You are on page 1of 22

Study Guide

FIN/571 Version 7

Week 1 Study Guide: Foundations of Finance


Reference
Parrino, R., Kidwell, D.S., & Bates, D.S. (2012). Fundamentals Of Corporate Finance (2nd ed.).
Retrieved from The University of Phoenix eBook Collection database.
In-Text Citation
Insert the paraphrased material (Parrino, Kidwell, & Bates, 2012, p. 1).
According to Parrino, Kidwell, and Bates (2012), Insert the paraphrased material (p. 1).
Insert the quotation (Parrino, Kidwell, & Bates, 2012, p. 1).
Reference
Investopedia.com. (2015). Retrieved from
http://www.investopedia.com/terms/l/llc.asp
In-Text Citation
Insert the paraphrased material ("Investopedia.com", 2015).
The "Investopedia.com" (2015) website Insert the paraphrased material.
According to "Investopedia.com" (2015), "Insert the quotation (Limited Liability Company LLC).
Glossary 721
Subject Index 729
Readings and Key Terms
Ch. 1 of Fundamentals of Corporate Finance
o Wealth - "The economic value of the assets someone possesses" (Parrino, Kidwell, &
Bates, 2012, p. 2).
Wealth, 2
o Stakeholders - "Anyone other than an owner (stockholder) with a claim on the cash
flows of a firm, including employees, suppliers, creditors, and the government"
(Parrino, Kidwell, & Bates, 2012, p. 2).
Stakeholders, 2, 3
o Residual cash flows - "The cash remaining after a firm has paid operating expenses
and what it owes creditors and in taxes; can be paid to the owners as a cash
dividend or reinvested in the business" (Parrino, Kidwell, & Bates, 2012, p. 3).
Residual cash flows, 3
o Bankruptcy - "Legally declared inability of an individual or a company to pay its
creditors" (Parrino, Kidwell, & Bates, 2012, p. 4).
Bankruptcy, 4
of Blockbuster, 200
and debt financing, 5
of Enron and WorldCom, 16, 1820
losses limited in, 659
from mismanagement of working
capital, 6
Bankruptcy costs, 520523
direct, 521

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

Study Guide
FIN/571 Version 7

indirect, 521523
Capital structure - "The mix of debt and equity that is used to finance a firm"
(Parrino, Kidwell, & Bates, 2012, p. 6).
Capital structure, 6, 504530
choosing, 526529
decisions on, 612
dividends in management of, 556
and financial risk, 510
in financing plan, 609
leasing, 535544
and Modigliani and Miller propositions,
506514
optimal, 505506, 520, 676
pecking order theory of, 526528
for selected industries, 527
trade-off theory of, 526528
use of debt in, 514526
Capital markets - "Financial markets where equity and debt instruments with
maturities greater than one year are traded" (Parrino, Kidwell, & Bates, 2012, p.6).
Capital markets, 6, 31, 32, 689691
Net working capital (NWC) - "The dollar difference between current assets and
current liabilities" (Parrino, Kidwell, & Bates, 2012, p.6).
Net working capital (NWC), 4, 6
cash flow invested in, 6869
on financial statements, 5354
in working capital management, 443, 450451
Sole proprietorship - "A business owned by a single individual" (Parrino, Kidwell,
& Bates, 2012, p. 6).
Sole proprietorships, 67
capital for, 572, 573
characteristics of, 572
financial liabilities of, 573574
life of, 573
taxation of, 7
Partnership - "Two or more owners who have joined together legally to manage a
business and share in its profits" (Parrino, Kidwell, & Bates, 2012, p. 7).
Partnerships, 7
characteristics of, 572
life of, 573
limited liability, 8
maximizing stock value for, 12
taxation of, 8
Partnership agreements, 572, 573
Limited liability partnership (LLP) - "Hybrid business organizations that combine
some of the advantages of corporations and partnerships; in general, income to the

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

Study Guide
FIN/571 Version 7

partners is taxed only as personal income, but the partners have limited liability"
(Parrino, Kidwell, & Bates, 2012, p. 8).
Limited liability partnerships (LLPs), 8
Limited partners, 7, 493
Limited partnerships, 7
capital for, 572, 573
characteristics of, 572
financial liabilities of, 573
life of, 573
private equity funds as, 493
o Limited liability company (LLC) - According to Investopedia.com (2015),"A
corporate structure whereby the members of the company cannot be held personally
liable for the company's debts or liabilities" (Limited Liability Company - LLC).
Limited liability companies (LLCs),
8, 571, 572
capital for, 573
characteristics of, 572
financial liabilities of, 574
life of, 573
partnership agreements in, 573
private equity funds as, 493
taxes as C-corporations, 574n.1
o Corporation - "A legal entity formed and authorized under a state charter; in a
legal sense, a corporation is a person distinct from its owners" (Parrino, Kidwell, &
Bates, 2012, p. 7).
Corporations, 78
capital for, 572573
C-corporations, 572574
characteristics of, 572
financial liabilities of, 574
and financial system, 3637
life of, 573
multinational, 673, 674
privately held, 8, 12
professional, 8
S-corporations, 8, 571, 572
stateless, 673
transnational, 673
o Prviately held corporations - "Corporations whose stock is not traded in public
markets" (Parrino, Kidwell, & Bates, 2012, p. 8).
Privately held corporations, 8, 12
o Agency conflicts - "Conflicts of interest between a principal and an agent" (Parrino,
Kidwell, & Bates, 2012, p. 14).
Agency confl icts, 1318, 14
and agency relationships, 14, 19

