Chapter 1

Capital structure
• What is it? Where is the best place to get $ on a long term basis. Best mix of debt/equity.

• What types of decisions are made? How much to borrow; What is the best (least exp.) way to borrow; How/where should $ be raised.
Sole proprietorship- simplest form, most common,un. Lblty, personal income tax, Partnership (general and limited)-easy, inexp, personal income tax, limited ability to grow, unl libty, difficulty
transferring ownership, Corporation- ownership easily transf.,stockoholders have lim liability, easier to raise $, more compl to start, double taxation fr div.
• Advantages and disadvantages of each form of business organization
Agency costs- Costs of the conflict of interest between mgmt and stockholders
• Direct and indirect- Direct: Corp, expenditure; auditors Indirect: Risky investments

• How do companies minimize? align stockholders and mgmt goals, stock options, maintain control of firm, proxy fight, BOD hires mgmt, takeover candidate
Financial markets
• Secondary vs. primary: primary: original sale of security, IPO, debt or equity seconday: dealer (OTC) vs auction (NYSE)
Chapter 2
Balance sheet
Sources vs. uses of cash- source: bring in $ (left decrease- right increase: sold assets/collected cash, borrowed funds) use: spending $ (left increase , right decrease- purchase assets, made pymt)
• Current- less than yr (AR, Cash, Inv). vs. fixed assets- relatively long life (machinery, patent)

• Current – paid in less than yr (AP) vs. long-term liabilities- note

Taxes- avg tax is tax bill/taxable income. Marginal is tax rate charged on next segment of income only
• Net Working Capital- diff between firms current assets and current liab. Usually positive in healthy firm

• Liquidity- speed and ease with which an asset can be converted into cash. Tradeoff of liquidity is foregone profit potential.

• Leverage- debt.

• Market value – amount recorded on BS vs. book value- price it could be sold today
Accounting issues to consider
• GAAP: revenue and expense recognition IS shows revenue earned, not cash received- expenses matched with revenue
• Noncash items such as depreciation
Cash flow from assets: how to calculate
Operating cash flow: Results from day-to-day producing and selling- EBIT+Depr-Taxes=OCF
Net capex: $ spent on FA less $ received from sales of FA- End FA-Beg FA+Dept= Net Capex
Change in NWC: change in CA and CL- Ending NWC (CA-CL at YE) – Beg NWC (CA-CL at end of prev yr)= Change in NWC- when +, company has invested or added NWC
Cash flow to creditors: Interest paid-Net new borrowing=CF
Cash flow to stockholders: dividends paid-net new equity raised=CF
CFAssets = CFCreditors + CFStockholdersS: (also OCF-Net Capex-Change in NWC=CFA)-

Chapter 3
Know what increases or decreases on either side of balance sheet represent: source or use
Common-size statement
• How we use them- BS (% of assts), IS (% of sales), SCF (% of total sources or uses)- allows companies of diff sizes to be compared, see change over years
• How we build them
Ratios: be able to calculate all if given financial statements (T=Total) (C=Current)
• Liquidity: how to calculate and what these numbers mean
o Current ratio- CA/CL- Usually >1 for healthy firm. High better for creditors, too high is inefficient use of cash
o Quick ratio- CA-Inv/CL- Inv lease liquid of CA. Large Inv may signal overpurchased units due to overestimating sales (slow moving is less liquid)
• Leverage: how to calculate and what these numbers mean
o Total Debt – TA-TE/TA and Debt/Equity-TD/TE
o Times Interest Earned- EBIT/Interest- measures how well company has interest obligations covered
• Profitability: how to calculate and what these numbers mean
o Profit margin- NI/Sales- how much profit generated per $1 of sales
o ROA- NI/TA- how much profit is earned per $1 of assets. Accounting rate of return (book assets)
o ROE- NI/TEquity- measures how much profit is earned per $1 of equity- Accounting rate of return (book equity)
• Market value measures: how to calculate and what these numbers mean
o P/E – PpS/EarningspS- measures how much willing to pay per $1 of earnings and PEG ratios- PE/growth rate- high PEG PE too high relative to growth
o P/Sales- PpS/SpS- measures how much investors are willing to pay per dollar of sales
o Market/Book ratio- MVpS/BVpS- Value <1 company hasn’t been successful in creating value for shareholders
DuPont identity=ROE- profit margin * total asset turnover * equity multiplier- if ROE is lacking ,can tell you where improvement is needed.

