Summary
# Introduction to finance and the goal of the firm
This topic introduces the core concepts of finance, its application in personal and corporate contexts, and the ultimate goal of maximizing shareholder wealth while considering stakeholder welfare and ethical practices.
## 1. Introduction to finance and the goal of the firm
Finance is fundamentally the art and science of managing money.
### 1.1 Personal finance
At the individual level, finance concerns decisions about:
* How much of their earnings individuals spend and save.
* How individuals invest their savings.
### 1.2 Business finance
In a business context, finance involves:
* How firms raise money from investors.
* How firms invest money to generate profits.
* How firms decide whether to reinvest profits or distribute them to investors (allocation).
### 1.3 The goal of the firm
The primary goal of a firm is to **maximize shareholder wealth**. In most cases, this is equivalent to maximizing the stock price.
#### 1.3.1 Maximizing stakeholders' welfare
Some suggest a balanced consideration for the welfare of all stakeholders, including:
* Employees
* Suppliers
* Customers
* Local communities
Managers should consider the long-term consequences of their actions and operate within legal and ethical boundaries.
#### 1.3.2 Profit maximization versus stock price maximization
Profit maximization does not always lead to the highest possible share price due to:
* **Timing of earnings:** When earnings are received matters.
* **Cash flows:** Actual cash generated is more critical than accounting profit.
* **Risk:** Higher risk can negatively impact stock price, even with higher profits.
**Example:**
Nick Dukakis, financial manager at Neptune Manufacturing, was comparing two investments, Rotor and Valve. Valve resulted in higher total earnings per share over three years ($3.00 compared to $2.80 for Rotor). If the decision was solely based on maximizing profits, Valve would be chosen. However, the timing of earnings and their associated risks would influence the ultimate decision for shareholder wealth maximization.
### 1.4 The role of business ethics
Business ethics refers to the standards of conduct and moral judgment in commerce. These standards aim to ensure adherence to the spirit and letter of laws and regulations.
**Ethical Guidelines for Decision Making:**
* Does the action violate the moral or legal rights of any individual or group?
* Does the action conform to accepted moral standards?
* Are there less harmful alternatives available?
### 1.5 The managerial finance function
The managerial finance function is responsible for key financial decisions:
#### 1.5.1 Investment decisions (Capital Budgeting Decisions)
These decisions involve selecting the assets and projects in which the firm should invest.
#### 1.5.2 Financing decisions (Capital Structure Decisions)
These decisions involve determining the mix of debt and equity a firm uses to finance its activities, including the percentage of debt.
#### 1.5.3 Working capital decisions
These decisions relate to the management of a firm's short-term resources such as inventory, accounts payable, and accounts receivable.
### 1.6 Financial activities and the balance sheet
A **balance sheet** is a financial statement that reports a company's assets, liabilities, and shareholder equity at a specific point in time.
### 1.7 The principal-agent problem
This problem arises when the owners of a firm (principals) and its managers (agents) are not the same people, and the agent's interests may not align with the principal's. This is particularly relevant in large corporations with a significant separation between ownership and management.
### 1.8 Relationship to accounting
* **Accounting** uses an **accrual basis**, recognizing revenue when sales are made and expenses when incurred, regardless of cash receipt or payment.
* **Finance** focuses on **cash flows**, recognizing revenues and expenses only when cash is actually received or paid.
**Example:**
Nassau Corporation sold a yacht for $1,000,000 on credit. While accounting recognized revenue and profit, the lack of cash collection presented a significant financial problem, highlighting the critical difference between accounting profit and financial cash flow.
### 1.9 Legal forms of business organizations
* **Sole Proprietorships:** Owned by one person, with unlimited liability.
* **Partnerships:** Owned by two or more people, with potential for unlimited liability for each partner.
* **Corporations:** Legal entities distinct from their owners (stockholders), with limited liability for stockholders (up to their investment).
### 1.10 Taxation
* Proprietorships and partnerships are taxed at individual income tax rates.
* Corporations are taxed at corporate tax rates, potentially leading to double taxation on profits and dividends.
* Interest payments are tax-deductible for corporations, reducing their taxable income.
**Example:**
Debt Co. paying interest reduces its taxable income compared to No-Debt Co., leading to different after-tax earnings.
### 1.11 Corporate governance
Corporate governance involves the laws and rules by which companies are operated, controlled, and regulated, including mechanisms like the board of directors, stock options, and external regulations.
> **Tip:** Understanding the fundamental difference between accounting profit and financial cash flow is crucial. A profitable company from an accounting perspective can still face severe financial distress if it lacks sufficient cash flow.
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# Financial management functions and organizational structure
Financial management encompasses the key decisions financial managers make regarding investment, financing, and working capital, and how the finance function is structured within a company, highlighting its relationship with accounting.
### 2.1 Financial managers' key decisions
Financial managers are responsible for a range of critical decisions that influence a firm's profitability and value. These decisions can be broadly categorized into investment, financing, and working capital management.
#### 2.1.1 Investment decisions
Investment decisions, often referred to as capital budgeting, involve the selection of long-term assets that are expected to generate future benefits for the firm. This process requires careful evaluation of potential projects to ensure they align with the goal of maximizing shareholder wealth.
* **Relevant cash flows:** The core of investment decisions lies in identifying and evaluating the incremental cash flows associated with a project. These are the additional cash inflows and outflows expected to result from undertaking a capital expenditure.
* **Initial Investment (CF0):** This represents the net cash outflow required at time zero to acquire a new asset. It includes the purchase price of the asset, installation costs, and any changes in net working capital, adjusted for any after-tax proceeds from the sale of old assets.
* **Operating Cash Flows (CF1, CF2, ...):** These are the incremental after-tax cash flows generated from the project's normal business operations over its life. They are calculated by starting with earnings before interest and taxes (EBIT), subtracting taxes, and then adding back non-cash charges like depreciation.
* **Terminal Cash Flow:** This is the after-tax cash flow that occurs in the final year of a project's life, typically resulting from the liquidation of the project's assets and the reversion of any initial investment in net working capital.
* **Sunk Costs vs. Opportunity Costs:** When evaluating investment decisions, it's crucial to distinguish between sunk costs and opportunity costs.
* **Sunk Costs:** These are past cash outlays that cannot be recovered and have no bearing on future decisions. They should be excluded from the incremental cash flow analysis.
* **Opportunity Costs:** These are potential cash flows that could be realized from the best alternative use of an owned asset. They represent a lost benefit and should be included as a cash outflow in the investment analysis.
#### 2.1.2 Financing decisions
Financing decisions concern how a firm raises the capital needed to fund its operations and investments. This involves determining the optimal mix of debt and equity, known as the capital structure.
* **Capital Structure:** This refers to the proportion of debt and equity a firm uses to finance its assets. The optimal capital structure aims to minimize the firm's overall cost of capital, thereby maximizing its value.
* **Cost of Debt:** This is the interest rate a firm pays on its borrowings. It is typically lower than the cost of equity due to lower risk for lenders and the tax deductibility of interest payments (after-tax cost of debt = before-tax cost of debt $\times (1 - T)$).
* **Cost of Equity:** This is the return required by shareholders for their investment in the firm. It is generally higher than the cost of debt due to the higher risk borne by equity holders. It can be estimated using models like the Capital Asset Pricing Model (CAPM).
* **Weighted Average Cost of Capital (WACC):** This represents the firm's overall cost of financing, calculated as a weighted average of the costs of its various capital components (debt, preferred stock, common stock), with weights based on their market value proportions in the capital structure. $$r_{WACC} = (w_d \times r_d) \times (1 - T) + (w_p \times r_p) + (w_s \times r_s)$$
* **Factors influencing capital structure:** Management must balance the benefits of debt (tax shield) against its costs (increased financial risk, bankruptcy costs, agency costs).
#### 2.1.3 Working capital management
Working capital management focuses on the efficient management of a firm's short-term assets and liabilities to ensure it can meet its short-term obligations and operate smoothly.
* **Net Working Capital:** Defined as current assets minus current liabilities, it represents the firm's investment in short-term operating assets.
* **Profitability-Risk Tradeoff:** A fundamental tradeoff exists between profitability and risk in working capital management. Lowering current asset levels generally increases profitability (by reducing financing costs) but also increases risk (by raising the likelihood of stockouts or an inability to meet short-term obligations).
* **Cash Conversion Cycle (CCC):** This measures the length of time a firm's cash is tied up in its operating cycle. A shorter CCC implies more efficient working capital management.
* **Operating Cycle (OC):** The time from the beginning of the production process to the collection of cash from the sale of the finished product. $OC = Average Age of Inventory (AAI) + Average Collection Period (ACP)$.
* **Cash Conversion Cycle (CCC):** The length of time between paying for raw materials and receiving cash from receivables. $CCC = OC - Average Payment Period (APP)$.
* **Strategies for managing the cash conversion cycle:**
* **Inventory Management:** Turning over inventory quickly to minimize carrying costs and financing needs, often using techniques like the Economic Order Quantity (EOQ) model.
* **Accounts Receivable Management:** Collecting receivables as quickly as possible by setting appropriate credit standards, terms, and monitoring collection efforts.
* **Accounts Payable Management:** Paying suppliers as late as possible within the credit terms to maximize the use of interest-free financing from suppliers.
### 2.2 Organization of the finance function
The finance function within a company is typically organized to oversee financial activities, reporting to senior management and interacting with other departments, particularly accounting.
* **Chief Financial Officer (CFO):** The top financial executive responsible for all financial activities.
* **Key roles reporting to the CFO often include:**
* **Treasurer:** Manages the firm's cash, credit, and financial assets, including the firm's relationships with banks and other financial institutions.
* **Controller:** Manages the firm's accounting activities, including cost accounting, financial accounting, and tax accounting.
* **Director of Risk Management:** Oversees the identification and management of financial risks.
* **Director of Investor Relations:** Manages communication with shareholders and the financial community.
* **Director of Internal Audit:** Reviews the firm's internal controls and accounting procedures.
* **Foreign Exchange Manager:** Manages the firm's exposure to currency fluctuations.
### 2.3 Relationship to accounting
The finance function relies heavily on accounting data but has a distinct focus.
* **Accounting:** Primarily uses the **accrual basis** of accounting, recognizing revenues when earned and expenses when incurred, regardless of when cash is actually received or paid. Accountants focus on the collection and presentation of past financial data.
* **Finance:** Primarily uses **cash flows** for decision-making. Financial managers use accounting statements to develop forecasts and make decisions based on future expected returns and risks. They are forward-looking, whereas accountants are primarily backward-looking.
* **Key Difference Illustrated:** A company might report a profit on its income statement (accrual basis) but have a severe cash shortage if its customers have not yet paid for their purchases (cash basis), highlighting the critical distinction for financial decision-making.
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# Legal forms of business organizations and taxation
This topic explores the various legal structures businesses can adopt and how these structures are treated for tax purposes in the United States.
## 3. Legal forms of business organizations and taxation
### 3.1 Legal forms of business organizations
Businesses can be organized into several legal forms, each with distinct characteristics regarding ownership, liability, and taxation.
#### 3.1.1 Sole proprietorships
A sole proprietorship is a business owned and operated by a single individual for profit.
* **Unlimited liability:** Creditors have the right to claim against the owner's personal assets to recover business debts.
* **Taxation:** Profits are taxed according to a progressive rate structure, typically ranging from $10\%$ to $37\%$.
#### 3.1.2 Partnerships
Partnerships are businesses owned and operated by two or more individuals for profit.
* **Articles of partnership:** A written contract formally establishes the partnership.
* **Liability:** Each partner is legally liable for all business debts.
* **Taxation:** Similar to sole proprietorships, profits are taxed according to a progressive rate structure ($10\%$ to $37\%$).
#### 3.1.3 Corporations
Corporations are legal entities distinct from their owners, with rights and duties similar to individuals.
* **Stockholders:** Owners of the corporation, whose equity is represented by shares of stock.
* **Limited liability:** Stockholders' liability for corporate debt is limited to the amount of their initial investment in the stock.
* **Dividends:** Periodic distributions of cash to stockholders.
* **Board of Directors:** Elected by stockholders to oversee corporate strategy and operations.
* **Taxation:** Corporations are taxed at a flat rate of $21\%$.
#### 3.1.4 Taxation and double taxation
In the U.S., sole proprietorships and partnerships are taxed at progressive rates, while corporations are taxed at a flat rate. A significant characteristic of corporations is **double taxation**. This occurs because profits are taxed once at the corporate level, and then again at the individual level when dividends are distributed to shareholders.
> **Tip:** Understanding the difference in tax treatment is crucial when choosing a business structure, as double taxation can significantly impact overall profitability.
### 3.2 Key considerations for business forms
When selecting a legal structure, several factors must be considered:
* **Liability:** The extent to which the owner's personal assets are protected from business debts.
* **Taxation:** How the business profits will be taxed, including the impact of double taxation for corporations.
* **Fund-raising capacity:** The ease and extent to which the business can raise capital.
* **Control and management:** The structure of decision-making and operational control.
* **Continuity:** The business's lifespan and its continuation after the owner's departure or death.
### 3.3 Comparison of tax treatments
| Business Form | Tax Rate Structure | Double Taxation |
| :------------------- | :---------------------------------------- | :-------------- |
| Sole Proprietorship | Progressive ($10\%$ to $37\%$) | No |
| Partnership | Progressive ($10\%$ to $37\%$) | No |
| Corporation | Flat rate ($21\%$) | Yes |
#### 3.3.1 Example of tax calculation for a sole proprietor
Consider Dan Webster, a sole proprietor with $80,000$ dollars in business income and no other income. His tax liability would be calculated based on the progressive tax brackets.
