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Quick study business business finance 600dpi

Balance Sheet & Income Statement
Sole Proprietorship

Balance Sheet

• The easiest type of busin ess to form.

·It is unincorporated and owned by one person.

• This individu al has all the rights to all the profi ts and assumes all the firm's liabilities.
• Therc is unlimited li ability.
TIP: Files Schedule C for tax purposes.

• Reports the company's resources (assets) and how those resources were funded

(liabilities and shareholders' equity) on a particular date (end of the quarter

or fiscal year).

• Also called the Statement of Financial Position,
• Basically, the balance sheet gives a view of the firm 's financial condition at a point

in time.
TIP: Liabilities & equity are the means of financing assets.

• An agreement between two or more people in a joint busin ess.
• Gener al par tners are responsible for th e operations of the business and are

personally liable for the liabilities.

• Limited partners are limited to their investment.
TIP: Files Form 1065 for tax purposes.

• Represent the company 's resources.
• To qualify as an asset, the following requirements apply:
I. company must own the resource
2. resource must be of value
3. resource must have a quantifiable (measurable) cost



• A separate legal entity that is distin ct/;,ol1J the persons who own it.
• Courts view a corporation as an "artificial person."
• It can:
· owe debts

· pay taxes

· be sued

• It has limited liabilities and ease of ownership transfer.
TIP: Files Form 1120 for tax purposes.

• Represent what the company owes to others.
• To qualify as a liability, the following requirements apply:
I. must be quantifiable (measurable)
2. occurrence must be probable

Shareholders' Equity
• Represents sources offunds through:
I. equity investment(s) or
2. retained earnings (what the company has earned through operations since
its inception)

• Sometim es called "Subchapter S," as it is a tax concept.
• The IRS will allow most corporations with I 00 or fewer shareholders to enjoy the
benefits of incorporation without being taxed as if they were partnerships.
TIP: Files Form 11205 for tax purposes.


Limited Liability Company (LLC)

Income Statement

• Currently. the historical cost regime is the guiding principl e under generally

accepted accounting principles (GAAP).

• However, th e concept offair value, as the supcrior method of valuation , is ga ining

• An LLC has characteristics of a corporation. as it offers some of the benefits ofa
corp orat/on , particularly the limitation of an owner's liability.
• It is al so deemed a separate legal entity.
• LLCs are preferred because they combine the limited liability protection of a
corporation and the pass-throu gh taxation of a partn ership.
TIP: Forms fil e d for tax purposes vary.

• Demonstrates how much a company earns over a specific time period.
• /t associates the custs alld exp enses with the earning o./Ih ctf ,.e venue.

• Also called:
1. Consolidated Statement of" Earnings
2. Profit and Loss Statement (P&L)
3. Statement of Revenues and Expenses
• The major components of the income statement are:
1. revenues
2. expenses
3. gains
4. losses

Financial Markets


Purpose of the Financial Ma rkets

• Actual or expected inflows of cash or other assets, OR reductions in liabilities,

• A means of raising ca pi tal for a firm 's capital investments or for new start-ups.
• Thi s is accompli shed vi a the issu ance of stocks and bonds.

resulting fro/11 producing, delivering,
entity 's central operations.

Prim ary vs. Secondary Markets


providing gooc!.l· Or sen 'ices constituting an


Pr imary Market
• The market in which sec urities are sold by the company,
• Primary market includcs:

· public and private place ments of securities

· U.S. Securities & Exchange COJ1lmiss ion (SEC) registration

· underwriters

• In thi s market, the fi r m raises capital.
Seconda ry M arket
• The market in which securities that have already been issued are traded among
• Secondary market includes:

· stock exchanges (e.g. , New York Stock Exchange'- NY SE)

· over-th e-cou nter (OTC) market (e.g. , NASDAQ)

• Actual or expected outflows of cash or oth er assets, O R incurring liabilities,
resultingfrom producing, delivering, Or p roviding goods


ser vices consritlltillg

all enti(Y:I' central operatiom.

• Increases in equity or net assets from peripheral or incident al activiti es of an entity
and from all other transactions except those resulting from revenues or investments
by shareholders or owners.
TIP: Basically, net cash inflows that are NQ.I a direct re sult of the firm's line

of business.
• Decreases in equity or net assets from peripheral or incidental activities of an

entity and from all other transaction s except those resulting frum cx pcns<.: s Of

distributions to shareholders or owners.

TIP: Basically, net cash outflows that are NOT a direct result o f the fi rm's line
of business.

• Alil/OlIg h a company s shares are traded in the second{IIY market, the company does
1/ 0 1 receive capital/i-om the Iransactions.

Dealer vs. Auction Markets
Dealer Market
• The market in which several traders carry an il/vento,y and provide prices at which
they stand ready to buy (bid) and sell (ask) the securities.
TIP: The NASDAQ market is also an example of a dealer market.

