Prof. J. Kwak
Essentials of Corporate Finance, 9th ed.
ESSENTIALS OF CORPORATE FINANCE
CHAPTER 1: Introduction to Financial Management
Business Finance and the Financial Manager
Capital Budgeting: The process of planning and managing a firm’s long-term investments.
Capital Structure: The mixture of debt and equity maintained by a firm.
Working Capital: A firm’s short-term assets and liabilities.
The Agency Problem and Control of the Corporation
Agency Problem: The possibility of conflict of interest between the owners and management of a firm.
Stakeholder: Someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm.
Financial Markets and the Corporation
Primary Market: Refers to the original sale of securities by governments and corporations.
Secondary Markets: Those in which securities from the primary market are bought and sold after the original sale.
1. Auction Markets: Brokers and agents match buyers and sellers, but do not actually own the commodity being traded.
Has a physical location, e.g., Wall Street.
2. Dealer Markets: Also called over-the-counter (OTC) markets; dealers buy and sell for themselves.
CHAPTER 2: Financial Statements, Taxes, and Cash Flow
The Balance Sheet
Balance Sheet: Financial statement showing a firm’s accounting value on a particular date.
Assets = Liabilities + Shareholders’ equity (or)
Shareholders’ equity = Assets – Liabilities
Net Working Capital: Current assets less current liabilities
NWC = Current Assets – Current Liabilities
Market Value: True value of any asset; the amount of cash I would get if I actually sold it.
Book Value: Values shown on the balance sheet; generally not what the assets are actually worth.
Generally Accepted Accounting Principles (GAAP): The common set of standards and procedures by which audited financial statements are prepared.
Assets at historical cost, “carried on the books.”
The Income Statement
Income Statement: Financial statement summarizing a firm’s performance over a period of time.
Revenues – Expenses = Income
Net Income: The bottom line
1. Net Sales – (Cost + Depreciation) = Earnings before Interest and Taxes
2. Earnings before Interest and Taxes – Interest paid = Taxable income
3. Taxable income x Tax Rate = Taxes
4. Taxable income – Taxes = Net Income
Earnings Per Share = Net Income/Total shares outstanding
Dividends Per Share = Total dividends/Total shares outstanding
Addition To Retained Earnings: The difference between net income and cash dividends.
Added to the cumulative retained earnings account on the balance sheet.
Addition to Retained Earnings = Net Income – Cash Dividends
Noncash Items: Expenses charged against revenues that do not directly affect cash flow; the most important is depreciation.
Average Tax Rate: Total taxes paid divided by total taxable income.
Marginal Tax Rate: Amount of tax payable on the next dollar earned.
Cash Flow From Assets: The total of cash flow to creditors and cash flow to stockholders, consisting of the following: operating cash flow, capital spending, and change in net working capital.
Cash flow from assets = Cash flow to creditors + Cash flow to stockholders (or)
Operating cash flow – (Net capital spending + ∆NWC) = Cash flow from assets
Operating Cash Flow: Cash generated from a firm’s normal business activities; operating expenses.
Expenses associated with financing assets are not included because they are not operating expenses.
E.g., depreciation & interest.
1. Net Sales – Costs = Earnings before interest and taxes (EBIT)
2. EBIT – Taxes = Operating Cash Flow
3. (add depreciation and interest back in if applicable)
Capital Spending: The net spending on fixed assets.
Purchases of fixed assets – Sales of fixed assets (or)
Ending net fixed assets – Beginning net fixed assets + Depreciation = Net investment in fixed assets (capital spending)
Change In Net Working Capital: The amount spent on net working capital.
∆NWC = (Present Current Assets – Present Current Liabilities) – (Past Current Assets – Past Current Liabilities) (or)
∆NWC = Ending NWC – Beginning NWC
Free Cash Flow: Another name for cash flow from assets.
Cash Flow To Creditors: A firm’s interest payments to creditors less net new borrowing.
Interest – Net new borrowing = Cash flow to creditors (or)
Interest – (Ending Liabilities – Beginning Liabilities) = Cash flow to creditors
Cash Flow To Stockholders: Dividends paid out by a firm less net new equity raised.
Dividends paid – Net new equity raised = Cash flow to stockholders (or)
Dividends paid – (Ending Owners’ Equity – Beginning Owners’ Equity) = Cash flow to stockholders
CHAPTER 3: Working with Financial Statements
Standardized Financial Statements
Common-Size Statements: A standardized financial statement presenting all items in percentage terms.
Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales.
Financial Ratios: Relationships determined from a firm’s financial information and used for comparison purposes.
Short-Term Solvency, or Liquidity, Measures: Intended to provide information about a firm’s liquidity.
Return on (Book) Equity: Amount of profit generated for every dollar in equity. How the stockholders fared during the year; the true bottom-line measure of performance. Sometimes called return on net worth.
Return on Equity = Net Income / Total Equity (or)
Return on Equity = Return on Assets x Equity Multiplier
Market Value Measures: The market price per share of stock. Based on information not necessarily in financial statements.
Need EPS = Net Income / Shares Outstanding
Price-Earnings Ratio: Measures how much investors are willing to pay per dollar of current earnings. Higher ratio often taken to mean that the firm has significant prospects for future growth. (but no or small earning could still = high PE)
PE Ratio = Price Per Share / Earnings Per Share
Price-Sales Ratio: Factors in revenues during extended periods of negative earnings, e.g., recent start-ups.
PS Ratio = Price Per Share / Sales Per Share [SPS = Sales / Shares Outstanding]
Market-to-Book Ratio: Compares the market value of a firm’s (total) investments to their cost.
Market-to-Book Ratio = Market Value Per Share / Book Value Per Share [BVPS = Total Equity / Shares Outstanding]
Enterprise Value-EBITDA Ratio: An estimate of the market value of the firm’s operating assets; i.e., all assets except cash.
Enterprise Value = Total Market Value of the Stock [Stock Market Value x Shares Outstanding] + Book Value of all Liabilities – Cash (or)
Enterprise Value = Total Assets – Cash
EBITDA Ratio = Enterprise value / EBITDA
The Dupont Identity
DuPont Identity: Popular expression breaking ROE into three parts: operating efficiency (profit margin), asset use efficiency (total asset turnover), and financial leverage (equity multiplier).
ROE = Profit Margin x Total Asset Turnover x Equity Multiplier (or)
(Net Income / Total Equity) = (Net Income / Sales) x (Sales / Assets) x (Assets / Total Equity)
Extended DuPont Chart: See Page 68
Using Financial Statement Information
Standard Industrial Classification (SIC) Codes: US Code used to classify a firm by its type of business operations; used for peer group analysis.