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 Finance is the science and art of managing money.
 Financial Services is the area of finance concerned with the
design and delivery of advice and financial products to
individuals, business, and governments.
 Managerial Finance concerns the duties of financial manager
in a business.
 Financial Managers administer the financial affairs of all types
of business – private and public, large and small, profit seeking
and not for profit.
 Sole Proprietorship is a business owned by one person and
operated for his or own profit. Strengths: owner receives all
profits (loss), low organizational costs, income included and
taxed on proprietor’s personal tax return, independence,
secrecy, and ease of dissolution. Weaknesses: unlimited
liability, limited fund-raising power, lacks continuity when
proprietor dies.
 Unlimited Liability, creditors can make claims against the
owner’s personal assets to recover debts owed by the
 Partnership is a business owned by two or more people and
operated for profit. Strengths: can raise more funds, enhanced
borrowing power, more available brain power and managerial
skill, income included and taxed on partner’s personal tax.
Weaknesses: unlimited liability (regular partnership),
partnership is dissolved when a partner dies and difficult to
liquidate or transfer partnership.
 An article of Partnership is a written contract used to formally
establish a business partnership.
 Corporation is an entity created by law. Strengths: limited
liability, ownership is readily transferable, long life of firm, and
better access of financing. Weaknesses: taxes generally higher,
more expensive to organize, subject to greater government
regulation, and lacks secrecy (disclosure).
 Stockholders are the owners of a corporation, whose
ownership, or equity, takes the form of either common stock
or preferred stock.
 Limited Liability is a legal provision that limits stockholders’
liability for a corporation’s debt to the amount they initially
invested in the firm by purchasing stock.
 Common Stock is the purest and most basic form of corporate
 Dividends are periodic distributions of cash to the stockholders
of a firm.
 Board of Directors is a group elected by the firm’s stockholders
and typically responsible for approving strategic goals and
plans, setting general policy, guiding corporate affairs, and
approving major expenditures.
 President or Chief Executive Officer (CEO) is the corporate
official responsible for managing the firm’s day-to-day
operations and carrying out policies established by the Board
of Directors.
 Financial Analyst prepares the firm’s financial plans and
 Capital Expenditure Manager evaluates and recommends
proposed long-term investments.
 Project Finance Manager arranges financing for approved long-
term investments.
 Cash Manager maintains and controls the firm’s daily cash
 Credit Analyst/Manager administers the firm’s credit policy by
evaluating credit applications, extending credit, and
monitoring and collecting accounts receivables.
 Pension Fund Manager oversees or manages the assets and
liabilities of the employees’ pension fund.
 Foreign Exchange Manager manages specific foreign
operations and the firm’s exposure to fluctuations in exchange
 Maximizing the Wealth of the Shareholders is the goal of the
firm, and also of managers.
 Share price is the simplest and best measure of stockholder
 To enrich shareholders, managers must first satisfy the
demands of other interest groups such as customers,
employees, or suppliers.
 The key variables that managers must consider when making
business decisions are return (Cash flows) and risk. These are
the key determinants of share price.
 Earnings per Share represent the amount earned during the
period on behalf of each outstanding share of common stock.
 Profit Maximization: Timing is important, Cash flow is a
straightforward measure of the money flowing into and out of
the company, and Risk matters a great deal.
 Timing, the receipt of funds sooner rather than later is
 Cash Flows, only when earnings increases are accompanied by
increased future cash flows is a higher stock price expected.
 Risk is the chance that actual outcomes may differ from those
 Risk Averse, requiring compensation to bear risk. In other
words, investors expect to earn higher returns on riskier
investments, and they will accept lower returns on relatively
safe investments.
 Stakeholders are groups such as employees, customers,
suppliers, creditors, owners, and others who have a direct
economic link to the firm.
 Business Ethics are the standards of conduct or moral
judgment that apply to persons engaged in commerce.
 Ethical behavior is viewed as necessary for achieving the firm’s
goal of owner wealth maximization.
 Treasurer (CFM) typically manages the firm’s cash, oversees its
pension plans, and manages key risks.
 Controller (CFA) is responsible for the firm’s accounting
activities, such as corporate accounting, tax management,
financial accounting, and cost accounting.
