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Business Finance Chapter 1-4

Notes on Chapters 1-4

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Introduction to Finance (FIN2303)

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Algonquin College

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Business Finance Chapter 1  1 Corporate Finance and the Financial Manager o What is Corporate Finance?  Corporate finance is the study of ways to answer these questions: Long term investments?  Buildings, machinery, equipment, research &amp;amp; development facilities  Long term financing for investments?  Financial activity management?  Collecting from customers  Paying suppliers The Financial Manager  o Shareholders are not directly involved in making business decisions Corporation employs managers to represent the owners; interests and make decisions on their behalf Financial Management Decisions  Capital Budgeting - Planning and managing a firm’s long-term investments  Identify investment opportunities that are worth more to the firm than they will cost to acquire  Capital Structure - Specific mixture of short-term debt, long-term debt and equity the firm uses to finance its operations  Two concerns: 1. How much should the firm borrow 2. What are the least expensive sources of funds for the firm  What percentage of the firm’s cash flow goes to creditors and what percentage goes to shareholders?  Working Capital Management - Difference between a firm’s short-term assets (inventory) and its short-term liabilities (money owed to suppliers)  Day-to-day activity that ensures the firm has sufficient resources to continue its operations and avoid costly interruptions   o     1. How much cash and inventory should we keep on hand? 2. Should we sell on credit? 3. How do we obtain any needed short-term financing? 1 Forms of Business Organization  Sole Proprietorship - Business owned by one person Simplest type of business to start Least regulated form of organization Advantages  You keep all the profits            Disadvantages  Owner has unlimited liability for business debts  No distinction between personal and business income, all business income is taxed as personal income  Amount of equity that can be raised is limited to the proprietor’s personal wealth  Partnership - Two or more owners General Partnership  All partners share in gains or losses  All have unlimited liability for all partnership debts Limited Partnership  One or more general partners have unlimited liability  Run the business for one or more limited partners who do not actively participate in the business Advantages  Partnerships based on informal agreement are easy and inexpensive to form  General partners have unlimited liability for debts  Partnership terminates when a general partner wishes to sell out or dies  Limited partner’s interest can be sold without dissolving the partnership Disadvantages  Unlimited liability  Limited life  Difficult to transfer ownership  Corporation - Legal entity separate and distinct from its owners Can borrow money and own property Can sue and be sued Can enter into contracts Can own stock in another corporation  Forming a corporation: 1. Prepare an article of incorporation  Corporation’s name  intended life  Business purpose  Number of shares that can be issued Formed under Canada Business Corporation Act or provincial law 1. Set bylaws - Rules describing how the corporation regulates its own existence  Describe how directors are elected  May be amended or extended from time to time by the shareholders Advantages  Ownership can be easily transferred Indirect - Lost opportunity Direct - Benefits management or an expense from the need to monitor management actions  Do Managers Act in the Shareholders’ Interests? Managerial Compensation  Tied to financial performance and share value  Better performers within the firm get promoted Control of the Firm  Shareholders elect the board of directors who hire and fire management Stakeholders - Shareholder, creditor, or other individual that has a claim on the cash flows of the firm  Management and shareholders are the only parties with an interest in the firm’s decisions  Corporate Social Responsibility and Ethical Investing Well-managed large corporations seek to maintain a reputation as good corporate citizens with detailed policies on important social issues 1 Financial Markets and the Corporation  Cash Flows to and from the Firm (A) Cash flows to the firm from the financial market (B) The firm invests the cash in current and fixed assets © These assets generate some cash  (D) Some goes to pay corporate taxes  (E) After taxes are paid some of the cash flow is reinvested into the firm (F) The rest goes back to the financial markets as cash paid to creditors and shareholders  Money vs. Capital Markets Money Market - Where short-term debt securities of many varieties are bought and sold  Bankers acceptance  Treasury bills Capital Market - Long-term debt and shares of stock  Primary vs. Secondary Markets Primary - Original sale of securities by government and corporations  Public offerings - selling securities to the general public  Private placements - a negotiated sale involving a specific buyer Secondary - Where securities are bought and sold after the original sale  Auction market 1. Physical location, buying and selling done by the dealer, match those who want to sell with those who want to buy  Dealer market 1. Over-the-counter (OTC) market - stocks and