* **Tax calculation:**
* $0.10 \times \$9,525$ (for the first tax bracket)
* $0.12 \times (\$38,700 - \$9,525)$ (for the second tax bracket)
* $0.22 \times (\$80,000 - \$38,700)$ (for the third tax bracket)
* **Total taxes due:** Summing these amounts provides the total tax liability.
### 3.4 Distinction between ordinary income and capital gains
* **Ordinary income:** Income generated from the sale of goods or services.
* **Capital gain:** Income earned from selling an asset for more than its cost. Both are taxed at the same rate.
> **Tip:** Interest payments made by a business are tax-deductible, which can reduce the firm's overall tax liability. This is illustrated by comparing two corporations, Debt Co. and No-Debt Co., where Debt Co.'s interest expense reduces its taxable income.
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# Financial markets and institutions
Financial markets and institutions play a crucial role in the economy by facilitating the flow of funds between savers and borrowers, and by providing essential financial services. This section delves into the definitions, functions, and types of financial markets and institutions, as well as key concepts related to valuation and financial analysis.
### 4.1 Types of financial markets
Financial markets are platforms where buyers and sellers transact financial securities. They can be broadly categorized based on the maturity of the instruments traded and how the securities are traded.
#### 4.1.1 Money markets
Money markets facilitate the trading of short-term debt instruments with maturities of one year or less. These markets are characterized by:
* **Short-term lending and borrowing:** Transactions typically involve short-term deposits, treasury bills issued by governments, commercial paper issued by businesses, and negotiable certificates of deposit issued by banks.
* **Low risk:** Due to their short maturity, money market investments are considered among the least risky investments available.
* **Examples:** The Eurocurrency market, based in London, deals with short-term bank deposits denominated in various currencies. Key interbank rates include LIBOR (London Interbank Offered Rate) and EURIBOR (EURo Interbank Offered Rate).
#### 4.1.2 Capital markets
Capital markets are where long-term debt and equity securities are traded, with maturities exceeding one year.
* **Long-term funds:** They enable suppliers and demanders of long-term funds to conduct transactions.
* **Key securities:** Bonds and stocks are the primary instruments traded in capital markets.
* **Bonds:** These are long-term debt instruments that represent a loan made by an investor to a borrower (typically a corporation or government). They typically pay a fixed coupon (interest) payment and return the principal at maturity.
* **Stocks (Shares):** These represent ownership interest in a corporation. Returns can come from dividends and capital appreciation.
* **Common Stock:** Basic ownership units, carrying voting rights.
* **Preferred Stock:** A hybrid security with features of both debt and equity, often paying a fixed dividend and having priority over common stock in liquidation.
#### 4.1.3 Primary vs. Secondary Markets
* **Primary Market:** This is where securities are initially issued. The issuer of the security (e.g., a company selling new stock or bonds) is directly involved in the transaction, raising funds from investors. This includes private placements (selling directly to investors) and public offerings.
* **Secondary Markets:** These markets facilitate the trading of previously issued securities among investors. The issuing company is not directly involved in these transactions. This is where most daily trading of stocks and bonds occurs.
#### 4.1.4 Broker Markets vs. Dealer Markets
* **Broker Markets:** These are organized exchanges (like the New York Stock Exchange - NYSE) where buyers and sellers are brought together to trade securities. Brokers act as agents, facilitating the transaction. Trading often occurs on centralized trading floors.
* **Dealer Markets:** These markets, like NASDAQ, do not have a centralized trading floor. Instead, securities dealers act as market makers, buying and selling securities for their own accounts. They profit from the bid-ask spread. Dealers are linked via telecommunications networks.
* **Bid Price:** The highest price a buyer is willing to pay for a security.
* **Ask Price:** The lowest price a seller is willing to accept for a security.
* **Bid-Ask Spread:** The difference between the ask and bid price, representing the dealer's profit margin.
### 4.2 Financial Institutions
Financial institutions act as intermediaries, channeling savings into loans or investments. They are crucial for the functioning of financial markets.
* **Commercial Banks:** These institutions accept deposits from savers and provide loans to individuals and businesses. Examples include Belfius, BNP Paribas Fortis, KBC, and ING.
* **Investment Banks:** These institutions assist companies in raising capital, advise on mergers and financial restructuring, and engage in trading and market-making activities. Examples include Goldman Sachs, HSBC, Merrill Lynch, and JPMorgan Chase & Co.
* **Shadow Banking System:** This refers to a group of institutions that engage in lending activities similar to traditional banks but do not accept deposits, thus operating under different regulatory frameworks.
### 4.3 Valuation Fundamentals
The fundamental principle of valuation is that the worth of an asset is the present value of its expected future cash flows.
* **Key Inputs for Valuation:**
* **Cash Flows:** The expected cash inflows and outflows generated by an asset.
* **Timing of Cash Flows:** When the cash flows are expected to occur.
* **Risk:** The uncertainty associated with the expected cash flows.
* **Required Return (Discount Rate):** The rate of return investors demand for bearing the risk of an investment.
* **Basic Valuation Model:**
$$V_0 = \sum_{t=1}^{n} \frac{CF_t}{(1+r)^t}$$
Where:
* $V_0$ = Value of the asset at time zero
* $CF_t$ = Cash flow expected in year $t$
* $r$ = Required return (discount rate)
* $n$ = Time period (investment's life or investor's holding period)
### 4.4 Time Value of Money Concepts
The time value of money (TVM) recognizes that a dollar received today is worth more than a dollar received in the future, due to its earning potential.
* **Compounding:** The process of calculating the future value of an investment by earning interest on interest.
* **Future Value of a Single Amount:**
$$FV_n = PV \times (1 + r)^n$$
Where $FV_n$ is the future value at the end of period $n$, $PV$ is the present value, $r$ is the interest rate, and $n$ is the number of periods.
* **Discounting:** The process of calculating the present value of a future cash flow.
* **Present Value of a Single Amount:**
$$PV = \frac{FV_n}{(1 + r)^n}$$
* **Annuities:** A series of equal periodic cash flows.
* **Ordinary Annuity:** Cash flows occur at the end of each period.
* **Annuity Due:** Cash flows occur at the beginning of each period. Annuity due values are higher than ordinary annuities because each cash flow has an additional period to earn interest.
* **Future Value of an Ordinary Annuity:**
$$FV_{OA} = CF \times \left[ \frac{(1+r)^n - 1}{r} \right]$$
* **Present Value of an Ordinary Annuity:**
$$PV_{OA} = CF \times \left[ \frac{1 - \frac{1}{(1+r)^n}}{r} \right]$$
* **Perpetuities:** An annuity with an infinite life.
* **Present Value of a Perpetuity:**
$$PV = \frac{CF}{r}$$
* **Present Value of a Growing Perpetuity:**
$$PV = \frac{CF_1}{r-g}$$
Where $g$ is the constant growth rate of the cash flows.
* **Mixed Streams:** Cash flows that are not equal or do not follow a specific pattern. Their present or future values are calculated by summing the present or future values of each individual cash flow.
* **Compounding More Frequently Than Annually:** When interest is compounded more frequently (e.g., semi-annually, quarterly), the effective annual rate is higher than the nominal rate. The formulas are adjusted by dividing the annual rate by the number of compounding periods per year and multiplying the number of periods by the same factor.
$$FV_{n} = PV \times \left(1 + \frac{r}{m}\right)^{m \times n}$$
$$PV = \frac{FV_n}{\left(1 + \frac{r}{m}\right)^{m \times n}}$$
Where $m$ is the number of compounding periods per year.
### 4.5 Risk and Return
* **Total Rate of Return:** Measures the gain or loss on an investment over a period, expressed as a percentage of the initial investment.
$$r_t = \frac{C_t + (P_t - P_{t-1})}{P_{t-1}}$$
Where $C_t$ is the cash distribution, $P_t$ is the value at the end of the period, and $P_{t-1}$ is the value at the beginning of the period.
* **Expected Return:** The anticipated return on an investment, often composed of a risk-free rate plus a risk premium for riskier investments.
* **Risk Measurement:**
* **Standard Deviation ($\sigma$):** A statistical measure of the dispersion of returns around the average return, indicating the asset's volatility or risk.
* **Beta ($\beta$):** A measure of a stock's systematic risk (nondiversifiable risk) relative to the overall market. A beta of 1 means the stock's price tends to move with the market; a beta greater than 1 indicates higher volatility than the market, and a beta less than 1 indicates lower volatility.
* **Diversification:** Investing in a portfolio of assets with low correlations with each other can reduce overall portfolio risk without necessarily sacrificing returns. This process helps to eliminate diversifiable (unsystematic) risk, leaving only nondiversifiable (systematic) risk.
### 4.6 Cost of Capital
The cost of capital represents the firm's cost of financing and is the minimum rate of return a project must earn to be acceptable.
* **Weighted Average Cost of Capital (WACC):** The overall cost of financing for a firm, calculated as a weighted average of the costs of its long-term debt and equity financing.
$$r_{WACC} = (w_d \times r_d) \times (1 - T) + (w_s \times r_s)$$
Where:
* $w_d$ = Proportion of debt in the capital structure (market value weights)
* $r_d$ = Before-tax cost of debt
* $T$ = Corporate tax rate
* $w_s$ = Proportion of common stock equity in the capital structure (market value weights)
* $r_s$ = Cost of common stock equity
* **Cost of Debt ($r_d$):** The interest rate on the firm's debt. The after-tax cost of debt is used in WACC calculations due to the tax deductibility of interest payments: $r_d \times (1 - T)$.
* **Cost of Common Stock Equity ($r_s$):** The return required by shareholders. This can be estimated using the Capital Asset Pricing Model (CAPM):
$$r_s = R_f + [\beta \times (R_m - R_f)]$$
Where:
* $R_f$ = Risk-free rate of return
* $\beta$ = Beta coefficient of the stock
* $R_m$ = Market return
* **Cost of Retained Earnings ($r_r$):** Typically considered equal to the cost of common stock equity ($r_s$), as retained earnings represent equity financing.
### 4.7 Capital Budgeting
Capital budgeting is the process of selecting long-term investments that align with the firm's goal of maximizing shareholder wealth.
* **Relevant Cash Flows:** These are the incremental cash flows (after-tax) that result from a proposed project. They include:
* **Initial Investment ($CF_0$):** The net cash outflow at the beginning of the project (purchase price of new asset, installation costs, increase in net working capital, minus after-tax proceeds from the sale of the old asset).
* **Operating Cash Flows ($CF_1, CF_2, \dots, CF_n$):** The incremental after-tax cash inflows generated by the project during its life. Often calculated as Net Operating Profit After Taxes (NOPAT) plus depreciation.
* $NOPAT = EBIT \times (1 - T)$
* $OCF = NOPAT + Depreciation$
* **Terminal Cash Flow:** The after-tax cash flow occurring in the final year, typically from the sale of the asset and the recovery of net working capital.
* **Capital Budgeting Techniques:**
* **Payback Period:** The time required for a project's cash inflows to recover the initial investment. Shorter payback periods are generally preferred.
* For an annuity: Payback Period = Initial Investment / Annual Cash Inflow
* For mixed cash flows: Cumulate cash flows until the initial investment is recovered.
* **Net Present Value (NPV):** The difference between the present value of cash inflows and the initial investment. A positive NPV indicates that the project is expected to increase shareholder wealth. Projects with $NPV > 0$ are acceptable.
$$NPV = \sum_{t=1}^{n} \frac{CF_t}{(1+r)^t} - CF_0$$
* **Profitability Index (PI):** The ratio of the present value of cash inflows to the initial investment. Projects with $PI > 1$ are acceptable.
$$PI = \frac{\text{Present Value of Cash Inflows}}{\text{Initial Investment}}$$
* **Internal Rate of Return (IRR):** The discount rate at which the NPV of a project equals zero. Projects with $IRR > \text{Cost of Capital}$ are acceptable.
* **Capital Rationing:** When a firm has limited funds for capital expenditures, it must select projects that maximize total NPV within the budget constraints. This is often achieved by ranking projects based on their NPV/Investment ratio.
* **Sunk Costs and Opportunity Costs:** Sunk costs (past outlays) are irrelevant to investment decisions, while opportunity costs (foregone benefits) are relevant and treated as outflows.
### 4.8 Leverage
Leverage refers to the use of fixed costs to magnify the effects of changes in sales on earnings.
* **Operating Leverage:** The use of fixed operating costs to magnize the effects of sales changes on Earnings Before Interest and Taxes (EBIT).
* **Operating Breakeven Point:** The sales level at which EBIT = $0$.
$$Q_{BE} = \frac{FC}{P - VC}$$
Where $Q$ is units, $FC$ is fixed operating costs, $P$ is sales price per unit, and $VC$ is variable operating cost per unit.
* **Degree of Operating Leverage (DOL):** Measures the sensitivity of EBIT to changes in sales.
$$DOL = \frac{\% \text{ Change in EBIT}}{\% \text{ Change in Sales}}$$
* **Financial Leverage:** The use of fixed financial costs (like interest and preferred dividends) to magnify the effects of EBIT changes on Earnings Per Share (EPS).
* **Financial Breakeven Point:** The EBIT level at which EPS = $0$.
* **Degree of Financial Leverage (DFL):** Measures the sensitivity of EPS to changes in EBIT.
$$DFL = \frac{\% \text{ Change in EPS}}{\% \text{ Change in EBIT}}$$
* **Total Leverage:** The combined effect of operating and financial leverage on the sensitivity of EPS to changes in sales.