Cash Flow
Cash Flow Statement
• Provides information about cash receipts and cash payments.
• It can be summarized by various periods such as monthly, quarterly, and yearly.
• It provides information concerning the sources and uses of cash to investors.
• The ca~hfl()w statement is de~ign ed to convert the accrual basis oj"acclJlIl1lil/g USl!d
to prepare the income statement and ba lance sheel back to a cash basis.
• The cash flow statement is divided into three categories:
I. Net cash flow from operating activities: Operating activiti es arc the daill'

·\ uction Market
• A market with a phvsicallocalioll whcre buyers and sellers arc matched, with
little dealer activit)'.

• Auction markets have entities call ed specialists, wh o make a ma rket in at least

one stock.

• The role oflh e specialisl is to maintain afair and orderly market when Older
imbalances occlir by {((king the opposite side oj'the transaction.

· buy orders greater than sell orders, the specialist sells

· sell orders greater than buy orders, the specialist buvs

internal activities ofa business thaI eilher require cash IIr genemte il.
TIP: They include cash collections from customers; cash paid to suppliers and

employees; cash paid for operating expenses, interest and taxes, and cash
revenue from interest dividends.


Cash Flow


2. Net cash flow from investing activities: Investing activities
are discretionarv investmenlS made by managemelll.

TIP: These primarily consist of the purchases (or sales)

of equipment.

3. Net cash flow from financing activities: Financing activities
are those external sources alld uses rf cash Ihal afJixI cash flow.
TIP: These include sales of common stock, changes in short­
or long-term loans, and dividends paid_

Free Cash Flow
• The cash flow that is available to:

· pay dividends· service debt· repurchase stock

• The cash flow that is available to all of the firm's suppliers of capital.
• The higher the firm's free cash flow, the healthier the firm,
because the firm will have 1110re cash available for growth, debt
payments and dividends.
• Some commonly used formulas representing free cash flow are:
Free Cash Flow (FCF) = EBIT * (I - tax rate) + Depreciation
- Change in NWC - Net Capital Expenditures
Free Cash Flow (FCF) = Cash Flow from Operations ­
Net Capital Expenditures (to maintain productive efficiency)
Free Cash Flow (FCF) = Cash Provided by Operations ­
Capital Expenditures - Dividends Paid
[NOTE: EBIT = Earnings Before Interest & Taxes:

NWC = Net Work ing Capital]

Corporate Financial Planning Tools
Importance of Planning
• Corporations, just like individuals, need to regularly perform
financial planning in order to:
· provide a better understanding of the interactions between
investments and financing
· further a greater understanding of various real options
available, as well as contingency planning

· delineate internal consistency among goals

Financial Forecasting
• In dctermining the amount of external financing needed in order
to carryon the business operations, the Percentage of Sales
Method is utilized as a major financial forecasting approach ,
which is based on the premise that lIlos1 balance sheel and
income sratemenl accounls


with Sales.

• The Percentage of Sales Method is utilized to prepare the Pro­
Forma Financial Statements (i.e. , forecasted), which then helps
the organization ascerlain IhefirJn :\. needsjiyr externalfinancing.
• Particular balance sheet accounts that generally vary elosely with
Sales are:

· Cash

· Accounts Receivable (AIR)

· Inventory

· Accounts Payable (AlP)

• Fixed Assets are also often tied closely to Sales, lin less Ihere is


• Retained Earnings on the balance sheet represent the cumulative
10lal of Ihefirm S earnings Ihal have been reinvesled in Ihefirm.
TIP: Thus, the change in this account is linked to Sales; how­
ever, the link comes from relationship between Sales growth
and Earnings.
• The Notes Payable, Long-Term Debt, and Common Stock
accounts do 1101 vary aUlomalically wilh Sales.
TIP: The changes in these accounts depend upon how the firm
chooses to raise the funds needed to support the forecasted
growth in Sales.

Income Statement
• On the income statement, costs are expressed as a percentage
of Sales.
• Since we are assuming that all eosts remain at a fixed percentage
of Sales, Net Income can be expressed as a percentage of Sales.
TIP: This indicates the Profit Margin.
• Taxes are expressed as a percentage of Taxable Income.
• Dividends and Additions to Retained Earnings are expressed
as a percentage of Net Income in order to determine the Payout
and Retention Ratios, respectively.
• To calculate the External Funds Needed (EFN) when the fixed
assets are being utilized at full capacity, use the formula:
EFN = ~(S, - So) - --"- (S, - S,J - (PM )(S,)(b)


So = Current Sales
SI = Forecasted Sales = So(\ + Forecasted Growth Rate in Sales)
A \ = Assets (at time 0) that vary directly with Sales
L * 0 = Liabilities (at time 0) that vary directly with Sales

PM = Profit Margin = (Net Income)/(Sales)
b = Retention Ratio = (Addition to Retained Earnings)I(Net Income)

• Ratio analysis facil itates finan cial statement interpretation.
• This is basically achi eved by reduc ing the large number of fin ancial statement items to a relati ve ly

sma ll set of ratios.