long-term debt Third Markets - Trading exchange-listed securities in OTC markets                   Fourth Markets - Trading institution-to-institution trading without using the services of brokers or dealers 1 Financial Institutions - Act as intermediaries between investors and firms raising funds  To incorporate a company you must have at least one common share Balance Sheet CA STD/CL FA LTD TA Equity Total Capital Structure D + E = 1 Debt + Equity = 1 Networking Capital = CA - CL Current Assets - Current Liabilities Business Finance Chapter 2  2 Statement of Financial Position (Balance Sheet) Snapshot of the firm, organizes and summarizes what a firm owns (its assets), what a firm owes (its liabilities) and the difference between the two (the firm’s equity) o Assets  Current - Life of less than one year  Cash  Accounts Receivable  Inventory  Fixed - Relatively long life (capital assets)  Tangible  Building  Equipment  Land  Intangible  Trademark  Patent - Taxes = Operating Cash Flow  Revenues - Costs  Taxes included  Depreciation, interest not included  Capital Spending - Net spending on fixed assets  Purchases of fixed assets - Sales of Fixed assets  Ending Fixed Assets  - Beginning Fixed Assets  + Depreciation  = Net Investment in Fixed Assets  Change in Net Working Capital - Amount spent on net working capital  Ending Net Working Capital  - Beginning Net Working Capital  = Change in Networking Capital  Operating Cash Flow  - Net Capital Spending  - Changes in Net Working Capital  = Cash Flow from Assets o Cash Flow to Creditors  Interest Paid  - Net New Borrowing  = Cash Flow to Creditors o Cash Flow to Shareholders  Dividends Paid  - Net New Equity  = Cash Flow to Shareholders 2 Taxes o Average Tax Rate - Percentage of your income that goes to pay taxes  Tax Bill/Taxable Income o Marginal Tax Rate - Extra tax you pay if you earned one more dollar o Taxes on Investment Income  Dividend Tax Credit - Applies only to dividends paid by Canadian corporations  Capital Gains 50% marginal rate    o o o Corporate Taxes Taxable Income Capital Gains and Carry-Forward/Back  Carry-Back - Firm files a revised tax return and receives a refund of prior year’s taxes (3 years)  Carry-Forward - Applies to operating losses (7 years)  2 Capital Cost Allowance (CCA) - Depreciation for tax purposes in Canada Income Statement Revenues, sales, earning 10000 1% COGS, Cost of Sales 5000 Gross Margin / Profit 5000 50% Admin expenses Distributing expenses 2500 Depreciation, amortization, depletion 500 5% 3000 EBIT (Earning before interest and taxes) 2000 Interest expense 200 EBT (Earning before taxes) 1800 Tax (30%) = 540 Net Income = 1260 12% Cash Flow From Asset = Cash Flow to Credit/Bond/Stake Holders + Cash Flow to Shareholders Cash flow from assets = Operating cash flow (+) Ebit (earnings before interest and taxes) + Depreciation, Amort, depletion - Taxes - Net capital spending Ending Net Fixed Assets - Beg Net fix assets Net Addition to Cash - Difference between sources and uses o The Statement of Cash Flows - Summary of the sources and uses of cash in the form of a financial statement  Group activities into:  Operating Activities  Financing Activities  Investment Activities 3 Standardized Financial Statements o Common-Size Statement - Express the statement of financial position as a percentage of total assets and to express the statement of comprehensive income as a percentage of sales o Common-Base-Year Financial Statement - Expressing each item relative to the base year amount 3 Ratio Analysis o Financial Ratio - Comparing and investigating the relationships between different pieces of financial information o Short-Term Solvency or Liquidity Ratios  Firm’s ability to pay its bills over the short run without undue stress  Current Ratio = Current Assets/Current Liabilities  $ of assets for every 1$ in current liabilities  High current ratio indicates liquidity  Quick Ratio = Current Assets-Inventory/Current Liabilities  Large inventories may be a cause of overestimated sales, overbought/overproduced  Cash Ratio = Cash+Cash Equivalents/Current Liabilities  Net Working Capital to Total Assets = Net Working Capital/Total Assets  Amount of Short-term liquidity  Low values means low level of liquidity o Long-Term Solvency or Financial Leverage Ratios  Address the firm’s long-run ability to meet its obligations  Total Debt Ratio = Total Assets - Total Equity/Total Assets  Takes into account all debts to all creditors  $ of debt per 1$ in assets  Debt/Equity Ratio = Total Debt/Total Equity  Equity Multiplier = Total Assets/Total Equity  Long-Term Debt Ratio = Long-Term Debt/Long-Term Debt + Total Equity  Times Interest Earned = EBIT/Interest  How well a company has its interest obligations covered  Cash Coverage Ratio = EBIT + Depreciation/Interest  EBIT doesn’t account for depreciation o Asset Management or Turnover Ratios  How efficient a firm uses its assets to generate sales  Asset Utilization Ratios  Inventory Turnover = Cost of Goods Sold/Inventory      How many times the company sold or turned over the entire inventory The higher the ratio is the more efficiently t is managing inventory Profitability Ratios  How efficiently the firm uses its assets and how efficiently the firm manages its operations  Profit Margin = Net Income/Sales  Generates $ in profit for every 1$ in sales  Higher the better  Gross Profit Margin = Sales - COGS/Sales  Operating Profit Margin = Sales - COGS - SGA/Sales  Return on Assets = Net Income/Total Assets  