* **Degree of Total Leverage (DTL):** Measures the sensitivity of EPS to changes in sales.
$$DTL = \frac{\% \text{ Change in EPS}}{\% \text{ Change in Sales}}$$
* The relationship is multiplicative: $DTL = DOL \times DFL$.
### 4.9 Payout Policy
Payout policy refers to how a firm distributes cash to shareholders, either through dividends or stock repurchases.
* **Cash Dividends:** Periodic cash payments to shareholders, decided by the board of directors. Common policies include:
* **Constant Payout Ratio:** A fixed percentage of earnings is paid as dividends.
* **Regular Dividend Policy:** A fixed dollar amount of dividend is paid consistently.
* **Low-Regular-and-Extra Dividend Policy:** A stable, low regular dividend supplemented by an additional "extra" dividend when earnings are high.
* **Stock Dividends:** Distribution of additional shares to existing shareholders, which increases the number of shares outstanding but does not affect the firm's total value or shareholders' proportional ownership. The stock price typically adjusts downward.
* **Stock Splits:** A corporate action that increases the number of shares outstanding by dividing existing shares, usually to lower the stock price per share and increase liquidity. The par value per share decreases proportionally.
* **Share Repurchases:** A company buying back its own shares from the market. This can increase EPS by reducing the number of shares outstanding and may be more tax-efficient for shareholders than cash dividends in some jurisdictions.
### 4.10 Working Capital Management
Working capital management involves the efficient management of current assets and current liabilities to optimize the trade-off between profitability and risk.
* **Net Working Capital (NWC):** The difference between current assets and current liabilities ($NWC = \text{Current Assets} - \text{Current Liabilities}$).
* **Cash Conversion Cycle (CCC):** The length of time a firm's cash is tied up in its operating cycle. It is calculated as:
$$CCC = \text{Operating Cycle} - \text{Average Payment Period (APP)}$$
$$ \text{Operating Cycle (OC)} = \text{Average Inventory Period (AIP)} + \text{Average Collection Period (ACP)}$$
Minimizing the CCC reduces the need for financing and can increase profitability.
* **Inventory Management:**
* **Economic Order Quantity (EOQ) Model:** Determines the optimal order size to minimize total inventory costs (order costs + carrying costs).
$$EOQ = \sqrt{\frac{2 \times S \times O}{C}}$$
Where $S$ is annual usage in units, $O$ is cost per order, and $C$ is carrying cost per unit per year.
* **Reorder Point:** The inventory level at which a new order should be placed.
$$ \text{Reorder Point} = (\text{Daily Usage} \times \text{Lead Time in Days}) + \text{Safety Stock}$$
* **Just-in-Time (JIT) System:** A strategy to minimize inventory by receiving materials only when needed for production.
* **Accounts Receivable Management:** Aims to collect receivables quickly without sacrificing sales. Key aspects include:
* **Credit Standards:** Minimum requirements for extending credit.
* **Credit Terms:** The conditions of sale, including discount periods and net payment periods.
* **Credit Monitoring:** Reviewing accounts receivable to track payment patterns (e.g., using aging schedules).
* **Accounts Payable Management:** Paying suppliers as late as possible without damaging relationships or incurring penalties.
* **Cost of Giving Up an Early Payment Discount:** The annualized cost of not taking a supplier's discount.
$$ \text{Cost of Giving Up Discount} = \left( \frac{\text{Discount %}}{100\% - \text{Discount %}} \right) \times \left( \frac{365}{\text{Net Period} - \text{Discount Period}} \right) \times 100\% $$
If this cost is higher than the cost of borrowing funds, it is beneficial to take the discount and borrow.
---
# Valuation fundamentals and bond valuation
This topic outlines the fundamental valuation model and the relationship between risk and return, with a detailed exploration of bond valuation, including the influence of coupon rates, required returns, and time to maturity on bond prices.
### 5.1 The basic valuation model
The core of valuation lies in linking an asset's risk and return to determine its worth. This is achieved through the basic valuation model, which calculates the present value of all expected future cash flows associated with an asset.
The fundamental valuation model is expressed as:
$$V_0 = \frac{CF_1}{(1+r)^1} + \frac{CF_2}{(1+r)^2} + \dots + \frac{CF_n}{(1+r)^n}$$
Where:
* $V_0$ = Value of the asset at time zero (present value)
* $CF_t$ = Cash flow expected in year $t$
* $r$ = Required return (discount rate)
* $n$ = Time period (investment's life or investor's holding period)
This formula essentially discounts each future cash flow back to its present value using the required rate of return and sums them up to find the asset's current value.
### 5.2 Key valuation inputs
To effectively use the valuation model, several key inputs are crucial:
* **Cash Flows:** These are the expected inflows and outflows of money an asset is anticipated to generate.
* **Timing of Cash Flows:** The timing of when cash flows are received or paid is critical, as money received sooner is generally worth more than money received later due to the time value of money.
* **Risk:** The uncertainty surrounding the expected cash flows. Higher risk generally demands a higher required return.
* **Required Return:** The minimum rate of return an investor expects to earn on an investment, given its risk. This is often referred to as the discount rate or the opportunity cost of capital.
### 5.3 Bond valuation
Bonds are debt instruments representing a loan made by an investor to a borrower (typically a corporation or government). Bond valuation involves determining the present value of the future cash flows a bond will generate for its holder. These cash flows consist of periodic interest payments (coupons) and the repayment of the bond's principal (par value) at maturity.
#### 5.3.1 Bond fundamentals
* **Par Value (Face Value):** The amount of money the borrower must repay at maturity. This is typically $1,000$ dollars.
* **Coupon Rate:** The annual interest rate paid on the bond's par value. This rate is fixed for the life of the bond.
* **Coupon Payment:** The actual dollar amount of interest paid periodically (usually semi-annually). It is calculated as the coupon rate multiplied by the par value.
* **Maturity:** The date on which the bond's principal amount must be repaid.
* **Required Return (Yield to Maturity - YTM):** The annual rate of return an investor expects to earn on a bond if it is held until maturity. This rate is influenced by market conditions, inflation, and the risk associated with the bond.
#### 5.3.2 The bond valuation formula
The value of a bond ($B_0$) is the present value of its future coupon payments (an annuity) plus the present value of its par value (a single future sum).
For annual coupon payments:
$$B_0 = C \left[ \frac{1 - \frac{1}{(1+r)^n}}{r} \right] + \frac{M}{(1+r)^n}$$
Or more concisely:
$$B_0 = \sum_{t=1}^{n} \frac{C}{(1+r)^t} + \frac{M}{(1+r)^n}$$
Where:
* $B_0$ = Value (or price) of the bond at time zero
* $C$ = Annual coupon interest payment in dollars
* $n$ = Number of years to maturity
* $M$ = Par value in dollars
* $r$ = Required return on the bond (discount rate)
When bonds pay interest semi-annually, the formula is adjusted:
* The annual coupon payment ($C$) is divided by 2 to get the semi-annual coupon payment.
* The number of years to maturity ($n$) is multiplied by 2 to get the total number of semi-annual periods ($2n$).
* The required annual return ($r$) is divided by 2 to get the semi-annual required return ($r/2$).
The formula for semi-annual payments becomes:
$$B_0 = \sum_{t=1}^{2n} \frac{C/2}{(1+r/2)^t} + \frac{M}{(1+r/2)^{2n}}$$
#### 5.3.3 Factors affecting bond values
* **Required Return (Yield to Maturity):**
* When the required return ($r$) is **equal to** the coupon rate, the bond sells at its **par value**.
* When the required return ($r$) is **greater than** the coupon rate, the bond sells at a **discount** (below par value). Investors demand a higher return than the bond's coupon offers, so the price must fall to compensate.
* When the required return ($r$) is **less than** the coupon rate, the bond sells at a **premium** (above par value). The bond's coupon offers a higher return than the market requires, so investors will pay more for it.
* **Time to Maturity:**
* As a bond approaches its maturity date, its price will converge towards its par value. This is because, at maturity, the bond's value is simply its par value, regardless of the coupon rate or the original discount/premium.
* The longer the time to maturity, the more sensitive a bond's price is to changes in the required return. Bonds with longer maturities have more future cash flows that need to be discounted, making their present value more volatile when the discount rate changes.
#### 5.3.4 Yield to Maturity (YTM)
YTM is the total annualized compound rate of return an investor can expect to earn on a bond if it is purchased at its current market price and held to maturity. It is the discount rate that equates the bond's current market price to the present value of its expected future cash flows.
* **Calculation:** YTM is typically calculated using financial calculators or spreadsheet software (e.g., Excel's YIELD or IRR functions) because it requires solving for the discount rate in the bond valuation formula.
* **Relationship to Coupon Rate and Price:**
* If a bond sells at par, its YTM equals its coupon rate.
* If a bond sells at a discount, its YTM is greater than its coupon rate.
* If a bond sells at a premium, its YTM is less than its coupon rate.
#### 5.3.5 Interest Rate Risk
Interest rate risk is the risk that the value of a bond will decline due to rising interest rates (an increase in the required return). Bonds with longer maturities and lower coupon rates are more susceptible to interest rate risk.
### 5.4 Linking Risk and Return
The required return ($r$) used in valuation is directly related to the perceived risk of the investment. Higher risk implies a higher required return. This relationship is fundamental to financial decision-making, ensuring that investors are adequately compensated for bearing greater uncertainty. For bonds, factors like default risk, liquidity preference, and inflation contribute to the required return. The term structure of interest rates (represented by the yield curve) illustrates the relationship between interest rates and the time to maturity for debt securities of similar risk.
---
# Capital budgeting techniques
Capital budgeting is the process by which a company evaluates and selects long-term investments that are expected to contribute to the firm's goal of maximizing owner wealth.
### 6.1 Overview of Capital Budgeting
Capital budgeting involves a systematic five-step process:
1. **Proposal Generation:** Managers propose new investment projects.
2. **Review and Analysis:** Financial managers assess the merits of these proposals.
3. **Decision Making:** Projects are authorized based on predefined dollar limits, often involving senior executives or the board of directors.
4. **Implementation:** Approved projects are executed, with expenditures sometimes occurring in phases.
5. **Follow-up:** Managers monitor project results, comparing actual outcomes to projections and making adjustments as needed.
**Key Terminology:**
* **Capital Expenditure:** A cash outflow expected to produce benefits over a period longer than one year.
* **Operating Expenditure:** A cash outflow resulting in benefits received within one year.
* **Incremental Cash Flows:** The additional cash flows (outflows or inflows) expected from a proposed capital expenditure. These are the only cash flows considered relevant for decision-making.
* **Independent Projects:** Projects whose cash flows are unrelated; accepting one does not affect the desirability of others.
* **Mutually Exclusive Projects:** Projects that compete with each other, where accepting one means rejecting others serving a similar function.
* **Unlimited Funds:** A situation where a firm can accept all acceptable independent projects.
* **Capital Rationing:** A situation where a firm has a limited budget for capital expenditures, forcing it to choose among competing projects.
**Relevant Cash Flow Components:**
* **Initial Investment (CF₀):** The net cash outflow at time zero required to acquire the asset. This includes the installed cost of the new asset, less any after-tax proceeds from selling the old asset, and adjusted for any change in net working capital.
* **Installed Cost:** Purchase price plus installation and any other costs necessary to make the asset operational.
* **After-Tax Proceeds from Sale of Old Asset:** Sale proceeds minus any taxes due on the sale (or plus any tax refunds if sold at a loss).
* **Change in Net Working Capital:** The difference between the change in current assets and the change in current liabilities. An increase in net working capital is a cash outflow; a decrease is a cash inflow.
* **Operating Cash Flows (CF₁ to CF$_{n-1}$):** The incremental, after-tax cash inflows generated by the project during its operating life. Calculated as Net Operating Profit After Taxes (NOPAT) plus depreciation. NOPAT is calculated as EBIT × (1 - Tax Rate).
* **Terminal Cash Flow (CF$_{n}$):** The after-tax cash flow occurring in the final year of a project's life, typically from selling the asset and recovering any net working capital investment.
* **After-Tax Salvage Value:** The net proceeds from selling the asset at the end of its life, minus any taxes due or plus any tax refunds related to the sale.
**Important Considerations for Cash Flows:**
* **Sunk Costs:** Cash outlays already made that have no bearing on current decisions. These are excluded from incremental cash flow analysis.
* **Opportunity Costs:** Cash flows that could be realized from the best alternative use of an owned asset. These are included as cash outflows in the incremental cash flow analysis.
* **Depreciation:** A non-cash expense that reduces taxable income but does not involve an actual cash outlay in the current period. It is added back to NOPAT to calculate operating cash flow.
### 6.2 Capital Budgeting Techniques
Several techniques are used to evaluate capital budgeting projects, each with its own strengths and weaknesses.
#### 6.2.1 Payback Period
The **payback period** is the time required for an investment to generate cash inflows sufficient to recover its initial investment.
* **Decision Rule:** Accept a project if its payback period is less than a predetermined maximum acceptable period; otherwise, reject it. For ranking projects, choose the one with the shorter payback period.
* **Calculation:**
* For annuities (equal annual cash flows):
$$ \text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow}} $$
* For mixed cash flows: Cumulate the cash flows year by year until the initial investment is recovered. The payback period is the number of years to recover the investment plus the fraction of the next year's cash flow needed.
* **Advantages:** Simple to calculate and understand; provides a crude measure of liquidity and risk (shorter payback suggests less risk).
