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Finance and Risk Management summary
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Summary of all the lecture material and relevant literature. Includes sample quiz questions, all tutorial answers and sample questions from Connect.
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LECTURE 1: CORPORATE FINANCE & FINANCIAL STATEMENT ANALYSIS - CH 1,2&3Corporate finance: making decisions regarding what assets to buy/sell and when to buy/sell those assets
1. Investment: what long term investments will you make?
○ Timing: cash outflows today to generate future cash inflows
2. Financing: where will you get long-term financing for your long term projects?
○ Timing: cash inflows today and cash outflows in the future in order to meet obligations
3. Liquidity: how will you manage your everyday activities?
○ Timing: balance of cash inflows and outflows in the short-term
The goal of financial management (manage risk, maximize share price, avoid financial distress): to
maximize value of owner’s equity (market value of shareholdings)/current value per share of existing
equity
Financial management: keep track of the cash that comes in and goes out of the business, corporate
decisions:
1. Capital budgeting: the process of planning and managing a firm’s long-term investments
a. Size, timing, and risk of cash flows, value>costs
2. Capital structure: the mixture of long-term debt (borrowing) and equity (owners’ investment)
maintained by a firm → How to finance long term investments? How much should the firm
borrow? What are the least expensive sources of funds for the firm? Find the best possible
capital structure > least expensive
3. Working capital management: the management of a firm’s short-term assets and liabilities →
how to operate the firm? How much short-term cash flow does a company need to pay its bills?
How much cash do we have? Do we sell on credit? How do we obtain short-term financing?
Financial analysis: cash flow is the main valuation input of the stock of the company
Forms of business organization: The corporation: business created as a distinct legal entity composed of
one or more individuals or entities
- Advantages : unlimited life, easy transfer of ownership, limited liability, increased access to
funding: capital markets, easier to borrow money
- Disadvantage: double taxation on owners -firm pays taxes on profit, owner pays taxes on income
Sole proprietorship: business owned by a single individual
- Advantages: easiest way, owner can make all decisions, profit is all yours
- Disadvantages: finance everything, unlimited liability, business dies if owner dies
Partnership: business formed by two or more individuals or entities
- General or limited partners
- Same (dis)advantages + difficult to change partners (except for limited partnership
Managerial vs shareholder goals
- Corporation is a set of contracts
- Agency relationship: contract between shareholders & managers
- Separation of control and management
- Financial goal: maximize shareholder’s wealth
, - Managerial goal can be different from shareholder’s wealth maximization
- Conflict of interest may arise between controlling and minority shareholders→ agency
problems
Corporate governance: system created to provide a solution to agency problems - transparency, timely
information disclose, thus though creates extra costs
- Monitor management behavior - agency costs
- Devise contracts that align the incentives of managers to those of shareholders:
- Managerial compensation plans
- Threats of termination of employment
- Threats of takeover
CASH FLOWS FROM OPERATIONS
● The most important item to take from financial statements
● Cash flow is not the same as net working capital
● Cash flow from assets = cash flows to creditors and equity investors
● Total cash flow comes from operating activities, investing activities and financing activities
● What are the distributions to shareholders by a corporation called? Dividends
Dividend, shareholder’s claim is paid from net income. The rest of net income goes to retained earnings
Raising capital: companies raises cash they need for their operation from investors by utilizing financial
markets
Types of financial markets - classification by the maturity of assets:
1. Money market: assets will mature within 1 year
2. Capital market: assets will mature in over 1 year
Types of financial markets - classification by owners of assets:
1. Primary market: first sale market where company receives cash
a. Corporations raise external funds through financial assets, such as stocks and bonds
b. Market for new issues
2. Secondary market: after sale market
a. The sale of securities from one investor to another; they trade those securities among
themselves to convert them to money.
b. Provide the means for transferring ownership of corporate securities
c. Are as important as primary markets because investors are much more willing to
purchase securities in a primary market transaction when they know they can resell
those securities if desired.
d. Auction market (physical), dealer market (electronic)
,Managers should not focus on the current equity value because doing so will lead to an overemphasis on
short-term profits at the expense of long-term profits.