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

Study Guide
FIN/571 Version 7

aligning interests of management and stockholders, 1416


for diff erent forms of business, 572, 573
manager-stockholder, 14
with ownership and control, 14
payoff functions leading to, 658661
in private equity firms, 494
and regulatory reforms, 1618
o Agency costs - "The costs arising from conflicts of interest between a principal and
an agent; for example, between a fi rms owners and its management" (Parrino,
Kidwell, & Bates, 2012, p. 14).
Agency costs, 14, 523526
of debt, 659660
of equity, 660661
ethics conflicts involving, 19
and payoff functions, 658661
in private equity firms, 494
stockholder-lender, 524526
stockholder-manager, 523
Ch. 2 of Fundamentals of Corporate Finance p.24
o Financial and real assets - "Assets that are claims on the cash fl ows from other
assets; business loans, stocks, and bonds are financial assets. nonfinancial assets
such as plant and equipment; productive assets are real assets; many financial assets
are claims on cash flows from real assets" (Parrino, Kidwell, & Bates, 2012, p. 723,
725).
Financial assets, 25, 305, 306
Real assets, 25, 305, 306
o Primary and secondary markets - "A financial market in which new security issues
are sold by companies directly to investors / a financial market in which new
security issues are sold by companies directly to investors" (Parrino, Kidwell, &
Bates, 2012, p. 725,726).
Primary markets, 30
Secondary markets, 30, 271273
corporate bonds transactions in, 239
efficiency of, 272273
transactions in, 271272
types of, 273
o Marketability - "The ease with which a security can be sold and converted into
cash" (Parrino, Kidwell, & Bates, 2012, p. 724).
Marketability, 30, 255, 595
Marketability discount, 584585
Marketability risk premium (MRP), 255
o Liquidity - "The ability to convert an asset into cash quickly without loss of value"
(Parrino, Kidwell, & Bates, 2012, p. 724).
Liquidity, 30, 444

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

Study Guide
FIN/571 Version 7

marketability vs., 30
in money markets, 31
of seasoned vs. unseasoned stocks, 481
Liquidity discounts, 585n.3
Liquidity position, 8788
Liquidity ratios, 8790
o Private and public markets - " / financial markets where securities registered with
the SEC are sold" (Parrino, Kidwell, & Bates, 2012, p. 2).
Private markets, 32
private equity firms, 493494
private investments in public equity, 494
private placements, 32, 492493
public markets vs., 492
raising capital in, 491494
Public markets, 8, 3133. See also Initial public offerings
private markets vs., 492
as wholesale markets, 491
o Market efficiency - "The degree to which the transaction costs of bringing buyers
and sellers together are minimized / the degree to which current market prices refl
ect relevant information and, therefore, the true value of the security" (Parrino,
Kidwell, & Bates, 2012, p. 2).
Efficient market, 3334
o Financial intermediation - "Conversion of securities with one set of characteristics
into securities with another set of characteristics" (Parrino, Kidwell, & Bates, 2012,
p. 723).
Financial intermediation, 34, 35
o Initial public offering (IPO) - "The first offering of a corporations stock to the
public" (Parrino, Kidwell, & Bates, 2012, p. 724).
Initial public off erings (IPOs), 36, 37, 479488
advantages of, 480
bundling options and common stock in, 654
cost of, 480, 486488, 491
disadvantages of, 480481
distribution of shares, 483
investment banking services for, 481483
origination of, 481482
proceeds from, 483484
underpricing of, 485486
underwriting for, 482483
as venture capitalists exit strategy, 478
Inside directors, 17
Insider trading, 299300
o Real and nominal interest - "The interest rate that would exist in the absence of
inflation / the rate of interest that is unadjusted for inflation" (Parrino, Kidwell, &
Bates, 2012, p.725,726).

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

Study Guide
FIN/571 Version 7

Real rate of interest, 3840, 259


Nominal rate of interest, 38, 676
Ch. 3 of Fundamentals of Corporate Finance p.48
o Generally Accepted Accounting Principles (GAAP) - "A set of rules that defines how
companies are to prepare financial statements" (Parrino, Kidwell, & Bates, 2012,
p.723).
Generally accepted accounting principles
(GAAP), 16, 5052
fundamental accounting principles in, 5051
international, 5152
revenue recognition under, 6768
sales vs. leases, 536
for tax depreciation, 356
o Book value - "The net value of an asset or liability recorded on the fi nancial
statementsnormally refl ects historical cost" (Parrino, Kidwell, & Bates, 2012,
p.721).
Book value, 50
adjusted book value valuation approach,
582584
of assets, 5758, 411
of liabilities, 58
market vs., 5758
of stockholders equity, 58
Book-value balance sheet, 5860
Book value rate of return, 318
o Balance sheet - "Financial statement that shows a firms financial position (assets,
liabilities, and equity) at a point in time" (Parrino, Kidwell, & Bates, 2012, p. 722).
Balance sheet, 5260
assets on, 5255, 619
book-value vs. market-value, 5758
common-size, 8485
dividends on, 552
effect of decision making on, 4
equity on, 5557, 619
finance, 411412
in financial planning models, 614, 617622
historical trends on, 617618
liabilities on, 5455, 619
pro forma, 614615, 617622
relationship of other statements and, 6667
stock repurchases on, 552
working capital accounts on, 618619
Balance sheet identity, 411412

