Finance and the Firm
 Three fields of finance (corporate finance, investment and portfolio management, financial institutions and financial markets)
 Major decisions faced by financial managers (capital budgeting, capital structure, working capital management)
 Three forms of business organization
 The goal of financial management in corporation (maximizing the current price of the existing stock)
 How investors monitor managers to ensure that managerial decisions are in the best interests of the owners
Sample questions
1.1. The person generally directly responsible for overseeing the cash and credit functions, financial planning, and capital expenditures is the:
 treasurer.
 director.
 controller.
 chairman of the board.
1.2. The management of a firm’s shortterm assets and liabilities is called:
 working capital management.
 debt management.
 equity management.
 capital budgeting.
1.3. The primary goal of the financial manager is
 minimizing risk
 maximizing profit
 Maximizing value per share of existing stocks
 minimizing return
1.4. Capital structure decisions include consideration of the:
 amount of longterm debt to assume.
 cost of acquiring funds.
III. current assets and liabilities.
 net working capital.
 I and II only
 II and III only
 III and IV only
 I, II, and IV only
 Financial Markets and Interest Rates
Financial markets

 Primary market vs. secondary market
 Money market vs. capital market
 Money market securities: Treasury bills, commercial paper, negotiable certificates of deposits (NCDs)
 Capital market securities: Treasury bonds, municipal bonds, corporate bonds, common stocks, preferred stocks
 Public offering vs. private placement
 Major stock exchanges
 Organized security exchange (e.g., NYSE)
 Overthecounter exchange (OTC, e.g., NASDAQ)
Interest Rates
 The riskfree rate of interest (R_{F}) reflects the real rate of interest (k^{*}) plus a premium (IP) to compensate investors for inflation (rising prices). R_{F} = k^{* }+IP
 The nominal rate of interest (k_{N}) contain an inflation premium (IP) to compensate investors for inflation and a risk premium (RP) to compensate investors for issuer risk characteristics such as the risk of default.
 The riskfree interest rate changes over time in response to changes in the supply of funds available and in the demand for funds.
 Understand the term structure of interest rates (yield curve).
 Risk premiums on debt securities should reflect the following: default risk, maturity risk (interest rate risk), liquidity risk, contractual provisions, and tax provisions
 The returns required on risky assets (stocks and bonds) change over time in response to changes in the riskfree rate and/or in the risk premium required by investors
Sample questions
2.1. By definition, the money market involves the buying and selling of
 funds that mature in more than one year
 flows of funds
 stocks and bonds
 shortterm funds
2.2. The largest and best known security exchange is the
 American Stock Exchange (ASE).
 Chicago Board of Trade (CBOT).
 Pacific Stock Exchange (PSE).
 New York Stock Exchange (NYSE).
2.3. Your uncle would like to restrict his interest rate risk and his default risk, but he would still like to invest in corporate bonds. He would most likely invest in
 AAA bonds with 10 years to maturity
 BBB bonds with 10 years to maturity
 AAA bonds with 5 years to maturity
 BBB bonds with 5 years to maturity
2.4. The is/are a graphic depiction of the term structure of interest rates.
 riskreturn profile
 aggregate demand curve
 yield curve
 supply and demand functions
2.5. The rate on 1year Treasury notes is 5.50%, the rate on 10year treasury bonds is 5.85%, and the rate on 10year AAA rated corporate bonds is 6.60%. The approximate risk premium on the corporate bonds is
 0.35%. c. 0.75%.
 1.10% d. 1.45%.
Use the following information to answer questions 2.6. and 2.7.
Security Yield
Riskfree longterm capital 6.7%
Grade AA longterm corporate bonds 8.0%
Grade BB longterm corporate bonds 9.4%
The S & P 500 stock index 13.5%
 If inflation were to unexpectedly increase by 1%, then the rate on newly issued AA and BB corporate bonds would
 be approximately 8.0% and 9.4%.
 also increase by approximately 1% each.
 decrease since the riskfree rate no longer covers expected inflation.
 none of the above.
 Among firms, who experiences the lowest average cost of longterm financing?
 corporations with AArated debt
 corporations with only equity financing
 corporations with BBrated debt
 corporations that issue highyield bonds
 Financial Institutions
 Financial institutions (serving as intermediaries by channeling the savings of individuals, business, and governments into loans and investments.)
