Forms of Business Organizations and Their Characteristics

Chapter 1: ● ● ● ● Know all the characteristics of forms of organizations: ○ Sole Proprietorship ■ Advantages - easiest to start, least regulated, single owner keeps all profits, taxed once as personal income ■ Disadvantages - limited to life of owner, equity capital limited to owner’s personal wealth, unlimited liability, difficult to see ownership interest ○ Partnerships ■ General & Limited ● unlimited liability applies to all partners in a general partnership but only to the general partners in a limited partnership. ● Limited partners cannot be involved in the business or else they may be deemed as general partners ■ Advantages - two or more owners, more capital available, relatively easy to start, income taxed once as personal income ■ Disadvantages - unlimited liability (general partnership, limited partnership), partnership dissolves when one partner dies or wishes to sell, difficult to transfer ownership ○ Corporation (largest group 85%) ■ Advantages - limited liability, unlimited life, separation of ownership and management, transfer of ownership is easy, easier to raise capital ■ Disadvantages - double taxation (income taxed at the corporate rate and then dividends taxed at the personal rate) Know the roles and reporting structure of the financial managers of a firm: ○ CFO (Chief Financial Officer) - The top financial manager within a firm ○ Treasurer - oversees cash management, credit management, capital expenditures, and financial planning ○ Controller - oversees taxes, cost accounting, financial accounting, and data processing Know the 3 financial management decisions: § Capital budgeting - What long-term investments or projects should the business take on? what product or service will the firm sell, should we replace old equipment with newer, more advanced equipment, etc. ○ Capital structure - How should we pay for our assets? Should we use debt or equity? § Working capital management - How do we manage day-to-day finances of the firm? who should we sell to on credit, how much inventory should we carry, when should we pay our suppliers, etc. Agency problems of corporations: ○ Agency Relationship: ■ Principal hires an agent to represent his/her interests. ■ stockholders (principals) hire managers (agents) to run the company ○ Agency Problem: ■ Conflict of interest between principal and agent EX: price with real estate broker Sarbanes - Oxley Act - in place to hold managers accountable (helps with the agency problem) (primary goal was to fix auditing) 1. Confirm the validity of the annual financial report 2. List deficiencies in internal controls 3. Accept responsibility for material errors in the annual report False: The act provides incentives for companies to go public in US markets ● Quick Quiz from PPT: ○ What is the goal of financial management? - maximizing the current value of the company’s stock ○ What is the difference between a primary market and a secondary market? ■ Primary Market - where securities are created, first issued, and sold to investors ■ Secondary Market - where those securities are traded by investors Chapter 2: ● Components of the Income Statement and Balance Sheet ○ Balance Sheet - a snapshot of the firm’s assets and liabilities at a given point in time. ■ Assets are listed in order of decreasing liquidity** (cash, account receivables…) ○ Ease of conversion to cash, Without significant loss of value ○ 3 MAIN THINGS: LIQUIDITY, DEBT VS EQUITY, AND BOOK VS MARKET VALUE ○ Balance Sheet Identity : assets = liabilities + shareholder’s equity ○ Income Statement - is more like a video of the firm’s operations for a specified period of time ■ You generally report revenues first and then deduct any expenses for the period ■ Matching principle – this principle leads to non-cash deductions like depreciation. This is why net income is NOT a measure of the cash flow during the period ○ Income Statement Identity : revenues - expenses = income ● 2017 corporate tax act ○ Taxes are always changing ○ The tax cuts and jobs act of 2017 will