Corporate Finance – exam summary
Chapter 1
Difference between accounting and finance
Accounting: records the past and works with real amounts
Finance: discounting future cash flows and works with forecasts
Corporate Finance is the study of ways to answer these questions:
- Investment: what long-term investments will you make?
- Financing: where will you get long-term financing for your long-term projects?
- Liquidity: how will you manage your everyday activities?
The Financial Manager, responsible for answering the three questions instead of the owner
Capital Budgeting: responsible for investment decisions
Capital Structure: responsible for financing decisions, think of how much should the
firm borrow and what mixture of debt and equity is best?
Working Capital Management: responsible for short-term financial planning, day-to-
day activity to ensure that the firm has sufficient resources to continue its operations
Also, oversee accounting and audit function in the firm, and ensure financial welfare
Goal of financial management: make money or add value for the owners (shareholders)
Profitability (most important), liquidity, security, independence
Stock markets
Important because it can inform management of the performance of competitors, suppliers,
customers and economy. Financial markets facilitate flow of money from those that have
surplus cash to those that need financing.
Primary vs. Secondary markets
Primary market refers to original sale of securities governments and corporations, secondary
markets are those in which these securities are bought and sold after the original sale.
Primary market: securities are sold to investors, money that is raised goes to issuing
firm, first share issue is called an Initial Public Offering, second share issue is called a
seasoned offering
Secondary market: investors trade securities with each other, money that is raised
goas to seller of securities, share prices
Dealer: agent who buys and sells securities from inventory
Broker: agent who arranges security transactions among investors
Chapter 3
The annual report presents three financial statements and is released every year:
1. Statement of financial position / balance sheet
2. Income statement
3. Statement of cash flows
, 1. Statement of financial position / balance sheet
Assets: non-current (does not turn into cash within a year) and current (will turn into
cash within a year)
Liabilities: non-current (not due in the coming year) and current (must be paid within
this year)
Shareholders’ equity: also called owners’ equity, is the difference between total assets
and total liabilities
Balance sheet equation
Assets = liabilities + shareholders’ equity
Net Working Capital: the difference between a firm’s current assets and its current
liabilities. NWC is positive when current assets exceed current liabilities, meaning that the
cash that becomes available within 12 months is more than the cash that must be paid over
the same period. Important to ensure that NWC is positive.
Book value: based on accounting figures and standards, often used in balance sheet
Market value: based on prices or market valuations
For current assets, market and book value will be somewhat similar because they are
bought and converted into cash over a short span of time.
2. Income Statement: measures performance over some period of time
Revenues – expenses = income
Net income is often expressed on a per-share basis and is called earnings per share
(EPS)
Expenses are based on matching principle: revenue is realized at the time of sale
Non-Cash Items: e.g. depreciating
EPS = Net Income / Total shares outstanding
Average Tax Rates: % of income that is paid in taxes > tax bill divided by taxable income
Marginal Tax Rate: tax you would pay if you earn one more unit of currency
Average Tax Rate = (0.15 x 200,000 + 0.20 x 40,000) / total taxable income
^ example numbers used
3.Cash Flow Statement: difference between cash that came in and cash that went out
Often most important item
Total Cash Flow comes from operating, investing and financing activities
Cash Flow does not equal Working Capital, cause CF is over a period of time instead
of snapshot
Cash Flow does not equal Profit, cause depreciation decreases profit but not CF
Ratio Analysis
Financial ratios are used to analyze and compare performance of a company
Profitability Ratios:
1. Profit margin = Net Income / Sales (operating efficiency)
2. Return on Asset = Net Income / Total Assets (asset use efficiency)
3. Return on Equity = Net Income / Total Equity (equity efficiency)
, Financial Leverage Ratios:
1. Debt-Equity Ratio = Debt / Equity
2. Total Debt Ratio = Debt / Debt + Equity (or Total Assets)
3. Equity Multiplier = Total Assets / Equity
Market Value Ratios:
1. Earnings Per Share (EPS) = Net Income / Shares outstanding
2. Price Earnings Ratio (PE Ratio) = Price per Share / EPS
The Du Pont Identity > way of analyzing financial performance
ROE = Net Income / Equity
Why is a positive ROE always larger than ROA? Cause the equity multiplier is > 1
ROE = ROA x (assets/equity)
Using Financial Statement information
Why do we evaluate financial statements? Because we do not have market value
information and we want to know more.
Internal uses: performance evaluation, compare performance of multiple divisions
within a company, planning for the future, financial decision making
External uses: useful to parties outside the firm like creditors or potential investors,
because it is a prime source of information about a firm’s financial health. Also used
for evaluating main competitors and identifying potential targets. Lastly, for reporting
for tax and authorities.
When evaluating a firm based on financial statements, what is the standard of comparison?
1. Time Trend Analysis: standard based on history, e.g. past 10 years.
2. Peer Group Analysis: standards based on firms that are similar in the same market,
assets or operations. Identify a peer group. However, difficult because no
companies are identical.
Problems with Financial Statement Analysis
Basic problem: there is no theory to help us identify what to look at or guide us in
establishing standards. There is little help with financial statements, so we can’t say
what ratio or value matters the most.
Peer Group Analysis only works when the firms are strictly in the same line.
The existence of different standards and procedures makes it difficult to compare
financial statements across national borders.
Different firms use different accounting procedures > difficult to compare statements.
Fluctuations around the year, e.g. firms in seasonal businesses (ice cream shop) >
difficult to compare statements of financial position.
Unusual events such as one-time profit from asset sale may affect performance and
give misleading signals.
Conclusion: difficult to compare statements because of many different reasons.
Chapter 4
