. - *Benchmarking* - A type of cross-sectional analysis in which the firm's ratio values are compared with those of a key competitor or with a group of competitors that it wishes to emulate. 2. **Time-Series Analysis** Evaluation of the firm's financial performance over time using financial ratio analysis. 3. **Combined Analysis** Combines cross-sectional and time-series analyses A. **LIQUIDITY RATIOS** B. **ACTIVITY RATIOS** Measure the speed with which various accounts are converted into sales or cash, or inflows or outflows C. **DEBT RATIOS** - *Financial Leverage -* The magnification of risk and return through the use of fixed-cost financing, such as debt and preferred stock - *Degree of Indebtedness -* Ratios that measure the amount of debt relative to other significant balance sheet amount**s** D. **PROFITABILITY RATIOS** **Common-Size Income Statements -** An income statement in which each item is expressed as a percentage of sales. **Operating Profit Margin "pure profits" --** Measures the percentage of each sales dollar remaining after all costs and expenses *[other than interest]*, etc are deducted. **Net Profit Margin --** *[including the interest]* E. **MARKET RATIOS** Provides an assessment of how investors view the firm's performance. **DuPONT ANALYSIS** **Modified Dupont Formula** Relates the firm's return on total assets (ROA) to its return on equity (ROE) using the financial leverage multiplier (FLM) II. **TIME VALUE OF MONEY** **Future Value vs. Present Value** - **Compounding -** Used to find the future value of each cash flow at the end of an investment's life. - **Discounting -** Used to find the present value of each cash flow at time zero **Future Value -** The value on some future date of money that you invest today. **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 **Types of Annuities:** **Annuity** - A stream of equal periodic cash flows over a specified time period. - These cash flows can be inflows or outflows of funds **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. III. **COST OF CAPITAL** **Basic Concepts:** - **Capital -** A firm's long-term sources of financing, which include both debt and equity. - **Capital Structure -**The mix of debt and equity financing that a firm employs. - **Cost of Capital -** Represents the firm's cost of financing and is the minimum rate of return that a project must earn to increase the firm's value. - **Weighted Average Cost of Capital (WACC)** - A weighted average of a firm's cost of debt and equity financing, where the weights reflect the percentage of each type of financing used by the firm. **Sources of Long-Term Capital** **▪** *Long-term capital for firms derives from four basic* *sources:* long-term debt, preferred stock, common stock, and retained earnings. ▪ Not every firm will use all of these financing sources **Cost of Long-term Debt** The financing cost associated with new funds raised through long-term borrowing. **Net Proceeds** - The funds received by the firm from the sale of a security. **Flotation Costs** - The total costs of issuing and selling a security. - Increase the cost of common equity. **Capital Structure Weights** - **Market Value Weights** - Weights that use market values to measure the proportion of each type of capital in the firm's financial structure. - In calculating a firm's WACC, market value weights should be used rather than book or par values - **Target Capital Structure** - The mix of debt and equity financing that a firm desires over the long term. - The target capital structure should reflect the optimal mix of debt and equity for a particular firm. IV. **CAPITAL BUDGETING TECHNIQUES** **Capital Budgeting** - The process of evaluating and selecting long-term investments that contribute to the firm's goal of maximizing owners' wealth **Motives for Capital Expenditure** - **Capital Expenditure** An outlay of funds by the firm that the firm expects to produce benefits over a period of time greater than 1 year - **Operating Expenditure** An outlay of funds by the firm resulting in benefits received within 1 year **Capital Budgeting Process** *Consists of five distinct but interrelated steps:* 1. **Proposal Generation** Managers at all levels in a business make proposals for new investment projects that are reviewed by finance personnel. Proposals that require large outlays receive greater scrutiny than less costly ones. 2. **Review and Analysis** Financial managers perform formal review and analysis to assess the merits of investment proposals. 3. **Decision Making** - Firms typically [delegate capital expenditure] decisions on the [basis of dollar limits]. - Generally, the [board of directors] or a team of very senior executives must [authorize expenditures] beyond a certain amount - Often, [plant managers have authority to make decisions] necessary to keep the [production line moving.] 4. **Implementation** Following approval, firms make expenditures and implement for a large project often occur in phases. 5. **Follow-up** - Managers monitor results and compare actual costs and benefits to the projections that they originally used to justify making the investment. - Managers may take actions to expand, contract, or shut down investments when actual outcomes differ from projected ones. *Independent versus Mutually Exclusive Projects* **Independent Projects** - Projects whose cash flows are unrelated to (or independent of) one another; accepting or rejecting one project does not change the desirability of other projects.' **Mutually Exclusive Projects** - Projects that compete with one another so that the acceptance of one eliminates from further consideration all other projects that serve a similar function. *Unlimited Funds versus Capital Rationing* **Unlimited Funds** - The financial situation in which a firm is able to [accept all independent projects] that provide an acceptable return **Capital Rationing** - The financial situation in which a firm has only a [fixed number of dollars] available for capital expenditures and numerous projects compete for these dollars *Accept--Reject versus Ranking Approaches* **Accept--Reject Approach** - The evaluation of capital expenditure proposals to determine whether they meet the firm's minimum acceptance criterion. **Ranking Approach** - The ranking of capital expenditure projects on the basis of some predetermined measure, such as how much value the project creates for shareholders. **Payback Period** - The time it takes an investment to generate cash inflows sufficient to recoup the initial outlay required to make the investment. **Decision Criteria** If the payback