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FNCE 5101 Class Notes

7/13/10 Ch 2

7/13/2010 3:02:00 PM

Financial Statements Balance Sheet firms financial position at a specific point in time o As of 12/31 o snapshot as of a certain day o left side shows assets o right side shows liabilities and shareholders equity o **A=L+SE** equity is the owners claims against the assets liabilities are the creditors claims against the assets a firm finances its assets with both liabilities and equity o assets are listed in order of liquidity liquidity: how quickly they can be converted to cash for an amount close to what you paid for it Account receivable money owed to company by its customers o liabilities must be listed by the order in which they are due Account payable money a company owes its suppliers o Retained Earnings amount of earnings retained and invested back into the business and not paid out in dividends to shareholders Evidence of growth, used to invest in future growth o Total common equity common stock + retained earnings o Total Equity TCE + preferred stock Income Statement statement of a companys revenue and expenses over a period in time o Revenue Expenses = Net Income Sales - operating expenses (rent, salaries, utilities, lease payments, supplies, depreciation + amortization) - interest (bowing from a bank, issuing bonds) - taxes - preferred dividends

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Net Income depreciation cost of using an asset applies to tangible assets amortization cost of using intangible assets preferred dividends considered to be an expense because a company is under an obligation to pay them if there is preferred stock outstanding EBITDA earnings before interest, taxes, depreciation, and amortization EBIT = EBITDA - DA

o EBT = EBIT I o Net Income = EBT * (1 tax rate) o Ex. 3 (pg 79) NI = $3m EBIT = $6m, tax = $40% Interest Expense = $1m o Ex. 4 (pg 79) EBITDA = 7.5m NI = 1.8m Int. Exp. = 2m tax = 40% DA = 2.5m Statement of Retained Earnings how much of a companys earnings were retained and not paid out in dividends o RE (prev yr) + NI (curr yr) common dividends (curr yr) = curr RE o Ex. 6 (pg 79) Comm. Div = 20m o Addition to RE = RE (curr yr) RE (prev yr) Statement of Cash Flows reports effect of operating, investing, and financing activities on cash flows over a period of time o Operating cash flows generated by and used in normal course of business Includes: net income (adjusted for D/A), changes in inventories and accounts receivables, and changes in

accounts payable and accruals (liabilities for unpaid expenses: interest/salaries/rent payable) o Investing includes purchases or sales of fixed assets o Financing includes cash raised during the yr by issuing bonds or stock, borrowing from banks (notes payable); & cash paid in the payment of dividends, buying back stocks or bonds, and in paying off notes payable o Net cash flow vs. net income NCF NI + DA Ex. 10 (pg. 79) Ch 3 Who are interested in ratios? Creditors, Stockholders, Managers 5 types of ratios liquidity: how quickly they can be converted to cash for an amount close to what you paid for it o can company pay debts as they come due? o CURRENT ratio = current assets / current liabilities current assets are: cash, marketable securities, A/R, inventory MS = low-risk, short-term investment fixed assets ARE NOT current current liabilities are accounts payable, short-term notes payable (<1yr), accruals a company with a low ratio lacks liquidity in the sense that it cannot convert its assets into cash quick enough to meet its maturing obligations compare it to industry average or do a trend analysis of the company o QUICK ratio = same as current ratio, but inventory is removed from CA because it is the least liquid Asset management: how effectively a firm manages its assets NCF = 650k

o INVENTORY TURNOVER = Problems with ratio: sales in numerator is as of day reported in balance sheet. Maybe use an average? since inventory is purchased at cost, maybe we should use cost of goods sold instead of sales this overstates ratio o Days sales outstanding (pg. 93) = receivables / sales per day how well firm is managing its receivables how long it takes from time of credit sale to when cash is received compare to industry average o Fixed Asset Turnover how effectively a firm manages its net fixed assets problems: assets are posted at cost, so if an old company bought assets eons ago, ratio will be inflated o total asset turnover = sales / total assets sales generated from each $ of assets used debt management o debt total debt / total assets how is firm financed o times interest earned = EBIT / interest expense funds available to pay interest expense how well does firm have interest expense covered o EBITDA Coverage = (EBIT + DA + lease payments) / (interest expense + principle + lease payments) there is more to it than interest expense, they may

want to pay down principle and lease payments o TIE and EBITDA Coverage are used by lenders if looking to lend a short-term loan, lender can assume depreciation generated funds will be there to pay loan long term lenders cannot make this assumption and will use TIE; firm will have used funds for other issues HW: self-test 1, ch 3: problems 1,3,4,5,6,7,8,9,10,12