drop the corporate tax rate to a flat 21 percent beginning in 2018 ● Marginal vs Average taxes ○ Marginal tax rate - the percentage paid on the next dollar earned ○ Average tax rate - the tax bill / taxable income ■ Average tax rates vary widely across different companies and industries ● Net Working Capital ○ Net working capital = Current Assets - Current Liabilities ○ Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out ○ Usually positive in a healthy firm ● Book Value ○ The balance sheet provides the book value of the assets, liabilities, and equity ○ Book value - the net value of the firm’s assets found on its balance sheet, and is value at time of purchase ○ Market value - the price at which the assets, liabilities, or equity can actually be bought or sold ○ Which is more important to the decision making process? - market values are generally more important for the decision making process because they are more reflective of the cash flows that would occur today. ● Shareholder’s Equity = several components and that total equity includes all of these components, not just the “common stock” item. Retained earnings belong to the shareholders. ● Liquidity** ○ Ease of conversion to cash ○ Without significant loss of value ○ Current assets tend to be the most liquid ● Current assets vs current liabilities ○ Current assets: left side and at the top of balance sheet because most liquid ○ Current liabilities: right side and indicated how assets are paid for. ■ Total equity = total assets – total liabilities Chapters 5 & 6: ● Definition of discount rate, present value, future value ○ Present Value – The current value of future cash flows discounted at the appropriate interest (discount rate) ■ ■ the longer the time period, the lower the present value the higher the interest rate, the smaller the present value Future Value – The Future value of current cash flows compounded by the appropriate interest (growth rate) ○ Discount/Interest rate – “exchange rate” between earlier money and later money ○ ● ● Simple vs compound interest (calculate differences and definitions) ○ Simple interest: interest from the historic value, no compounding ○ Compound interest: Interest that earns interest on past interest EAR vs APR characteristics (definitions) ○ EAR (effective annual rate) - The interest rate stated as though it were compounded once a year, used to compare 2 investments with different compounding periods ○ APR (annual percentage rate) - The interest rate per period multiplied by the number of periods in the year, annual rate quoted by law ○ ● ● ● ● ● ● For a positive stated annual interest rate and multiple (more than one) compounding periods per year, the EAR is always larger than the APR Calculate them both Annuity & perpetuity calculations & definitions ○ Annuity - finite series of equal payments that occur at regular intervals, a series of constant level cash flows that occur at the end of each period for some fixed number of periods -- A level stream of cash flows for a fixed period of time ○ Perpetuity - infinite series of equal payments, a constant stream of cash flows forever, EX: winning the lottery ■ With interest- only loans that are NOT perpetuities, the entire principal is: repaid at some point in the future ○ Amortization is the process of paying off loans by regularly reducing the principal ○ Annuity due - a series of payments that are made at the beginning of each period ○ If the interest is greater than zero, the value of an annuity due is always greater than an ordinary annuity – (payment at end of period) Find the number of years Find the interest rate Find the present value Find the future value **** Pay attention to wording. 