period is **less than** the maximum acceptable payback period, [a**ccept**] the project If the payback period is **greater than** the maximum acceptable payback period, **[reject]** the project **Net Present Value** - A capital budgeting technique that measures an investment's value by calculating the present value of its cash inflows. **Decision Criteria** If the NPV is **[greater than \$]0**, **[accept]** the project If the NPV is **[less than \$0, reject]** the project **Profitability Index** - is simply equal to the present value of cash inflows divided by the absolute value of the initial cash outflow **Internal Rate of Return** - 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 rate of return that the firm will earn if it invests in the project and receives the given cash inflows. - **Decision Criteria** - If the IRR is **greater than** the cost of capital, **[accep]**t the project - If the IRR is **less tha**n the cost of capital, **[reject]** V. **STOCK VALUATION** **Common Stock Ownership** - **Privately Owned (Stock) -** owned by private investors; not publicly traded - **Publicly Owned (Stock) -** owned by public investors - **Closely Owned (Stock) -** owned by an individual or a small group of investors (such as a family); they are usually privately owned companies - **Widely Owned (Stock**) - owned by many unrelated individual and institutional investors. **COMMON STOCK** **Par Value Common Stock** - An arbitrary value that is established for legal purposes in the firm's corporate charter and that can be used to find the total number of shares outstanding by dividing it into the book value of common stock **Preemptive Rights -** Allows common stockholders to maintain their proportionate ownership in the corporation when new shares are issued, thus protecting them from dilution of ownership. - ***Dilution of Ownership -*** A reduction in each previous shareholder's fractional ownership resulting from the sale of new common shares. - ***Dilution of Earnings*** - A reduction in each previous shareholder's fractional claim on the firm's earnings resulting from the sale of new common shares. - ***Rights -*** Financial instruments that allow stockholders to purchase additional shares at a price below the market price, in direct proportion to their fractional ownership. **Authorized, Outstanding, and Issued Shares** - **Authorized Shares** - [Shares of common stock] that a firm's corporate charter [allows it to issue] - **Outstanding Shares** [- Issued shares] of common stock held by [investors,] including [both private and public] investors - **Treasury Stock** - [Issued shares] of common stock held by the [firm]; often these shares have been [repurchased] by the firm - **Issued Shares -** [Shares] of common stock that have been [put into circulation]; the sum of outstanding shares and treasury stock. **Voting Rights** - **Proxy Statement -** A statement transferring the votes of a stockholder to another party. - **Proxy Battle -** The attempt by a nonmanagement group to gain control of the management of a firm by soliciting a sufficient number of proxy votes. - **Supervoting Shares** - Stock that carries with it multiple votes per share rather than the single vote per share typically given on regular shares of common stock. - **Nonvoting Common Shares -** Common stock that carries no voting rights; issued when the firm wishes to raise capital through the sale of common stock but does not want to give up its voting control **Dividends** - The payment of dividends to the firm's shareholders is at the discretion of the company's board of directors. - Most corporations that pay dividends distribute them quarterly. - Cash dividends are the most common **International Stock Issues** **American Depositary Shares (ADSs)** - Dollar-denominated receipts for the stocks of foreign companies that are held by a U.S. financial institution overseas. **American Depositary Receipts (ADRs)** - Securities, backed by American depositary shares (ADSs), that permit U.S. investors to hold shares of non-U.S. companies and trade them in U.S. markets **PREFERRED STOCK** **Par-Value Preferred Stock --** With stated face value that is used with the specified dividend percentage to determine the annual dollar dividend **No-Par Preferred Stock --** With no stated face value but with a stated annual dollar dividend - Most corporations do not issue preferred stock, but preferred shares are common in some industries such as financial services - Preferred stock gives its holders privileges that make them senior to common stockholders - Preferred stockholders are promised a fixed periodic dividend, stated either as a percentage or as a dollar amount **Basic Rights of Preferred Stockholders** - Preferred stock is often [considered quasi-debt] because, much like interest on debt, it [specifies a fixed periodic payment], but unlike debt, preferred stock has [no maturity date.] - [Preferred stockholders are also given preference] over common stockholders in the liquidation of assets in a legally bankrupt firm, although they must "stand in line" behind creditors. **Features of Preferred Stock** - **Restrictive Covenants** - These covenants include provisions about passing (i.e., skipping) dividends, the sale of senior securities, etc. - **Cumulative --** All passed (unpaid) dividends in arrears, along with the current dividend, must be paid before dividends can be paid to common stockholders - **Noncumulative -** Passed (unpaid) dividends do not accumulate. - **Callable Feature** -- Allows the issuer to retire the shares within a certain period of time and at a specified price - **Conversion Feature** -- Allows holders to change each share into a stated number of shares of common stock. **Market Efficiency and Stock Valuation** - Because the flow of new information related to a stock is continual and the content of that information is unpredictable (otherwise, it would not be new information), stock prices fluctuate, always moving toward a new equilibrium that reflects the most recent information available - This general concept is known as market efficiency **Zero-Growth Dividend Model** An approach to dividend valuation that assumes a constant, [nongrowing dividend stream]. **Constant-Growth Dividend Model** A widely cited dividend valuation approach that [assumes ] [dividends will grow at a constant rate], but a rate less than the required return **Gordon Growth Dividend Model** common name for the [constant-growth dividend model] that is widely cited in dividend valuation. **Variable-Growth Dividend Model** allows for a change in the dividend growth rate.