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

Study Guide
FIN/571 Version 7
o

Income statement - "A financial statement that reports a fi rms revenues, expenses,
and profi ts or losses over a period of time" (Parrino, Kidwell, & Bates, 2012, p.
723).
Income statement, 6063
common-size, 8586
in financial planning models, 613, 616617
pro forma, 613, 616617
relationship of other statements and, 6667
Statement of cash flows - "A financial statement that shows a firms cash receipts
and cash payments and investments for a period of time" (Parrino, Kidwell, &
Bates, 2012, p. 726).
Statement of cash flows, 6367
Depreciation - "Allocation of the cost of an asset over its estimated life to reflect the
wear and tear on the asset as it is used to produce the firms goods and services"
(Parrino, Kidwell, & Bates, 2012, p. 722).
Depreciation, 5455. See also Incremental depreciation and amortization accelerated, 55,
61
and cash flow invested in long-term assets, 70
and FCF, 349
GAAP vs. IRS rules for, 356359
on statement of cash flows, 64, 65
straight-line, 55, 6162, 358
Depreciation charges, 358
Depreciation expense, 6162
Treasury stock - "Stock that the firm has repurchased from investors" (Parrino,
Kidwell, & Bates, 2012, p. 727).
Treasury stock, 56
Market value - "The price at which an item can be sold" (Parrino, Kidwell, & Bates,
2012, p. 724).
Market value (MV), 50, 57
of assets, 5758, 411412
book value vs., 5758
of common stock, 56
of liabilities, 58
of stockholders equity, 58
in WACC, 428
Market-value balance sheet, 5860
Market-value ratios, 89, 100101
Cash flows to investors - from the sale of securities to investors" (Parrino, Kidwell,
& Bates, 2012, p. 722).
Cash flows to investors (CFI), 6771
Average and marginal tax rate - "Total taxes paid divided by taxable income / the
tax rate paid on the last dollar of income earned" (Parrino, Kidwell, & Bates, 2012,
p. 722,724).

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

Study Guide
FIN/571 Version 7

Average tax rate, 7273, 356, 357


Marginal tax rate, 7273, 344, 356, 357, 364

Content Overview
Key financial decisions
o

Key finance axioms - A statement or idea that people accept as self-evidently true
Identify and define various axioms of finance, such as agency, financial
intermediation, stakeholders, IPO, liquidity, and so on.
The Risk-Return Trade-off
The more risk an investment has, the higher its expected return should be If you bet
on a horse, you want greater odds on the long shot If you invest in a risky business
Semiconductor, oil wells, junk bonds), you should demand a greater return. Every
decision you make should be evaluated for risk
The Time Value of Money
A dollar received today is worth more than a dollar received in the future If you
receive a dollar today, you can invest it and earn more Because of inflation, a dollar
you receive today will buy more than a dollar you receive in the future So the sooner
you get the money, the better The sooner you invest your money, the better (i.e.
retirement)
Cash is King
You can not spend profit or net income. These are paper figures only Cash is what is
received by the firm and can be reinvested or used to pay bills. Cash flow does not
equal net income; there are timing differences in accrual accounting between when
you record a transaction and when you receive or pay the cash
Incremental Cash Flows
Its only the increase or decrease in cash that really counts. Its the difference between
cash flows if the project is done versus if the project is not done Consider all related
cash flows, i.e., equip., inventory, etc.
Curse of Competitive Markets
Its hard to find and maintain exceptionally profitable projects. High profits attract
competition
How to keep very profitable projects Product differentiation (Kleenex, Xerox),
Low cost (Costco, Honda), Service and quality (Mercedes, Lexus)
Efficient Capital Markets
The markets are quick and the prices are right. Information is incorporated into
security prices at the speed of light! Assuming the information is correct, then the
prices will reflect all publicly available information regarding the value of the firm.
Example: announcing a stock split
The Agency Problem
Managers are typically not the owners of a company. Managers may make decisions

