IS2218 Mid Term Cheat Sheet Session 1 Corporate G overnance Inves tment decisions (capital budgeting or capi tal expenditure (CAPEX) ) • Tangi ble assets (e.g., factory) • Intangible assets (e.g., R&D, adver tising) • Acquisition of real assets F inancing deci sions (raising money /capital for investments and operations) • Equi ty financing: investors receive shares and become shareholders • Debt financing: investors lend money and expect to be repaid in the future • Sale of financial assets • A share of stock has value as a claim on the firm ’ s real assets, and on the income that those assets will produce • Securities are financial assets that can be purchased and traded by investors in markets Corporations • Shareholders do not directly own the business ’ real assets, but they have i ndirect ownership via financial assets (shar es) • Shareholders have limited liability and cannot be held per sonally responsib le • Shareholders appoint a board of direct ors – separati on of ownership and control ( permanence) • Private company: shares privately owned by a small group of investors • Public company: new shares issue d and traded in public market s Drawbacks of corporations • Agency problem • Cost (time and money) in managing l egal aff airs • Corporations are taxed sepa rately , so shareholders are taxed when corporations pay tax on their profits, and when they receive di vidends or sell their shares • In contrast, other income is taxed on ce only as personal income Goals of Corporations • Shareholders desire wealth maxim isation (current mar ket value of investments) • Op portunity cost of capital: the minimum rate of return on capital investment set by the investment opportunities available to shar eholders in financ ial mark ets Agen cy Problem • Managers are agents for stockholders and are tempted to act in their own interests (e.g., rejecti ng a risky but val uable investment due to job security) than ma ximising value M itigating the A g ency Problem • Executive compensation: fixed base salary + annual award tie d to earnings or other measures of financial performance/stock options • Corporate governance o Legal Requirements (protect investors from sel f - dealing by in siders) o Board of Directors (required to approve important financial decision s) o Activist Shareholders (institutional shareholders and pension funds) o Take overs o Transparency (accounting and reporting) Session 2 & 3 Accounting Generally Accepted Accounting Principles (GAAP) • Assets must be shown in the balance sheet at their historical cost a djusted for depreciation • If the asset has increased in value, i t s book value in the balance sheet will understate the market value • Similarly, liabilities record the amount of money the corporation promised to pay E quity = Total Assets – Total Liabilities Stock Price = Market Value of Equity/No. of Shares Income Statements Cash Flows (different from income) • Depreciation: To calculate the cash produced by the business, add the depre ciation charge (non - cash pa yment) and subt ract the expenditure on new capital equi pment (cash payment) • Accrual Accounting: Practice of matching revenues and expenses during the time of sale • Cash Outf low = COGS + Change in Inventor ies • Cash Inflow = Sales – Change in Uncollected Bills ** Employee stock compensation is considered an expense, but because it is paid in shares in the firm, it does not represent a cash outflow ** Interest payments are included under operations because unlike dividends, interest payment s are not discretionary – th e firm must pay interest when payment is due, hence treated as a business expense rather than a financing deci sion • Free Cash Flow : Cash flow available for distribution to investors after firm pays for new investments or addition s to working capital ( = Interest + Cashflow from Operations + Cashfl ow from Investments ( exclude cash flow from financing) ) • If a firm w as financed entirely b y equity , add interest into pre - tax income, t hen calcu late the income after tax Accounting Malpractice • Revenue Re cognition : increases this year ’ s sales at the expense of next year ’ s sales • Cookie - jar reserves: Reserves used to artific ially inflate income during bad years • Off - balance sheet assets and liabilities : Exclude some liabilities (e.g., debts of other com panies in wh ich the firm has an ownership stake) from its financial statement Session 4 & 5 Cor porate Performance Measures of Profitability Market Value and Market Value Added • Market Capitalisation = T otal ma rket value of equi ty = Share price * No . of Shares • Market Valu e Added = Market Capitalisation – Book value of equity • Market - to - book Ratio = Ma rket value of e quity /Book value of equity • Remark: When firm s buy back the ir own shares from investors , the repur chase reduces the book value of shareholder ’ s equity P roblems with Market Va lue and Market Value Added • Market values reflect investor s ’ exp ectations about future performance • Market values fluctuate and are noisy measures • Market value of private companie s are unknown E conomic V alue Added • E VA = Net income – Cost of capital = After tax operating income – ( Cost of capital (usually in percentage) * Total Capitalisation (long - term debt + equity) ) • After tax operating income = (1 – tax rate) * I nterest expense + N et income ** Net income if the company is financed by equity fully • Recognises that companies need to cover their opportunity costs before they add value Rates of Return ** ROA will always be smaller than ROC Problems with EVA and Rates of Return • Show current performance • Not affected by stock market price movements • Intangible assets (e.g., brand name) Measures of Efficiency ** Efficient firms hold only a small level of invento ries ** Balance sheet shows the cost of inventories (rather than the amount the final goods are sold for) – hence, COGS is used instead of sa les ** High ratio indicates an efficient credit department DuPoint System ** Does not account for debt Measuring Financ ial Leverage ** Ratio of long term debt to total capital isation ** Problems: Debt ratio use book values, hence, if the market value of the compan y cover s its debt, then lenders should get their money back ** Extent to which inte rest obligations are covered by earnings Return on Equity ** When the firm raises cash by borrowing , it must make interest payments to its lenders – reducing net profits ** If a firm borrows , then it has fewer equity holders to share the remaining profits ** If the firm is financed entirel y by equity, then the leverage ratio and debt burden equal to 1, an d ROE equals ROA ** If the firm borrows, then the leverage ratio is greater than 1 (assets > equity), and the debt burden is less than 1 (part of the profits is absorbed by interest) Measuring Liquidity Li quidity is the ability to sell an asset on short notice • Net working capital = Current assets – Current liabilities (measures the company ’ s potential net reservoir of cash)