Profit per $ of assets  Return on Equity = Net Income/Total Equity  Measure of how the shareholders fared during the year o Market Value Ratios  Market price per share of the stock  EPS = Net Income/Shares Outstanding  Price/Earnings Ratio = Price per share/Earnings per Share  How much investors are willing to pay per dollar of current earnings  Higher the better 3 The Du Pont Identity 3 Using Financial Statement Information o Internal Uses  Managers are evaluated and compensated on the basis of accounting measures of performances such as profit margin and return on equity  Firms compare the performance of multiple divisions using financial statement information  Planning for the future - generating projections o External Uses  Useful for short-term and long-term creditors and potential investors  Investments and credit analysis  Acquiring another firm o    Changes in Cash = Sources and Uses of Cash Balance Sheet Source Use Assets ^ x Used cash to purchase a building x Increased accounts receivable (we paid for inventory) Business Finance Chapter 4 Long-Term Financial Planning and Corporate Growth  Investment in new assets o Arises from investment opportunities o Result of firm’s capital budgeting decisions  Degree of financial leverage the firm chooses to employ o Determines the amount of borrowing the firm uses to finance its investments in real assets o Firm’s capital structure policy  Amount of cash the firm thinks is necessary to pay shareholders o Firm’s dividend policy  Amount liquidity and working capital the firm needs on an ongoing basis o Net working capital decision  4 Financial Planning o Formulates the way financial goals are to be achieved o o o Growth as a Financial Management Goal  Growth by itself is not an appropriate goal  Rapid growth is not always good for a firm  Appropriate goal is increasing the market value of the owners’ equity Dimensions of Financial Planning  Short Run - 12 months  Long Run - 2-5 years (Planning Horizon)  Aggregation - The process by which smaller investment proposals of each of a firm’s operational units are added up and treated as one big project  3 alternative business plans for the next years  Worst case  Normal case  Best case What Planning Can Accomplish   Examining Interactions  Linkage between investment proposals and financing choices available  Exploring Options  Provides the opportunity for the firm to develop, analyze, compare many different scenarios  Avoiding Surprises  Identify what may happen to the firm if different events take place  Ensuring Feasibility and Internal Consistency  Establish the direction that we want to travel in and take educated guesses about what we will find along the way  Communication with Investors and Lenders  Securities regulators require that firms issuing new shares or debt file a detailed financial plan 4 Financial Planning Models o The Ingredients  Sales Forecast  Given as a growth rate in sales    Perfect sales forecasts are not possible because sales depend on the uncertain future state of the economy and on industry conditions  Pro Forma Statements  Forecasted statements of comprehensive income and financial position and a statement of cash flows  Asset Requirements  Projected capital spending  Financial Requirements  Necessary financial arrangements  Dividend policy  Debt policy  Cash Surplus or Shortfall  Designated source of external financing needed to deal with any shortfall or surplus in financing to bring the statement of financial position into balance  Economic Assumptions  Economic environment 4 The Percentage of Sales Approach - Financial planning method in which accounts are projected depending on a firm’s predicted sales level o Dividend Payout Ratio - Amount of cash paid out to shareholders divided by net income o Retention Ratio - Retained Earnings divided by net income o Capital Intensity Ratio - Total assets to sales o External Financing Needed (EFN) - The amount of financing required to balance both sides of the balance sheet or statement of financial position 4 External Financing and Growth o o o EFN = Increase in total asset - addition to retained earnings  = A x g - ( p(S)R x (1+g) Internal Growth Rate - Set EFN = 0, rate firm can grow before any external financing is required  (ROA x R) / (1 - ROA x R)  ROA = Net Income/Total Assets  R = Retention Ratio Sustainable Growth Rate, maximum growth rate a firm can achieve with no external equity financing while it maintains a constant debt/equity ratio  g* = ROE x R / (1-ROE x R)  o  Growth depends on:  Profit margin  An increase in profit margin, p, increases the firm's ability to generate funds internally and thereby increase its sustainable growth  Dividend policy  A decrease in the percentage of net income paid out as dividends increases the retention ratio, R. This increases internally generated equity and thus increases sustainable growth  Financial policy  An increase in the debt/equity ratio, D/E, increases the firm's financial leverage. Since this makes additional debt financing available, it increases the sustainable growth rate  Total asset turnover  An increase in the firm's total asset turnover, S/A, increases the sales generated for each dollar in assets. This decreases the firm's need for new assets as sales grow and thereby increases the sustainable growth rate. Notice that increasing total asset turnover is the same thing as the decreasing capital intensity. 4 Some Caveats on Financial Planning Models o Plans are modified over and over