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

Study Guide
FIN/571 Version 7

that are in their best interests and not in line with the long term best interests of the
owners
Example, cutting Research and Development costs on new products to maximize
current income
Taxes Bias Business Decisions
Because cash is king, we must consider the after-tax cash flow on an investment. The
tax consequences of a business decision will impact (reduce) cash flow. Companies
are given tax incentives by the government to influence their decisions. Examples :
investment tax credit and environmental credits reduce taxes; purchase of Prius
All Risk is Not Equal
Some risk can be diversified away and some cannot Dont put all your eggs in one
basket
Diversification creates offsets between good results and bad results. Example: drilling
for oil wells
Ethical Behavior Means Doing the Right Thing
Ethical Dilemmas are everywhere in finance; just read the news (back date stock
options, Madoff). Unethical behavior eliminates trust, results in loss of public
confidence
Shareholder value suffers and it takes a long time to recover
Social responsibility means firms have to be responsible to more than just owners, all
stakeholders.
http://10axioms.blogspot.com/2011/05/10-axioms-of-financial-management.html
o Determine difference between nominal and real interest rates.
The nominal interest rate (or money interest rate) is the percentage increase in money
you pay the lender for the use of the money you borrowed. For instance, imagine that
you borrowed $100 from your bank one year ago at 8% interest on your loan. When
you repay the loan, you must repay the $100 you borrowed plus $8 in interesta total
of $108.
But the nominal interest rate doesnt take inflation into account. In other words, it is
unadjusted for inflation. To continue our scenario, suppose on your way to the bank a
newspaper headline caught your eye stating: Inflation at 5% This Year! Inflation is
a rise in the general price level. A 5% inflation rate means that an average basket of
goods you purchased this year is 5% more expensive when compared to last year.
This leads to the concept of the real, or inflation-adjusted, interest rate. The real
interest rate measures the percentage increase in purchasing power the lender receives
when the borrower repays the loan with interest.. In our earlier example, the lender
earned 8% or $8 on the $100 loan. Fortunately, the market for U.S. Treasury
securities provides a way to estimate both nominal and real interest rates. You can
start comparing current real and nominal interest rates by looking at rates on
comparable maturity Treasury securitiespick one that is not adjusted for inflation
and one that is adjusted for inflation (more about these below). Chart 1 illustrates that
there is certainly a difference between the real and nominal interest rates. This
difference gives us an idea of the current inflation premium.100 loan.
Interest Rates in the Real World. Advertised interest rates that you may see at banks
or other financial service providers are typically nominal interest rates. This means its
up to you to estimate how much of the interest rate a bank may pay you on a savings

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

Study Guide
FIN/571 Version 7

deposit is really an increase in your purchasing power and how much is simply
making up for yearly inflation.Now, lets look at some of the inflation-adjusted
securities that provide a real interest rate. The blue line in Chart 1 plotted the
inflation-adjusted interest rates paid on these securities over the past several years, In
1997, the U.S. government began offering bonds called Treasury Inflation-Protected
Securities (TIPS). Unlike other investments that pay a nominal interest rate, TIPS
earn a real interest rate. The TIPS securities earn a fixed rate of interest just like many
other types of government bonds. But, in addition to the fixed rate, the principal value
of your TIPS bond is adjusted for inflation. So, at maturity, TIPS investors receive an
inflation-adjusted principal amount. Also, for the unlikely event of deflation, there is
a safeguard built into the TIPS system: the final payment of principal cannot be less
than the original par value. I-bonds, issued by the U.S. Treasury, are another type of
investment that earns a real rate of return. Unlike TIPS investors, who receive an
adjusted principal value at the end of the investment time period, I-Bond investors
receive interest payments that are adjusted for inflation twice each year.
As with any investment or loan, its simply important to understand the interest rate
that you are paying or receiving. With this knowledge, you will be able to compare it
with other investments or loans and make sure you are getting a deal that is right for
you and your financial situation.
http://www.frbsf.org/education/publications/doctor-econ/2003/august/real-nominalinterest-rate
o Determine difference between private and public markets.
On the private market transactions are directly between two parties and can take any
form the parties agree to. Public Market - Transactions in public markets are
conducted on organized exchanges. Securities traded on public markets use
standardized contracts because they involve so many parties.
http://www.answers.com/Q/Private_market_vs_public_market
o Determine difference between financial and real assets.
Businesses are evaluated according to the assessment of both financial and real assets
and the ability of each to generate cash flow. Financial assets usually show continued
growth and increased value, but the building and vehicle components of the real
assets lose value over time. Real estate is a stable real asset that generally appreciates
over time and adds value to the business portfolio.
Businesses require both financial and real assets to continue to deliver their products
and meet the financial obligations that enable them to remain in operation. Financial
assets generate the income to purchase real assets, and in turn, real assets are used to
produce goods and services to generate revenue. A diversified portfolio with a
balance of financial and real assets creates a strong company that is able to weather
the ups and downs of the financial market.
http://www.ask.com/business-finance/difference-between-financial-real-assets3ac187ab4c82c658
o Understand financial intermediation.
The process performed by banks of taking in funds from a depositor and
then lending them out to a borrower. The banking business thrives on the financial
intermediation abilities of financial institutions that allow them to lend out money at

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

10

Study Guide
FIN/571 Version 7

relatively high rates of interest while receiving money on deposit at


relatively low rates of interest.
http://www.businessdictionary.com/definition/financial-intermediation.html
Finanacial statements

o Identify the components of a balance sheet.


