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FINE2000 - Midterm Package and slides.pdf

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FINE 2000
Alan Marshall

FINE2000 MIDTERM EXAM STUDY PACKAGE PExam-AID Tutor: Alac Kim & Yiran Li Bacos Preface This document was created by the York University chapter of Students Offering Support (York SOS) to accompany our FINE2000 Exam-AID session. It is intended for students enrolled in any section of “FINE2000 – Introduction to Corporate Finance” 2013 course who are looking for an additional resource to assist their studies in preparation for the exam. Please do NOT share this with other students and instead tell them about the session or to contact York SOS to make a donation to get a copy of it. ([email protected]) References Brealey, Richard A. Fundamentals of Corporate Finance. Toronto: McGraw-Hill Ryerson, 2009. Print. Students Offering Support: Laurier Chapter BU383 2010&2011 Package Tips for General Midterm Success Use mnemonics to remember concepts better. An example of a mnemonic would be acronyms. Do practice multiple choice questions. Doing these practice questions can assess your understanding of what you have learned and can help you identify areas of weakness. Practice multiple choice questions are found in textbooks, on textbook companion websites, and/or provided by your professor. Read a multiple choice question and try to answer it BEFORE looking at the possible answers. Having an answer in mind before looking at possible answers can reduce the chances of being fooled by wrong answers. Use logic and process of elimination on multiple choice questions. For example, if you know that answer A is wrong, then logically an answer “A and B are correct” in the same question must also be incorrect. When you don ‟t know the answer, eliminating wronganswers (as opposed to just random guessing) can increase your ch ances of getting the question right. Practice writing answers to short answer questions. If you know ahead of time what the questions will be on the short answer section, make a list of essential points you want to include in each answer and practice writing the answer on paper. If you don’t know what questions will be on the short answer section, you could try scanning the material to identify concepts that have enough content to be a possible short answer question. Again, you can make a list of essential points you want to include in each answer and practice writing the answer on paper. Even if the question you thought of doesn’ t show up on the short answer section, doing this can help solidify what you learned. Don’t spend too much time on a difficult question. It is better to move onto easier questions to ensure getting those marks than to get hung up on a difficult question, especially when time is limited. Get adequate sleep the night before your test. Sleeping at night helps consolidate what you learned during the day into memory so that it is better remembered in future. Not only does staying up late the night before a test destroy your concentration during the test the next day, but your brain has not effectively learned the material. What is Students Offering Support? Students Offering Support is a national network of student volunteers working together to raise funds to raise the quality of education and life for those in developing nations throughraising marks of our fellow University students. This is accomplished through our Exam-AID initiative where student volunteers rungroup review sessions prior to a midterm or final exam for a $20 donation. All of the money raised through SOS Exam-AIDs is funneled directly into sustainable educational projects in developing nations. Not only does SOS fund these projects, but SOS volunteers help build the projects on annual volunteer trips coordinated by each University chapter. Introduction to corporate finance There are various ways that a business can be organized: • Sole proprietorships – business owned and operated by one individual • Partnerships • Corporation – legally distinct from its owners • Companies need to make good investment and financing decisions made by the financial manager What is finance? • Study of allocation, monitoring and control of scarce resources over time and under conditions of risk and uncertainty What is financial management? • Acquisition, management, and financing of resources needed by firms by means of money wit h due regard for prices in external financial markets Goals of the Corporation • Shareholders want managers to maximize market value o Delegation to managers o Agency problems Flow of savings to corporation 1. Cash raised from investors (financing decision) 2. Cash invested inoperating assets (capital budgeting decision) 3. Cash generated by operations 4. Cash reinvested (retained earnings/internal financing) 5. Cash returned to investors (interest payments/dividends) • Stock market – where securities are issued and traded • When companies ‘go public’ o First issue – initial public offering (IPO) o Issuance after IPO – seasoned equity offers or follow-on offers • Primary market – issue of shares that increases both the amount of cash held by company and number of shares held by public • Secondary market – transfer of ownership of existing shares between shareholders • Financial intermediaries - organization that raises money from investors and provides financing for individuals, companies and other organizations o Mutual funds o Private equity fund o Pension fund o Financial Institutions – e.g. banks • Functions of Financial markets and intermediaries o Transporting cash across time o Offering liquidity o Creating a payment mechanism o Reducing risk Accounting and Finance The Balance Sheet • Shows value of firm’s assets and liabilities at a particular time • total assets = total liabilities + owners’ equity • Current assets – more liquid – more likely to be turned into cash • Assets are