 The role of the investment banker in securities offerings
 Types of Financial Intermediaries
Financial Institutions Categories  Primary Sources of Funds 
Depository Institutions  
Commercial banks  Individual savings 
Savings and loan associations  Individual savings 
Savings banks  Individual savings 
Credit unions  Individual savings 
Contractual Savings Organizations  
Insurance companies  Premium paid on policies 
Pension funds  Employee/employer contributions 
Securities Firms  
Investment companies & mutual funds  Individual savings (investments) 
Investment banking firms  Other financial institutions 
Brokerage firms  Other financial institutions 
Finance Firms  
Finance companies  Other financial institutions 
Mortgage banking firms  Other financial institutions 
3.1. A __________________ allows firms access to a specified amount of bank funds over a specified period of time.
 line of credit
 term loan
 debt security
 savings account
3.2. In November 1999 President Clinton signed legislation repealing the GlassSteagall Act. The GlassSteagall Act was Depression Era legislation designed to
 require the integration of investment banking and insurance activities.
 encourage the chartering of state banks.
 severely limit the amount of funds held by a single mutual fund.
 separate commercial banking from investment banking activities.
 Stocks and Bonds
 Legal aspect of bond financing
 The general features, ratings, popular types, and international issues of corporate bonds (risk and return tradeoff)
 The rights and features of common stock
 The rights and features of preferred stock
 Compare debt and equity capital (ownership interest, voting rights, claims on income and assets, tax deductibility, etc.)
Sample questions
4.1. A is a complex and lengthy legal document stating the conditions under which a bond has been issued.
 sinking fund
 bond indenture
 bond debenture
 warrant
4.2. Corporate bonds which feature stock purchase warrants have
 lower coupon interest rates because bondholders have the option to purchase more bonds at a specified price for a specified time.
 higher coupon interest rates because bondholders have the option to purchase more bonds at a specified price for a specified time.
 lower coupon interest rates because bondholders have the option to purchase shares of stock at a specified price for a specified time.
 higher coupon interest rates because bondholders have the option to purchase shares of stock at a specified price for a specified time.
4.3. Which of the following best describes a junk bond?
 The stated interest rate is adjusted periodically and they tend to sell at or close to par value.
 Short maturities, usually 1 to 5 years, they can be renewed for similar periods at the option of the holder.
 Debt rated BB or lower, they are highrisk bonds with high yields.
 Bonds that can be redeemed for par at the option of their holder at specific dates after issue.
4.4. Preferred stockholders
 are senior to bondholders.
 are senior to common stockholders.
 receive interest payments.
 generally have “super” voting rights.
 Time Value of Money
 How to determine the future value of an investment made today.
 How to determine the present value of cash to be received at a future date.
 How to find the return on an investment.
 How to determine the number of time periods.
 How to determine the future and present value of investments with multiple cash flows.
 Annuity and perpetuity
· Future Value and Compounding A future value (FV) is the amount of money an investment today (present value, or PV) will grow to over some period of time (n) at some given interest rate (k). The fundamental future value equation for multiple time periods is: FV = PV(1 + k)^{n}, where n represents the number of time periods.
· Present Value and Discounting. The fundamental present value equation for multiple time periods is: PV = FV[1/(1 + k)^{n}].
· Determining the Discount Rate. The basic PV equation contains four variables: present value (PV), future value (FV), discount rate (k), and the number of time periods (n). Given any three of these, we can always solve for the fourth. The implied interest rate in an investment is k= (FV / PV)^{1/n} – 1, or
· Finding the Number of Periods. Finding the number of periods is simply solving the basic PV or FV equation for n.
· Future and Present Values of Multiple Cash Flows

 Future Value with Multiple Cash Flows The future value of a set of cash flows is equal to the sum of the future values of the individual flows.
 Present Value with Multiple Cash Flows Similarly, the present value of a set of cash flows is equal to the sum of the present values of the individual flows.
 A Note on Cash Flow Timing In solving time value problems, it is important to specify when each cash flow occurs: at the beginning each period, or at the end. Unless told otherwise, we generally assume cash flows occur at the end of each period.
 Valuing Level Cash Flows: Annuities and Perpetuities
o Present Value for Annuity Cash Flows. The fundamental present value equation for an ordinary annuity is: Annuity Present Value = C (1 – 1/(1 + k)^{n})/k
o Future Value for Annuities. The fundamental future value equation for an ordinary annuity is: Annuity Future Value = C [(1 + k)^{n }– 1]/k.
o A Note on Annuities Due. When payments occur at the beginning of each time period, we have an annuity due.
o Perpetuities. A perpetuity is an annuity where t is equal to infinity. Thepresent value of a perpetuity is C/k.