* **Disadvantages:** Ignores cash flows beyond the payback period; does not consider the time value of money; the maximum acceptable period is subjective.
#### 6.2.2 Net Present Value (NPV)
The **Net Present Value (NPV)** measures the investment's value by calculating the present value of its expected cash inflows and subtracting the initial investment.
* **Decision Rule:** Accept a project if its NPV is positive; reject it if its NPV is negative. For mutually exclusive projects, accept the one with the higher positive NPV.
* **Formula:**
$$ \text{NPV} = \sum_{t=1}^{n} \frac{CF_t}{(1+r)^t} - CF_0 $$
Where:
* $CF_t$ = Cash flow in year $t$
* $r$ = Discount rate (usually the firm's weighted average cost of capital, WACC)
* $n$ = Project's life
* $CF_0$ = Initial investment
* **Advantages:** Considers the time value of money; accounts for all cash flows over the project's life; provides a direct measure of the expected increase in shareholder wealth.
* **Disadvantages:** Requires an accurate estimate of the discount rate; can be complex to calculate manually for projects with mixed cash flows.
#### 6.2.3 Profitability Index (PI)
The **Profitability Index (PI)** measures the present value of expected future cash flows relative to the initial investment.
* **Decision Rule:** Accept a project if its PI is greater than 1.0; reject it if its PI is less than 1.0. For mutually exclusive projects, choose the one with the higher PI.
* **Formula:**
$$ \text{PI} = \frac{\text{Present Value of Cash Inflows}}{\text{Initial Investment}} $$
Or, equivalently:
$$ \text{PI} = \frac{\text{NPV} + \text{Initial Investment}}{\text{Initial Investment}} $$
* **Advantages:** Similar to NPV, it considers the time value of money and all cash flows; useful for capital rationing as it provides a measure of "bang for the buck."
* **Disadvantages:** Can lead to incorrect rankings for mutually exclusive projects of different scales compared to NPV.
#### 6.2.4 Internal Rate of Return (IRR)
The **Internal Rate of Return (IRR)** is the discount rate at which the NPV of an investment equals zero. It represents the effective rate of return that the project is expected to earn.
* **Decision Rule:** Accept a project if its IRR is greater than the firm's cost of capital; reject it if its IRR is less than the cost of capital. For mutually exclusive projects, choose the one with the higher IRR.
* **Calculation:** Solved by finding the discount rate ($r$) that makes the NPV equal to zero. This is typically done using financial calculators or spreadsheet software.
$$ 0 = \sum_{t=1}^{n} \frac{CF_t}{(1+IRR)^t} - CF_0 $$
* **Advantages:** Considers the time value of money and all cash flows; provides a percentage return that is intuitively appealing to managers.
* **Disadvantages:** Can yield multiple IRRs for non-conventional cash flows (cash flows change sign more than once); can lead to incorrect rankings for mutually exclusive projects of different scales compared to NPV, especially if initial investments or cash flow patterns differ significantly.
**NPV Profile:** A graph that plots a project's NPV at various discount rates. It helps visualize the sensitivity of NPV to changes in the discount rate and can aid in comparing projects, especially when their IRRs are close or when dealing with mutually exclusive projects. The crossover rate is the discount rate at which the NPVs of two projects are equal.
### 6.3 Choosing Between Techniques
While all techniques have merit, **NPV is generally considered the superior capital budgeting technique** because it directly measures the expected increase in shareholder wealth and avoids the potential reinvestment rate assumption issues associated with IRR and the time value of money shortcomings of payback period. When rankings conflict between NPV and IRR for mutually exclusive projects, NPV should be prioritized.
### 6.4 Capital Rationing
When a firm faces capital rationing (a limited budget for investments), it must select a combination of acceptable projects that maximizes the total NPV within the budget constraint. This is typically achieved by ranking projects based on their Profitability Index (NPV/Initial Investment ratio) and selecting projects starting from the highest ratio until the budget is exhausted.
---
# Leverage and its impact on firm performance
Leverage amplifies the effects of changes in sales on a firm's profitability and risk by utilizing fixed operating and financial costs.
### 7.1 Understanding Leverage
Leverage refers to the use of fixed costs to magnify the effects of changes in sales on a firm's earnings. Firms face two primary types of leverage: operating leverage and financial leverage.
#### 7.1.1 Operating Leverage
Operating leverage is concerned with the relationship between a firm's sales revenue and its earnings before interest and taxes (EBIT), or operating profits. It arises from the presence of fixed operating costs.
* **Fixed Operating Costs:** These are costs that a firm must incur regardless of its sales volume in a given period. Examples include rent, salaries, and depreciation.
* **Variable Operating Costs:** These costs vary directly with the sales volume. Examples include raw materials and sales commissions.
**Breakeven Analysis:** This technique helps determine the sales volume necessary to cover all costs.
* **Operating Breakeven Point (in units):** The sales volume at which EBIT equals zero.
$$ \text{Q}_{\text{BE}} = \frac{\text{FC}}{\text{P} - \text{VC}} $$
Where:
* $ \text{Q}_{\text{BE}} $ = Operating breakeven point in units
* $ \text{FC} $ = Fixed operating costs
* $ \text{P} $ = Selling price per unit
* $ \text{VC} $ = Variable operating cost per unit
**Degree of Operating Leverage (DOL):** This measures the sensitivity of EBIT to a change in sales. A DOL greater than 1 indicates operating leverage.
$$ \text{DOL} = \frac{\%\ \text{change in EBIT}}{\%\ \text{change in Sales}} $$
A more direct formula for calculating DOL at a base sales level ($ \text{Q} $) is:
$$ \text{DOL} = \frac{\text{Q} \times (\text{P} - \text{VC})}{\text{Q} \times (\text{P} - \text{VC}) - \text{FC}} $$
Or, using EBIT:
$$ \text{DOL} = \frac{\text{EBIT} + \text{FC}}{\text{EBIT}} $$
A higher DOL implies greater operating leverage, meaning a small change in sales will result in a larger percentage change in EBIT.
#### 7.1.2 Financial Leverage
Financial leverage is the use of fixed financial costs to magnify the effects of changes in EBIT on a firm's earnings per share (EPS). The primary fixed financial costs are interest on debt and preferred stock dividends.
* **Financial Breakeven Point:** The level of EBIT required to cover interest and preferred dividends, resulting in EPS of $0.
$$ \text{EBIT} = \text{Interest Expense} + \text{Preferred Dividends} $$
If preferred dividends are paid out of after-tax earnings, the formula needs adjustment:
$$ \text{EBIT} = \text{Interest Expense} + \frac{\text{Preferred Dividends}}{1 - \text{Tax Rate}} $$
**Degree of Financial Leverage (DFL):** This measures the sensitivity of EPS to a change in EBIT. A DFL greater than 1 indicates financial leverage.
$$ \text{DFL} = \frac{\%\ \text{change in EPS}}{\%\ \text{change in EBIT}} $$
A more direct formula for calculating DFL at a base EBIT level is:
$$ \text{DFL} = \frac{\text{EBIT}}{\text{EBIT} - \text{Interest Expense} - \left( \frac{\text{Preferred Dividends}}{1 - \text{Tax Rate}} \right)} $$
A higher DFL means that a given percentage change in EBIT will result in a larger percentage change in EPS.
#### 7.1.3 Total Leverage
Total leverage combines the effects of both operating and financial leverage. It measures the sensitivity of EPS to changes in sales.
**Degree of Total Leverage (DTL):** This is the numerical measure of a firm's total leverage. A DTL greater than 1 indicates total leverage.
$$ \text{DTL} = \frac{\%\ \text{change in EPS}}{\%\ \text{change in Sales}} $$
The DTL can also be calculated by multiplying the DOL and DFL:
$$ \text{DTL} = \text{DOL} \times \text{DFL} $$
This multiplicative relationship highlights how operating leverage magnifies sales-to-EBIT changes, and financial leverage further magnifies EBIT-to-EPS changes.
> **Tip:** Understanding leverage is crucial for financial decision-making. It helps in analyzing how changes in sales or EBIT will impact shareholder returns and the associated risk. It also informs decisions about the firm's capital structure.
### 7.2 Impact on Firm Performance
Leverage significantly influences a firm's performance by affecting both its profitability and its risk profile.
#### 7.2.1 Profitability
* **Magnification of Returns:** When sales are increasing, leverage amplifies the positive impact on EBIT and EPS because fixed costs remain constant. This allows for a proportionally larger increase in profits for shareholders.
* **Magnification of Losses:** Conversely, when sales are decreasing, fixed costs become a greater burden, leading to a proportionally larger decrease in EBIT and EPS. This amplifies losses for shareholders.
#### 7.2.2 Risk
* **Increased Volatility:** Higher levels of operating or financial leverage lead to greater volatility in a firm's earnings. This means that profits and losses will fluctuate more significantly with changes in sales.
* **Financial Risk:** Financial leverage, in particular, increases financial risk. The obligation to pay interest and preferred dividends, regardless of the firm's operating performance, raises the possibility of financial distress or bankruptcy if EBIT is insufficient to cover these fixed financial charges.
> **Example:** Consider two companies with identical sales and variable costs, but differing fixed operating costs. The company with higher fixed operating costs (higher operating leverage) will experience a larger percentage change in EBIT for any given percentage change in sales compared to the company with lower fixed operating costs.
### 7.3 Capital Structure and Leverage
A firm's capital structure (the mix of debt and equity) directly influences its financial leverage.
* **Debt Financing:** Using debt increases financial leverage because interest payments are fixed financial charges. The tax deductibility of interest payments also reduces the after-tax cost of debt, making it an attractive financing option up to a certain point.
* **Equity Financing:** Relying solely on equity financing results in zero financial leverage. However, equity is typically more expensive than debt due to its higher risk and lack of tax deductibility for dividends.
The optimal capital structure for a firm aims to balance the benefits of debt (tax shields, lower cost of capital) against its costs (increased financial risk, probability of bankruptcy, agency costs). While there's no single optimal structure for all firms, financial theory suggests that firms with stable revenues and low business risk can generally afford to use more debt.
---
# Working capital management strategies
Working capital management involves optimizing the balance between current assets and current liabilities to maximize profitability and minimize risk.
### 8.1 The cash conversion cycle
The cash conversion cycle (CCC) measures the length of time between a firm's cash outlay for raw materials and its collection of cash from the sale of finished goods. It can be calculated as:
$$ CCC = AAI + ACP - APP $$
Where:
* $AAI$ = Average Age of Inventory
* $ACP$ = Average Collection Period
* $APP$ = Average Payment Period
Minimizing the CCC is a key objective, as it reduces the need for external financing and increases funds available for expansion or other investments.
### 8.2 Inventory management
Effective inventory management aims to balance the costs of holding inventory against the costs of ordering and the risk of stockouts.
#### 8.2.1 Inventory level viewpoints
* **Financial Manager:** Prefers low inventory levels to optimize the use of funds.
* **Marketing Manager:** Desires large inventories to meet customer demand promptly.
* **Manufacturing Manager:** Focuses on efficient production to ensure availability of goods at low cost.
* **Purchasing Manager:** Concerned with securing necessary raw materials efficiently.
#### 8.2.2 Common inventory management techniques
* **ABC Inventory System:** Categorizes inventory based on investment value.
* **A Items:** High dollar investment, requiring the most rigorous monitoring.
* **B Items:** Moderate dollar investment, monitored with periodic checks.
* **C Items:** Low dollar investment, managed with simpler methods like the two-bin system.
* **Economic Order Quantity (EOQ) Model:** Determines the optimal order size to minimize total inventory costs (ordering and carrying costs).
* **Order Costs:** Fixed clerical costs per order.
* **Carrying Costs:** Variable costs per unit of holding inventory.
* The EOQ formula is:
$$ EOQ = \sqrt{\frac{2 \times S \times O}{C}} $$
Where:
* $S$ = Annual usage in units
* $O$ = Cost per order
* $C$ = Carrying cost per unit per year
* **Reorder Point:** The inventory level at which a new order should be placed.
$$ Reorder Point = (Days \ of \ lead \ time \times Daily \ usage) + Safety \ stock $$
* **Safety Stock:** Extra inventory held to prevent stockouts.
* **Just-in-Time (JIT) System:** Aims to minimize inventory by receiving materials precisely when needed for production, emphasizing quality and timely delivery.
* **Computerized Systems:**
* **Materials Requirement Planning (MRP) System:** Applies EOQ concepts and uses computers to manage inventory based on production needs.
* **MRP II:** An extension of MRP that integrates data across various business functions.
* **Enterprise Resource Planning (ERP) System:** Integrates external supplier and customer data with internal departmental data for real-time resource management.
### 8.3 Accounts Receivable Management
The goal is to collect receivables promptly without sacrificing sales due to aggressive collection or uncompetitive credit terms.
#### 8.3.1 Credit Selection and Standards
* **Credit Standards:** Minimum requirements for extending credit.
* **The Five C's of Credit:**
* **Character:** Past repayment history.
* **Capacity:** Ability to repay.
* **Capital:** Debt-to-equity ratio.
* **Collateral:** Available assets as security.
* **Conditions:** Economic and industry factors.
* **Credit Scoring:** Uses statistical methods to assess creditworthiness for high-volume, small-dollar transactions.
* **Relaxing Credit Standards:** Can increase sales but also increase bad-debt expenses and the investment in receivables.
#### 8.3.2 Credit Terms
* **Terms of Net 30:** Full payment is due within 30 days from the start of the credit period.
* **Early Payment Discount:** A price reduction offered for prompt payment (e.g., 2/10 net 30 means a 2% discount if paid within 10 days, otherwise full payment is due in 30 days).