Chapter 4
If given current financial statements and sales forecast for future year(s), be able to forecast income statement and balance sheet to determine external financing needed
• Retention ratio- Additions to RE/NI

• Dividend payout=Dividents/NI

• Capacity of fixed assets- if not running at full capacity, increase in ales may not generate need for future FA. Oper at 75% cap, then full capacity sales are 1000/.75=$1333.33. Since sales
only increased to $1200, FA would not need to increase and thus less additional external financing is needed
Internal growth rate: max growth rate w/no ext fin. Required increase in A is exactly =to addition of RE. ROA*b/1-ROA*b (ROA=NI/TAend bal- b=retention ratio)
Sustainable growth rate: max growth rate w/no equity fin. Maintains debt/equity ratio. ROE*b/1-ROE*b (ROE=NI/TEendbal)
Determinants of growth
• Profit margin-increase in PM increases funding internatlly, thus sustainable growth

• Dividend policy-decrease in % paid out in div. increases internally generated funds, thus sustainable growth

• Financial policy- increase in debt/equity ratio allows for more debt financing, thus increases sustainable growth

• Total asset turnover- increase in this increases sales generated from ech $1 sales of assets, this increases sustainable growth rate

Chapter 5
Time value of money- $ worth more today than future. Based on idea of investing and earning.
 • Understand simple vs. compound interest (earning interest on interest)
Ex: $100 1 yr 5%= $100*1.05=$105 FV Ex:$100 2 yrs. 5%= 1st yr. $105, 2nd yr- $105*1.05=$110.25
• Present value- $1/ (1+r) t

• Future value- $1 * (1+r) t

• Discount rate-

• Time periods- greater # of time periods, greater FV for compounding, PV declines when discounting

Chapter 6
Discounted cash flows: know how to calculate if given word problem
• Be able to calculate PV, FV, i/y, n or pmt if given others
o Multiple cash flows
o Perpetuities- some stream of CF goes on indefinitely- impossible to discount each one to find PV. PV=C/r (C=Cash Flow, r=rate)
o Growing annuities
Loan types
• pure discount loan- simple –amount borrowed is amount repaid at given int rate, interest-only loan- pays interest only and pric at some point and amortized loan

Chapter 7
Bonds and bond valuation
• What is price of bond if given coupon rate, maturity, yield, and face value?
• What is yield to maturity if given coupon rate, maturity, price and face value?
• Understand relationship between coupon rate and yield to maturity
• Understand relationship between interest rate changes and bond price fluctuation
o What makes a bond more sensitive to this interest rate risk?
• Know how to calculate with annual, semi-annual or quarterly coupon payments
• Know bond features: maturity, security, seniority, etc.
• Know different issuers of bonds (Federal government, local government, corporation) and features unique to each issuer
• Know different types of bonds (zero coupon, convertible, etc.)
• Bond market and pricing characteristics
• Know relationship graphed on yield curve, typical shapes and what they mean
Chapter 8
Stock valuation- Ex: $100 stock, sell in yr. div 1st yr $10, 15% rate of return PV=($10+$100)/1.15=$95.65
• Zero growth dividend-Po=D/R.- 10/.15= 66.67

• Constant growth dividend- Po=D1/(R-g) = constant growth div 8%- Po=(10*1.08)/(.15-.08)= $154.29

• Nonconstant growth dividend (basic)-

Required Rate of Return- R=(D1/Po) + g – in word form:(Dividend yield +Capital gains yield)- Ex: Stock $30/share. Div next yr $2, expect growth 10%. What is RRR- R=2/30 +10%= 16.67%
Stock
• Shareholder rights- voting (proxy)