 APR vs. EAR
 APR refers to Annual Percentage Rate
 EAR stands for Effective Annual Rate
 EAR=(1+APR/m)^m1
 Loan Amortization
 Pure Discount Loan: repay a single lump sum in the future
 Interest Only Loan: pay interest each period and repay the entire principal in the future
 Amortized Loan: repay parts of the loan amount over time
Valuation of Stocks and Bonds
 Bonds and Bond Valuation
 Bond Features and Prices A bond is a form of interestonly loan; the loan principal is called the face or par value, and the periodic interest payments are called coupons. The coupon rate is the coupon amount divided by the par value. The number of years until the face value is paid is the bond’s maturity.
 Bond Values and Yields The market value of a bond is equal to the present value of all of the promised payments discounted at the bond’s yield to maturity (YTM). The YTM, in turn is the market’s required rate of return on the bond.
 Bond prices and market interest rates move in opposite directions.

 When coupon rate = YTM, price = par value.(“selling at par”)
 When coupon rate > YTM, price > par value (premium bond, or “selling at a premium”)
 When coupon rate < YTM, price < par value (discount bond, or “selling at a discount”)
 Common Stock Valuation
 Cash Flows The market value of a share of common stock is equal to the present value of all of its future dividend cash flows, D, discounted at the appropriate discount rate, R.
 Some Special Cases
 Zero Growth If the future cash flows, D, are not expected to change, then the present value, P_{0 }equals D/k_{s}.
 Constant Growth If the future cash flows are expected to change at a constant rate, g, then P_{0} equals D_{1}/( k_{s} – g).
Sample questions
 The future value technique uses ___________ to find the future value, and the present value technique uses ______________ to find the present value.
 a) compounding; discounting
 b) compounding; compounding
 c) discounting; discounting
 d) discounting; compounding
 How much money will Elian have in three years if he places $1500 into a CD earning an annual interest rate of 6.5% compounded annually?
 $1597.50
 $1695.00
 $1792.50
 $1811.92
 William has a choice of investing $2,500 for 5 years in CD #1 that pays 6% compounded annually or a CD #2 that pays 6.5% simple interest annually (meaning it does not pay interest on the interest). What will be the value of each investment at the end of five years?
 #1, $3,250.00; #2, $3,312.50
 #1, $3,250.00; #2, $3,425.22
 #1, $3,345.56; #2, $3,312.50
 #1, $3,345.56; #2, $3,425.22
5.4. An annuity stream of cash flow payments is a set of:
a) level cash flows occurring each time period for a fixed length of time. b) level cash flows occurring each time period forever. c) increasing cash flows occurring each time period for a fixed length of time. d) increasing cash flows occurring each time period forever. 
5.5. A 9 percent preferred stock pays an annual dividend of $4.50. What is one share of this stock worth today?
 a) $4.50
 b) $5.00
 c) $45.00
 d) $50.00
 Risk and Return
I. Fundamental Concepts about Return and Risk
 Return is defined as:
B. Risk is the chance that the actual return will differ from what is expected.
 Measuring the Risk of a Single Asset
 Probability distribution
 Standard Deviation and Coefficient of Variation
Expected rate of return:
Coefficient of variation:
III. Return and Risk of a Portfolio
 Portfolio return is the weighted average of the returns of each asset in the portfolio.
 Portfolio risk depends not only on the risk of each asset in the portfolio but also on the correlation between each asset.
 Positively correlated, meaning they each move in the same direction
 Negatively correlated, meaning them move in opposite directions
 Uncorrelated, meaning there is no relationship between them
 The risk of a portfolio may be reduced through diversification.
 Risk and return: Beta and the Capital Asset Pricing Model (CAPM)
 Overall risk of a security consists:
 Nondiversifiable risk (systematic risk or market risk) is measured by the beta coefficient, which is a relative measure of the relationship between an asset’s return and the market return
 Diversifiable risk (unystematic risk)
 CAPM: Kj=R_{F}+b_{j}*(kmR_{F})
 Security Market Line (SML): The required returns on all stocks are graphed against their corresponding betas.
Sample Questions
6.1. Last year Mike bought 100 shares of Dallas Corporation common stock for $53 per share. During the year, he received dividends of $1.45 per share. The stock is currently selling for $60 per share. What rate of return did Mike earn over the year?