* **Early Payment Discount Period:** The window during which the discount is available.
* **Credit Period:** The deadline for full payment.
* **Impact of Changes:** Adjusting credit terms can influence sales, bad-debt expenses, and the investment in accounts receivable.
#### 8.3.3 Credit Monitoring
* **Average Collection Period (ACP):** Measures the average time to collect receivables.
* **Aging of Accounts Receivable (Aging Schedule):** Breaks down receivables by age to identify overdue accounts and assess collection efficiency.
* **Common Collection Techniques:** A progression of methods from polite reminders to legal action.
### 8.4 Accounts Payable Management
Managing accounts payable involves optimizing payment timing to benefit from supplier credit terms.
* **Spontaneous Liabilities:** Financing that arises automatically from business operations, primarily accounts payable and accruals.
* **Accounts Payable Management:** Paying bills as late as possible within stated credit terms to maximize the use of interest-free supplier financing, without harming credit ratings.
* **Cash Discounts:** Firms should evaluate the cost of giving up a discount versus the cost of borrowing funds externally.
* **Cost of Giving Up an Early Payment Discount:** The implied annualized interest rate paid for delaying payment.
$$ Cost \ of \ Giving \ Up \ Discount = \left( \frac{CD}{100\% - CD} \right) \times \left( \frac{365}{N} \right) $$
Where:
* $CD$ = Stated discount percentage
* $N$ = Number of days payment can be delayed by giving up the discount
Firms should take the discount if its cost exceeds the cost of external short-term financing.
* **Stretching Accounts Payable:** Paying bills as late as legally possible within credit terms to reduce the cost of foregoing discounts.
* **Accruals:** Liabilities for services received but not yet paid. Firms have some flexibility in managing accruals, such as delaying payroll payments.
---
# Dividend policy and stock repurchases
Dividend policy and stock repurchases are crucial components of a firm's overall financial management, reflecting how a company distributes its earnings to shareholders and impacts its valuation.
### 9.1 Understanding Dividend Policy
Dividend policy refers to the firm's plan for deciding whether to distribute cash to shareholders, how much cash to distribute, and the method of distribution.
#### 9.1.1 Dividend Payment Procedures
* **Board of Directors' Decision:** The board of directors typically decides on dividend payments, usually at quarterly or semiannual meetings. The primary considerations are the firm's recent performance and future cash flow generation.
* **Dividend Stability:** Boards are reluctant to cut dividends unless there's a serious threat to the firm's cash-generating ability.
* **Key Dates:**
* **Date of Record:** The date on which shareholders must be registered to receive the declared dividend.
* **Ex-Dividend Period:** A period starting two business days before the date of record, during which a stock is sold without the right to receive the current dividend.
* **Payment Date:** The date on which the company actually mails the dividend payments.
#### 9.1.2 Factors Affecting Dividend Policy
Several factors influence a firm's dividend policy:
* **Legal Constraints:** Loan agreements often impose restrictions on dividend payments to protect creditors, such as limiting dividends to a certain percentage of earnings or until specific earnings thresholds are met.
* **Growth Prospects:** Rapidly growing firms typically retain more earnings for reinvestment, leading to lower dividend payouts. More mature firms with fewer growth opportunities may distribute a larger proportion of their earnings.
* **Owner Considerations:** High dividend payouts may lead to a dilution of ownership control and earnings if new equity capital must be raised through stock issuance.
* **Market Considerations:** The "catering theory" suggests firms may adjust dividend policies to meet investor preferences for high-dividend stocks.
#### 9.1.3 Types of Dividend Policies
Firms adopt various approaches to dividend distribution:
* **Constant-Payout-Ratio Policy:** A fixed percentage of earnings is distributed as dividends each period. This means the dividend amount fluctuates with earnings.
* Example: A firm with a 40% payout ratio that earns $10 per share would pay a $4 dividend per share.
* **Regular Dividend Policy:** A fixed-dollar dividend is paid each period. This policy aims to provide a stable income stream to shareholders.
* This policy is often built around a target dividend-payout ratio, with adjustments made towards the target as earnings increase predictably.
* **Low-Regular-and-Extra Dividend Policy:** A low, stable regular dividend is paid, supplemented by an "extra" dividend in periods of exceptionally high earnings. The extra dividend is not guaranteed in future periods.
#### 9.1.4 Other Forms of Dividends
* **Stock Dividend:** The payment of a dividend in the form of additional shares of stock. Shareholders receive more shares in proportion to their existing holdings.
* **Mechanics:** No cash is distributed; the firm's total equity remains the same, but the number of outstanding shares increases, leading to a roughly proportional decrease in the stock price.
* **Accounting Impact:** A stock dividend involves a transfer of funds between stockholders' equity accounts (e.g., retained earnings to common stock and paid-in capital in excess of par).
* **Stock Split:** A method to reduce the market price per share by increasing the number of shares outstanding.
* **Mechanics:** For example, in a 3-for-2 stock split, each shareholder receives one additional share for every two shares owned. The stock price is adjusted downwards (divided by the split ratio) to reflect the increased number of shares.
* **Impact:** While the total value of a shareholder's holdings theoretically remains unchanged, stock splits can sometimes lead to a slight increase in market value due to signaling effects or a slight increase in total dividends paid.
* **Reverse Stock Split:** The opposite of a stock split, where a company consolidates shares to increase the market price per share.
### 9.2 Stock Repurchases (Share Buybacks)
A share repurchase occurs when a company buys back its own shares from the open market.
#### 9.2.1 Reasons for Share Repurchases
* **Undervalued Shares:** Management may believe the company's shares are undervalued, and repurchasing them is seen as a good investment.
* **Returning Cash to Shareholders:** Repurchases are an alternative method of distributing excess cash to shareholders.
* **Tax Advantages:** Cash dividends are taxed when received, whereas shareholders may defer taxes on capital gains from share repurchases until they sell their shares.
* **Impact on EPS:** By reducing the number of outstanding shares, repurchases can increase earnings per share (EPS), assuming net income remains constant.
* **Flexibility:** Share buyback programs are generally more flexible than dividend policies; companies can easily adjust the pace of repurchases.
#### 9.2.2 Share Repurchase Mechanics
* Companies often receive authorization from the board of directors or the general assembly to repurchase a specific number of shares over a defined period.
* Repurchased shares are typically canceled (destroyed).
### 9.3 Dividend Policy and Shareholder Value
The overall dividend policy and the use of share repurchases can significantly influence a firm's stock valuation.
* **Impact of Management Actions:** Any management decision that increases shareholder expectations of future dividends, without a corresponding increase in perceived risk, is likely to increase the firm's value. Conversely, actions that increase risk or decrease dividend expectations will reduce firm value.
* **Growth vs. Stability:** The optimal payout policy involves balancing the need for reinvestment in growth opportunities with the desire to return cash to shareholders. The decision often depends on the firm's growth stage, cash flow generation, and tax considerations.
> **Tip:** When analyzing dividend policies, pay close attention to the specific dates (record date, ex-dividend date) as they determine who is entitled to receive the dividend. Also, remember that stock dividends and splits do not inherently change a shareholder's wealth, but can affect stock liquidity and psychological perceptions.
---
# Common stock valuation and the cost of capital
This section explains how to value common stocks using various models and how to calculate the cost of capital for a firm.
### 10.1 Common stock valuation
Common stock valuation involves determining the worth of a share of common stock. This is typically done by estimating future cash flows and discounting them back to their present value. The core idea is that the value of an asset is the present value of its expected future cash flows.
#### 10.1.1 Valuation models
Several models are used to value common stocks, primarily focusing on dividends or free cash flows.
##### 10.1.1.1 Dividend valuation models
These models use expected dividends to value common stock.
* **Zero-growth dividend model:** This model assumes that dividends will remain constant indefinitely, treating them as a perpetuity. The value of the stock ($P_0$) is calculated as:
$$P_0 = \frac{D}{r}$$
where $D$ is the constant annual dividend and $r$ is the required return on equity.
* **Constant-growth dividend model (Gordon Growth Model):** This model assumes that dividends will grow at a constant rate ($g$) indefinitely, where $g$ is less than the required return ($r$). The value of the stock is calculated as:
$$P_0 = \frac{D_1}{r - g}$$
or
$$P_0 = \frac{D_0(1+g)}{r - g}$$
where $D_1$ is the expected dividend at the end of year 1, $D_0$ is the dividend paid yesterday, $r$ is the required return on common stock, and $g$ is the constant dividend growth rate.
* **Variable-growth dividend model:** This model accounts for periods where the dividend growth rate changes before settling into a constant growth rate. It involves discounting the dividends during the non-constant growth period and then using the constant-growth model to value the stock from the point where growth becomes constant.
#### 10.1.2 Free cash flow stock valuation model
This model values the entire company by calculating the present value of its expected free cash flows, discounted at the firm's weighted average cost of capital (WACC). The value of the entire company ($V_C$) is the market value of all assets. To find the value of common stock ($V_S$), the market value of debt ($V_D$) and preferred stock ($V_P$) are subtracted:
$$V_S = V_C - V_D - V_P$$
where $V_C = \sum_{t=1}^{n} \frac{FCF_t}{(1+r_{WACC})^t}$
$FCF_t$ is the free cash flow expected at the end of year $t$, and $r_{WACC}$ is the weighted average cost of capital.
#### 10.1.3 Other valuation approaches
* **Book value per share:** This is calculated by dividing the firm's total stockholders' equity by the number of common shares outstanding. It is based on historical accounting data and may not reflect the firm's true market value or earning potential.
$$Book\ Value\ per\ Share = \frac{Total\ Stockholders\text{'}\ Equity - Preferred\ Stock}{Number\ of\ Common\ Shares\ Outstanding}$$
* **Price/Earnings (P/E) multiples approach:** This method estimates a stock's value by multiplying the firm's expected earnings per share (EPS) by the average P/E ratio for its industry.
$$P_0 = Expected\ EPS \times Average\ Industry\ P/E\ Ratio$$
This approach is quick but sensitive to fluctuations in P/E ratios and earnings forecasts.
#### 10.1.4 Factors affecting common stock value
Management decisions significantly impact stock value:
* **Changes in expected dividends:** Actions that increase the expected future dividends, without increasing perceived risk, will increase the stock's value.
* **Changes in risk:** Actions that increase the perceived risk of future cash flows will lead to a higher required return, thus reducing the stock's value. Conversely, reducing risk can increase value.
### 10.2 Cost of capital
The cost of capital represents the firm's cost of financing and is the minimum rate of return a project must earn to increase shareholder wealth. It's a blend of the costs of different sources of long-term financing.
#### 10.2.1 Sources of long-term capital
Firms typically raise long-term capital from:
* Long-term debt
* Preferred stock
* Common stock (including retained earnings)
#### 10.2.2 Cost of debt
The cost of debt ($r_d$) is the interest rate a firm pays on its long-term debt. Since interest payments are tax-deductible, the **after-tax cost of debt** is used in WACC calculations:
$$After\text{-}Tax\ Cost\ of\ Debt = r_d \times (1 - T)$$
where $r_d$ is the before-tax cost of debt and $T$ is the firm's tax rate.
#### 10.2.3 Cost of preferred stock
The cost of preferred stock ($r_p$) is the dividend paid on preferred stock divided by the net proceeds from its sale. For perpetual preferred stock:
$$r_p = \frac{D_p}{N_p}$$
where $D_p$ is the annual preferred dividend and $N_p$ is the net proceeds from selling one share of preferred stock.
#### 10.2.4 Cost of common stock equity
The cost of common stock equity ($r_s$) is the return required by shareholders. It can be estimated using the Capital Asset Pricing Model (CAPM):
$$r_s = R_F + [\beta \times (r_m - R_F)]$$
where $R_F$ is the risk-free rate, $\beta$ is the stock's beta coefficient (a measure of systematic risk), and $r_m$ is the expected return on the market portfolio. The cost of retained earnings ($r_r$) is typically equal to the cost of common stock equity ($r_s$).
#### 10.2.5 Weighted average cost of capital (WACC)
WACC represents the firm's overall cost of financing. It is calculated as a weighted average of the costs of each source of capital, with weights based on the market value proportions of each capital component in the firm's target capital structure.
For a firm with debt and common stock:
$$r_{WACC} = (w_d \times r_d \times (1 - T)) + (w_s \times r_s)$$
For a firm with debt, preferred stock, and common stock:
$$r_{WACC} = (w_d \times r_d \times (1 - T)) + (w_p \times r_p) + (w_s \times r_s)$$
where $w_d$, $w_p$, and $w_s$ are the weights of debt, preferred stock, and common stock equity, respectively, in the firm's capital structure.
> **Tip:** When calculating WACC, always use market value weights for debt and equity, and ensure that the cost of debt is adjusted for taxes. If a target capital structure is provided, use those weights for future investment decisions.
