FIN222 Lecture Notes - Lecture 1: Critical Role, Cash Flow, Interest Rate

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2 Jun 2018

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LECTURE 1.

INTRODUCTORY

Definition of

Finance

Finance is the study of how people allocate scarce resources over

time.

In order to make optimal financial decisions in a way that increase

value, it involves a lot of quantifications:

- return (or cost)

- risk

- value of financial securities (such as shares and bonds)

- value of investment opportunity

- relationship between 2 companies

- benefit of debt

- efficiency of current assets/liability management

The three types

of firms

There are 3 types of firms in Australia:

• Sole traders is a business owned and run by one person

• Partnerships is a business owned and run by more than one

person

• Corporations is a legally defined, artificial being, separate

from its owners

Firms with unlimited personal liability include sole traders and

partnerships.

Firms with limited liability include limited partnerships and

corporations.

Corporations

General characteristics:

• Shareholders do not affect the day-to-day affairs of the

company

• Shareholders’ liability is limited to fully paid-up value of the

shares.

• Separation of ownership and control

Advantage:

**Note: In the case of bankruptcy, as long as

the share has been fully paid, shareholder

cannot be required to make any further

payment to the company.

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Document Summary

Finance is the study of how people allocate scarce resources over time. In order to make optimal financial decisions in a way that increase value, it involves a lot of quantifications: The three types of firms return (or cost) risk. Value of financial securities (such as shares and bonds) Value of investment opportunity relationship between 2 companies. Benefit of debt efficiency of current assets/liability management. Firms with unlimited personal liability include sole traders and partnerships. Firms with limited liability include limited partnerships and corporations. Corporations general characteristics: shareholders do not affect the day-to-day affairs of the company, shareholders" liability is limited to fully paid-up value of the shares, separation of ownership and control. **note: in the case of bankruptcy, as long as the share has been fully paid, shareholder cannot be required to make any further payment to the company. Example: allows share ownership to change w/out interfering with the operation of business, allows the firm to hire professional managers.

Related Questions

1) The subarea of finance where you need to value uncertain cash flows occurring at different points in time is:

a. investments

b. corporate finance

c. capital markets

d. bank management.

e. all of the above subareas

2) Which of the following statements is correct?

a. One advantage of forming a corporation is that equity investors are usually exposed to less liability than they would be in a partnership.

b. Corporations face fewer regulations than sole proprietorships.

c. One disadvantage of operating a business as a sole proprietor is that the firm is subject to double taxation, because taxes are levied at both the firm level and the Owner level.

d. It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship, extensive legal documents ace required.

e. If a partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her investment in the business.

3) Which of the following statements is correct?

a. Corporations generally face fewer regulations than sole proprietorships.

b. Corporate shareholders are exposed to unlimited liability.

c. It is usually easier to transfer ownership in a corporation than in a partnership.

d. Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation.

e. Less of a corporation's income is generally subject to federal taxes.

4) The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to:

a. Maximize its expected total corporate income.

b. Maximize its expected EPS.

c. Minimize the chances of losses.

d. Maximize the stock price per share over the long run, which is the stockâs intrinsic value.

e. Maximize the stock price on a specific target date.

5) Which of the following is correct?

a. In most corporations, the CFO ranks above the CEO.

b. By Law in most states, the chairman of the board must also be the CEO.

c. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person.

d. The CFO generally reports to the firm's chief accounting officer, who is normally the controller.

e. The CFO is responsible for raising capital and for making sure that capital expenditures are desirable, but he or she is not responsible for the validity of the financial statements, as the controller and the auditors have that responsibility.

6) The primary operating goal of a publicly-owned firm trying to best serve its stockholders should be to

a. Maximize managers' own interests, which are by definition consistent with maximizing shareholders' wealth.

b. Maximize the firmâs expected EPS, which must also maximize the firmâs price per share.

c. Minimize the firmâs risks because most stockholders dislike risk in turn, this will maximize the firmâs stock price.

d. Use a well-structured managerial compensation package to reduce conflicts that may exist between stockholders and managers.

e. Since it is impossible to measure a stock's intrinsic value, the text states that it is better for managers to attempt to maximize the current stock price than its intrinsic value.

7) Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and bondholders?

a. Compensating managers with stock options.

b. Financing risky projects with additional debt.

c. The threat of hostile takeovers.

d. The use of covenants in bond agreements that limit the firmâs use of additional debt and constrain managers' actions.

e. Abolishing the Security and Exchange Commission.

8) Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and managers?

a. Pay managers large cash salaries and give them no stock options.

b. Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover.

c. Beef up the restrictive covenants in the firmâs debt agreements.

d. Eliminate a requirement that members of the board of directors must hold a high percentage of their personal wealth in the firmâs stock.

e. For a firm that compensates managers with stock options, reduce the time before options are vested, i.e., the time before options can be exercised and the shares that are received can be sold.

9) Which of the following mechanisms would be most likely to help motivate managers to act in the best interests of shareholders?

a. Decrease the use of restrictive covenants in bond agreements.

b. Take actions that reduce the possibility of a hostile takeover.

c. Elect a board of directors tlta.t allows managers greater freedom of action.

d. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.

e. Eliminate a requirement that members of the board of directors have a substantial investment in the firmâs stock.

10) Which of the following is correct?

a. Potential conflicts between stockholders and bondholders are increased if a firm's bonds are convertible into its common stock.

b. Because bankruptcy requires that corporate bondholders be paid in full before stockholders receive anything, bondholders generally prefer to see corporate managers invest in high risk/high return projects rather than low risk/low return projects.

c. There is no good reason to expect a firmâs stockholders and bondholders to react differently to the types of assets in which it invests.

d. Stockholders should generally be happier than bondholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns.

e. Bondholders should generally be happier titan stockholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns.

11) You recently sold 100 shares of Microsoft stock to your brother at a family reunion. At the reunion your brother gave you a check for the stock and you gave your brother the stock certificates. Which of the following best describes this transaction?

a. This is an example of a direct transfer of capital

b. This is an example of a primary market transaction.

c. This is an example of an exchange of physical assets.

d. This is an example of a money market transaction.

e. This is an example of a derivative market transaction.

12) Which of the following statements is correct?

a. The NYSE does not exist as a physical location. Rather it represents a loose collection of dealers who trade stock electronically.

b. An example of a primary market transaction would be your uncle transferring 100 shares of Walmart stock to you as a birthday gift.

c. Capital market instruments include both long-term debt and common stocks.

d. If your uncle in New York sold 100 shares of Microsoft through his broker to an investor in Los Angeles, this would be a primary market transaction.

e. While the two frequently perform similar functions, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise large blocks of capital from investors.

13) Which of the following is a primary market transaction?

a. You sell 200 shares of IBM stock on the NYSE through your broker.

b. You buy 200 shares of IBM stock from your brother. The trade is not made through a broker--you just give him cash and he gives you the stock.

c. IBM issues 2,000,000 shares of new stock and sells them to the public through an investment banker.

d. One financial institution buys 200,000 shares of IBM stock from another institution. An investment banker arranges the transaction.

e. IBM sells 2,000.000 shares of treasury stock to its employees when they exercise options that were granted in prior years.

14) Money Markets are markets for:

a. Foreign currencies.

b. Consumer automobile loans.

c. Common stocks.

d. Long-term bonds.

e. Short-term debt securities such as Treasury bills and commercial paper.

15) You recently sold 200 shares of Disney stock, and the transfer was made through a broker. This is an example of:

a. A money market transaction.

b. A primary market transaction.

c. A secondary market transaction.

d. A futures market transaction.

e. An over-the-counter market transaction.

16) Which of the following statements is correct?

a. Hedge funds are legal in Europe and Asia, but they are not permitted to operate in the United States.

b. Hedge funds are legal in the United States, but they are not permitted to operate in Europe or Asia.

c. Hedge funds have more in common with investment banks than with any other type of financial institution.

d. Hedge funds have more in common with commercial banks than with any other type of financial institution.

e. Hedge funds are not as highly regulated as most other types of financial institutions.

17) Which of the following factors statements is correct?

a. The New York Stock Exchange is an auction market, and it has a physical location.

b. Home mortgage loans are traded in the money market.

c. If an investor sells shares of stock through a broker, then it would be a primary market transaction.

d. Capital markets deal only with common stocks and other equity securities.

e. While the distinctions are blurring, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties.

18) Which of the following statements is correct?

a. The term "IPO" stands for Introductory Price Offered, and it is the price at which shares of a new company are offered to the public.

b. IPO prices are generally established by the market, and buyers of the new stock must pay the price that prevails at the close of trading on the day the stock is offered to the public.

c. In a "Dutch auction," investors who want to buy shares in an IPO submit bids indicating how many shares they want to buy and the price they are willing to pay. The company determines how many shares it wants to sell. The highest price that enables the company to sell the desired number of shares is the price that all buyers must pay.

d. It is possible that the price set in an IPO is so high that investors will refuse to buy the number of shares that the company wants to sell. In this situation, the IPO is said to be oversubscribed.

e. It is possible that the price set in an IPO is so low that investors will want to buy more shares than the company wants to sell. In that case, the company will have to issue more shares than it wants to sell.