 11.7 percent
 13.2 percent
 14.1 percent
 15.9 percent
6.2. Which of the following is true regarding the beta coefficient?
 It is a measure of unsystematic risk
 A beta greater than one represents lower systematic risk than the market.
 Generally speaking, the higher the beta the higher the expected return.
 A beta of one indicates an asset is totally riskfree.
7. Accounting Basics; Financial Statement Analysis
I. The Balance Sheet

 Assets: The LeftHand Side
 The balance sheet is a snapshot of a firm’s accounting value as of a particular date. Assets are listed on the lefthand side, and liabilities and owners’ equity on the righthand side.
 Assets are things the firm owns – cash, marketable securities, machinery, etc. Assets can be tangible (e.g., machinery) or intangible (e.g., prepaid rent).
 Liabilities and Owners’ Equity
 Liabilities are amounts owed by the firm to others – notes payable, longterm debt, etc.
 Owners’ equity (sometimes called “shareholders’ equity”) is the difference between total assets and total liabilities.
 The Balance Sheet Equation: Total Assets = Total Liabilities + Owners’ Equity
 Net Working Capital
 Net working capital is the difference between the firm’s current assets and current liabilities.
 Net working capital can be positive or negative, but is usually positive in a healthy firm, since a positive value indicates that more liquid assets are available than shortterm liabilities are due over the next year.
 Liquidity
 The liquidity of an asset is measured by the speed with which it can be converted into cash without significant loss in value. There is a tradeoff between liquidity and foregone potential returns.
 Market Value versus Book Value
 The balance sheet values of a firm’s assets (book values) generally do reflect the historical cost of an asset.
 The current worth of an asset is its market value. Market value is the relevant value for financial decisions, because it is the market value of the firm that is reflected in share prices.
 Assets: The LeftHand Side
 The Income Statement
 The income statement measures the firm’s performance over a specified period of time.
 The income statement equation is: Revenues – expenses = net income.
 Net income divided by the number of shares outstanding is earnings per share (EPS).
 GAAP and the Income Statement
 Generally Accepted Accounting Principles (GAAP) require that revenue be recorded on the income statement when earned, or accrued, even if the actual cash inflow from payment has not occurred.
 Costs on the income statement are determined according to the matching principle; that is, costs are matched with the revenues they produce.
 Noncash items such as depreciation are reflected in expenses that are booked but for which no cash is actually paid out. This generally causes accounting income and cash flow to differ.
 Taxes
 The income statement measures the firm’s performance over a specified period of time.
Average vs. Marginal Tax Rates (An average tax rate is equal to total taxes paid divided by total taxable income; A marginal tax rate is the tax rate applied to the next dollar earned. The firm’s marginal tax rate is generally the relevant rate for financial decisionmaking.)
 Standardized Financial Statements The values in commonsize statements are standardized in order to facilitate comparison to common benchmarks.
 CommonSize Balance Sheets are prepared by presenting all statement values as a percentage of total assets .
 CommonSize Income Statements are prepared by presenting all statement values as a percentage of sales.
 Ratio Analysis
 ShortTerm Solvency, or Liquidity, Ratios measure the firm’s ability to meet shortterm obligations.
 Current Ratio = Current Assets/Current Liabilities
 Quick Ratio = (Current Assets – Inventory)/Current Liabilities
 Cash Ratio = Cash/Current Liabilities
 LongTerm Solvency Measures gauge the extent to which a firm uses debt financing rather than equity financing.
 Total Debt Ratio = (Total Assets – Total Equity)/Total Assets
 Times Interest Earned = EBIT/Interest
 Cash Coverage = (EBIT + Depreciation)/Interest
 Asset Management, or activity, Measures indicate how effectively the firm’s managers use the assets under their control. Generally, higher turnover measures suggest greater efficiency.
 Inventory Turnover = Cost of Goods Sold/Inventory
 Days’ Sales in Inventory = 365/Inventory Turnover
 Receivables Turnover = Sales/Accounts Receivable
 Days’ Sales in Receivables (Average Collection Period) = 365/Receivables Turnover
 Total Asset Turnover = Sales/Total Assets
 Profitability Ratios measure management’s ability to control expenses and, as a result, generate income from sales, from the firm’s asset base, or from the funds supplied by equityholders.