10% is already weekly, not an APR, so you do not divide by 52 in this case**** FORMULAS: EAR = [1+(quoted rate/m)]^m - 1 m = the how many times the interest is compounded ● Semiannually → m=2 ● Quarterly → m=4 ● Monthly → m=12 ● Weekly → m=52 ● Daily → m=365 APR = I usually convert it to days, so if it is 2 weeks, that would be 14 days, then I do (365/14)*(%given) to get the APR Future Value of an Annuity = C(((1+r)^t - 1)/r) ^^ Example: Find the future value of an annuity of $100 per year for 10 years at 10 percent per year: $100,000(((1+0.10)^10 - 1)/0.10) = $1593.74 ^^ Example 2: Find the future value of an annuity of $400 per year for 10 years at 5% $400,000(((1+0.05)^10 - 1)/0.05) = $5,031.16 ^^ Example 1: The annuity present value factor for a 30-year annuity with an interest rate of 10 percent per ear is ____ {1-[1/(1+0.10)^30]} / 0.10 = 9.4269 ^^ Example 2: What is the present value of an ordinary annuity that pays $100 per year for 20 years if the interest rate is 10 percent per year? 1st step: {1-[1/(1+0.10)^20]} / 0.10 = 8.5136 2nd step: 8.5136 * $100 = $851.36 Formula for the present value of an annuity due is: (1+r) * (PV of an ordinary annuity) PV calculator example: Use a financial calculator to compute the present value of $100 per year for 30 years if the discount rate is 5% 1) ALWAYS 2nd FV to clear the time value of money 2) 30 N 3) 5 I/Y 4) 100 PMT 5) CPT PV 6) = $1537.25 Ralph has $1,000 in an account that pays 10 percent per year. Ralph wants to give this money to his favorite charity by making three equal donations at the end of the next 3 years. How much will Ralph give to the charity each year? N=3 I/Y=10 PV=-1000 PMT= 402.11 Calculator Example: You owe $1200 on your credit card, which charges 1.5% per month. If you pay $50 per month starting at the end of this month, how many months will it take to pay off your credit card? 1) ALWAYS clear TVM 2) 1200 PV 3) 50 (-) PMT 4) 1.5 I/Y 5) CPT N 6) = 29.98 = 30months Example: What is the future value of an annuity due of $100 per year for 10 years at 10 percent per year? 100(((1+0.10)^10 - 1)/0.10) * (1+0.10) = $1753.12 Present value of a perpetuity = C/r FIN 300 Exam 1 Formulas (Ch. #, slide #) Notes: calculator instructions are on slide 5.8, Basic Equation Rules are on slide 5.27, for Annuity questions be careful to pay attention to wording to know to enter BGN or END, YOU HAVE TO MAKE SURE THE PERIODS MATCH (EX. IF INTEREST RATE IS IN YEARS AND COMPOUNDS MONTHLY MUST CONVERT TO MONTHS AND VICE VERSA) 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. Net Working Capital (2.6): a. Current Assets - Current Liabilities = NWC Income (2.9): a. Revenues - Expenses = Income Marginal vs Average Tax Rates (2.11): a. Marginal- percentage paid on the next dollar earned b. Average- tax bill / taxable income Cash Flow from Assets (2.21): a. Cash flow to creditors (bondholders) + Cash Flow to Stockholders = CFFA b. Operating Cash Flow – Net Capital Spending – Changes in NWC = CFFA Change in NWC (2.25): a. Ending NWC – Beginning NWC = Change in NWC Cash Flow from Assets or Free Cash Flow (2.26): a. Operating Cash Flow – Net Capital Spending – Change in NWC = CFFA Cash Flow to Creditors (2.28): a. Interest Paid – Net new borrowing (difference in long-term debt) = CFTC Cash Flow to Stockholders 2.29: a. Dividends paid – Net new equity raised = CFTS Future Value General Formula (5.5): a. FV = PV (1+r)^t b. R = period interest rate, expressed as decimal c. T = number of periods Compound vs Simple Interest (5.11) Present Value General Formula (5.14): a. PV = FV / (1+r)^t Discount Rate (5.28): a. R = [(FV / PV) ^1/t] – 1 b. Calculator keys ex. 5.29 Finding the Number of Periods (5.37): a. No directly given formula, but calculator keys ex is on slide 5.37 Multiple Cash Flows- FV (6.5-6.8): a. These problems require several steps which are laid out in the slides, all revolving around FV b. If timeline is an easier visually see 6.15 Multiple Cash Flows- PV (6.17- 6.19): a. These problems require several steps which are laid out in the slides above, all revolving around PV b. Visual is on 6.18 c. Pay attention the change in division vs. multiplication 16. Annuity Present Value Formula (6.26-6.28): a. C * {[1-(1/(1+r)^t]/r} = Annuity Present Value b. Calculator Instructions on 6.29 & 6.32 (put 0 in for values you do not need if calculator is pushing out weird numbers) c. We can also use this to find the specific payments or other variables if everything else