generally shown at historical cost, which are not equal to their market values  e.g. assets can be written down but not up • Asset side is where money is invested in (investment) and right side is where money came from (capitalization)  therefore read balance sheet from right to left The Income Statement • Shows revenues, expenses and net income of a firm over a period of time • Cash and profits are not the same due to o Inclusion of non-cash items –e.g. depreciation o Revenue recognition policies – sale may be included but cash has not received (since performance is met and no collection risk) o Accrual accounting - Revenue – Expense matching – recognizing expense in periods other than cash outflow occurs • Cash outflow = Cost of goods sold – change in inventories The Statement of Cash Flows • shows the firm’s cash inflow and outflow over a period of time • It has three sections – operating, financing and investing • Operating o Cash from operations = net income + non-cash expense items (depreciation) – gain (loss) on asset sales + deferred taxes +/- cash provided by (used in) working capital o Increase in cash:  Decrease in current assets  Increase in current liabilities o Decrease in cash  Increase in current assets  Decrease in current liabilities o Change in assets is inversely related to change in cash, while liabilities is directly related • Investing o Increase in cash  Sales of fixed assets, investment, and subsidiaries o Decrease in cash  Purchase of PPE  Marketable securities  Acquisitions • Combining the above two = cash flow from assets = cash from operating activities + casm fro investment activities • Financing activities o Increase in cash  New issues of debt, preferred and equity shares o Decrease in cash  Retirements  Dividends • Combining all = change in cash = cash from (used in) operating activities + cash from (used in) investment activities + cash from (used in) financing activities • Cash can be used to pay off debt (to creditors), to pay dividends (to shareholders) or add to existing cash balance Taxes • Federally: o Interest is treated as ordinary income o Capital gains – 50% is taxable o Dividends is subject to gross-up and tax credit • Provincially: o Dividends are subject to gross-up and tax credit • Taxes are calculated according to th e Income Tax Act –hence taxable income can be very different from GAAP income o E.g. company’s depreciation method is usually different from CCA method o Allowed to deduct interest paid to debholders when calculating taxable income, not dividends to shareholders Measuring Performance • Performed against standard benchmarks, compared to industry averages, or drew from historical data • Three types of analyses – o common size – on balance sheet express everything as a % of total assets, on income statement express everything as a % of net sales, express everything as a % of total inflow or outflow of cash o index (common base year) analysis o ratio analysis  Which is most appropriate to use?  How to calculate?  Compare to industry norms  If discrepancy – why? – solutions?  Identify trends in ratios over time  If a trend is observed – why? • Liquidity Ratios - Measure a company’s ability to pay off its short -term financial obligations. Generally, the higher the liquidity ratio is the larger the margin of safety that a company has to cover short-term debt. o Current Ratio - The amount of assets available to pay off 1 dollar of short -term debt (rule of thumb – good ratio is 3:1) o Quick/acid test ratioThe amount of liquid assets available to pay off 1 dollar of short-term debt (rule of thumb – 2:1) o Net working capital to total capital ratio - Expresses net working capital as a percentage of long-term invested capital o Interval measure – whether liquid assets are large relative to regular outgoings – how long can a firm continue operation if does not make any sales o Cash ratio – cash + marketable securities – most liquid assets compared to current liabilities. Generally the higher the better but it does not matter if the firm is able to borrow quickly • Efficiency ratio -how efficiently the firm is using its assets o Inventory Turnover – amount of times inventory is re-stocked over the course of the year o Day’s inventory – calculates inventor turnover in days o Asset turnover – amount of sales generated for every dollar’s worth in asset s – higher value indicates firm is working near capacity o Average collection period – speed with which customers pay their bills • Profitability Ratios o Net profit margin – measures how much out of every dollar of sales a company can actually keep o Operating profit margin – how much for one dollar sale do shareholders and debt holdersearn together o Return on Assets– profit per dollar of assets o Return on invested capital – return earned on debt, capital leases, and preferred and common equity o Return on Equity – amount of profit a company generates with the amount invested by shareholders o Payout ratio – proportion of earnings that is paid out as dividends • All ratio formulae are provided on page 558 of the textbook • DuPont Analysis o The DuPont Analysis measures assets at their gross book value rather than at net book value in order to produce a higher ROE. Financial accounting depreciation methods produce lower ROEs in the initial years that an asset is purchased, thus DuPont uses gross book value to avoid investing in new assets. o From the identity we can determine which part of the business is underperforming • Market value added – the difference between the market value of the firm’s equity and its book value • Residual income – the net profit of a firm or division after deducting the cost of the capital employed – also known as Economic value added (EVA) o = after-tax operating profit –cost of capital * invested capital o Also = (return on invested capital – cost of capital) * invested capital Time Value of Money The idea behind the Time