Exit Exam Finance Review

Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Stock & Bond Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Risk, Return and Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Capital Asset Pricing Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Working Capital Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Capital Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Financial Statement Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Time Value of Money

▪ Discounting (finding a PV) – moving back on the time line

▪ Compounding (finding a FV) – moving forward on the time line

▪ Sooner is better - $5,000 received today is better than $5,000 received one year from today

▪ Annuity (equal payments for a fixed period)

▪ Annuity Due (Payments are at the beginning of the period)
▪ Ordinary Annuity (Payments are at the end of the period)

▪ Perpetuity (equal payments for an infinite period)

Compounding facts:

▪ The more frequent interest is compounded, the higher the future value

▪ The more frequent interest is compounded, the lower the present value

▪ Savers prefer more frequent compounding (receiving more in the future)

▪ Borrowers prefer less frequent compounding (pay less in the future)

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Stock Valuation
Discounted Cash Flow (Constant Growth Model): Price of stock = PV( ∞ dividends)= D1/r-g
Stock price depends on: Dividends, rate of return and growth

The constant growth stock valuation model can be rewritten as:

𝑃𝑜=𝐷1/(𝑟−𝑔) 𝑟= 𝐷1/𝑃𝑜+𝑔%

Next year’s annual dividend divided by the current stock price (the first term) is called the dividend yield.

The rate at which a stock’s price is expected to appreciate or depreciate (the second term or g%) is called
the capital gains yield.

Investors TOTAL return is the sum of the dividend yield and capital gains yield (r%). Investors make
money from both receiving dividends and having the stock price appreciate.

Stock facts:

▪ Ownership position - residual claim on assets and income (last in line)

▪ Limited liability
▪ Variable dividends
▪ Voting rights

Bond Valuation

0---------------------1-----------------2-----------------3--------------------4
+PMT +PMT +PMT +PMT
+FV

PV = bond price

Bond facts:

▪ Creditor position – priority claim on assets and income (first in line)

▪ Coupon rate generally FIXED over life (PMT=coupon rate*par value)
▪ Required return CHANGES over life = f (economy, inflation, industry, company-specific risk)
▪ Inverse relationship between interest rate changes and price of bond
▪ No voting rights
▪ Some may have a call provision (allows the firm to call back the bond & refinance if rates fall)
▪ Some may have a sinking fund (requires firm to repay principle periodically)
▪ Some may be convertible into common stock at predetermined ratio (upside return potential)

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Risk, Return, Diversification

Risk can be broken down into two components:

1. Market Risk (systematic, non-diversifiable)

▪ Cannot be eliminated by holding a portfolio

▪ Caused by general market (economic) movements, and since this affects all companies and
their stock values similarly, it cannot be shed away.
▪ Measured by Beta.

2. Unique Risk (non-systematic, diversifiable, firm-specific)

▪ Caused by events specific to that firm.

▪ Can be eliminated by holding a portfolio.
▪ The more negatively correlated two assets are, the more risk can be shed
▪ Need 20-30 stock portfolio for sufficient diversification
______________________________________________________________

1 + 2 = Total Risk

If you hold a stock by itself, you are subject to both risks – you can measure a stock’s total risk by
standard deviation. Standard deviation measures volatility, without regard to what caused the
stock price to move. Since unique risk can be eliminated by simply holding a portfolio, the
market does NOT compensate investors for bearing that risk. Only systematic risk matters. How
do we measure systematic risk? Beta! The CAPM specifies the relationship between “relevant
risk” – beta – and a stock or portfolios expected return.

Capital Asset Pricing Model

▪ Specifies relationship between a beta (risk) and return

▪ Ki = Krf + (KM – Krf)Bi

▪ SML = Security Market Line is graph of CAPM equation

Some facts about Beta

▪ Measures tendency of a security to move with the market → market risk!

▪ Compute by regression of historical company returns vs. historical “market” returns
▪ Regression produces Characteristic Line; slope of Characteristic Line = Beta
▪ Beta of a risk-free asset = 0
▪ Beta of the overall market = 1
▪ Beta of a portfolio (Bp) is simply a weighted average of individual security betas.

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Working Capital Management
Balance Sheet

Cash & marketable securities Accounts payable

Accounts receivable Accruals
Inventories Notes payable
Current assets Current liabilities

Gross plant & equipment Long-term debt

-Accumulated depreciation Bonds
Net plant and equipment
Preferred stock
Common stock
Retained earnings

TOTAL ASSETS TOTAL LIAB & EQUITY

Net Working Capital = NWC = CA- CL

CA represent a USE of cash (you must pay for them)

CL represent a SOURCE of cash (you are borrowing)
Generally CA > CL, so NWC is + and is a USE of cash that must be funded

Capital Budgeting
The goal is to come up with a time line of cash flows that you can apply NPV, IRR, etc. in order to
determine whether the project (fixed assets – plant & equipment) should be accepted or rejected.

0----------1-----------------2-----------------3--------------------4
+OCF +OCF +OCF +OCF → I.S.
-NCS +ATSV → B.S.
-NWC +NWC → B.S.

Independent Mutually exclusive

Payback = # Accept if
years to recover PB < prespecified cutoff Accept project with fastest payback
project’s cost given PB < prespecified cutoff

NPV = PV cash Accept if Accept project with largest NPV

inflows – PV NPV > 0 given NPV > 0
cash outflows
IRR - % rate of Accept if Accept project with largest IRR
return project is IRR > % required return given IRR > % required return
earning

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Capital Structure
Capital structure refers to the mix of debt and equity (e.g. 30% debt, 70% equity). The use of debt is
oftentimes referred to as financial leverage. The more debt, the more financial leverage. Debt can be
short-term or long-term.

Advantages of using debt

▪ Debt is cheaper than stock (lower risk investment to consumer)
▪ Interest payments are tax-deductible (even cheaper!)

Disadvantages of using debt

▪ Required interest payments, if not made, can cause bankruptcy

Goal is to find capital structure that maximizes firm value

Financial Statement Analysis

Income Statement Statement of Cash Flows
Sales
-Cost of goods sold CF from operating activities
Gross profit NI, Depr, ∆CA, ∆CL
-Operating expenses (mkt, advert,..) CF from investing activities
-Depreciation expense ∆FA
Operating profit = EBIT CF from financing activities
-Interest expense ∆NP, ∆LTD, ∆EQ
Earnings before taxes = EBT Net increase in cash
-Taxes
Net Income → Common dividends
→ Additions to retained earnings
Liquidity– Ability to meet short-term obligations as they come due
Current Ratio = CA / CL
Quick Ratio = (CA-INV) / CL

Debt Management (Financial Leverage) – Use of debt in the capital structure

Total Debt Ratio = TD / TA
Debt/Equity Ratio = TD / TE
Equity Multiplier = TA / TE
TIE = EBIT / Interest expense

Asset Management – Efficient or effective use of assets

Inventory Turnover = COGS / INV
Days’ Sales in Inventory = 365 / INVTURN
Receivables Turnover = SALES / AR
Days’ Sales in Receivables = 365 / RECTURN
Fixed Asset Turnover = Sales / FA
Total Asset Turnover = Sales / TA

Profitability
Net Profit Margin = NI / S
Return on Assets (ROA) = NI / TA
Return on Equity (ROE) = NI / TE
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