---
## Common mistakes to avoid
- Review all topics thoroughly before exams
- Pay attention to formulas and key definitions
- Practice with examples provided in each section
- Don't memorize without understanding the underlying concepts
Glossary
| Term | Definition |
|------|------------|
| Finance | The science and art of managing money, involving decisions about how individuals and firms raise and invest money to earn profit or achieve financial goals. |
| Shareholder Wealth Maximization | The primary goal of a firm, which generally translates to maximizing the stock price by making decisions that increase the present value of expected future cash flows to shareholders. |
| Stakeholders | Individuals or groups who have an interest in a firm, including employees, suppliers, customers, and the local community, whose welfare managers should consider alongside shareholders' interests. |
| Business Ethics | Standards of conduct and moral judgment that apply to individuals engaged in commerce, aimed at ensuring adherence to laws and regulations and promoting fair practices. |
| Investment Decisions | Decisions related to the acquisition of assets that are expected to generate future returns, often referred to as capital budgeting decisions. |
| Financing Decisions | Decisions concerning how a firm raises money to finance its activities, including determining the optimal mix of debt and equity in its capital structure. |
| Working Capital Decisions | Decisions relating to the management of a firm's short-term assets and liabilities, such as inventory, accounts receivable, accounts payable, and cash, to ensure smooth day-to-day operations. |
| Balance Sheet | A financial statement that reports a company's assets, liabilities, and shareholder equity at a specific point in time, providing a snapshot of the firm's financial position. |
| Principal–Agent Problem | A conflict that arises when the owners (principals) of a firm delegate decision-making authority to managers (agents), who may not always act in the best interests of the owners. |
| Accrual Basis Accounting | A method of accounting that recognizes revenues when earned and expenses when incurred, regardless of when cash is actually received or paid. |
| Cash Basis Accounting | A method of accounting that recognizes revenues and expenses only when cash is actually received or paid, focusing on the movement of cash within the firm. |
| Sole Proprietorship | A business owned and operated by one person, characterized by unlimited liability for the owner and ease of formation. |
| Partnership | A business owned by two or more people, where partners share in profits and losses, and typically have unlimited liability for the business's debts. |
| Corporation | A legal business entity that is separate and distinct from its owners, offering limited liability to stockholders and the ability to raise capital through the sale of stock. |
| Limited Liability | A legal protection that shields the personal assets of owners (shareholders) from business debts and liabilities, limiting their risk to the amount of their investment. |
| Stock | A security that represents ownership in a corporation, entitling the holder to a claim on the firm's assets and earnings, and potentially to voting rights and dividends. |
| Dividends | Periodic distributions of cash or stock to the shareholders of a firm, representing a return on their investment. |
| Board of Directors | A group elected by the firm's stockholders to oversee the management of the corporation, approve strategic goals, set policy, and make major financial decisions. |
| Taxation | The process by which governments collect revenue from individuals and businesses, often through taxes on income, sales, or property. |
| Double Taxation | A situation where corporate profits are taxed twice: first at the corporate level when earned, and then again at the individual level when distributed to shareholders as dividends. |
| Corporate Governance | The system of laws, rules, and practices by which a company is operated, controlled, and regulated, aimed at ensuring accountability, fairness, and transparency in corporate affairs. |
| Stock Options | Securities that give the holder the right, but not the obligation, to buy a company's stock at a predetermined price within a specified period, often used as an incentive for management. |
| Restricted Stock | Shares of stock granted to employees as part of their compensation package, which are subject to certain vesting conditions or restrictions before they can be fully owned and traded. |
| Activist Investors | Investors who specialize in acquiring significant stakes in companies and then actively influencing management to implement changes aimed at improving financial performance or shareholder value. |
| Sarbanes-Oxley Act of 2002 | A U.S. federal law enacted to improve corporate governance and financial reporting, enhance the reliability of accounting information, and prevent corporate fraud and conflicts of interest. |
| Financial Institutions | Intermediaries that channel savings from individuals and businesses into loans or investments, facilitating the flow of funds in the economy. Examples include banks, insurance companies, and mutual funds. |
| Financial Markets | Forums where suppliers and demanders of funds can transact business directly, facilitating the buying and selling of financial securities like stocks and bonds. |
| Primary Market | The financial market in which securities are initially issued by corporations or governments to investors, allowing the issuers to raise capital directly from the public. |
| Secondary Market | The financial market in which previously issued securities are traded among investors, without the direct involvement of the original issuer. |
| Money Market | A market for short-term debt instruments with maturities of one year or less, characterized by low risk and high liquidity. |
| Capital Market | A market for long-term debt and equity securities, with maturities greater than one year, used for raising long-term funds for businesses and governments. |
| Bonds | Long-term debt instruments issued by corporations or governments, representing a loan from the investor to the issuer, with promises of periodic interest payments and repayment of the principal at maturity. |
| Stocks (Shares) | Securities representing ownership in a corporation, entitling holders to a claim on the firm's assets and earnings, and potential voting rights and dividends. |
| Eurobond Market | A market where bonds denominated in U.S. dollars or other currencies are issued and traded outside their country of origin, facilitating international capital flows. |
| Yield Curve | A graphic depiction of the relationship between the interest rates and the time to maturity for bonds of similar risk, showing how yields vary with maturity. |
| Efficient-Market Hypothesis (EMH) | A theory suggesting that security prices fully reflect all available information, making it impossible to consistently earn excess returns by trying to find mispriced securities. |
| Behavioral Finance | An emerging field that blends finance and psychology, arguing that stock prices and other security prices can deviate from their true values due to investor behavior, emotions, and cognitive biases. |
| Securities and Exchange Commission (SEC) | The primary government agency in the U.S. responsible for enforcing federal securities laws and regulating the securities industry to protect investors. |
| Private Equity | External equity financing raised through a private placement, typically by early-stage firms with attractive growth prospects, often involving venture capitalists or angel investors. |
| Angel Investors (Business Angels) | Wealthy individual investors who invest their own capital in promising startups and early-stage companies in exchange for equity and potential high returns. |
| Venture Capitalists (VCs) | Formal business entities that pool capital from various investors to make equity investments in private companies with high growth potential, often providing strategic guidance and oversight. |
| Going Public (IPO) | The process by which a privately held company first offers its shares to the public through an Initial Public Offering (IPO), enabling it to raise capital and become publicly traded. |
| Prospectus | A legal document that provides detailed information about a security offering, including the issuer's financial condition, management, business operations, and the terms of the offering. |
| Roadshow | A series of presentations to potential investors by a company and its investment bankers to gauge demand for a new security offering and generate interest before pricing the issue. |
| Investment Bank | A financial intermediary that specializes in assisting companies with raising capital through the sale of new securities, advising on mergers and acquisitions, and engaging in trading and market-making activities. |
| Market Capitalization | The total market value of a publicly traded firm's outstanding stock, calculated by multiplying the current market price per share by the number of shares outstanding. |
| Securitization | The process of pooling various types of loans, such as mortgages, and then selling claims or securities backed by those pools in the secondary market, transforming illiquid assets into tradable securities. |
| Mortgage-Backed Securities (MBS) | Securities that represent claims on the cash flows generated by a pool of mortgages, where investors receive payments derived from the principal and interest payments made by homeowners. |
| Subprime Mortgages | Mortgage loans made to borrowers with lower incomes, poorer credit histories, or higher risk profiles compared to prime borrowers, often carrying higher interest rates. |
| Financial Crisis | A situation where the value of financial assets drops rapidly, leading to the failure of financial institutions, disruptions in credit markets, and potential economic recession. |
| Crisis of Confidence | A situation where investors and the public lose faith in the stability and reliability of financial institutions or markets, leading to panic selling, liquidity shortages, and market instability. |
| Spillover Effects | The transmission of economic or financial disturbances from one sector, market, or country to others, often occurring through interconnected financial systems or trade relationships. |
| Recession | A significant decline in economic activity spread across the economy, lasting more than a few months, typically visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. |
| Time Value of Money | The concept that money available at the present time is worth more than the same amount in the future due to its potential earning capacity; a dollar today is worth more than a dollar tomorrow. |
| Compounding | The process of calculating the future value of an investment by earning interest on both the principal amount and the accumulated interest from previous periods. |
| Discounting | The process of calculating the present value of a future cash flow by determining how much it would be worth today, given a specific rate of return or opportunity cost. |
| Future Value (FV) | The value on a specific future date of an investment made today, considering compound interest over a specified period. |
| Present Value (PV) | The current worth of a future sum of money or stream of cash flows, given a specified rate of return or discount rate; it represents the amount that would need to be invested today to yield that future amount. |
| Annuity | A stream of equal periodic cash flows, occurring over a specified period, which can be either inflows or outflows. |
| Ordinary Annuity | An annuity for which the cash flow occurs at the end of each period. |
| Annuity Due | An annuity for which the cash flow occurs at the beginning of each period, resulting in a higher future or present value compared to an ordinary annuity due to additional compounding. |
| Perpetuity | An annuity with an infinite life, providing a perpetual stream of equal cash flows at regular intervals. |
| Growing Perpetuity | An annuity with an infinite life, providing a perpetual stream of cash flows that grow at a constant rate each period. |
| Mixed Stream (Uneven Cash Flows) | A stream of cash flows that varies in amount from one period to the next, lacking a regular pattern, such as a series of investments or returns that change over time. |
| Nominal Interest Rate | The stated rate of interest charged by a lender or paid by a borrower, before accounting for the effects of inflation or compounding frequency. |
| Real Interest Rate | The rate of return on an investment adjusted for inflation, measuring the increase in purchasing power that the investment provides. |
| Risk Premium | The additional return that an investor expects to receive for bearing the risk associated with a particular investment, above and beyond the risk-free rate of return. |
| Yield to Maturity (YTM) | The total annual rate of return anticipated on a bond if the bond is held until it matures, calculated by discounting all future cash flows (coupon payments and principal) back to the present value and solving for the discount rate. |
| Bond Valuation | The process of determining the fair value of a bond by calculating the present value of its expected future cash flows, including coupon payments and the par value, discounted at the required rate of return. |
| Discount (Bond) | The amount by which a bond sells below its par value, occurring when the required return is higher than the coupon rate. |
| Premium (Bond) | The amount by which a bond sells above its par value, occurring when the required return is lower than the coupon rate. |
| Interest Rate Risk | The risk that the value of a bond will decline due to an increase in prevailing interest rates, as higher rates make existing bonds with lower coupon rates less attractive. |
| Capital Budgeting | The process of selecting long-term investment projects that are expected to contribute to the firm's goal of maximizing owner wealth. |
| Incremental Cash Flows | The additional cash inflows and outflows—both positive and negative—that are expected to result from a proposed capital expenditure project, focusing only on the changes caused by the investment. |
| Initial Investment (CF0) | The total cash outflow required at the beginning of a capital project to acquire the necessary assets and make them operational, including purchase price, installation costs, and changes in net working capital. |
| Operating Cash Flows (CF1, CF2, ..., CFn) | The incremental after-tax cash inflows and outflows generated by a project during its operating life, typically calculated from after-tax profits by adding back non-cash charges like depreciation. |
| Terminal Cash Flow | The after-tax cash flow occurring in the final year of a project, often related to the liquidation or sale of assets used in the project and the recovery of any investment in net working capital. |
| Sunk Costs | Cash outlays that have already been made and cannot be recovered, which should be ignored when evaluating current investment decisions as they do not affect future cash flows. |
| Opportunity Costs | The potential benefits or cash flows that are forgone when one alternative is chosen over another. These are relevant cash flows that should be considered in decision-making. |
| Payback Period | A capital budgeting technique that measures the time required for an investment to generate cumulative cash inflows equal to its initial investment; it indicates how quickly the initial outlay is recovered. |
| Net Present Value (NPV) | A capital budgeting technique that measures the value of an investment by calculating the present value of its expected future cash inflows and subtracting the initial investment. A positive NPV indicates that the project is expected to add value to the firm. |
| Profitability Index (PI) | A capital budgeting technique that calculates the ratio of the present value of future cash inflows to the initial investment, indicating the relative profitability of a project per dollar invested. A PI greater than 1.0 suggests an acceptable project. |
| Internal Rate of Return (IRR) | A capital budgeting technique that determines the discount rate at which the net present value (NPV) of a project's cash flows equals zero. It represents the effective rate of return that the investment is expected to yield. |
| Net Present Value Profile | A graph that plots the net present values (NPVs) of a project at various discount rates, used to visualize the relationship between NPV and the cost of capital and to identify potential conflicts in project rankings. |
| Capital Rationing | A situation where a firm has a limited amount of capital available for investment and must choose among mutually exclusive projects or a subset of independent projects that exceed the available budget. |
| Leverage | The use of fixed costs (operating and financial) to magnify the effects of changes in sales on a firm's earnings before interest and taxes (EBIT) and earnings per share (EPS). |
| Operating Leverage | The use of fixed operating costs to magnify the effects of changes in sales on a firm's EBIT. A higher degree of operating leverage implies greater sensitivity of EBIT to sales fluctuations. |
| Operating Breakeven Point | The level of sales in units or dollars at which a firm's earnings before interest and taxes (EBIT) equal zero, meaning that total revenues exactly cover total operating costs (fixed and variable). |
| Financial Leverage | The use of fixed financial costs, such as interest on debt and preferred stock dividends, to magnify the effects of changes in EBIT on a firm's earnings per share (EPS). |