• There arc certain caveats one should keep in mind when conducting such an analysis:
· A sing le ralio does 1101 provide sufficienl injiJrmalionji"Oln which lojudge overall pelformallce.

· Financial statements should be compared at the same poin t in time during the year.

· Audited statements are pre fe rable.

· Maintain con si stency in the accounting methods.

· Consider the effects of inflation if comparing companies over long pe riods.

Benchmarking Tips
• Furthermore, in terms of benchmarking, the following tips are useful in deci di ng th e hea lth of a

particular company:

I. Avoid rules of thumb at all cost, as they can get you in trouble.
TIP: For example, one rule states that the hi gher the current ra tio, the better. This mi ght not
always be the case because too high a current ratio suggests a lack of asset utilization.
2. Compare current year ratios to prior year ratios (time seri es an alysis ) for positive or

adverse trends.

3. Compare current year ratios to those of your competitors (if data is available), and then to yo ur
industry as a whole. This is also called cross-sectio nal analysis.

Organizing Ratios
• While there are many ways to organ ize ratios, one approac h is to group ratios by these four categori es.
This methodology suggests the following:
1. Liquidity: Indicator of the firm's ability to meel ils shorl-lerm/inallcial obligalions.
2. Efficiency: Indicator of various aspects of operaliollal efficiency.
TIP: Here, atte ntion is focused on specific assets , rather than on the overall efficiency of asset
utilization measure d by the profitability ratios.
3. Debt (Long-Term Solvency): Indicator of the firm's ability to meel bOlh fh e prin Cipal and illlereSI
paymenls on long-term obligations.
4. Profitability: Indicator of the firm's efficiency in using Ih e capilal commilled by stockholders
and lenders.

[NOTE: The following are generic ratios mai nly used by manufacturing organization s. When performing
finan cial analysis, one must seek specific ratios utili zed by the indu stry. For exam ple, bank s have very specific
ratios for regulatory purposes. As such, those ratios are more relevant for analyzing ban ki ng orga nizations than
are the ones presented here.]

Liquidity Ratios
NetWorking Capital = Current Assets - Current Liabilities

Current Ratio ~ Current Assets

Current Liabili ties

Quick Ratio (Acid Test) = Current Assets - Inventory

Current Liabilities

Efficiency Ratios
Inventor y Turnover = Costs of Goods Sold (COGS)


Average Collection Period = Accounts Receivable (AIR)

Average Sales per Day

Average Payment Period = Acco unt s Payable (A l P)

Average Purchases per Day

Fixed Asset Turnover = Sales

Net Fixed Assets

Total Asset Turnover = Sales

Total Assets
TIP: It is important to match the average collection p eriod ratio to the average p aym ent period
ratio for cash flow purposes.

Debt Ratios
Debt Ratio = Total Liabilities

Total Assets

Debt-Equity Ratio = Long-Term Debt

Stock holders' Equity

Times Interest Earned = Earnings Before Interest & Taxes (EBIT)

(a.k.a., Coverage Ratio)

Fixed-Payment Coverage Ratio = EB IT + Lease Payments

Interest + Lease Payments + {(principal + pref. dividend s) • [1 /( I-T)] f

Cash Coverage Ratio = EBIT + Depreciation

TIP: An acceptab le debt ratio is purely based upon indu stry standa rds and corporate ma nage­
ment's philosophy.
• The Times Interest Earned Ratio mcasurcs the firm's ability to make contractual interest paymcnts and
the Fixed-Payment Coverage Ratio measures the firm's ability to meet all fixed payment obligations.
These two coverage ratios are akin to an individual's ability to pay credit cards, mortgages, etc.
• The Cash Coverage Ratio attempts to measure the fir m's ability to pay intcrest with available cas h.

Profitability Ratios
Cross Profit Margin

= Gross Pro fit


Operating Profits


Net Profit Margin ~ Net Profit after Taxes


Return on Total Assets = Net Profit after Taxes

Total Assets

Operating Profit Margin


Ret urn on Equity

Net Pro fit after Taxes

Stockholders' Equity

Earnings per Share = Earnings Available for Common Stockholders

N umber of Shares of Common Stock Outstanding

Pri celEarnings (PIE) Ratio = Market Price per Sh are o f Common Stoc k

Earnings per Share (EPS)
..,.I!..E G Ra tio = PIE Ratio
Annual EPS Growth
I If': Both the PIE Ratio and the PEG are market,based ratios, as opposed to historical/
accounting-oriented ratios.
olfthe PEG rati o is eq ual to I, it means that the market is pricing the stock to fully reflect the stock's
EPS growth. This is " normal" in theory because, in a rational and effic ient market, the PiE is supposed
to refl ect a stock's future earnings growth.
oIf the PEG ratio is greater than I, it indicates that the stock is possibly overvalued or that the market
expects future EPS growth to be g reater than the current "in the Street" consensus number.
o If the PEG rati o is less than I. it is a sign ofa possibly undervalued stock or that the market does not
expect the company to achieve the earnings growth that is reflected "in the Street" estimates.
DuPont Formula
o A system used to di ssect the financial health of an organization.
o It states that the Return on Investment (ROI) = the Net Profit Margin (NPM) * Total Asset Turnover
(TAT) * Leverage (LEV).
o Or, as a formula:


