Important Finance Concepts And Definitions For Undergraduate Studies

Chapter 1

Sole Proprietorship

• Disadvantages- unlimited liability, limited life, new equity is limited to owner’s wealth, difficult to sell ownership interest.

• Advantages- income taxed only once, no agency problems.

General Partnership

• Disadvantages- unlimited liability, minute life, harder than sole prop to sell ownership interest.

• Advantages- income taxes only once, few agency problems.

Limited Partnership

• Disadvantages- limited partners are not managers, limited life, difficult to sell ownership interest, agency problems.

• Advantages- limited partners have limited liability, income taxed only once.

Corporation

• Disadvantages- agency problems, income taxed twice.

• Advantages- owners have limited liability, owners can participate in management, unlimited life, easier to sell ownership interest.

Ease of raising money by selling fresh ownership interests- Corporations, limited partnership, sole proprietorship, general partnership.

Ease of borrowing money- general partnership, sole proprietorship, limited partnership, corporations.

Chapter One

1. Name the advantages and disadvantages of the different organizational forms:

1. Name organizational forms that give limited liability to their owners.

Unlimited liability- sole proprietorship, general partnership

Limited liability- limited partnership (little partner), corporation

1. Name organizational forms with limited life.

Sole proprietorship, general partnership, limited partnership

1. Name organizational forms that rep it easier to sell new equity interests.

Easiest to hardest- corporations, minute partnership, sole proprietorship, general partnership

1. Name organizational forms who derive it easier to borrow money.

General partnership, sole proprietorship, limited partnership, corporation. Corporations have minute liability and financial protection which makes it difficult to borrow.

1. Name the organization make who has the disadvantage of double taxation: Corporations
2. Define agency problems. Explain why some organizational forms have more agency problems than others. Describe the methods to reduce agency problems.

Agency problems occur between owners and managers. Sole proprietorship has zero agency problems, general partnership has few, and limited partnership and corporations have agency problems. To minimize, provide incentives for managers, stockholders use voting rights, and outsiders can fire bad management.

1. Explain the goal of a corporation. To maximize original market value of owner’s equity.

1. Why is this goal is is better than other possible goals?

Accounting profits are easy to manipulate, and therefore do not do value

1. Define the Sarbanes Oxley Act of 2002. Justify “going dark”. Why would a company want to do this? Name the disadvantages of going dark.

Sarbanes Oxley Act- act intended to strengthen protection against corporate accounting fraud and financial malpractice. Going dark means going private or moving foreign to avoid costs of abiding by the act. Going gloomy makes it more difficult to raise equity through stocks and bonds.

1. Different types of financial markets

1. Primary vs. Secondary

Primary- Company issues stocks or bonds to investors. Company to investors

Secondary- investors trade or sell stock to someone else. Investor to investor

1. Auction vs. Dealer

Auction- physical place where people buy and sell. NYSE- most stringent Dealer- a dealer lists prices for people to buy and sell. NASDAQ

Chapter Two

1. Be able to put together an accounting (or book value) balance sheet.
   1. Define GAAP and how GAAP relates to accounting financial statements.

GAAP- General Approved Accounting Principles is the well-liked set of standards and procedures by which audited financial statements are prepared; shows assets at historical cost.

1. Name examples of current assets, net fixed assets, and intangible assets.

Current assets- cash, inventory, accounts receivable

Net fixed assets- buildings, land, office furnishings

Intangible- patents, trademarks

1. Name examples of fresh liabilities and long term liabilities.

Current liabilities- accounts payable, notes payable

Long term liabilities- bank loans

1. Define net working capital. Unique assets- current liabilities
2. Define equity. Define the difference between the “common stock” anecdote and the “retained earnings” account.

Equity- difference between total value of assets and total value of liabilities

Common stock- equity without priority for dividends or in bankruptcy

Retained earnings- difference between score income and cash dividends

1. Define liquidity. Ability to convert assets to cash
   1. Name the characteristics of highly liquid assets. Name the characteristics of less liquid assets.

Highly liquid- converted to cash with shrimp decrease in price

Less liquid- if cash is needed expeditiously, asset’s tag is reduced

1. Name examples of assets with high and low liquidity.

High- Cash, bank deposits, checking accounts, savings accounts, cds, stocks, bonds, accounts receivable, inventory

Low- land, buildings, equipment, office furniture, patents, trademarks

1. Explain the typical relation between liquidity and expected rate of return.

Higher the liquidity of an asset, the lower the rate of return

1. Explain situations when liquidity is especially valuable for a corporation.

If the company has several upcoming liabilities

1. Explain how a market value balance sheet is different than an accounting (or book value) balance sheet. Market value is what you would bag if you sold it, while book value is the historical cost.
   1. Explain how the market values of assets, liabilities and equities are determined.
2. Be able to put together an accounting income statement.
   1. Define the accrual basis of accounting.

Account when sale is made even if all cash is not yet collected.

1. Explain how cost of goods sold (CGS) is calculated.

Cost of products to company X number sold.

1. Define the straight line accounting depreciation.

Straight line depreciation= cost of asset- get value/ useful life

Accounting depreciation is not a cash expense.

Depreciation affects the value of tangible fixed assets.

1. Define dividends per share (DPS) and earnings per share (EPS).

DPS- Dividends/ Shares

EPS- Net income/ Shares

1. Define dividend payout ratio.

Dividend Payout Ratio= DPS/ EPS

1. Know how to put together a corporation’s income tax statement.
   1. Define the average tax rate.

Average tax rate= amount of tax/ amount of income

1. Be able to calculate a corporation’s cash flows.
   1. Explain the difference between a corporation’s “creditors” and the corporation’s liabilities.

Creditors refers to recent liabilities, liabilities refers to everything.

1. Define operating cash flows, capital spending, and change in net working capital.

Operating cash flow= earnings before interest and taxes+ depreciation- taxes

Capital spending= Change in find fixed assets+ depreciation

Cash hobble from assets= Operating cash flow- capital spending- change in net working capital

1. Define cash flows to creditors and cash flows to stockholders.

Cash flows to creditors= interest paid- net new borrowing

Cash flows to stockholders= dividends paid- net new equity raised

1. Define cash flows from assets.

Cash flow from assets= cash flow to creditors+ cash flow to stockholders

Chapter Three

1. Name internal and external reasons to use financial ratios. Explain why financial ratios are more important when market value information is not available.

Internal- measuring performance to decide compensation for managers, making projections for the future.

External- should we extend credit or loan money to a firm or individual, will a competitor have enough funds to undertake a new project, should we acquire another firm.

Financial ratios can provide information for private firms or measuring performance of a particular division.

1. Explain why ratios are easy and useful.

Because it can be difficult to determine market values from financial statements.

1. Explain what to consider when comparing a corporation’s financial ratios from this year to a previous year.

Consider how the firm (and economic and competitive environment) has changed over time.

1. Define an SIC code.

4 digit code to find similar firms.

1. Explain how a high current ratio be either good or unpleasant news about a corporation.

Good- indicates liquidity and higher current assets than current liabilities

Bad- Insufficient use of recent assets

1. Explain how a low total debt ratio can be either good or bad news about a corporation. Tax benefits for debt?

Good having no debt- firm is not relying on debt financing

Bad without having debt- interest payments are a tax deduction. If you pay more interest, you pay fewer taxes.

When the firm’s assets become more valuable, there is an increased return on equity

Chapter 4

Future value- FV= PV (1+r) ^t

Present value- PV= FV/ (1+r) ^t

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