 The Treasurer’s focus tends to be more external, whereas the
Controller’s focus is more internal.
 Foreign Exchange Manager is responsible for managing and
monitoring the firm’s exposure to loss from currency
 The primary economic principle used in managerial finance is
Marginal Cost-Benefit Analysis which states that financial
decisions should be made and actions taken only when the
added benefits exceed the added costs. (Prob. Solving)
 There are two basic differences between finance and
accounting; one is related to the emphasis on cash flows and
the other to decision making.
 Accrual Basis recognizes revenue at the time of sale and
recognizes expenses when they are incurred.
 The financial manager places emphasis on cash flows, the
intake and outgo of cash.
 The financial manager uses Cash Basis which recognizes
revenues and expenses only with respect to actual inflows and
outflows of cash. (Prob. Solving)
 The second major difference between finance and accounting
has to do with Decision Making. Financial Managers make
decisions bases on their impact on the value of the firm, not
on accounting principles used to construct a balance sheet.
(Prob. Solving)
 Investment Decisions: current assets and fixed assets.
 Financing Decisions: current liabilities and long-term funds.
 Managers are entrusted to only take actions or make decisions
that are in the best interests of the firm’s owners, its
 Corporate Governance refers to the rules, processes, and laws
by which companies are operated, controlled, and regulated.
 A well-defined corporate governance structure is intended to
benefit all corporate stakeholders by ensuring that the firm is
run in a lawful and ethical fashion, in accordance with best
practices, and subjects to all corporate regulations.
 Individual Investors own relatively small quantities of shares
and as a result do not typically have sufficient means to
directly influence a firm’s corporate governance.
 In order to influence the firm, individual investors often find it
necessary to act as a group by voting collectively on corporate
 Institutional Investors are investment professionals that are
paid to manage and hold large quantities of securities on
behalf of individuals, businesses, and governments.
 Institutional Investors often directly influence a firm’s
corporate governance by exerting pressure on management to
perform or communicating their concerns to the firm’s board.
 Government Regulation generally shapes the corporate
governance of all firms. Two main types if issues (1) false
disclosures and (2) undisclosed conflicts of interests.
 Sarbanes-Oxley Act of 2002 (SOX) is an act aimed at
eliminating corporate disclosure and conflict of interest
problems. Contains provisions about corporate financial
disclosures and the relationships among corporations,
analysts, auditors, attorneys, directors, officers, and
 Managers can be viewed as the Agents of the firm’s
 Principal-Agent Relationship is an arrangement in which an
agent acts on the behalf of a principal, where the shareholders
are the principals.
 Agency Problem arises when managers place personal goals
ahead of the goals of shareholders. These problems in turn
give rise to agency costs.
 Agency Costs are costs borne by shareholders due to the
presence or avoidance of agency problems, and in either case
represent a loss of shareholder wealth.
 Incentive Plans is a management compensation plan that ties
management compensation to share price; granting of stock
 Stock Options are options extended by the firm that allow
management to benefit from increases in stock prices over
 Performance Plans is a plan that ties management
compensation to measures such as EPS. Performance shares
and/or cash bonuses are used as compensation under these
 Performance Shared are shares of stock given to management
for meeting stated performance goals.
 Cash Bonuses are cash payments tied to the achievement of
certain performance goals.
 When a firm’s internal corporate governance is unable to keep
agency problems in check, it is likely that rival managers will
try to gain control of the firm.
 The constant Threat of Takeover tends to motivate
management to act in the best interest of the firm’s owners.
 Much of the evidence suggests that Share Price Maximization
– the focus of this book – is the primary goal of most firms.

 Firms can obtain funds from external sources. The first source
is through a financial institution. A second source is through
financial markets. A third source is through private placement.
 Financial Institution serves as an intermediary that channels
the savings of individuals, businesses, and governments into
loans or investments. This includes banks, life insurance,
mutual funds, and pension.
 Individuals as a group are the Net Suppliers for financial
institutions: They save more money than they borrow.
 Firms are Net Demanders of funds: They borrow more money
than they save.
 The government, like business firms, is typically a Net
Demander of funds: It typically borrows more than it saves.
 Commercial Banks are institutions that provide savers with a
secure place to invest their funds and that offer loans to
individual and business borrowers.