The three key sections of a balance sheet are:
Assets
Liabilities
Owners equity
Assets and liabilities are sub-divided into current (short-term) and non-current (longterm) and may have several components within each sub-division such as cash at
bank, inventory, property, accounts payable, or business bank loans. The individual
items will differ depending on the nature of the business and industry.
It is called a balance sheet because assets minus liabilities (net assets) must equal the
owners equity (they must balance). A balance sheet is based on the formula:
Owners equity = Assets Liabilities
https://www.smallbusiness.wa.gov.au/business-topics/money-tax-and-legal/moneymatters/understand-your-accounts/understanding-balance-sheets/components-of-abalance-sheet/
o Explain the balance sheet identity and why it must balance.
The balance sheet reflects a companys health. It lists the assets and liabilities for a
specified period, such as the most recent quarter or a fiscal year. Potential investors or
loan officers examine the balance sheet when a business applies for a commercial
mortgage or other loan. One of the calculations they make is balance sheet identity.
http://smallbusiness.chron.com/balance-sheet-identity-37248.html
A balance sheet should always balance. The name "balance sheet" is based on the fact
that assets will equal liabilities and equity every time.
The assets on the balance sheet consist of things of value that the company owns or
will receive in the future and which are measurable. Liabilities are what the company
owes, such as taxes, payables, salaries and debt. The equity sections displays the
company's retained earnings and the capital that has been contributed by shareholders.
The balance between assets, liability and equity makes sense when applied to a
simpler example, such as buying a car for $10,000. In this case, you might use a
$5,000 loan (debt), and $5,000 cash (equity) to purchase it. Your assets are worth
$10,000 total, while your debt is $5,000 and equity is $5,000. In this simple example,
assets equal debt plus equity.
http://www.investopedia.com/ask/answers/09/does-balance-sheet-always-balance.asp
o Describe how market values differ from book values.
Book value is the price paid for a particular asset. This price never changes so long as
you own the asset. On the other hand, market value is the current price at which you
can sell an asset.
For example, if you bought a house 10 years ago for $300,000, its book value for
your entire period of ownership will remain $300,000. If you can sell the house today
for $500,000, this would be the market value.

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

11

Study Guide
FIN/571 Version 7

Book values are useful to help track profits and losses. If you have owned an
investment for a long period of time, the difference between book and market values
indicates the profit (or loss) incurred.
The need for book value also arises when it comes to generally accepted accounting
principles. According to these rules, hard assets (like buildings and equipment) listed
on a company's balance sheet can only be stated according to book value. This
sometimes creates problems for companies with assets that have greatly appreciated these assets cannot be re-priced and added to the overall value of the company.
o Identify the components of an income statement.
The income statement consists of revenues and expenses along with the resulting net
income or loss over a period of time due to earning activities. The income statement
shows investors and management if the firm made money during the period reported.
The operating section of an income statement includes revenue and expenses.
Revenue consists of cash inflows or other enhancements of assets of an entity, and
expenses consist of cash outflows or other using-up of assets or incurring
of liabilities.
The non-operating section includes revenues and gains from non-primary business
activities, items that are either unusual or infrequent, finance costs
like interest expense, and income tax expense.
The "bottom line" of an income statement is the net income that is calculated after
subtracting the expenses from revenue. It is important to investors - also on a per
share basis (as earnings per share, EPS) - as it represents the profit for the accounting
period attributable to the shareholders.
https://www.boundless.com/finance/textbooks/boundless-finance-textbook/financialstatements-taxes-and-cash-flow-2/the-income-statement-32/elements-of-the-incomestatement-179-8370/
o Identify the basic income statement equation and the information it provides.
The income statement is one of the three primary financial statements used to assess a
companys performance and financial position (the two others being the balance
sheet and the cash flow statement). The income statement summarizes
the revenues and expenses generated by the company over the entire reporting period.
How it works/Example:
The income statement is also known as a profit and loss (P&L) statement, statement
of earnings, statement of operations or statement of income.
The basic equation on which an income statement is based is:
Revenues Expenses = Net Income
All companies need to generate revenue to stay in business. Revenues are used to pay
expenses,interest payments on debt and taxes owed to the government. After the costs
of doing business are paid, the amount left over is called net income. Net income is
theoretically available to shareholders, though instead of paying out dividends, the
firm's management often chooses to retain earnings for future investment in the
business.

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

12

Study Guide
FIN/571 Version 7

Income statements are all organized the same way, regardless of industry. The basic
outline is shown in the following example:
Income Statement for Company XYZ, Inc.
for the year ended December 31, 2008
Total Revenue

$100,000

Cost of Goods Sold


Gross Profit

($ 20,000)
$ 80,000

Operating Expenses
Salaries
$10,000
Rent
$10,000
Utilities
$ 5,000
Depreciation $ 5,000
Total Operating Expenses
Operating Profit (EBIT)

($ 30,000)
$ 50,000

Interest Expense
Earnings before tax (EBT)

($ 10,000)
$ 40,000

Taxes
Net Income

($ 10,000)
$ 30,000

Number of Shares Outstanding


Earnings Per Share (EPS)