Role of treasurer:
- Cash manager
- Credit manager
- Capital expenditures
- Financial planning
Role of controller:
- Tax manager
- Cost accounting manager
- Financial accounting manager
- Data processing manager
working capital management:
- the amount of cash the firm should keep on hand
- The amount of inventory the firm should keep on hand
- Sources of short-term financing
- The credit terms that should be offered
- Determining whether to pay cash for a purchase or use the credit offered by the supplier
NOT the amount of stock the firm should issue
- NOT The decision to begin development of a new product
capital structure decision
- Choosing among various sources of funding
- Planning for the future of the firm in terms of capital needs and sources of funding
- Deciding whether or not the firm should issue stock
- Deciding how much the firm should borrow
- NOT Optimizing the mix of company sales versus bad debt losses
- NOT Deciding whether or not to extend credit to a new customer
part of the financial planning process:
- Planning for the future of the firm in terms of capital needs and sources of funding
- Deciding how much the firm should borrow
- Choosing among various sources of funding
- Identifying which of the firm's long-term investment opportunities will increase the value of
the firm
- NOT Preparing the tax returns for the firm
- NOT Deciding whether or not to extend credit to a new customer
capital budgeting function:
- whether or not to open a new store.
- whether or not to buy a major piece of equipment.
- whether or not to develop a new product.
- whether or not to expand into a foreign country.
- NOT whether or not to issue new shares of stock to fund operations.
- NOT whether or not to issue credit to a new customer.
, LECTURE 2: CASH FLOWS, FINANCIAL RATIOS, TIME VALUE OF MONEY - CH 3, 4 & 5
Investing and Financing Cash flows (Chapter 3)
● Cash flow from assets = operating cash flows (OCF) + investing activities
● Investing activities = - capital expenditures + other investing activities
○ Capital expenditures reduce cash flows since it is a cash outflow, hence the negative sign
○ If there is a sale of other fixed assets, it will be cash inflows
● - capital expenditures = net fixed assets 2015 - net fixed assets 2014 + depreciation 2015
○ To remove the effect of increasing in Accumulated Depreciation because of current
year’s depreciation
● - capital expenditures = gross fixed assets 2015 - gross fixed assets 2014
● Total cash flow = cash flow from operating activities + cash flow from investing activities + cash
flow from financing activities
● The balance sheet identity; Cash flows from assets = cash flows from financing activities
○ One of these two can be negative indicating cash payments to either creditors or
shareholders
○ If cash flows from assets is negative it indicates a need for outside financing which
should be raised from creditors and/or shareholders
○ It is also possible that the fir increased cash and cash equivalents
● Cash flow from financing activities = cash flow from/to creditors + cash flow from/to
shareholders
● Cash flow from/to creditors = changes in long term debt (LTDt - LTDt-1) - interest expense
○ Increase/positive LTD: raising new debt / collecting cash from cerditos
○ Decrease /negative LTD: paying the existing debt
● Cash flow from/to shareholders = changes in common stock (CS t - CS t-1) - dividends
○ Increase CS: issuing shares, new equity financing
○ Decrease CS: repurchasing shares, reducing equity financing
○ Positive result indicates cash flows (collected) from creditors/shareholders
○ Negative result indicates cash flows (paid) to creditors/shareholders
Financial Ratios (Chapter 3)
Financial ratio analysis helps financial managers (or even investors) to understand how healthy a
company is and how well it has performed, it is used for comparison purposes.
A ratio is one financial item divided by another. Single values, such as total assets or net income do not
provide a reasonable comparison.
Liquidity/short-term solvency ratios: can the company meet its obligations over the short term?
● Current ratio = current assets / current liabilities
● Quick ratio = (current assets - inventory) / current liabilities → better indication than current
● Cash ratio = cash and cash equivalents / current liabilities
Financial leverage/long-term solvency ratios: can the company meet its obligations over the long term?
● Total debt ratio = (total assets - total equity) / total assets
● Debt-equity ratio = total debt /total equity
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