 Investment Banks are institutions that assist companies in
raising capital, advice firms on major transactions such as
mergers or financial restructurings, and engage in trading and
market making activities.
 Glass-Steagall Act is an act of Congress in 1933 that separates
the activities of commercial and investment banks.
 Shadow Banking System are group of institutions that engage
in lending activities, much like traditional banks, but do not
accept deposits and therefore are not subject to the same
regulations as traditional banks.
 Financial Markets are forums in which suppliers of funds and
demanders of funds can transact directly.
 Private Placement involves the sale of a new security directly
to an investor or group of investors.
 Public Offering is the sale of either bonds or stocks to the
general market.
 Primary Market is a financial market in which securities are
initially issued; the only market in which the issuer is directly
involved in the transaction.
 Secondary Market is a financial market in which pre-owned
securities are traded.
 Money Market is a financial relationship created between
suppliers and demanders of short-term funds (short-term debt
instruments or marketable securities).
 Marketable Securities are short term debt instruments, such as
treasury bills, commercial paper, and negotiable certificates of
deposit issued by the government, business, and financial
institutions, respectively.
 Eurocurrency Market is the international equivalent of the
domestic money market. It arises when a firm or individual
makes a bank deposit in a currency other than the local
currency of the country where the bank is located.
 Capital Market is a market that enables suppliers and
demanders of long-term funds (bonds and stocks) make
 Bond is a long-term debt instrument used by business and
government to raise large sums of money, generally from a
diverse group of lenders.
 Preferred Stock is a special form of ownership having a fixed
periodic dividend that must be paid prior to payment of any
dividends to common stockholders.
 Broker Market, the securities exchanges on which the two
sides of a transaction, the buyer and seller, are brought
together to trade securities.
 Securities Exchanges are organizations that provide the
marketplace in which firms can raise funds through the sale of
new securities and purchasers can resell securities.
 Dealer Market is the market in which the buyer and seller are
not brought together directly but instead have their orders
executed by security dealers that “make markets” in the given
 Market Makers are security dealers who “make markets” by
offering to buy or sell certain securities at stated price.
 Nasdaq Market is an all-electronic trading platform used to
execute securities trades.
 Over-The-Counter Market (OTC) is where smaller, unlisted
securities are traded.
 Bid Price is the highest price offered to purchase a security.
 Ask Price is the lowest price at which a security is offered for

 Generally Accepted Accounting Principles (GAAP) is the
practice and procedure guidelines used to prepare and
maintain financial records and reports; authorized by FASB.
 Financial Accounting Standards Board (FASB) is the accounting
profession’s rule-setting body, which authorizes GAAP.
 Public Company Accounting Oversight Board (PCAOB) is a not-
for-profit corporation established by the Sarbanes-Oxley Act of
 Stockholders’ Report is an annual report that publicly owned
corporations must provide to stockholders; it summarizes and
documents the firm’s financial activities during the past year.
 Letter to Stockholders is the first element of the annual
stockholders’ report and the primary communication from
managements. It describes the events that are considered to
have had the greatest effect on the firm.
 The four key financial statements: (1) Statement of
Comprehensive Income, (2) Statement of Financial Position, (3)
Statement of Changes in Equity, and (4) Statement of Cash
Flows + (5) Notes to Financial Statement.
 Income Statement provides a financial summary of the firm’s
operating results (financial performance) during a specified
 Dividends Per Share (DPS) is the dollar amount of cash
distributed during the period on behalf of each outstanding
share of common stock.
 Balance Sheet is a summary statement of the firm’s financial
position (stability and liquidity/solvency) at a given point in
 Current Assets are short-term assets, expected to be
converted into cash within one year or less.
 Current Liabilities are short-term liabilities, expected to be
paid within one year or less.
 Long-Term Debt is debts which payment is not due in the
current year.
 Paid-in Capital in Excess of Par is the amount of proceeds in
excess of the par value received from the original sale of
common stock.
 Retained Earnings represent the cumulative total of all
earnings, net of dividends, which have been retained and
reinvested in the firm since its inceptions.
 Statement of Stockholders’ Equity shows all equity account
transactions that occurred during a given year.