30,000
$1.00

Anyone interested in active investing, picking stocks or investigating the financial


health of a company must know how to read financial statements, including the
income statement. The importance of the information contained in the income
statement cannot be overemphasized.
A firm's ability or inability to generate earnings over the long term is the key driver
of stock and bondprices. Operating profit (EBIT) is the source of debt repayment, and
if a company can't generate enough EBIT to pay its debt obligations, it will have to
enter bankruptcy or sell itself. Net income is the source of compensation to
shareholders (owners of the company), and if a company cannot generate
enough profit to compensate owners for the risks they've taken, the value of the
owners' shares willplummet. Conversely, if a company is healthy and growing,
higher stock and bond prices will reflect the increased availability of profits.
Please note that earnings/net income/profits are not the same as cash or cash flow. It
is possible for a firm to be profitable on the income statement, but not be
generating cash flow, and vice versa. To see a company's cash flow, you will need to
examine its statement of cash flows

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

13

Study Guide
FIN/571 Version 7

http://www.investinganswers.com/financial-dictionary/financial-statementanalysis/income-statement-1104
o Understand the calcualtion of cash flows from operating, investing, and financing
activities required in the statement of cash flows.
Under U.S. and ISA GAAP, the statement of cash flow can be presented by means of
two ways:
The indirect method
The direct method
The Indirect Method
The indirect method is preferred by most firms because is shows a reconciliation from
reported net income to cash provided by operations.
Calculating Cash flow from Operations
Here are the steps for calculating the cash flow from operations using the indirect
method:
Start with net income.
Add back non-cash expenses.
(Such as depreciation and amortization)
Adjust for gains and losses on sales on assets.
Add back losses
Subtract out gains
Account for changes in all non-cash current assets.
Account for changes in all current assets and liabilities except notes payable and
dividends payable.
In general, candidates should utilize the following rules:
(Such as depreciation and amortization)
The following example illustrates a typical net cash flow from operating activities:

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

14

Study Guide
FIN/571 Version 7

Cash Flow from Investment Activities


Cash Flow from investing activities includes purchasing and selling long-term assets
and marketable securities (other than cash equivalents), as well as making and
collecting on loans.
Here's the calculation of the cash flows from investing using the indirect method:

Cash Flow from Financing Activities


Cash Flow from financing activities includes issuing and buying back capital stock,
as well as borrowing and repaying loans on a short- or long-term basis (issuing bonds
and notes). Dividends paid are also included in this category, but the repayment of
accounts payable or accrued liabilities is not.
Here's the calculation of the cash flows from financing using the indirect method:

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

15

Study Guide
FIN/571 Version 7

http://www.investopedia.com/exam-guide/cfa-level-1/financial-statements/cash-flowindirect.asp
o Understand the difference between marginal and average tax rates.
The difference between marginal and average tax rates is a fairly important concept
for all tax payers to better understand the way the government gets paid. Youve
probably heard both terms, but maybe never knew what they were. Well, lets fix
that.Marginal Tax Rate
Your marginal tax rate is the highest rate that you are taxed. For many people, a
portion of their income is taxed at one rate, and the rest is taxed at another rate. For
instance, if you make right around $40,000 a year, you may pay 15% on the first
$20,000 or so and 28% on anything over $20,000. So, lets break that down:
15% of $20,000 is $3,000
28% of $20,000 is $5,600
Total tax liability is $8,600
In this case, your marginal tax rate would be 28%, the highest rate at which your
income is taxed.
Average Tax Rate
The average tax rate is the actual percentage of income going to pay taxes. In the
example above we can calculate average tax rate as follows:
$8,600 / $40,000 = .215 * 100 = 21.5%
So, in this example, your average tax rate is 21.5%, a bit lower than your 28%
marginal rate. Its good to know this because this represents your actual tax liability.
Why the Two Tax Rates?
In the United States, we have something called a progressive tax system, meaning, the
more money you make, the higher your tax rate. If the person in the example above
only made $20,000, hed wouldnt have had to pay the 28%instead only the 15%
would apply. Our progressive tax system taxes you at a lower rate for the first so
many dollars you make, everything over that amount gets taxed at a higher rate, and
so on until you reach the cap, which, for 2008, was 35%.
So, it all boils down to this, your marginal tax rate is the highest rate at which youre
taxed, but it does not represent the percentage of your income that goes toward
paying taxes. That number is the average tax rate.
https://answers.yahoo.com/question/index?qid=20101010231157AANR6E0
o Understand how each of the financial statements articulates with the other.
"Financial statement articulation" describes how different financial statements link
together. For example, the same net income figure appears on a year's income

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

16

Study Guide
FIN/571 Version 7

statement, statement of stockholders' equity, and statement of cash flows.