ROI = Nct Profit aftcr Taxes * Sales
* Total
Equ ity
Tota I Assets

r '

o One can value stock with any of the fo ll ow ing :
I. no dividend growth assumption
2. const ant dividend growth assumption
3. unusual dividend growth model
o In add ition, multip les, su ch as the PIE Rat io, are common ly

utili zed .

o Furthermore. in advancc va luati on, discoullt;; are also taken to
reduce the vallie o/, lIlaill ~V privatelv held COIllIllO II srock (/'or tax
o Examples would include d iscounts for minority intercst and lack
of control.
Valuing Stock with No Div idend Growth
Price =

Requ ired Rate of Return

Valuing Stock wit h Constant Div idend Growth
Price = Dividends
K- g
K = Requ ired Rate of Return
g = Growth Rate of Di vi dends
Capita l A sset P rici ng Mod el (CA PM)
oTo determ ine the requ ired rate o f retu rn , the Ca pital Asset

Pricing M odel (CAPM) is common ly uscd:

K\ = R+f3(K-R)

K = Requ ired Rate of Return

Risk-Free Rate

f3 = Bcta (measure of risk)

K", = Retu rn on a Market Portfol io


Time Value of Money
Today vs. Tomorrow
A dollar is worth more now than that same dollar will be worth in the future.
o This , the basic tenet of the time value o/mone),. is true because of at least three reasons:
1. I nflation reduces the purchasing power 0/ the doll([l:
2. Because of the uncertainty surrounding the receipt of a dollar, an agreement 10 receive SOOllel;
rather than latC/; will increase the value of that dollar.
3. Time values involve thc important concept of opportunity costs. In other words, a dollar today is
worth more than a dollar in one year because the dollar today can be productivel)' invested and will
grow into more than a dollar in one year.

o The process of determining the future value of a present sum.


Preferre d Stock
o Ho lders o{preferred stock receive a f Lred dividelldji'O lI1 the

company on a regular basis.

o There is no m at u r ity date on preferred stock- it is li ke a

perpetual inst ru ment.

o Preferred stock has characterist ics similar to d ebt instru men ts,
but it DOES NOT have an advantage d uri ng liquidat ion.
o Also, un li ke with bonds. whi le fi rms attempt to pay annua l
fi xed dividends , they are not required to pay them if there are no
earnings .

TIP: This is not the case w ith bonds, where int erest payment s
a re mandatory,

o The opposite of compounding. it represents the present value of the future sum.

o Steady stream of cash flows of equal amounts. Examples would include:

· fixed-amount pensions

· fixed-rate mortgage payments

· fixed-amount annuity policy payments

Bond Valuation
o A bond is a fixed-income security.
o The holder o/,rhe hund receives a specified annual interest income alld a specified amount at maturit)!.
o In general. the difference between a bond and other forms of indebtedness (such as loans and trade
credits) is that bonds are sold to the public.
o A fter issuance. the bonds can be traded by investors on exchanges.
o Bonds possess certain characteristics, such as having:

· a par value

· coupon interest

· a maturity date

o Whcn an investor pays more than the par value for the bond.
o Premiums take place when the bond coupon rate exceeds the going market interest rate,


o The opposite of a premium, this occurs when the market rate of interest exceeds the
coupon interest rate.
Bond Price
o DeTermined by taking the present value (PV) of the sum of the coupon interest rate plus the present
value (PV) of the bond's par value.
oThe discount rate used is the going market rate of interest for that type of bond.

Price of Bond = (rV of Coupon Rate Interest) + (PV of Par Value)

Stock Valuat ion
Common S tock

,{olders of common stock receive two types of investment returns:

I. dividends
2. share appreciation

ol n general. though, common stock is valued based on three factors :

I. annual dividends
2. growth of dividends
3. disco unt rate
o The rate at which future dividends arc to be discounted is call ed the required rate of return.


Pricin g Prefe rred Stock
Prefe rred Stoc k Value = Constant Di vidend
Discount Rate
o Divi dends represent a return on a stock ho lder's investment.
o Dividends pl ay a sign ifican t portion of valuing stock .
o It has been suggested rhar dividen ds should olll\' be paid after all
.fi nancing and illvestment requirement,';,' are sali~fied.
o In deve loping div idend po li cy. co rporate offi cers shou ld
determine the potential for growth on future earnings. as we ll
as the res iliency of the company's earnings during the various
phases of the business cycl e.

TIP: Ult im at ely, compa re t he yiel d s and p a yo uts of oth er
firms in your industry.
Dividend Yield
o Equa ls the rate of return from a div idend relative to the price
ofa stock.
Dividend Yield Formula = Cu rrent Div idend

Cu rrent Price of Stock

Dividend Payout Ra ti o = Dividends per Share

Earnings per Share

Record Date

o The date that establ ishes which stockholders of record wi ll
receive the div idend .