 Net Profit Margin = Net Income/Sales
 Return on Assets = Net Income/Total Assets
 Return on Equity = Net Income/Total Equity
 Market Value Measures integrate marketbased values with accounting values and, as a result, bring us closer to the measurement of the effects of managerial decisions on shareholder wealth.
 PriceEarnings Ratio = Price per Share/Earnings per Share
 MarkettoBook Ratio = Market Value per Share/Book Value per Share
 ShortTerm Solvency, or Liquidity, Ratios measure the firm’s ability to meet shortterm obligations.
 The Du Pont Identity is a means of decomposing ROE into its component parts. It suggests that ROE is a function of those decisions which impact profitability, asset utilization, and financial leverage. The Du Pont identity is computed as follows: (Net Income/Sales) (Sales/Assets) (Assets/Total Equity).
 Using Financial Statement Information
 Why Evaluate Financial Statements? Financial statement analysis is crucial to an understanding of firm performance, both in terms of what the firm has done in the past, and what the firm is likely to do in the future.
 Internal Uses of financial statement analysis include: evaluation of managerial performance via the evaluation of the effects of management decisions on firm variables (e.g., profitability, sales growth), and planning for the future.
 External Uses of financial statement analysis include analyses performed by creditors and potential investors, evaluation of competitor firms, and performance assessment for the purpose of acquiring another firm.
 Choosing a Benchmark
 TimeTrend Analysis is the comparison of current data with historical data. That is, past performance is the relevant benchmark.
 Peer Group Analysis involves comparison to firms that are similar to the firm being evaluated. In other words, the benchmark is the subject firm’s peer group.
 Problems with Financial Statement Analysis arise because there are no clear or universally accepted guidelines regarding the determination of optimal values for the ratios discussed above. Other potential difficulties that may arise in financial statement analysis include: (1) identification of comparable peer groups; (2) differences in accounting procedures; (3) differences in fiscal years for financial statements; and, (4) unusual events which have an impact on reported financial results. These problems, as well as differences in interpretation of the date, frequently result in differing opinions about a firm’s future performance.
 Why Evaluate Financial Statements? Financial statement analysis is crucial to an understanding of firm performance, both in terms of what the firm has done in the past, and what the firm is likely to do in the future.
Sample Questions
7.1. Cash and equivalents are $1,561; shortterm investments are $1,052; accounts receivables are $3,616; accounts payable are $5,173; shortterm debt is $288; inventories are $1,816; other current liabilities are $1,401; and other current assets are $707. What is the amount of total current liabilities?
 $8,752
 $6,974
 $6,862
 $6,574
7.2. CatchaTan Co. had net sales of $750,000 over the past year. During that time, average receivables were $150,000. Assuming a 365day year, what was the average collection period? 
a. 5 days 
b. 36 days 
c. 48 days 
d. 73 days 
 Capital Budgeting Basics
Decision Rules
 Calculate, interpret, and evaluate the payback period.
 Apply net present value (NPV) and internal rate of return (IRR) to relevant cash flows to choose acceptable capital expenditures.
 Use net present value profiles to compare NPV and IRR techniques in light of conflicting rankings.
Estimating Incremental Cash Flows
 Understand basic capital budgeting terminology.
 Independent vs. Mutually Exclusive Projects
 Unlimited Funds vs. Capital Rationing
 Conventional vs. Nonconventional Cash Flow Patterns
 Incremental cash flow
 Determine relevant cash inflows using the income statement format (Free Cash Flow=EBIT(1tax rate)+depreciationchange in net working capitalnet capital spending
Sample Questions
8.1. Consider the following fouryear project. The initial aftertax outlay or aftertax cost is $1,000,000. The future aftertax cash inflows for years one, two, three, and four are $400,000, $300,000, $200,000, and $200,000, respectively. What is the payback period without discounting cash flows?
a. 2.5 years
b. 3.0 years
c. 3.5 years
d. 4.0 years
8.2. Dweller Inc. is considering a fouryear project that has an initial aftertax outlay or aftertax cost of $80,000. The future aftertax cash inflows from its project are $40,000, $40,000, $30,000, and $30,000 for years one, two, three, and four, respectively. Dweller uses the NPV method and has a discount rate of 12%. Will Dweller accept the project?
a. Dweller accepts the project because the NPV is greater than $30,000
b. Dweller rejects the project because the NPV is less than $4,000
c. Dweller rejects he project because the NPV is $3,021
d. Dweller accepts the project because the NPV is greater than $28,000