"Articulation" is based on the mathematical properties of accounting records; failure
to articulate in the following ways indicates that the financial statements are in error.
Net income reconciles to statement of retained earnings
Net income at the bottom of the income statement should equal Net income on the
statement of retained earnings, presented as part of the statement of stockholders'
equity. Note that this link works for "net income attributable to shareholders," also
known as "net income attributable to the parent company." It does not always work
for "consolidated net income."
Net income reconciles to cash flows statement
Net income at the bottom of the income statement should equal net income on the
cash flows statement, as presented at the beginning of operating cash flows, under the
indirect method. This works for "consolidated net income" only.
Current assets and liabilities reconcile to cash flows statement
Under the indirect method, operating cash flows present a series of changes in
current assets and liabilities. These changes should equal changes in all current assets
and liabilities presented in the balance sheet.
Stockholders' equity on the balance sheet reconciles to the stockholders' equity
statement
All stockholders' equity items listed on the balance sheet should equal individual
stockholder equity balances listed in the statement of stockholders' equity. Most
statements of stockholders' equity are presented in the columnar format. The numbers
in the last row should equal the year-end balances on the balance sheet.
Cash on the balance sheet reconciles to the cash flows statement
Cash, usually presented as "cash and cash equivalents" on the balance sheet, should
equal cash presented on the statement of cash flows.
Reconciliation to notes
Notes to the financial statements provide more detail explaining values in the
financial statements themselves. Values in the notes sometimes, but not always,
reconcile to the financial statements themselves.
Financial statement "articulation" describes how financial statements should link
together. Ultimately, the income statement, the statement of cash flows, and the
statement of stockholders' equity explain how balances in the balance sheet change
from one period to the next.
http://accounting.answers.com/financial-statements/6-ways-that-financial-statementsarticulate
Fundamental decisions in financial management
There are two fundamental types of financial decisions that the finance team needs to
make in a business: investment and financing. The two decisions boil down to how
to spend money and how to borrow money. Recall that the overall goal of financial
decisions is to maximize shareholder value, so every decision must be put in that
context.
Investment
An investment decision revolves around spending capital on assets that will yield the
highest return for the company over a desired time period. In other words, the
decision is about what to buy so that the company will gain the most value.

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

17

Study Guide
FIN/571 Version 7

To do so, the company needs to find a balance between its short-term and long-term
goals. In the very short-term, a company needs money to pay its bills, but keeping all
of its cash means that it isn't investing in things that will help it grow in the future.
On the other end of the spectrum is a purely long-term view. A company that invests
all of its money will maximize its long-term growth prospects, but if it doesn't hold
enough cash, it can't pay its bills and will go out of business soon. Companies thus
need to find the right mix between long-term and short-term investment.
The investment decision also concerns what specific investments to make. Since
there is no guarantee of a return for most investments, the finance department must
determine an expected return. This return is not guaranteed, but is the average return
on an investment if it were to be made many times.
The investments must meet three main criteria:
It must maximize the value of the firm, after considering the amount of risk the
company is comfortable with (risk aversion).
It must be financed appropriately (we will talk more about this shortly).
If there is no investment opportunity that fills (1) and (2), the cash must be returned
to shareholder in order to maximize shareholder value.
Financing
All functions of a company need to be paid for one way or another. It is up to the
finance department to figure out how to pay for them through the process of
financing.
There are two ways to finance an investment: using a company's own money or by
raising money from external funders. Each has its advantages and disadvantages.
There are two ways to raise money from external funders: by taking on debt or
selling equity. Taking on debt is the same as taking on a loan. The loan has to be paid
back with interest, which is the cost of borrowing. Selling equity is essentially
selling part of your company . When a company goes public, for example, they
decide to sell their company to the public instead of to private investors. Going
public entails selling stocks which represent owning a small part of the company.
The company is selling itself to the public in return for money.
https://www.boundless.com/finance/textbooks/boundless-financetextbook/introduction-to-the-field-and-goals-of-financial-management1/introducing-finance-22/types-of-financial-decisions-investment-and-financing145-3871/
o Understand the concerns of capital budgeting, financing, and working capital decisions
and how they affect the balance sheet.
Organizational structures and forms
o Identify forms of business organization and their respective strengths and
weaknesses.

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

18

Study Guide
FIN/571 Version 7

Week 1 Electronic Reserve Videos


Types of corporate business structures include General corporations, Subchapter S
corporations, and Limited Liability corporations. Each type is explained. Pros and
cons of the Subchapter S corporations are included.
Item Number: 42248
Date Added: 10/17/2011
2011
http://digital.films.com/PortalViewVideo.aspx?xtid=42248&loid=116024
Answering a series of targeted questions helps determine the type of business entity
that works best for an entrepreneur. Three types of business structure are sole
proprietorship, partnership, and corporation.
Item Number: 42248
Date Added: 10/17/2011
2011
http://digital.films.com/PortalViewVideo.aspx?xtid=42248&loid=116023
5 Focuses of Organizational Structure Strengths and Weaknesses
1. Functional Structure
Strengths
Easier to manage work within a group
Contains people who speak the same language and nurtures technical expertise,
attracts and develops experts
Lower labor costs
Workload can be balanced upon demand
Weaknesses
Coordination and communication between departments may be slower and less
accurate
Individual department managers have limited decision making authority
Different departments have different priorities; resolving conflicts may be costly;
customers interests could be overlooked
2. Product or Service-Based Structure
Strengths
Responsibility for each product can be pinpointed at the division level
Focus on one product can produce higher quality state-of-the-art output
Team spirit develops around each product line
Competition among divisions can boost business
Encourages independent decision making
Quicker response to customer request
Weaknesses
Less sharing of resources across divisions
More duplication of effort resulting in higher costs
Customers who want more than one product/service will have to work with more
than one division