is provided 17. Future Values for Annuities (6.48) a. FV = C [ { ( 1 + r ) ^ t } - 1 ] / r 18. Perpetuity (6.51): a. PV = C / r b. C = payment c. R = interest rate, written as a decimal 19. APR (6.57): a. Periodic rate * number of periods per year = APR b. APR / periods per year = Periodic Rate c. Ex. 6.63 20. EAR (6.58-6.59): a. [1+(APR/m)]^m – 1 b. M is the number of compounding periods per year c. ex. 6.62 Exam Practice Questions Future Value Questions ● ● ● ● ● ● If you have Principal of $1000 today and interest rates are 7%, how much will you have in 1 year? ○ N=1; I/Y=7; PV= -1000 ○ FV=$1070 If you have Principal of $700 and interest rates are 8%, how much will you have in 2 years? ○ N=2; I/Y=8; PV= -700 ○ FV=$816.48 If you have Principal of $2200 today and interest rates are 16%, how much will you have in 4 years? ○ N=4; I/Y=16; PV= -2200 ○ FV= $3983.41 If you can invest $1500 today and earn 6% in the first two years and then 8% in the 3rd year, how much will you have at the end of the 3rd year? ○ $1500 x (1+0.06)^2= $1685.40 ○ $1685.40 x (1.08)=$1820.23 Or, ○ $15000 x 1.06 x 1.06 x 1.08= $1820.23 Or, ○ N=2; I/Y=6; PV= -1500 === FV: $1685.40 ○ N=1; I/Y=8; PV= -1685.4 === FV: $1820.23 Discounting ● What is the Present Value of $1800 one year from today with an interest rate of 8%? ○ $1800/(1+.08)= ○ N=1; I/Y=8; FV=1800 ○ PV= -$1666.66 ● What is the Present Value of $35000 that you will receive in 4 years if the interest rate is 5%? ○ $35000/(1+.05)^4= ○ N=4; I/Y=5; FV= 35000 ○ PV= -$28,794.59 ● What is the Present Value of $126,000 that you will receive in 6 years if the interest rate is 7%? ○ $126000/(1.07)^6= ○ N=6; I/Y=7; FV= 126000 ○ PV= -$83,959.12 Multiple Cash Flows ● You currently have $9000 in your bank account and think for the next 5 years you will be able to deposit $7000 at the end of each year in a bank account paying 6% interest. How much will you have at the end of 5 years? ○ End Year 1: 9000 x 1.06 + 7000= $16,540 ● ○ End Year 2: 16540 x 1.06 +7000= $24,532.4 ○ End Year 3: 24,532.4 x 1.06 +7000= $33,004.34 ○ End Year 4: 33004.34 x 1.06+ 7000= $41,984.46 ○ End Year 5: 41,984.46 x 1.06+7000= $51,503.68 ○ Or ○ PV= -9000; PMT= -7000; N=5; I/Y=6 ○ FV= $51,503.68 You are offered an investment that will pay you: $500 in year one, $700 in year two, and $400 in year three. You can earn 9% on similar investments. What is the most you would pay for this investment? ○ $500/1.09= $485.72 ○ $700/(1.09)^2= $589.18 ○ $400/(1.09)^3= $308.87 ○ Total PV= $1356.77 ○ Or: ○ N=1; I/Y=9; FV=500; PV= $485.72 ○ N=2; I/Y=9; FV= 700; PV= $589.18 ○ N=3; I/Y=9; FV= 400; PV= $308.87 ○ Total PV= $1356.77 Annuity (use PMT key) 1. Man offered 6-year $300 million contract paying him $50 million per year that he accepts. What is the real value of this 6-year annuity payment if we assume that the discount rate is 5%? a. CALC: 6, N, 50000, PMT, 5, I/Y, CPT, PV = -253,784,603 2. You want to earn $6,000 a month for retirement. You can earn .6 a month on your money and will need this income stream to last 30 years. How much do you need to put into your retirement account at retirement? a. N = 30 years x 12 months b. 360, N, .6, I/Y, 6000, PMT, CPT, PV = -$883,928 3. You can save $3,500 per year with an interest rate of 6%. If you plan on retiring young how much money will you have to spend in 30 years to start living the dream? a. 30, N, I/Y, 6, PMT, -3500, CMP, FV = $276,703.65 Annuity Due: 1. Professor Trager want to buy Kroger field in 12 years. They can put 15,000 per month into an account that pays 9% per year. They can make the first deposit today. How much will they have in 12 years to buy the field? a. Put calc in BGN mode for annuity due: 2nd BGN 2nd Set, CE/C b. N = 12 years x 12 months I/Y = 9 years /12 months c. 144, N, 15000, +/-, PMT, I/Y, .75, CPT, FV = $3,896,666.10 Perpetuity ● You have won the Bluegrass Lottery and you will be receiving $50,000 a year forever. If you can earn 8% on your money and someone wanted to offer you a lump sum for your ticket, how much would it be worth to you? ○ PV=C/r ○ $50,000/0.08= $625,000