 Statement of Retained Earnings reconciles the net income
earned during the year and any cash dividends paid, with the
change in retained earnings between the starts and the end of
that year. An abbreviated form of the Statement of
Stockholders’ Equity.
 Statement of Cash Flows provides a summary of the firm’s
operating, investing, and financing cash flows and reconciles
them with changes in its cash and marketable securities during
the period (how cash is generated and spent).
 Notes to the Financial Statements provide explanatory notes
keyed to relevant accounts in the statements; they provide
detailed information on the accounting policies, procedures,
calculations, and transactions underlying entries in the
financial statements.
 Ratio Analysis involves methods of calculating and interpreting
financial ratios to analyze and monitor the firm’s performance.
 Cross-Sectional Analysis is a comparison of different firms’
financial ratios at the same point in time; involves comparing
the firm’s ratios to those of other firms in its industry of to
industry averages.
 Benchmarking is a type of cross-sectional analysis in which the
firm’s ratio values are compared to those of a key competitor
or group of competitors that it wishes to emulate.
 Time –Series Analysis evaluates financial performance over
time using financial ratio analysis. Comparison of current to
past performance.
 Combined Analysis is the most informative approach to ratio
analysis combines cross-sectional and time-series analyses. It
assesses the trend in the behavior of the ratio in relation to
the trend for the industry.
 Liquidity of a firm is measured by its ability to satisfy its short-
term obligations as they come due.
 Current Ratio is a measure of liquidity calculated by dividing
the firm’s current assets by its current liabilities.
 Quick (Acid-Test) Ratio is a measure of liquidity calculated by
dividing the firm’s current assets minus inventory by its
current liabilities.
 Activity Ratios measures the speed with which various
accounts are converted into sales or cash – inflows or
 Inventory Turnover measures the activity, or liquidity, of a
firm’s inventory. (COGS/Ave. Inv.)
 Average Age of Inventory is the average number of days’ sales
in inventory. (365/Inv. Turnover) or (Ave. Inv./(COGS/365))
 Account Receivable Turnover (NS/Ave. AR)
 Average Collection Period is the average amount of time
needed to collect accounts receivable. (Ave. AR/(NS/365))
 Average Payment Period is the average amount of time
needed to pay accounts payable. (AP/(Purch./365))
 Total Asset Turnover indicated the efficiency with which the
firm uses its assets to generate sales. (NS/Ave. TA)
 Debt Position of a firm indicates the amount of other people’s
money being used to generate profits.
 Financial Leverage is the magnification of risk and return
through the use of fixed-cost financing, such as debt and
preferred stock.
 Degree of Indebtedness measures the amount of debt relative
to other significant balance sheet amounts.
 Ability to Service Debts is the ability of a firm to make the
payments required on a scheduled basis over the life of a debt.
To Service Debts simply means to pay debts on time.
 Coverage Ratios is the firm’s ability to pay certain fixed
 Debt Ratio measures the proportion of total assets financed by
the firm’s creditors. (TL/TA)
 Times Interest Earned Ratio measures the firm’s ability to
make contractual interest payments; sometimes called the
interest coverage ratio. (EBIT/IE)
 Common-Size Income Statement (Vertical) is an income
statement in which each item is expressed as a percentage of
 Gross Profit Margin measures the percentage of each sales
dollar remaining after the firm has paid for its goods. (GP/NS)
 Operating Profit Margin measures the percentage of each
sales dollar remaining after all costs and expenses other than
interests, taxes, and preferred stock dividends are deducted;
the “pure profits” earned on each sales dollar. (OP/NS)
 Net Profit Margin measures the percentage of each sales
dollar remaining after all costs, expenses, including interests,
taxes, and preferred stock dividends, have been deducted.
 Earnings Per Share (EPS) is generally of interest to present or
prospective stockholders and management. (NI-Preferred
Stock/Number of CS outstanding shares)
 Dividend Per Share (DPS) is the amount of cash actually
distributed to each shareholder.
 Return on Total Assets (ROA) measures the overall
effectiveness of management in generating profits with its
available assets; also called the Return On Investment (ROI).