Ex-Dividend Da te

o Usually four business days prior to the record date. this date

esta blishes who is entitled to the div idend .

o When the stock goes ex, dividend. the price of the stock decl ines
by the amount of d ividend per share.

Payment Date

oThe date when the firm mai ls div idend checks to stockholders.
Stock Dividends
o Dividends in the form of additional shares, NOT a cash

divid end .

TIP: Sharehold e rs do no t real !y gai n anyth ing fro m st ock divi ,
d e nds beca use the p rice o f t he sto ck decline s b y the same
percentage as the stock di vidend.
St ock S p lits
o Sim ila r to stock dividends, but they usua lly involve the issuance
of even more shares.

Capital Budgeting Techniques
Balancing Risk & Reward

Process & Met hodologies
- The process of evaluating investment proposals is ca ll ed
capital budgeting.
- There are several methodologies util ized in perform ing
th is task. but, in general, the fin anc ial eva luation process
I. Determini ng the relevant cash flow s.
2. Ascertai ning the investment return sought.
3. Compari ng that fi g ure to th c m inimum accepta ble
criter ia.
- W hi le not exhaustive, some techni ques used in the

evaluation process are outli ned be low.

Payback Meth od
- Also tho ug ht of as " getting back your investm ent."
- The criteria used for th is methodology is, simply, to sel ect
the project that recoups your original investment the
quickest (in the shortest time period).

TIP: Th is me th od ha s many weaknesses, in cl uding ,
for instance, the ignorin g of cash flows aft er the
recouping of the origin al investm e nt.
- A di scoun ted payback method can also be performed.
Accoun tin g Rate of Return
- The projected net p rofit fro m an investment.
Accounting Rate of Retu rn = Annua l Average Cash Inflow
Tota l Cash O utflow
Net P re sent Value (N P V)
-If th e NPV is positive, the organ ization will accept the
proj ect; if negative, it w ill reject it.

TIP: A positive NPV a d ds value to th e o rg a nization.


PV of Cash Inflows - PV of Cash O utflows

Benefit-Cost Ratio (BCR)
-If the HeR is greater than /, the investment is attractive.

TIP: A m ajor purpose for usin g t he BC R is to equate
investments of different sizes in order to compare
"apples with a p ples."
BC R = PV of Cash Inflows

PV of Cash Outflows

Internal R a te of Return (lRR)
- The model is the same as the NPV; howevel; the goal is

ascertain the discount rate that makes the diffe rence
between the PV o{th e outflows and inflo ws eq ual to O.
IR R = PV of Cash Infl ows - PV of Cash Outflows = 0

TIP: The NPV and t he !RR will usually provide the
same results BUT not always! A growing c onsen s us
holds that, alth ough the IR R is more appeali ng
beca use the res u lts a re d e scrib e d in percentage
t erms , as o p p osed to the do ll ar fi g ure pro vided b y
the NPY, t he N PV is technically sounder.
Economic Value Added (EVA)
- A methodology stat ing that a company creates value for
owners ollly when its op erating income exceeds the cost of

capital employed.


EBIT (I-Tax Rate) - WACC

- The retllrn on YOllr money should be proportional to the risk involved.
- In other words, the more risk, the higher the expected return and vice versa.

- Risk is a measure of the volatility of return s and the 1I11certainty oj/iltllre olltcomes.

- Volatility is the fluctuation that occurs away f rom the mean return.

TIP: The greater the volatility, the greater the risk .
Expected Return


Dividend + Capital Appreciation

Value of Stock in Prior Period

Measuring Risk
- The simplest way to measure risk is to divide it into two major components:
I. level of risk
2. risk oftime

- The level of risk can be determined by comparing the risk of one asset compared to

another asset.

- The risk of time suggests that the longer the funds remain inve stcd, the greater the risk.

TIP: In other words, investing for a short period with no chance o f loss is called risk-free
(i. e ., T- Bills). Longer periods will require a risk premium to compensate for risk of loss.
Total Risk = Risk-Free Rate + Risk Premium
Standard Deviation (SD)
- One measure of risk is the standard deviation (SD) of an asset.
- The SD measures the volatility ofreturns around the average retllrn:

Incremental Cash Flows
- Before deciding upon whether to undertake a project, an
organi zation should first determine two important values:
I. initial investment
2. incremental cash flows

- Initial investment is the actllal cost ofstarting

an investment.
TIP: However, this simple definition can be mislead­
ing because additional expenses needed to be
determined for the initial investment component
would incorporate packing and delivery costs, sales
from the existing equipment that is being replaced,
and taxes.
- Incremental cash flows are those that the firm will

receive in addition to the existing cash flow after the

project is accepted.

TIP: The additional tax benefits from the deprecia­
tion must be incorporated into this equation as well.

.ri cc of


10 per



r, = Returns

T = Expected Value

Pi = Probability


the risk.