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Business Finance Chapter 1-4

Course: Introduction to Finance (FIN2303)

71 Documents

Students shared 71 documents in this course

University: Algonquin College

Was this document helpful?

Business Finance Chapter 1

1.1 Corporate Finance and the Financial Manager

oWhat is Corporate Finance?

Corporate finance is the study of ways to answer these questions:

Long term investments?

Buildings, machinery, equipment, research & development

facilities

Long term financing for investments?

Financial activity management?

Collecting from customers

Paying suppliers

oThe Financial Manager

Shareholders are not directly involved in making business decisions

Corporation employs managers to represent the owners; interests and

make decisions on their behalf

oFinancial Management Decisions

Capital Budgeting - Planning and managing a firm’s long-term

investments

Identify investment opportunities that are worth more to the firm

than they will cost to acquire

Capital Structure - Specific mixture of short-term debt, long-term debt

and equity the firm uses to finance its operations

Two concerns:

1. How much should the firm borrow

2. What are the least expensive sources of funds for the firm

What percentage of the firm’s cash flow goes to creditors and what

percentage goes to shareholders?

Working Capital Management - Difference between a firm’s short-term

assets (inventory) and its short-term liabilities (money owed to suppliers)

Day-to-day activity that ensures the firm has sufficient resources to

continue its operations and avoid costly interruptions

1. How much cash and inventory should we keep on hand?

2. Should we sell on credit?

3. How do we obtain any needed short-term financing?

1.2 Forms of Business Organization

Sole Proprietorship - Business owned by one person

Simplest type of business to start

Least regulated form of organization

Advantages

You keep all the profits

Business Finance Chapter 1-4

Introduction to Finance (FIN2303)

Algonquin College

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Business Finance Chapter 1-4

Course: Introduction to Finance (FIN2303)

University: Algonquin College

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