Value of Money (TVM) is that as long as money can accumulate interest (a return), then any amount of money today is worth more than that same amount of money in any given time in the future due to its interest earning capacity. This does not however only apply to money. Capital goods are a prime example of tangible assets that yield services in the present as well as the future. They can appreciate in value so long as they have potential to earn a return (ie. Cars, homes, factories, etc.). This appreciation in value is referred to as the Net Productivity of Investment. For example, buying a home today can potentially double in value over ten years if it is subject to strong economic conditions. Key concepts of TVM Interest Rate- Rate of Return An interest rate or rate of return can be thought of as a form of compensation to a lender, paid by the borrower for borrowing a sum of money from the lender over a specified period of time. The interest rate is compensation for the foregone opportunity cost of the lender, had he kept the funds himself and used it for something other than lending. Interest rates are always quoted as an annual nominal figure (APR) which can be compounded in different ways; annually, semi annually, quarterly, monthly, semi-monthly, daily, etc. For example, if you are offered a savings account that pays 5% APR compounded monthly, your monthly rate of return would be 5%/12 = 0.41667% Given any APR, you can determine the Effective Annual Rate (EAR) given the number of compounding periods in a year: Future Value The future value of money or a capital good is the total value of it that has accumulated over a period of time t at a given rate of return r. Where, PV= Present Value FV= Future Value r = rate of return t = time elapsed It follows that t FV = PV * (1+ r) = PV * FVIF r,t This introduces the concept of compounding which is defined as the process of leaving your money plus any accumulated interest in an investment for mor e than one period (hence reinvesting the interest). Present Value However, in many cases investors are faced with the problem of figuring out how much they should invest now (present value) in order to accumulate a certain amount over time (future value). This raises the concept of the Present Value. Example You would like to save some money in order to buy a $2000 flat screen TV two years from now for your son’s 18 birthday. You found a GIC that offers an annual effective interest rate of 7% compounded annually. How much should you invest today in order to accumulate the $2,000 two years from now? The Value of Capital Goods Since many capital goods appreciate in value, the price of a capital good is determined by discounting the assets cash flows at its rate of return. This discount rate reflects the opportunity cost of investing the funds. Discounting the future cash flows (DCF) applies to many assets such as stocks, bonds, companies, and projects. Annuities Annuities are financial products that provide a stream of equal cash flows at regular time intervals. These cash flows can be either paid out or received. There are two basic types of annuities that will be focused on in this course; The Annuity Due and the Annuity Immediate. The Annuity Due is a stream of cash flows whereby each payment is made at the BEGINNING of each period whereas The Annuity Immediate is a stream of cash flows whereby each payment is made at the END of each period. The following are timeline illustrations for each annuity type where payments of $X are made for two years: Future Value of Annuities The future value of an annuity refers to the value of a stream of cash flows at a given time in the future. Each cash flow payment earns a rate of return from the time of payment until the final date. Where, FV t Future Value of the annuity at the t thpayment period P= Value of each payment (all payments being equal) r = rate of return t = number of payments periods Example You just turned 16 and just got hired for your first part -time job. You would like to save some money for a trip to Europe with your friends immediately after you graduate from university. As such, you decide to save $1000 at the end of every year (starting this year) until the age of 22.You have found a bank that offers you annual compounding at 4.5%. How much will you have saved up right after graduation? The sum of all of these future values is the total amount of funds accumulated at the end of the six years. The sum is $6,716.90. Alternatively, the formula for the Future Value of The Annuity Immediate can also be used to arrive at the same figure. Present Value of Annuities The present value of an annuity refers to the value of a stream of payments discounted to time zero with respect to a given rate of return. To make this clearer, consider the following scenario: Your father has just retired today and you would like to provide him with an annual income of $50,000 each year for five years starting at the end of this current year. To do this, you purchase a Payout Annuity from Manulife Financial with just a onetime initial investment this very day at a specified rate of return r. This initial investment amount is also known as the present value of all of the annuity payments discounted all the way back to the initial day of purchase at a rate of return r. Where, PV t Present Value of the annuity at the t thpayment period P= Value of each payment (all payments being equal) r = rate of return t = number of payments periods Helpful Tips in solving TVM problems i) Draw a detailed timeline indicating all cash inflows, cash outflows, unknown figures (ie what you are solving for on the timeline), any PV or FV figures that are given, and lastly indicate each cash flow (payment) period ii) Determine your equation of value, in other words equate all cash inflows to cash outflows iii) Determine how to calculate the common point(s) in time that you are trying to solve for Growing