TIP; Furthermore, in order to compare the risk/return trade-offs of different invest­


ments, it is necessary to compare apples with apples and oranges with ora nges .
- The coefficient of variation (CV), which is simply the SD (of returns ) divided by the expected
return, performs this task.
CV = SD of Returns
Expected Returns
- As part of the Capital Asset Pricing Model (CAPM - described in the stock valuation section) ,
beta is a measure ofthe risk observed bv a particular security to the risk olan entire market.
-If the beta of the market equals I, all securities having bcta s greater than I arc riskier than
the market.
- Betas having less than I are less risky than the market.


Securities Market Line
- A graphical presentation that compares the risk ofa security (beta) to its In luired retul'll.
Arbitrage Pricing Theory (APT)
- Another method used in determining the required rate of return of an asset is called the
Arbitrage Pricing Theory (APT).

- Thi s rate is determined by several factors, not just the betas.

- For example, under APT, one would consider, among vario us other factors, changes in:

· interest rates

· industrial production

· earnings announcements

· inflation




* Cap ita l Employed

EB IT = Earnings Before Interest & Taxes
WACC = Weighted Average Cost of Capital
Capital Employed = Mo ney Invested in the Organi zat ion by
Creditors and Owners



=JI(r, - r)' P,

- The more returns fluctuate, the


Option Valuation
Black-Scholes Model
- There are several differeni methods used in valuing options.
- The most popular model utilized today is called Black-Scholes.
- While this model was not created for American Options (those that can be exercised at any time),
it is still commonly used.

- The model suggests that options can be priced based on these five vari ables:

I. current price of the underlying asset
2. option 's time to maturity
3. option 's strike price
4 . interest rate
5. expected volatility of return on the underlying asset

-/n general, the value of a call option rises with the price olthe underly ing asset and tlte option:V
tim e to matul'itv, but f alls with the strike price.
TIP: The value of a call rises as interest rates rise because a call option can be
viewed as a delayed purchase of the underlying asset.
- The higher the interest rate, the more valuable this deferral privilege becomes.

- Last, the option value rises when volatility increases!

TIP: While this seems counterintuitive, it makes sense because an option own e r
needs volatility to obtain upside potential.





to its
Ised as

. use in

Capital Concepts


Cost of Capital
• The r ate of return afirm must pay investors to induce them to purchase thefinn :\' stocks
and bonds,

TIP: Inve stment projects must be a bl e to g e ne rate at least th is c ost

Expected Return
• The future receipts that investors anticipalejinm their investments,
TIP: It co u ld be viewed from the firm's perspective as we ll, inso far a s this return is the
ra te expected from investmen ts,

Required Rate of Return
• The minimum future receipts that an investor will accept in choosing an investm ent,

Cost & Yiel d Formulas
Cost of Debt = Ann ual Coupon on Outstanding Bond


C + ( Par - p,,)


( Par + P,,)
C ,,= Dollar Amount of Coupon

?'or = Par Value of $ 1,000

N = Number of Years to Maturity

Ph = Current Quoted Price of the Bond

TIP: The tax rate must b e deducted fro m t he cost of debt, as interest payments
are ded uctible,


cost of debt = 12%

tax rate = 40%

after-tax cost of debt = 12%( 1- 40%) = 7, 2%

Cost of Preferred Stock = Preferred Div idend

(M arket Price of Preferred) * (I - Flotation Costs )
INOT E: For Cost of Common Stock, see Div idend Models, CAPM (under stock val uation),]
Cost of Retained Earnings =



D = Dividend s of Common Stock

P = Market Value of Com111on Stock

G = Constant Growth Rate of Dividends

Leverage & Capital Structure

• A mca~ ure of a fi rm's overall cost of capital based on the percentage values of the components
(i,e" stoc ks, bond s, ctc,) comprising the jinancial structure,
• A critica l poi nt concerns the weights used in computing the WACC.
• To obta in book value weights, simp ly ut ilize the balance sheet fig ures ,

TIP: It is m o re p ra cti cal, howe ver, t o use m arket valu e weights a s t hey re present th e
current market conditions ,
• Also, from a fi nancing perspect ive, the WAC C represe nts the minim um return that a jinll must
eam in order to create value for shareholders,

(~) + K (preferred) + K
D+ P+S

"D +P+S


C OIIIl/1011 )

' D+ P+S


= Cost of Particular Security (i, e" debt, preferred stock, common stock)

D= Debt

P = Prefcrred Stock

S = Common Stock


Basics of Underwriting





• Measures the effect of a change in earnings per shares
(EPS) as a result ofa change in earnings bcfore interest and
taxes (EBIT) ,
• It can also be viewed as the practice of using debt to

finance investments.

TIP: Because interest is tax deductible, more of the
operating income flows to the investors, at the risk
of having a heavy debt load.
Unleveraged Firm
• Does its financing through the usc of common stock and
no debt.
Leveraged Firm
• Finances part oj'its operations through debt.