| Financial Breakeven Point | The level of EBIT at which a firm's earnings per share (EPS) equal zero, meaning that EBIT is just sufficient to cover all fixed financial costs (interest and preferred dividends). |
| Total Leverage | The combined effect of operating leverage and financial leverage, measuring how changes in sales impact a firm's earnings per share (EPS). |
| Degree of Operating Leverage (DOL) | A numerical measure of a firm's operating leverage, calculated as the percentage change in EBIT divided by the percentage change in sales. |
| Degree of Financial Leverage (DFL) | A numerical measure of a firm's financial leverage, calculated as the percentage change in EPS divided by the percentage change in EBIT. |
| Degree of Total Leverage (DTL) | A numerical measure of a firm's total leverage, calculated as the percentage change in EPS divided by the percentage change in sales, or as the product of DOL and DFL. |
| Capital Structure | The mix of long-term debt and equity financing that a firm employs to fund its operations and investments. |
| Cost of Debt | The interest rate a firm pays on its long-term debt obligations, which is typically tax-deductible, reducing the effective cost to the firm. |
| Cost of Equity | The return required by the firm's shareholders on their investment in the company, reflecting the risk associated with owning the stock. |
| Weighted Average Cost of Capital (WACC) | The overall cost of financing for a firm, calculated as a weighted average of the costs of its various sources of long-term capital (debt, preferred stock, common equity), with weights based on their market values in the capital structure. |
| Capital Asset Pricing Model (CAPM) | A model used to estimate the required return on a company's common stock, relating the expected return to the stock's systematic risk (beta), the risk-free rate, and the expected market return. |
| Beta Coefficient | A measure of a stock's volatility or systematic risk in relation to the overall market. A beta of 1.0 indicates the stock's price tends to move with the market, while a beta greater than 1.0 suggests higher volatility. |
| Cost of Retained Earnings | The return that shareholders require on the firm's earnings that are retained and reinvested in the business, which is typically equal to the cost of common equity. |
| Payout Policy | The decisions a firm makes regarding the distribution of cash to its shareholders, either through dividends or stock repurchases. |
| Cash Dividend | A payment made by a corporation to its shareholders, usually in the form of cash, representing a portion of the company's profits distributed to owners. |
| Stock Dividend | A dividend paid to shareholders in the form of additional shares of stock, rather than cash, which increases the number of shares outstanding but does not change the firm's total equity value or the shareholder's proportional ownership. |
| Stock Split | An action by a company to divide its existing shares into multiple new shares, typically to lower the market price per share and increase the stock's liquidity, without altering the company's total market value or equity structure. |
| Share Repurchase (Stock Buyback) | A program where a company buys back its own shares from the open market, which can reduce the number of outstanding shares, potentially increase earnings per share (EPS), and signal management's belief that the stock is undervalued. |
| Working Capital Management | The administration of a firm's current assets and current liabilities to ensure adequate liquidity and efficient use of resources for day-to-day operations. |
| Net Working Capital | The difference between a firm's current assets and its current liabilities, representing the capital available for operational needs. |
| Cash Conversion Cycle (CCC) | The length of time it takes for a firm to convert its investments in inventory and other resources into cash flows from sales. It measures how efficiently a firm is managing its working capital. |
| Operating Cycle (OC) | The average length of time from the beginning of the production process until the collection of cash from the sale of finished goods. |
| Inventory Management | The process of overseeing the procurement, storage, and use of inventory to ensure that adequate stock levels are maintained to meet demand without incurring excessive carrying costs or stockouts. |
| Economic Order Quantity (EOQ) | A model used in inventory management to determine the optimal order quantity that minimizes the total costs associated with ordering and holding inventory. |
| Reorder Point | The inventory level at which a new order should be placed to replenish stock, considering lead time and demand during that lead time, including safety stock. |
| Safety Stock | Extra inventory held to prevent stockouts due to uncertainties in demand or lead time. |
| Accounts Receivable Management | The process of managing customer credit and collecting payments to optimize cash inflows while minimizing bad debt losses and maintaining competitive credit terms. |
| Credit Standards | The minimum requirements a firm sets for extending credit to customers, often based on the 'Five C's of Credit' (character, capacity, capital, collateral, and conditions). |
| Credit Terms | The conditions under which a firm extends credit to its customers, including the length of the credit period and any available early payment discounts. |
| Early Payment Discount | A discount offered by a seller to customers who pay their invoices within a specified shorter period, incentivizing prompt payment and reducing the firm's investment in accounts receivable. |
| Aging of Accounts Receivable | A credit monitoring technique that categorizes accounts receivable based on their age since the invoice date, helping to identify overdue accounts and assess the effectiveness of collection efforts. |
| Spontaneous Liabilities | Short-term liabilities that arise automatically from the normal course of business operations, such as accounts payable and accruals, which fluctuate with sales or production levels. |
| Accounts Payable Management | The management of the time a firm takes to pay its suppliers, aiming to maximize the use of interest-free financing from suppliers without damaging supplier relationships or credit ratings. |
| Cost of Giving Up an Early Payment Discount | The implicit annualized interest rate incurred when a firm forgoes an early payment discount offered by a supplier, effectively borrowing funds from the supplier for an extended period. |
| Capital Expenditure | A cash outflow made by a firm to acquire or improve long-term assets, such as property, plant, and equipment, which are expected to provide benefits over a period longer than one year. |
| Revenue Stability | The degree to which a firm's revenues are predictable and consistent over time, impacting its ability to manage financial risk and take on debt. |
| Agency Costs | Costs incurred by principals (owners) to ensure that agents (managers) act in the principals' best interests, which can include monitoring costs, bonding costs, and residual loss. |
| Capital Structure Theory | Theoretical frameworks that explain how a firm's mix of debt and equity financing affects its value, considering factors like tax benefits of debt, bankruptcy costs, and agency costs. |
| Probability of Bankruptcy | The likelihood that a firm will be unable to meet its financial obligations and will face bankruptcy proceedings. This risk increases with higher levels of debt and financial leverage. |
| Financial Risk | The risk to a firm of being unable to meet its required financial obligations, such as interest payments and principal repayments, which can lead to financial distress or bankruptcy. |
| EBIT-EPS Analysis | A method used to evaluate the impact of different capital structures on a firm's earnings per share (EPS) at various levels of earnings before interest and taxes (EBIT), helping to identify the optimal capital structure. |
| Management Preferences | The choices and priorities of a firm's management regarding risk tolerance, financing strategies, and investment decisions, which can influence the firm's capital structure and overall value. |
| Voice in Management | The influence that shareholders or creditors have on a company's management and strategic decisions, often exercised through voting rights in general assemblies or through contractual covenants in debt agreements. |
| General Assembly | A meeting of a company's shareholders where they can vote on important corporate matters, including the election of the board of directors, approval of financial statements, and dividend policies. |
| Secured Creditors | Lenders who have a claim on specific assets of a company as collateral for their loans, giving them priority in repayment in the event of bankruptcy. |
| Unsecured Creditors | Lenders or suppliers who have claims against a company's assets but do not have specific collateral backing their claims, ranking below secured creditors in bankruptcy. |
| Equityholders (Shareholders) | Owners of a company who hold common or preferred stock, having a residual claim on the firm's assets and earnings after all creditors have been paid. |
| Common Stock | A type of equity ownership in a corporation that typically carries voting rights and a claim on the firm's residual earnings and assets after all debt and preferred stock obligations have been met. |
| Preferred Stock | A class of stock that typically pays a fixed dividend and has a claim on assets and earnings that is senior to common stock but subordinate to debt. It is often considered a hybrid security with characteristics of both debt and equity. |
| Authorized Shares | The maximum number of shares of stock that a corporation is legally permitted to issue, as specified in its corporate charter. |
| Outstanding Shares | Shares of common stock that have been issued by a company and are held by investors, including both public and private shareholders. |
| Voting Rights | The right of shareholders to vote on certain corporate matters, such as the election of directors and major policy decisions, typically exercised on a per-share basis. |
| Proxy Statement | A document provided to shareholders soliciting their votes on corporate matters, often used by management or dissident shareholders to solicit proxy votes for board elections or other proposals. |
| Nonvoting Common Shares | Shares of common stock that do not carry voting rights, issued by companies that wish to raise capital through equity issuance without diluting the voting control of existing shareholders. |
| Retained Earnings | The portion of a company's net earnings that is not distributed to shareholders as dividends but is instead reinvested in the business to fund growth, operations, or reduce debt. |
| Market Efficiency | The degree to which market prices reflect all available information, suggesting that it is difficult to consistently achieve superior investment returns due to prices quickly adjusting to new information. |
| Behavioral Finance | An area of finance that explores how psychological factors and cognitive biases influence investor decision-making and affect market prices, potentially leading to market inefficiencies. |
| Constant-Growth Dividend Model (Gordon Growth Model) | A stock valuation model that assumes dividends will grow at a constant rate indefinitely, used to estimate the intrinsic value of a stock based on expected future dividends and the required rate of return. |
| Variable-Growth Dividend Model | A stock valuation model that accounts for periods of varying dividend growth rates before settling into a constant growth rate in the future, providing a more realistic valuation for companies with changing growth patterns. |
| Free Cash Flow (FCF) | The cash flow available to a company's investors (creditors and owners) after all operating expenses, investments in assets, and working capital have been accounted for. It represents the cash that can be distributed to investors without impairing the company's operations. |
| Book Value Per Share | The equity attributable to each share of common stock as reported on the company's balance sheet, calculated by dividing total stockholders' equity by the number of outstanding shares. |
| Price/Earnings (P/E) Multiples Approach | A stock valuation method that estimates a stock's market price by multiplying its expected earnings per share (EPS) by the average price/earnings (P/E) ratio for comparable companies in the same industry. |
| Relevant Cash Flows | The incremental cash inflows and outflows—both initial investment and operating cash flows—that are expected to result from a proposed capital expenditure project and are relevant for decision-making. |
| Expansion Decision | A capital expenditure decision where a firm undertakes a new project to increase its output, sales, or market share. |
| Replacement Decision | A capital expenditure decision where a firm replaces an existing asset with a new one, requiring an analysis of the incremental cash flows associated with the replacement. |
| Real Options | Contingent claims or opportunities embedded within capital projects that allow managers to alter the project's cash flows or risk profile in response to future events or information, such as timing, growth, or abandonment options. |
| Inventory Turnover | A measure of how many times a company sells and replaces its inventory during a given period, indicating inventory management efficiency. |
| Average Collection Period (ACP) | The average number of days it takes for a firm to collect payments from its credit customers, reflecting the efficiency of its accounts receivable management. |
| Average Payment Period (APP) | The average number of days a firm takes to pay its own suppliers or accounts payable, indicating how efficiently it manages its short-term liabilities. |
| Aggressive Funding Strategy | A financing strategy where a firm uses short-term debt to finance its temporary or seasonal funding needs and long-term debt or equity to finance its permanent funding requirements. |
| Conservative Funding Strategy | A financing strategy where a firm uses long-term debt or equity to finance both its permanent and seasonal funding needs, resulting in potentially higher financing costs but lower risk. |
| Just-in-Time (JIT) System | An inventory management strategy aimed at minimizing inventory levels by having materials and components arrive exactly when they are needed for production, thereby reducing carrying costs and improving efficiency. |
| Materials Requirement Planning (MRP) System | An inventory management system that uses computer technology to compare production needs with available inventory balances and schedule orders for materials based on a product's bill of materials. |
| Enterprise Resource Planning (ERP) | A comprehensive computerized system that integrates various business functions, such as finance, accounting, marketing, and manufacturing, to provide a unified view of the organization's resources and operations. |
| Credit Scoring | A quantitative method used to assess the creditworthiness of loan applicants, assigning a score based on statistically derived weights applied to key financial and credit characteristics. |
| Credit Period | The number of days after the beginning of the credit period until the full payment of an account is due, influencing sales volume and the amount of investment in accounts receivable. |
| Aging of Accounts Receivable | A credit monitoring technique that breaks down accounts receivable into categories based on how long they have been outstanding, helping to identify overdue accounts and assess collection performance. |
| Collection Techniques | Methods used by firms to encourage timely payment of accounts receivable, ranging from polite reminders and telephone calls to more stringent actions like legal action or turning accounts over to collection agencies. |
| Spontaneous Liabilities | Financing sources that arise naturally from the firm's operating activities, such as accounts payable and accruals, which tend to increase or decrease with changes in sales or production levels. |
| Cash Discount | A reduction in the invoice price offered to customers for prompt payment, incentivizing early settlement of accounts receivable. |
| Cost of Giving Up an Early Payment Discount | The annualized cost of forgoing an early payment discount, representing the implicit interest rate paid to delay payment for an additional period. |
| Stretching Accounts Payable | A strategy where a firm pays its suppliers as late as possible within the agreed-upon credit terms to maximize the use of interest-free financing from suppliers, without harming its credit rating. |
| Accruals | Liabilities for expenses that have been incurred but not yet paid, such as wages payable or taxes payable, representing a form of short-term, interest-free financing. |
| Money Market | A market for short-term debt instruments with maturities of one year or less, characterized by low risk and high liquidity, used for managing short-term cash needs. |
| Capital Market | A market for long-term debt and equity securities, with maturities greater than one year, used for raising long-term funds for businesses and governments. |
| Income Statement | A financial statement that reports a company's revenues, expenses, and profits or losses over a specific period, providing insights into operational performance. |
| Statement of Cash Flows | A financial statement that summarizes a firm's cash inflows and outflows over a given period, categorized into operating, investing, and financing activities. |
| Current Ratio | A liquidity ratio that measures a company's ability to meet its short-term obligations by dividing current assets by current liabilities. |