7/15/10 Profitability Ratios Net Profit Margin = Net Income / Net Sales o 3.8% = $0.038 in income per $1 of sales o if % is below industry average, this can indicate trouble controlling costs or significant use of debt Return on Assets = Net Income / Total Assets o want to maximize this number this can be done by maximizing on profit margin or on asset turnover b/c ROA = net profit margin * asset turnover ratio (dupont equation) o Return on Equity = Net Income / Common equity want to maximize this number this can be done by maximizing on profit margin or on asset turnover or on financial leverage b/c ROE = net profit margin * asset turnover ratio * financial leverage (extended dupont equation) financial leverage aka equity multiplier = assets / equity if this ratio is higher than 1, this indicates a company has a lot of debt basic earning power = EBIT / total assets o ability of firms assets to earn operating income o useful when comparing companies with different debt and tax structures Market value Price-to-earnings = price per share / earnings per share o price per share = market price o EPS = Net Income / # of shares outstanding o high for firms with high growth potential price-to-cash flow = price per share / earnings per share o price per share = market price o EPS = (Net Income + D/A) / # of shares outstanding market-to-book = market price per share / book value per share o BVS common equity / # of shares outstanding

o amount investors are willing to pay per book value of each share Financial statements are backward looking, so we should use them to ask questions, not look for answers Ch 6 Companies can raise capital in 3 ways borrow from bank o expect to receive principal and interest issue stocks o expect to receive capital gains and dividend payments ssue bonds o expect to receive principal and interest payments

rate of return = (amount received amount invested) / amount invested actual achieved based on what was earned expected predicted based on statistics required based on risk o risk probability of earning a low/negative return risk aversion investors dont like risk, and require higher rates of return as an incentive if expected < required, no good (overvalued) if expected > required, good (undervalued) if expected = required, indifferent an assets risk and rate of return can be analyzed o on a stand-alone basis o as part of a portfolio Expected RoR & risk, stand-alone Expected ROR = the sum of (each probability * corresponding ROR) Low st dev = lower risk if looking at companies with different st devs and exp RORs, look at company with the lowest coefficient of variation (CV) CV = ST DEV / EXP ROR

Expected RoR & risk, portfolio expected ROR: sum of weight * expected ROR Correlation: tendency of two variables to move together o correlation coefficient (CC) = measure of degree of relationship between two variables o -1.0<CC<1.0 o if returns on 2 stocks were perfectly correlated, CC=1.0 ex. 1 goes up 10%, so does the other o if returns on 2 stocks were perfectly negatively correlated, CC=-1.0 ex. 1 goes up 10%, the other goes down 10% o if CC=0, there is no relation to movement o the lower CC is (closer to -1.0), the more diversified the portfolio is, hence lower the risk Diversifiable risk (firm-specific) can be virtually eliminated by diversifying Market risk inherent in market o cannot be eliminated, but can be measured o measure by degree at which stock moves with market o the lower the coefficient, the less risk the stock contributes to the portfolio Calculating required return security market line equation (pg 247) o derived from capital asset pricing model o req ROR = risk-free rate + (return on market risk-free rate)*CC ROM-RFR = market risk premium o slope of SML = MRP, indicates risk aversion the steeper the slope, the more risk averse, the higher ROR is required for the same CC o effect of inflation: risk-free rate will increase, and SML will increase parallel to original line, slope will not change HW: 1,2,3,4,9,10,11

Ch 4 Time-value of money Compound interest: Ex. invest $100 for 3yrs @ 5%; how much will you have at the end of 3yrs? 100, 105, 110.25, 115.76 Annuity series of payments, equal amounts, equal intervals ordinary fixed payments occur at the end of the time period annuity due - fixed payments occur at the beginning of the time period

7/13/2010 3:02:00 PM

7/13/2010 3:02:00 PM