19) The stock market is thought to be efficient because:

a. There are many brokers working the exchange floors

b. Computers can make very fast calculations these days

c. There are many stock analysts following the same stocks

d. Stocks are available and are very inexpensive

e. Speed trading is now an acceptable trading technique

20) If the stock is priced correctly but with better management the firm could be worth even more, then the firm would be:

a. A potential target for a stock investor

b. A potential target for a private equity firm

c. A potential target for a bond fund

d. A potential target for the SEC

e. A potential target for share repurchases

8. Your company issued bonds at a premium. Which of the following statements is NOT true?
A. The contra account, premium on bonds payable, is amortized each year by shifting part of its balance to interest expense.
B. On the date of issuance, the stated interest rate was greater than the market interest rate.
C. As the current date approaches the maturity date, the carrying value of the bond approaches the face value of the bond.
D. The account used to record the premium has a normal debit balance.

9. Which of the following would help a company improve its quick ratio without necessarily lowering the liability risk to a creditor?
A. Borrowing money on a long-term note just before the end of the accounting period.
B. Shifting resources from long-term assets to short-term assets such as supplies and inventory.
C. Shifting obligations from long-term liabilities to short-term liabilities.
D. Acquiring inventory by issuing a long-term note.

10. Which of the following is not used to calculate the times interest earned ratio?
A. Net income.
B. Income tax expense.
C. Interest earned on investments.
D. Interest expense.

11. Which of the following statements regarding treasury stock is true?
A. When a company reissues treasury stock for more than it originally paid for the stock, it does not report a gain.
B. When a company purchases treasury stock or pays a dividend, it increases total stockholders' equity.
C. Treasury stock is reported as an asset on the balance sheet.
D. Treasury stock is reported as issued and outstanding stock.

16. Typically, all other things equal, a profitable company that pays little or no dividends:
A. is a bad investment.
B. will reinvest profits which can lead to greater growth potential.
C. will experience relatively stable stock prices over time.
D. will appeal to investors who desire distributions of profit.

17. If a corporation declares and distributes a 10% stock dividend on its common shares, the account debited is:
A. Dividends Payable.
B. Common Stock.
C. Share Capital.
D. Retained Earnings.

20. Limited Liability Companies (LLCs) are like general partnerships in that:
A. income tax is not paid by the company itself.
B. the business has a separate legal identity.
C. liability is limited.
D. amounts paid to the owners are recorded as salaries expense.

21. Which of the following statements regarding financing activities is NOT true?
A. Cash dividends paid to a company's stockholders are reported as cash outflows from financing activities.
B. When a company issues stock for cash, it reports a cash inflow from financing activities.
C. When a company repurchases stock with cash, it reports a cash outflow for financing activities.
D. When a company repays a loan, it reports a cash outflow from investing activities.

22. Which of the following statements regarding quality of income ratio is NOT true?
A. A quality of income ratio will increase if a company's working capital management allows current assets such as inventory to increase out of control.
B. Variations in the ratio can be seasonal and are the result of sales fluctuations rather than reasons for alarm.
C. The quality of income ratio measures the portion of income that was generated in cash.
D. The quality of income ratio is useful when compared to industry competitors or to prior periods.

23. Which of the following types of information is not provided by the statement of cash flows?
A. Company management of current assets and liabilities.
B. Expenditures on long-term assets.
C. Current profitability as measured by specific revenues and expenses.
D. Reliance on external financing.

24. Cash and cash equivalents include:
A. assets that have stable long-term value.
B. assets that are short-term, highly liquid, and are purchased within three months of maturity.
C. assets that consistently grow in value over the long run.
D. assets that are expected to be used up within a year.

International Research Journal of Applied Finance ISSN 2229 â 6891

Vol. VI Issue â 8 August, 2015 Case Study Series

A Stock Valuation Case: An Application of the âMethod of Comparablesâ for Macyâs Shares

Halil D. Kaya* ,Julia S. Kwok

Abstract

The primary focus of this case is the application of the âMethod of Comparablesâ in the estimation of the value of a security. An investment decision will be made based on the comparison of the selling price and the estimated value. A security will be good for purchase if the estimated value is higher than the market price. This method utilizes basic financial ratios that are commonly provided by financial web sites. First, using Yahoo Finance website, the pricing, sales, book value of equity and shares outstanding data are collected for both the target firm and the competitor firms. Then, the pricing multiples (i.e. price earnings ratio, price to sales ratio and price to book ratio) of the competitors are calculated. After that, those multiples along with the target firmâs earnings, sales, book value and shares outstanding data are used to estimate target firmâs share value. The case also examines the impact of treating ânegativesâ in the data. Students will learn that replacing negative earnings with zeros tend to induce less bias in target firmâs value estimation than excluding the ânegativeâ data altogether.