• Common- share prop. Div., assets after liquidation, vote, new stock held
• Preferred- char. Of debt (can be convertible/callable, stated dividend, in liquidiation receive stated value only, credit rating, mayb have sinking fund), pref in pymnts and assets, taxed like
common stock, may not have voting privileges,
• Dividend types- ord income, fully taxable, not an expense, not tax ded., paid at discr. Of firm, not liability (unless declared)
Stock markets
• Dealer- maintains inv. vs. broker- brings buyers/sellers together

• NYSE – largest in world in terms of total value of shares listed, $ volume- most comm. Brokes, 2nd specialists, 3rd floor broker and NASDAQ- multiple market makers, 2nd in US
Chapter 9
Project/business assessment methodologies
• Know advantages, disadvantages, decision criteria and how to calculate:
o Net Present Value- investment should be accepted in NPV is positive,
o Payback Rule- length of time it takes to recover initial costs, adv:easy to use, biased towards liquidity, dis:ignores time value of $, diff levels of risk, no economic rationale,
ignores cash flows beyond cutoff, doesn’t always capture best overall investment
o Discounted Payback
o Internal Rate of Return- required return that results in zero NPV when it is used as discount rate (break-even discount rate)
o Profitability Index
• Know when NPV and IRR give different answers
o Nonconventional Cash Flows
o Mutually Exclusive Investments-
Chapter 10
• Know types of cash flows that are considered relevant or incremental to project
o Sunk costs, opportunity costs, side effects, net working capital, financing costs?
• If given sufficient information, be able to calculate:
o Operating Cash Flow of Project
 Bottom up
 Top down
 Tax shield
o Net Working Capital
o Capital Spending
o Project Cash Flows
o Net Present Value of cash flows
o IRR of cash flows
Chapter 11
Understand different types of analyses
• Scenario- Initial proj. and NPV are called base case. Set ranges to explore any proj. that are uncertain. Produced UB, LB, base case NPV, and IRR

• Sensitivity-Hold all variable constant except one and determine sensitive NPV is to change in one variable. IF NPV very sensitive, forecasting risk w/variable high
Operational leverage- degree to which project is committed to fixed prod. Costs. Low OL low fixed costs vice versa. High OL capital intensive- Uncertain cash flow minimize OL
Soft rationing: not enough capital based on allocation throughout firm (but as a whole does)- Hard rationing: firm as a whole does not have nec. capital to undertake value added projects
Chapter 12
  Total return (dollar or percent)
• Income and capital gain
 What is a risk premium? What types of assets have it?
 Efficient Market Hypothesis
• Know difference between three forms
Chapter 13
 Calculate expected return, and therefore expected risk premium if given risk-free rate and returns under different economic scenarios for individual securities or portfolio
 Portfolio theory: diversification
o Systematic/market versus unsystematic/specific risk: difference and examples
o Which is diversifiable? Which are investors compensated for?
o How do we measure systematic risk? What do different betas mean?
• Security Market Line
o What does it represent?
• Capital Asset Pricing Model (CAPM)
o Calculate any coefficient if given other inputs
o What does it represent/depend on?
Chapter 14
 Options: Put and Call
o What are terms/characteristics of each?
o Understand payoff/profit of each (and graph)
o When would an investor buy a put vs. call? When would he/she exercise the option?
o What determines pricing of the option?
• Employee Stock Options
o What is difference between this and typical call option?
• Other types of financial options and financial instruments with options
o Real option, managerial options, investment timing, etc.
o Warrants, convertible and callable securities
Chapter 15
• Calculate cost of capital using WACC method
o Calculate cost of equity under dividend growth model and SML approach
 What are advantages/disadvantages to each method? What if they produce different results?
o Calculate cost of debt
 What if multiple issues of debt?
 What if debt is not public?
o Calculate cost of preferred stock
o Calculate weights of each source of capital
• When is WACC appropriate or inappropriate rate to use?