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

19

Study Guide
FIN/571 Version 7

Company may be slow to recognize that a product should be changed, dropped or


added
Could be stifled by one product focus
3. Customer or Geography-Based Structure
Strengths
Unique needs of each type of customer are well served
Focus on customers needs and preferences
Unprofitable product lines more likely to be dropped
Weaknesses
May be less sharing of resources across division/departmental boundaries
More duplication of effort and infrastructure resulting in higher costs
Internal systems may evolve in different ways to serve different customer segments
4. Business Process Team Structure
Strengths
Focus on organization is outward to customer
Reduces number of levels of management flatten organizations (reduced
management cost; less need for coordination)
Time and money saved due to reduced need to pass information up and down the
hierarchy and between departments
Promotes self-management by employees (greater job satisfaction because of more
involvement)
Broadens individuals knowledge and skill bases
Faster decision making, reduced cycle time and improved responsiveness to
customers
Weaknesses
Involves major transformation of the organization (difficult, timely and costly
change; new systems required for virtually everything)
Company may need to retain functional expertise if not sufficient within each
process
May require major and costly training initiative
5. Matrix (Hybrid) Structure (contains more than one focus; has two or more bosses)
Strengths
Enables organization to use its resources efficiently (provides flexibility to assign
staff to project requirements and reassign as needed)
Takes full advantage of the use of teams (maintaining in-depth technical expertise in
critical functions)
Provides individuals an opportunity to work with different skills and expertise
Requires managers to cooperate with one another and moderates their power over
subordinates
Weaknesses
Multiple bosses may result in confusion
Slows down decision making
Conflicting demands from bosses leads to personal stress and reduced work quality
Power struggle between managers regarding resources
Can disrupt the work and get in the way of customer service
Subordinates may play one boss against another

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

20

Study Guide
FIN/571 Version 7

https://www.mbaboost.com/5-focuses-of-organizational-structure-strengths-andweaknesses/
o Determine types of business forms needed for specific business applications.
Business goals
o Wealth maximization
o Identify agency conflicts.
Confl icts of interest between a principal and an agent
o Know the concept of wealth maximization
Wealth maximization is a modern approach to financial management. Maximization
of profit used to be the main aim of a business and financial management till the
concept of wealth maximization came into being. It is a superior goal compared to
profit maximization as it takes broader arena into consideration. Wealth or Value of a
business is defined as the market price of the capital invested by shareholders. Wealth
maximization simply means maximization of shareholders wealth. It is combination
of two words viz. wealth and maximization. Wealth of a shareholder maximize when
the net worth of a company maximizes. To be even more meticulous, a shareholder
holds share in the company /business and his wealth will improve if the share price in
the market increases which in turn is a function of net worth. This is because wealth
maximization is also known as net worth maximization.
Finance managers are the agents of shareholders and their job is to look after the
interest of the shareholders. The objective of any shareholder or investor would be
good return on their capital and safety of their capital. Both these objectives are well
served by wealth maximization as a decision criterion to business.
How to calculate wealth?
Wealth is said to be generated by any financial decision if the present value of future
cash flows relevant to that decision is greater than the costs incurred to undertake that
activity. Wealth is equal to the present value of all future cash flows less the cost. In
essence, it is the net present value of a financial decision.
Wealth = Present Value of cash inflows Cost.
http://www.efinancemanagement.com/financial-management/wealth-maximization
o Understand the difference between profit and stock valuation.
The relationship between a company's earnings and its stock price can be
complicated. High profits don't necessarily mean a high stock price, and big losses
don't always lead to a low stock price. Of course, without earnings it is hard for
companies to stay in business for long. You could say that two of the major factors
that influence stock price are current earnings and promise of future earnings.
http://finance.zacks.com/relationship-between-earnings-stock-market-value4890.html
o Identify the major factors that affect stock prices.

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

21

Study Guide
FIN/571 Version 7

Have you ever wondered about what factors affect a stock's price? Stock prices are
determined in the marketplace, where seller supply meets buyer demand. But
unfortunately, there is no clean equation that tells us exactly how a stock price will
behave. That said, we do know a few things about the forces that move a stock up or
down. These forces fall into three categories:fundamental factors, technical factors
and market sentiment.
Fundamental Factors
In an efficient market, stock prices would be determined primarily by fundamentals,
which, at the basic level, refer to a combination of two things: 1) An earnings base
(earnings per share (EPS), for example) and 2) a valuation multiple (a P/E ratio, for
example).
An owner of a common stock has a claim on earnings, and earnings per share (EPS)
is the owner's return on his or her investment. When you buy a stock, you are
purchasing a proportional share of an entire future stream of earnings. That's the
reason for the valuation multiple: it is the price you are willing to pay for the future
stream of earnings.
Part of these earnings may be distributed as dividends, while the remainder will be
retained by the company (on your behalf) for reinvestment. We can think of the future
earnings stream as a function of both the current level of earnings and the expected
growth in this earnings base.
As shown in the diagram, the valuation multiple (P/E), or the stock price as some
multiple of EPS, is a way of representing the discounted present value of the
anticipated future earnings stream. (To learn about present value, see Understanding
the Time Value of Money.)
http://www.investopedia.com/articles/basics/04/100804.asp

Copyright 2013, 2011, 2010, 2008 by University of Phoenix. All rights reserved.

22