| Quick Ratio (Acid-Test Ratio) | A stricter liquidity ratio than the current ratio, measuring a company's ability to meet its short-term obligations using only its most liquid assets (cash, marketable securities, and accounts receivable). |
| Debt Ratio | A leverage ratio that indicates the proportion of a company's assets financed by debt, calculated by dividing total liabilities by total assets. |
| Times Interest Earned Ratio | A coverage ratio that measures a company's ability to meet its interest obligations, calculated by dividing earnings before interest and taxes (EBIT) by interest expense. |
| Asset-Use Efficiency | A measure of how efficiently a company uses its assets to generate sales, often calculated as the asset turnover ratio (sales/total assets). |
| Profit Margin | A profitability ratio that indicates the percentage of revenue remaining as profit after all expenses have been deducted, calculated as net income divided by sales. |
| Earnings Per Share (EPS) | A measure of a company's profitability on a per-share basis, calculated by dividing net income available to common stockholders by the number of outstanding common shares. |
| Return on Equity (ROE) | A profitability ratio that measures how effectively a company generates profits from its shareholders' investments, calculated by dividing net income by average shareholders' equity. |
| Price/Earnings (P/E) Ratio | A valuation ratio that compares a company's stock price to its earnings per share, indicating how much investors are willing to pay for each dollar of earnings. |
| Book Value Per Share | The value of a company's equity on its balance sheet on a per-share basis, calculated by dividing total shareholders' equity by the number of outstanding shares. |
| Depreciation | A non-cash expense that allocates the cost of tangible assets over their useful lives, reducing taxable income and providing a tax shield. |
| Operating Flows | Cash flows generated from a firm's core business activities, such as the sale of goods and services. |
| Investment Flows | Cash flows related to the purchase or sale of long-term assets, such as property, plant, and equipment, or investments in other companies. |
| Financing Flows | Cash flows resulting from debt and equity transactions, including the issuance or repayment of debt, and the issuance, repurchase, or payment of dividends on stock. |
| Free Cash Flow (FCF) | The cash flow available to a firm's investors (creditors and owners) after all operating expenses and investments in net fixed assets and net current assets have been accounted for. |
| Annuity | A series of equal periodic cash flows occurring over a specified period, which can be either inflows or outflows. |
| Perpetuity | An annuity with an infinite life, providing a perpetual stream of equal cash flows at regular intervals. |
| Present Value | The current worth of a future sum of money or stream of cash flows, discounted at a specific rate of return. |
| Discounting | The process of determining the present value of future cash flows by applying a discount rate. |
| Discount Rate | The rate of return used to discount future cash flows to their present value, typically representing the cost of capital or the required rate of return. |
| Yield Curve | A graphic representation of the relationship between interest rates and the time to maturity for debt securities of similar risk. |
| Yield to Maturity (YTM) | The total annual rate of return anticipated on a bond if held until maturity, considering all coupon payments and the difference between the purchase price and the face value. |
| Bond Valuation | The process of determining the current worth of a bond by calculating the present value of its future cash flows (coupon payments and principal repayment). |
| Interest Rate Risk | The risk that the value of a bond will decrease due to increases in prevailing interest rates. |
| Bond | A debt instrument representing a loan made by an investor to an entity, with promises of periodic interest payments and repayment of the principal at maturity. |
| Semiannual Interest Payments | Interest payments made on a bond twice a year, requiring adjustments to the discount rate and payment periods in valuation calculations. |
| Equity | Ownership interest in a company, represented by common or preferred stock. |
| Dividends | Distributions of a company's profits to its shareholders, typically paid in cash or stock. |
| Venture Capital | Equity financing provided to startup companies or businesses with high growth potential in exchange for an ownership stake, often involving significant risk and potential for high returns. |
| Business Angels | Wealthy individuals who invest their own capital in promising startups or small businesses in exchange for equity, often providing mentorship and industry expertise. |
| IPO (Initial Public Offering) | The first time a company offers its stock for sale to the public, marking its transition from a private to a public company. |
| Constant-Growth Model | A stock valuation model that assumes dividends will grow at a constant rate indefinitely, allowing for the calculation of a stock's intrinsic value. |
| Cost of Capital | The minimum rate of return a company must earn on its investments to satisfy its investors (both debt holders and equity holders), representing the cost of financing its operations. |
| Weighted Average Cost of Capital (WACC) | The average cost of all the capital sources used by a company, weighted by their respective proportions in the firm's capital structure. It represents the firm's overall cost of financing. |
| Payback Period | A capital budgeting technique that measures the time it takes for an investment to generate cash inflows sufficient to recover the initial investment. |
| NPV (Net Present Value) | A capital budgeting technique that measures the profitability of an investment by calculating the present value of its future cash flows minus the initial investment. |
| Incremental Cash Flows | The additional cash inflows and outflows resulting from a proposed investment project, considered relevant for capital budgeting decisions. |
| After-Tax Cash Flows | Cash flows adjusted for taxes, reflecting the actual net benefit or cost to the firm after considering tax implications. |
| Internal Rate of Return (IRR) | The discount rate at which the net present value (NPV) of an investment equals zero, representing the expected rate of return on the investment. |
| Sunk Costs | Cash outlays that have already been made and cannot be recovered, which are irrelevant to future investment decisions. |
| Opportunity Costs | The potential benefits forgone when one alternative is chosen over another, representing the value of the next-best alternative use of resources. |
| Operating Leverage | The extent to which a firm uses fixed operating costs in its operations, which magnifies the effect of changes in sales on EBIT. |
| Operating Breakeven Point | The sales level at which EBIT is zero, meaning that total revenues cover all fixed and variable operating costs. |
| Financial Leverage | The extent to which a firm uses debt financing, which magnifies the effect of changes in EBIT on EPS. |
| Total Leverage | The combined effect of operating and financial leverage on EPS, measuring how changes in sales impact earnings per share. |
| Payout Policy | The decisions a company makes regarding the distribution of its earnings to shareholders, either as dividends or through share repurchases. |
| Stock Dividend | A dividend paid to shareholders in the form of additional shares of stock, rather than cash, which increases the number of shares outstanding and reduces the stock price per share. |
| Stock Split | A corporate action that divides existing shares into multiple new shares, typically to lower the market price per share and increase liquidity, without changing the company's total market value. |
| Stock Repurchase | A program where a company buys back its own shares from the open market, which can reduce the number of outstanding shares, increase EPS, and potentially signal management's confidence in the company's value. |
| Working Capital Management | The administration of a firm's current assets and current liabilities to ensure sufficient liquidity and efficient use of resources for ongoing operations. |
| Net Working Capital | The difference between a firm's current assets and its current liabilities, representing the capital available for day-to-day operations. |
| Cash Conversion Cycle (CCC) | The number of days it takes for a firm to convert its investments in inventory and receivables into cash from sales, measuring the efficiency of working capital management. |
| Operating Cycle (OC) | The average time period from the acquisition of raw materials to the collection of cash from the sale of finished goods. |
| Inventory Management | The process of optimizing inventory levels to meet demand while minimizing costs associated with holding and ordering inventory. |
| Economic Order Quantity (EOQ) | A model used to determine the optimal order size for inventory that minimizes the total costs of ordering and carrying inventory. |
| Reorder Point | The inventory level at which a new order should be placed to replenish stock, considering lead time and safety stock. |
| Safety Stock | Extra inventory held to buffer against unexpected increases in demand or delays in replenishment. |
| Accounts Receivable Management | The process of managing customer credit and collections to optimize cash inflows, minimize bad debt losses, and maintain competitive credit terms. |
| Credit Standards | The minimum requirements a firm imposes for extending credit to customers, influencing sales volume and the level of accounts receivable. |
| Credit Terms | The conditions under which credit is extended to customers, including the length of the credit period and any available discounts for early payment. |
| Early Payment Discount | A discount offered to customers for paying their invoices within a specified shorter period, encouraging prompt payment and reducing the firm's investment in accounts receivable. |
| Stretching Accounts Payable | A strategy of paying suppliers as late as possible within the agreed credit terms to maximize the use of interest-free financing from suppliers, without damaging supplier relationships or credit ratings. |
| Accruals | Liabilities for expenses incurred but not yet paid, such as wages or taxes, which represent a form of short-term, interest-free financing. |
| Money Market | A market for short-term debt instruments with maturities of one year or less, characterized by high liquidity and low risk. |
| Capital Market | A market for long-term debt and equity securities, used for raising long-term funds for businesses and governments. |
| Income Statement | A financial statement that reports a company's revenues, expenses, and profits or losses over a specific period. |
| Balance Sheet | A financial statement that reports a company's assets, liabilities, and shareholder equity at a specific point in time. |
| Statement of Cash Flows | A financial statement that summarizes a firm's cash inflows and outflows over a given period, categorized by operating, investing, and financing activities. |
| Current Ratio | A liquidity ratio that measures a company's ability to meet its short-term obligations using current assets. |
| Quick Ratio (Acid-Test Ratio) | A stricter liquidity ratio than the current ratio, measuring a company's ability to meet short-term obligations using only its most liquid assets. |
| Debt Ratio | A leverage ratio indicating the proportion of a company's assets financed by debt. |
| Times Interest Earned Ratio | A coverage ratio that measures a company's ability to cover its interest expenses with its operating earnings. |
| Asset-Use Efficiency | A measure of how efficiently a company uses its assets to generate sales. |
| Profit Margin | A profitability ratio indicating the percentage of revenue that remains as profit after all expenses. |
| Earnings Per Share (EPS) | A company's net profit allocated to each outstanding share of common stock. |
| Return on Equity (ROE) | A measure of how effectively a company generates profits from its shareholders' investments. |
| Price/Earnings (P/E) Ratio | A valuation ratio comparing a company's stock price to its earnings per share. |
| Book Value Per Share | The net asset value per share of common stock as reported on the balance sheet. |
| Depreciation | An expense that allocates the cost of tangible assets over their useful lives. |
| Operating Flows | Cash flows generated from a company's core business operations. |
| Investment Flows | Cash flows related to the purchase or sale of long-term assets. |
| Financing Flows | Cash flows resulting from debt and equity transactions. |
| Free Cash Flow (FCF) | The cash flow available to investors after all operating expenses and investments have been accounted for. |
| Annuity | A series of equal periodic cash flows over a specified period. |
| Perpetuity | An annuity with an infinite life, providing a perpetual stream of equal cash flows. |
| Present Value | The current worth of a future sum of money or stream of cash flows. |
| Discounting | The process of determining the present value of future cash flows. |
| Discount Rate | The rate of return used to discount future cash flows to their present value. |
| Yield Curve | A graphic representation of the relationship between interest rates and the time to maturity for debt securities. |
| Yield to Maturity (YTM) | The total annual rate of return anticipated on a bond if held until maturity. |
| Bond Valuation | The process of determining the current worth of a bond by calculating the present value of its future cash flows. |
| Interest Rate Risk | The risk that a bond's value will decline due to increases in prevailing interest rates. |
| Bond | A debt instrument representing a loan made by an investor to an entity. |
| Semiannual Interest Payments | Interest payments made on a bond twice a year. |
| Equity | Ownership interest in a company. |
| Dividends | Distributions of a company's profits to its shareholders. |
| Venture Capital | Equity financing provided to startups or companies with high growth potential. |
| Business Angels | Wealthy individuals who invest in promising startups in exchange for equity. |
| IPO (Initial Public Offering) | The first time a company offers its stock for sale to the public. |
| Constant-Growth Model | A stock valuation model assuming dividends grow at a constant rate indefinitely. |
| Cost of Capital | The minimum rate of return a company must earn on its investments to satisfy its investors. |
| Weighted Average Cost of Capital (WACC) | The average cost of all capital sources used by a company, weighted by their market values. |
| Payback Period | The time required for an investment to generate cash inflows equal to its initial investment. |
| NPV (Net Present Value) | The present value of future cash flows minus the initial investment. |
| Incremental Cash Flows | The additional cash flows resulting from a proposed investment project. |
| After-Tax Cash Flows | Cash flows adjusted for taxes, reflecting the actual net benefit or cost to the firm. |
| Internal Rate of Return (IRR) | The discount rate at which the NPV of an investment equals zero. |
| Sunk Costs | Cash outlays already made that are irrelevant to future decisions. |
| Opportunity Costs | The potential benefits forgone when one alternative is chosen over another. |
| Operating Leverage | The extent to which a firm uses fixed operating costs, magnifying the effect of sales changes on EBIT. |
| Operating Breakeven Point | The sales level at which EBIT is zero. |
| Financial Leverage | The extent to which a firm uses debt financing, magnifying the effect of EBIT changes on EPS. |
| Total Leverage | The combined effect of operating and financial leverage on EPS. |
| Payout Policy | The decisions a company makes regarding the distribution of earnings to shareholders. |
| Stock Dividend | A dividend paid in the form of additional shares of stock. |
| Stock Split | A corporate action dividing existing shares into multiple new shares to lower the market price per share. |
| Stock Repurchase | A program where a company buys back its own shares from the market. |
| Working Capital Management | The administration of current assets and current liabilities to ensure liquidity and efficient resource use. |
| Net Working Capital | The difference between current assets and current liabilities. |
| Cash Conversion Cycle (CCC) | The number of days it takes for a firm to convert its investments in inventory and receivables into cash from sales. |
| Operating Cycle (OC) | The average time period from the acquisition of raw materials to the collection of cash from finished goods sales. |
| Inventory Management | The process of optimizing inventory levels to meet demand while minimizing costs. |
| Economic Order Quantity (EOQ) | A model to determine the optimal order size for inventory that minimizes total ordering and carrying costs. |
| Reorder Point | The inventory level at which a new order should be placed. |
| Safety Stock | Extra inventory held to buffer against unexpected demand or lead time variations. |
| Accounts Receivable Management | The process of managing customer credit and collections to optimize cash inflows and minimize bad debt losses. |
| Credit Standards | The minimum requirements for extending credit to customers. |
| Credit Terms | The conditions under which credit is extended, including the credit period and early payment discounts. |
| Early Payment Discount | A reduction in invoice price offered for prompt payment. |
| Stretching Accounts Payable | Paying suppliers as late as possible within credit terms to maximize interest-free financing. |
| Accruals | Liabilities for expenses incurred but not yet paid. |