Capital Structure



Shelf Registration
• Registration permitted by United States Securities &
Exchange Commission (SEC - Rule 415), whic h allows a
company to register all issues it expects to sell within two
years at one time, with subsequent sales at any time within
those two years,
• However, the corporation must still file the required
annual and quarterly reports with the S EC.
Blue Sky Laws
• State laws aimed at regulating the sale of securities within
the state and thereby protecting investors from being left
with "nothing but the hlue sky,"
• The difference between the price paid for a security by the
investment banker and the sales price.

Financial Leverage

Weight ed Average Cost of Cap it al (WACC)

WACC = K ,

TIP: It must be filed with th e SEC.
Offering Memorandum
• Similar to a prospectus, but ref ers olliv to privatelv held
Red Herring
• T he first document released by an underwriter o f a new
issue to prospective investors,
• This document offers financial d etails about the issue,
but does not contain all the il/fiJl'll/atiol/ that will appear ill
the final or statutory prospectus, and parts of the document
may be changed before the final prospectus is issued.

TIP: Because portions of the cover page of this
preliminary prospectus are printed in red ink, it is
popularly called the red herring.

Market Va lue of Bond

Approxi mate Yield to M a t u r ity

• A portion of a security registration statement that details
the firm :5operational andfinancial positiol/s.

Purchasing & Reselling Securities
• In his/her most basic function, an investment banker is a financial intermediary who purchases
securitiesji'Om issuers and then resells them to th e public.
• Underwriting is the process in which an investment hanker buys a securi(v issue from the
issuingfinl/ at a lower price than that/or which he/she plans to sell it.
• By doing so, the investment banker is basically guaranteeing to the issuer a specified amount
from the sale.
Private Placement
• When an investment banker organizes a direct sale of a new security to an individual, group of
investors, etc,
Best Efforts Basis
• A type of sales arrangement in which the investment banker uses his/her resources and skills
to sell the sewrity issue without taking the risk of underwriting

TIP: The securities unable to be sold are not the problem of the investment banker,
Competitive Bidding
• A method for selecting the investment banker who is willing to bid/or the highest price for
the security issue and is awarded the contract,
Negotiated Offering
• Another method for selecting an investment banker; the contract is awarded based 01/ means
other than competitive bidding
Underwriting Syndicate
• A group of investment banking firms that will underwrite a portion ofthe large security

TIP: This reduces the risk of loss to any single firm,


• Refers to the financing mix of an organi zati on,
• Usually, it will consi st of:

, debt

, preferred stock

, common stock

Degree of Financial Leverage = % change in EPS

% change in EBIT

TIP: In general, the more debt, the higher the degree
of financial leverage.

Operating Cycle
• The a moun t of time that elapses from the point when the
firm begins to build inventolY to the I'o int when cash is
collectedfi'olll sale oIthe resultingfinished product,
Operating C ycle = Average Age of Inventory + Average

Coli ection Period

Cash Co nversion Cycle
• In addition to the operating cycle, firms can measure the
cas h conversion cycle (CCC), wh ich is the amount of time
the firm's cash is lied up between pavmentIor production
inputs and receipt ofpaymentjinlll the sale oIthe reSUlting
finished product,
CCC = Operati ng Cycle - Average Payment Period

TIP: To im prove CCC, t he fo il o wi ng st eps should
be taken :
I , turn over inventory as quickly as possible
2, collect accounts receivable (AiR) as ,/uicklv as possible
3, pay accounts payable (A/P) as late as possible, without
damaging your cred it rating

Inventory Management

Hedging in Theory

Balancing Inventory Levels


The main purpose of inventory management is to de/ermine and maintain the level
o/invenlOlY that will ensure that customer orders are fulfilled on timc.
However, holding 100 lIluch inventory is an expense that a company does not desire.
Therefore, companies must achieve thc ideal balance between holding su ffici ent
inventory and satisfying customer orders in a timely manner.
A TIP: Rem e mber, holding inventory precludes investing in other
II. oppo rtunities .
The level of inventory should be increased if the added ben efits will be greater than
the cost of maintaining additional inventory.
.... Economic Order Quantity (EOQ)
In order to reach thi s idea l balance, a quantitative model call ed the Economic
Order Quantity is utilized.
o The EOQ is the quantity of an item which, when ordered regularly, results in
minimum ordering and storage costs. in order to ensure the proper levels a/inventory.

Hedging is a strategy designed to reduce investment risk using:
· call options

· put options

· short-selling

· futures contracts

o A hedge can help lock in profits. lIs fJlIIpose is to reduce Ihe volatilitv 0/ a

portfolio by reducillg the risk o/,Ios.\·.

o Thus. any loss on the original investment will be hedged (offset) by a
corresponding profitlinn! the hedging illstrument.
o Rules for the treatment of hedges differ between accounting and taxes.
TIP: The bottom line is that an item's designation as a hedge is based on its











Hedging in Practice



R = Required Number of Units per Ti me Period

o = Ordering Cost per Order

W = Cost of Warehouse/Storage

Number of Orders per Year = Annual Consumption


Foreign Exchange Markets & Rates
Currency Exchange Rate




The amount it costs to purchase one unit o/,currency with another currency.
It may be viewed as the price of buying one unit of a foreign currency, stated in
terms 0 f a domestic currency.
Exchange rates fluctuate daily and are reported in major financial newspapers and
other media.