Chapter 16
 What are different types of public offerings and characteristics of each?
o Initial vs. seasoned equity offering
o Cash vs. rights offering
 IPO pricing
o Underpricing or overpricing an issue
o What are issues with each? Why might they occur?
• What are floatation costs? Calculate if given information on commitment, offering prices, etc.
• Rights offering
o If given other information, calculate number of new shares, number of rights to purchase new share, value of right
o Understand what happens to shareholder value when right is issued/exercised
• What is dilution?

Chapter 17
 How do different capital structures affect risk to stockholders?
• M&M Proposition I: what is it and what conclusion is reached regarding capital structure?
• M&M Proposition II: what is it and what conclusion is reached regarding capital structure?
• What happens to those conclusions once taxes are considered?
• What are bankruptcy costs and what happens to those conclusions once bankruptcy costs are considered?
• What is optimal capital structure by definition once all is considered?
• Know/understand the graphs of WACC, cost of equity and cost of debt under different scenarios

Chapter 18
 What type of dividends are there?
• What is ex-dividend? How does date and/or price work?
• How do taxes affect dividend policy? Capital gains?
• What are advantages of high dividend payout?
• What are advantages of low dividend payout?
• Understand information content and clientele effects
• What are dividend policy considerations?
o Residual dividend, stability, compromise
• How does stock repurchase work? Do taxes favor this move? Advantages or disadvantages?
• Understand what a stock dividend, stock split, and reverse split are

Chapter 23
 In what ways can companies reduce risk exposure? What types of risk are companies exposed to?
 In long run, firm is either economically viable or not, and hedging will not change outcome. Short term hedging allows firms to adjust to changes. Hedging allows firms to insulate from
short-term price fluctuations and transition itself to be viable under new economic or market conditions.
o Forward contract: what is it, how does it work, how does a company hedge using it? Legally binding contract between two parties calling for the purchase/sale of an asset in the
future at a price agreed upon today; one party benefits while the other loses as prices change; credit risk of other party defaulting. Ex: utility cmp selling services and can’t change price
o Futures contract: what is it, how does it work, how does a company hedge using it? Functions like forward, although gains and losses are settled daily is “making to market.”
Reduces credit risk. Commodity futures and financial futures (ag products, finance assets- bonds-stocks). Like forwards, but account is maintained w/broker to settle daily gains/losses
o Swap contract: what is it, how does it work, how does a company hedge using it? An agreement between 2 parties to exchange specified cash flows at specified intervals. Acts
like a portfolio of forward contracts. Most popular are currency,interest rate, and commodity swaps.
o Options contract: what is it, how does it work, how does a company hedge using it? Puts/calls. One diff. from other types: buyer has the right, not obligation to exchange cash
for asset
 o Options on stocks, futures contract for commodity, futures contract for exchange and interest rate, notes, interest rate caps, and other interest rate instruments
o Risk profile- shows relationship between prices of some good service or rate and changes in firms value
You are considering investing in a process that is a cost-cutting proposal. Net income from the project is expected

to be $50 for each of the three years of the project's life. The process has an initial cost of $225 and will be

depreciated straight-line to zero. Assume a 34% tax bracket, a discount rate of 10% and a salvage value of $80.

Fill in the table below and then answer the following questions.

0 1 2 3

Capital Spending 225

Depreciation 75 75 75

Net Income 50 50 50

Aft-Tax Salvage 52.8

Total Cash Flow (225) 125 125 177.8

$75 * .34 =
1 What is the annual depreciation tax shield? $25.5

2 What is the after-tax cash flow from realized from equipment salvage? $80 * .66 = $52.8

3 What is the total after-tax cash flow resulting from this project?

0 1 2 3

Total After Tax (225) 125 125 177.8

Cash Flow

A capital investment opportunity has the following projected after-tax cash flow . . .

0 1 2 3

Aft-Tx Cash Flow (1,000) 400 450 500

4 Assuming a 10% discount rate NPV= $111

5 IRR = 16%