(NI /TA)
 Return on Common Equity measures the return earned on the
common stockholders’ investment in the firm. (NI-Pref. Stock
/Total Common Stock Equity)
 Market Ratios relates a firm’s market value, as measured by its
current share prices, to certain accounting values.
 Price Earnings Ratio (P/E) measures the amount that investors
are willing to pay for each dollar of a firm’s earnings; the
higher the P/E ratio, the greater the investor confidence.
 Market/Book Ratio (M/B) provides an assessment of how
investors view the firm’s performance. (MPS/BV)
 Book Value per share of Common Stock (CS Equity/Sh. Of CS

 Time Value of Money refers to the observation that it is better
to receive money sooner than later.
 A dollar today is worth more than a dollar in the future.
 Time Line is a horizontal line on which time zero appears at the
leftmost end and future periods are marked from left to right;
can be use to depict investment cash flows.
 The future value technique uses Compounding to find the
future value of each cash flow at the end of the investment’s
 Alternatively, the present value technique uses Discounting to
find the present value of each cash flow at time zero.
 Single Amount is lump-sum amount either currently held or
expected at some future date.
 Future Value of a Single Amount is the value given at a future
date of an amount placed on deposit today and earning
interest at a specified rate. (FV=PV x (1+r)^n)
 Compound Interest is the interest that is earned on a given
deposit and has become part of the principal at the end of a
specified period.
 Principal is the amount of money on which interest is paid.
 The higher the interest rate, the higher the future value. The
longer the period of time, the higher the future value.
 Present Value of a Single Amount is the current dollar value of
a future amount – the amount of money that would have to be
invested today at a given interest rate over a specified period
to equal the future amount. (PV=FV / (1+r)^n)
 Discounting Cash Flows is the process of finding present
values; the inverse of compounding interest.
 The higher the discount rate, the lower the present value. The
longer the period of time, the lower the present value.
 Annuity is a level of equal periodic stream of cash flows over a
specified time period.
 Ordinary Annuity is an annuity for which the cash flow occurs
at the end of each period.
 Future Value of an Ordinary Annuity (FV=CF x ((((1+r)^n)-1)/r))
 Present Value of an Ordinary Annuity (PV=(CF/r) x (1-
 Annuity Due is an annuity for which the cash flow occurs at the
beginning of each period.
 Future Value of an Annuity Due (FV of OA x (1+r))
 The future value of an annuity due is always greater than the
future value of an otherwise identical ordinary annuity.
 Present Value of an Annuity Due (PV of OA x (1+r))
 Perpetuity is an annuity with an infinite life, providing
continual annual cash flow. (PV=CF / r)
 Mixed Stream a stream of cash flow that is not an annuity; a
stream of unequal periodic cash flows that reflect no particular
 If PV, ex. 5 years (raise to 1, 2, 3, 4, 5)
 If FV, ex. 5 years (raise to 4, 3, 2, 1)

 Semiannual Compounding (2) involves compounding of
interest over two periods within the year.
 Quarterly Compounding (4) involves compounding of interest
over four periods within the year.
 The more frequently interest is compounded, the greater the
amount of money accumulated.
 Continuous Compounding involves compounding of interest in
an infinite number of times per year at intervals of
microseconds. (FV=PV x (e^(r x n)))
 Nominal (Stated) Annual Rate is the contractual annual rate of
interest charged by a lender or promised by a borrower.
 Effective (True) Annual Rate (EAR) is the annual rate of interest
actually paid or earned. (EAR=(1+((r/m)^m))-1)
 Determining deposits needed to accumulate a future sum
“end-of-year deposits”. (CF=FV / ((((1+r)^n)-1)/r))
 Loan Amortization is the determination of the equal periodic
loan payments necessary to provide a lender with a specified
interest return and to repay the loan principal over a specified
 Loan Amortization Schedule is a schedule of equal payments to
repay a loan “equal end-of-year payments”. (CF=(PV x R) / (1-
 Finding interest or growth rates (r=((FV/PV)^(1/n))-1)
 Finding an unknown number of periods

 Depreciation is a portion of the costs of fixed assets charged
against annual revenues over time.
 Modified Accelerated Cost Recovery System (MACRS) is a
system used to determine the depreciation of assets for tax
 Under MACRS, the depreciable value of an asset is its full cost,
including outlays for installation.