Annuities and Perpetuities We have already discussed annuities, so let’s define Perpetuity first. Perpetuity is a series of CF that continues indefinitely. As such, we are only able to find the PV of perpetuity because the FV of any infinite stream of positive CFs would produce a future value of “infinity” The PV of perpetuity that generates payments of amount P at interest rate r is: Present value of Growing Annuities A growing annuity is a finite stream of payments (n payments) that grow by a rate of g each period and earn a rate of return r. The present value at time t of such a growing annuity can be computed as follows: Home mortgages A home mortgage is simply a loan that one takes from a financial institution (lender) to purchase a home at time zero. This mortgage can then be paid back by equal installments at equal time intervals over a specified period of time given a certain rate of interest (APR). Think of a home mortgage as an amortized loan, because it’s all it really is however there is ONE KEY DIFFERENCE. In Canada, home mortgages offer APRs that are always compounded semiannually REGARDLESS of your payment frequency (annual, se mi-annual, monthly, etc). So, the first step in solving a mortgage problem is always to find the effective interest rate for each of your payment intervals. Given a standard APR on your mortgage, and your payment frequency per year m, your effective interest rate per payment period; i, can be computed as follows: Example You take out a ten year loan for $100,000 at an APR of 8%. You negotiate with your mortgage specialist to make monthly payments. What is your effective rate per payment period? What are your monthly payment amounts? A ten year loan with monthly payments generates a total of 120 payments over the loan term. The effective rate per monthly period is as follows: • The general formula for calculating period interest rate: o APR/m = (1 + effective annual rate) t/m-1 • APR vs. EAR o Generally, if the frequency of payment is mentioned, the rate is likely an APR Inflation and TVM • Inflation is the overall rise in price • Distinguish between real price – which reflects purchasing power – and nominal price • Quoting an interest rate (usually a nominal rate) today only indicates the amount of money to be received in the future but does not reflect how much that money is going to be worth • Real interest rate calculated by: 1 + rate interest rate = (1 + nominal interest rate) / (1 + inflation rate) • Real interest rate = nominal interest rate – inflation rate • Current dollar CF must be discounted by the nominal interest rate, real cash flow must be discounted by the real interest rate Valuing Bond Bonds A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. Usually, attached to a bond certificate is a specification of the issuer, principal, holder, maturity and coupons. The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest on bonds is usually paid every six months (semi- annually). The main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply "Treasuries". Two features of a bond - credit quality and duration - are the principal determinants of a bond's interest rate. Bond maturities range from a 90 -day Treasury bill to a 30-year government bond. Corporate and municipals are typically in the three to 10-year range. Two features of a bond - credit quality and duration - are the principal determinants of a bond's interest rate. Bond maturities range from a 90 -day Treasury bill to a 30-year government bond. Corporate and municipals are typically in the three to 10-year range. Companies (and rarely governments) always carry some sort of probability of de faulting on their credit. In other words, since bonds are a form of raising capital by means of debt, any holder of a bond can potentially default on their payments to their bond issuers. Therefore, there are institution that rate every corporation’s proba bility of default and assign a rating in order to inform investors of the risk associated with these potential bondholders. The two most commonly used rating companies are S&P and Moody’s. Under the S&P standard, any corporations with a rating of BBB and a bove are considered companies that have very little likelihood of credit default of credit default and almost considered as “risk free” (be careful with this judgment though!) Anything with a rating of BB/B+ or below is considered risky and is often referred to as a Junk Bond. Zero Coupon Bond A Zero coupon bond is an investment in which an issuer lends the holder a sum of money P and receives a face value F after a time period n which has accumulated interest at an APR i. The price (present value) of a zero coupon bond is computed as follows: Basic Bond Pricing Besides zero coupon bonds, there are bonds that offer actual coupons at regular intervals. These bonds are very similar to annuities in the sense that they generate a steady sequence of cash flows (coupons) for each coupon period for a specified amount of periods. The following is an illustration of a life of a bond where P is the purchase price of the bond, C is the coupon payment for the n periods, and F is the Face value received by the investo r at the end. So, the Price of a bond with C coupon payments and Face value for n coupon periods is just all of the coupon payments discounted back to time zero at the investor’s prospective yield rate, plus the Face value discounted back to time zero at the investor’s prospective yield rate j. The following is the basic pricing formula for bonds: Example Suppose you are interested in purchasing a ten year bond that pays 5% annual coupons and a face value of $2000 at the end of the ten years. Also, you are hoping to earn an 8% yield on your investment, what is the fair price of the bond today? Note: When the coupon rate is lower than the investor’s yield rate, the bond sells at a discount (P
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