TIP: A currency is considered strong when its exchange rate is rising
relative to most other currencies and as weak when its exchange rate
is falling reJative to most other currencies.


IU Gains & Losses
Gains and losses, where foreign markets are concerned, depend upon two factors:
I. status as an importer or exporter
2. rising or falling currencies

TIP: Take U.S. currency as an example.

o If the U.S. dollar rises against another foreign currency, U.S. importers will
suffer losses because more dollars are required /0 pay the foreign debts. while U.S.
exporters will obtain gains because their/oreign receivables become equivalent to
an increasing IIl1mber oidollars.
o The reverse holds true when the dollar falls against another currency. When the U.S.
dollar falls, U.S. importers will reap gains and U.S. exporters will suffer losses.


Leasing Basics
In general, leases are good/or lessees beca use leases:

· enable lessees to keep up with the latest technological adva nces

· permit flexible financing

o In general, leases are good/or lesso rs because they:
· enable lessors to benefit from depreciation and interest expense
o User of an asset that is leased from 0!1Oiher party.
o Owner of the property that is leased ill anoiller parly.
Capital Lease
o A longer-term lease than an operating lease.
o It is noncancelable and obligates the lessee to make payments lor tile lise a/an asset
over a predefined period oflime.
o The total payments over the term a/the lease are greater tha n Ihe lessor \ i lli!i(11
cost ofthe leased asset(.s).
TIP: For accounting purposes, these are treated as assets.


Florida Institutc of Finance (Joel M. DiCicco, Ph.D., C.P.A.;

Rainford Knight, Ph .D.)

Customer Hotline #



U.S. $5.95


Operating Lease
o A cancelable contractual arran gem ent whereby the lessee agrees 10 make
periodiC payments to the lessor (often fo r 5 years or less).
oln general, the total payments M e l' the term oj'tire lease are less than the lessor:s
initial cost ofthe leased asset(s) .
o Normally, the asset sti ll has a p()sitlve market value allile rermil1111iol1 ofthe lease.
TIP: For accounting purposes, these are treated as operating expenses.


download& &
nU [l a (ed ~ OT Utles at



Synthetic Lease
o Has characteristics of both operating and capitallcases jor reporting purposes.
TIP: For book purposes, these leases are treated as operating leas!1s; BUT,
for tal!. purposes, they are treated as capital leases.

ISBN-13: 978-142320858-7
ISBN-10: 142320858-7

Leveraged Lease
o Like any other lease EXCEPT that part orille asseTS purchase price isjinallced
by the lessor and the lenders.





Consider the following example of hedging in practical use:
· Suppose it's July and a farmer expects an unfavorable drop in the selling price of
corn by the time his anticipated 15.000 bushels are ready for sale
in September.
· The current price as of July is $4.50 per bushel.
· To hedge his risk of getting a low price for his corn, he sells three 5,000-bushel
futures contracts on October corn for more than the current price at $5.00 per
· When September arrives and he sells to the local grain elevator, prices have,
indeed, fallen to $3.90 a bushel.
· To offset this cash position, he is now able to buy, or extinguish, his October
corn contract on the market, where prices have also fallen.
· He pays $4.60 per bushel to lift his hedge.
· Between his cash andliltures positiolls. he has effec/ivelv reduced his losses
finm the price decline.
· In the cash market, he earned $3.90 per bushel; in the futures market, he earned
the difference between his selling and buying prices, or $0.40 per bushel.
· This yields an effective selling price of$4.30 per bushel or $64,500.00 for the
entire crop.
· Although this is still $3, 111111.1111 less than he wOllld have made al .JIIII' prices
($4.50 x 15,000 = $67,500.00), it is $6,000.00 more than he would have made
had he not hedged ($3.90 x 15,000 = $58,500.00).


~~IJ~ ~lllJlllllllllil1llrII1II1I

NOTE TO STUDENT: This guide is intended for ill/ill'lIIC/1iollol pU/poses Oil '.\'. Due to its
condensed format, this guide cannot cover every aspect of the subject. /lUI' s:/lOlild it be lIsed as
a substilUte Jor pro./essiollal/inancial Or tax-preparafion advice; rather, it is intended fo r usc in
conjunction with course work and assigned texts. Ne ither BarCh arts, ]nc. , its w riters. editors
nor design staff, are in any way responsible or liable for the use or mi s use of' the in form ation
contained in this guide.

All rights reserved. No part of this publication may be reproduced or transmitted in any form,
or by any mea ns, electronic or mechanical, including photocopy, recording, or any information
storage and retrieval system, without written permission from the publi sher.

© 2009 BarCharts, Inc. 0309


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