 Depreciable Life of an Asset is the time period over which an
asset is depreciated.
 Recovery Period is the appropriate depreciable life of a
particular asset as determined by MACRS.
 Statement of Cash Flows summarizes the firm’s cash flow over
a given period.
 Operating Flows are cash flows directly related to sale and
production of the firm’s products and services.
 Investment Flows are cash flows associated with purchase and
sale of both fixed assets and equity investments in other firms.
 Financing Flows are cash flows that result from debt and
equity financing transactions; include incurrence and
repayment of debt, cash inflow from the sale of stock, and
cash outflow to repurchase stock or pay dividends.
 Noncash Charge is an expense that is deducted on the income
statement but does not involve the actual outlay of cash
during the period; includes depreciation, amortization, and
 The statement of cash flows allows the financial manager and
other interested parties to analyze the firm’s cash flows.
 Operating Cash Flow (OCF) is the cash flow a firm generates
from its normal operations. (OCF=NOPAT + Depreciation)
 Net Operating Profits after Taxes (NOPAT) is a firm’s earnings
before interest and after taxes. (NOPAT=EBIT x (1-T))
 Free Cash Flow (FCF) is the amount cash flow available to
investors (creditors and owners) after the firm has met all
operating needs and paid for investments in net fixed assets
and net current assets. (FCF=OCF – NFAI – NCAI)
 Net Fixed Asset Investment (NFAI=Change in net FA + Dep’n)
 Net Current Asset Investment (NCAI=Change in net CA –
(Change in (AP + Accruals)))
 Financial Planning Process begins with long-term, strategic,
financial plans that in turn guide the formulation of short-
term, or operating, plans and budgets.
 Two key aspects of the financial planning process are cash
planning and profit planning.
 Long-term (strategic) Financial Plans lay out a company’s
planned financial actions and the anticipated impact of those
actions over periods ranging from 2 to 10 years.
 Generally, firms that are subject to high degrees of operating
uncertainty, relatively short production cycles, or both, tend to
use shorter planning horizon.
 Short-term (operating) Financial Plans specify short-term
financial actions and the anticipated impact of those actions
over periods ranging from 1 to 2 years.
 Key inputs of short-term financial plans include sales forecasts
and various forms of operating and financial data.
 Key outputs of short-term financial plans include a number of
operating budgets, the cash budget, and pro forma financial
 Cash Budget (cash forecast) is a statement of the firm’s
planned inflows and outflows of cash that is used to estimate
its short-term cash requirements.
 Cash budget is designed to cover a 1-year period, divided into
smaller time intervals. The more seasonal and uncertain a
firm’s cash flows, the greater the number of intervals.
 Sales Forecast is the prediction of the firm’s sales over a given
period based on external and/or internal data; used as the key
input to the short-term financial planning process.
 External Forecast is a sales forecast based on the relationships
observed between the firm’s sales and certain key external
economic indicators.
 Internal Forecast is a sales forecast based on a buildup, or
consensus, of sales forecasts through the firm’s own sales
 Cash Receipts include all of a firm’s inflow of cash during a
given financial period.
 The most common component of cash receipts are cash sales,
collection of accounts receivable, and other cash receipts.
 Cash Disbursements include all outlays of cash by the firm
during a given financial period.
 It is important to recognize that Depreciation and other
noncash charges are NOT included in the cash budget.
 Net Cash Flow is the mathematical difference between the
firm’s cash receipts and its cash disbursements in each period.
 Ending Cash is the sum of the firm’s beginning cash and its net
cash flow for the period.
 Required Total Financing is the amount funds needed by the
firm if the ending cash for the period is less than the desired
minimum cash balance; typically represented by notes
 Excess Cash Balance is the excess amount available for
investment by the firm if the period’s ending cash is greater
than the desired minimum cash balance; assumed to be
invested in marketable securities.
 There are two ways of coping with uncertainty in the cash
budget: (1) scenario analysis or “what if approach” and (2)
 Scenario Analysis or “what if approach” is based on
pessimistic, most likely, and optimistic forecast.
 The information provided by the cash budget is NOT
necessarily adequate for ensuring solvency.
 Effective cash planning requires a look beyond the cash