Introduction

March 14, 2015 was a sunny day. Mary took advantage of the nice weather to have lunch at the Mall. On her way back to work, she walked by Susanâs investment office. Susan was Maryâs college roommate. They both liked shopping together to find new fashionable clothes. Looking at her watch, Mary realized she had half an hour to spend. She thought she would drop by and say hello to Susan.

The Performance of Macyâs

âHi, Susan, how are you?â How is your business?â said Mary. Susan was a recent finance graduate. Susan replied, âI am doing fine. Thank you. After so many years, the market is still recovering from the mortgage crisis; many investors have been buying back stocks that they have sold during the crisis. What are you up to?â âI want to start my investment in securities, too. I have a couple thousand dollars, would Macyâs be a good stock to invest in now? That was our favorite store to shop among all of the department stores,â Mary exclaimed. She added, âAlso, I read from Motleyâs Foolâs article on Macyâs today about its earnings per share growth for the last 16 quartersâ (Zahid Waheed, 2014).

In response to Maryâs questions, Susan checked the monthly adjusted returns of Macyâs in Yahoo Finance. She found that, since March 2010, Macyâs stock price had an average annual increase of 23.5% over the last 5 years. The stock rose from $19.98 to $57.38. Susan then told Mary that Macyâs was indeed a growing stock. She added that its success could be attributed to the omni-channel integration, e-commerce and magic selling strategies which allowed merging of sales channels, online shopping and better customer care. Since investment strategy 101 is to buy low, and sell high, given Macyâs stock price had been going up, Susan was not sure whether Macyâs was currently overvalued or undervalued by the market.

The Method of Comparables

Susan remembered her class lecture on the two types of valuation of stocks, namely absolute and relative evaluation. The absolute evaluation focuses on finding the intrinsic value of the security based on fundamentals. That involves more complicated models of discounting cash flows from dividends, operations and residual income.

On the other hand, relative evaluation is quick and easy to use. It assumes two similar securities should sell for one price in an efficient market, i.e. âLaw of One Price.â So an analyst can estimate its stock price by multiplying target companyâs specific earnings, sales and equity value data by the earning, sales and equity âper shareâ financial multiples of its competitors.

Since Mary was not familiarized with financial models, Susan decided to use the easy-toperform-and-analyze âComparables Methodâ to estimate the relative value of Macyâs stock.

The Financial Data

Dillards, JC Penney and Nordstrom were selected as competitors of Macyâs as they were all in retail department store business. Susan would need some financial data regarding these companies. She went to SECâs (i.e. Securities and Exchange Commission) website and downloaded these companiesâ most recent balance sheet and income statement data. Out of those statements, she knew that she would need the EPS (i.e. earnings per share), the sales number, the number of outstanding shares, and the book value of equity. She also knew that she would need the current share price for each company. After some work, she had found all the necessary information to run the analysis. Below were the data that she had gathered:

All data are in US$ except for the number of outstanding shares. The share price as of March 15, 2014 is shown in the first column. The âEarnings per shareâ is shown in the second column. The third column reports the book value of equity. The last column shows the number of outstanding shares.

Firm	P ($)	EPS ($)	Sales ($)	BV of equity ($)	# of shares
Macy's	58.58	3.93	27,931 mil.	6,249 mil.	378.3 mil.
Dillard's	90.61	7.10	6,532 mil.	1,992 mil.	45.6 mil.
JC Penney	8.71	-5.57	11,859 mil.	3,087 mil.	249.3 mil.
Nordstrom	61.33	3.77	12,166 mil.	2,080 mil.	194.5 mil.

The Decision

Susan thinks that the following steps would be necessary to perform the analysis:

1.Based on the data above, calculate Sales per share, BV of equity/share values of all firms. Note that EPS is directly given.

2.Calculate P/E, P/Sales, and P/B for all of Macyâs competitors based on the data obtained.

3.Find the average of the P/E, P/Sales, and P/B multiples for the three competitors.

4.Multiply those averages calculated in step 3 with Macyâs EPS, Sales per share, and BV of equity/share values, respectively to get three value estimates for Macyâs shares.

5.The average of the three estimates would then be Susanâs best estimate of Macyâs value per share.

answer # 1-5 please

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FIN222 Lecture Notes - Lecture 1: Critical Role, Cash Flow, Interest Rate

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