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review for midterm

Review for Mid-term
Bingbing Wang
Chapter 1-1.1 The Four Types of Firms
• Sole Proprietorship
• Partnership
• Limited Liability Company
• Corporation
1.1 The Four Types of Firms (5 of 8)
• Corporation
• A legal entity separate from its owners
• Has many of the legal powers individuals have such as
the ability to enter into contracts, own assets, and
borrow money
• The corporation is solely responsible for its own
obligations. Its owners are not liable for any obligation
the corporation enters into.
1.1 The Four Types of Firms (7 of 8)
• Corporation
• Ownership
• Represented by shares of stock
• Owner of stock is called
‒Equity Holder
• Sum of all ownership value is called equity.
• There is no limit to the number of shareholders and, thus,
the amount of funds a company can raise by selling stock.
• Owner is entitled to dividend payments.
Chapter-Table 2.1 Global Conglomerate
Corporation Balance Sheet (1 of 2)
2.2 Balance Sheet (2 of 7)
• The Balance Sheet Identity:
Assets = Liabilities + Stockholders' Equity
2.3 Income Statement
2.3 Income Statement (1 of 6)
• Total Sales / Revenues
• minus
• Cost of Sales
• equals
• Gross Profit
2.3 Income Statement (2 of 6)
• Gross Profit
• minus
• Operating Expenses
• Selling, General, and Administrative Expenses
• R and D
• Depreciation and Amortization
• equals
• Operating Income
2.3 Income Statement (3 of 6)
• Operating Income
• plus/minus
• Other Income/Other Expenses
• equals
• Earnings Before Interest and Taxes (EBIT)
2.3 Income Statement (6 of 6)
• Earnings per Share
Net Income
Shares Outstanding
• Stock Options
• Convertible Bonds
• Dilution
• Diluted EPS
2.4 Statement of Cash Flows (2 of 4)
• Three Sections
• Operating Activity
• Investment Activity
• Financing Activity
2.4 Statement of Cash Flows (3 of 4)
• Operating Activity
• Adjusts net income by all non-cash
items related to operating activities
and changes in net working capital
• Depreciation – add the amount
of depreciation
• Accounts Receivable – deduct
the increases
• Accounts Payable – add the
• Inventories – deduct the
2.6 Financial Statement Analysis (10 of
• Valuation Ratios: used to gauge the market value of the firm
• P/E Ratio
P / E Ratio =
Market Capitalization
Share Price
Net Income
Earnings per Share
Chapter 3-The Interest Rate: An Exchange
Rate Across Time
• The rate at which we can exchange money today for money in
the future is determined by the current interest rate:
exchange rate across time
• Suppose the current annual interest rate is 7%. By
investing or borrowing at this rate, we can exchange $1.07
in one year for each $1 today.
• Risk–Free Interest Rate (Discount Rate), rf: The interest
rate at which money can be borrowed or lent without
• Interest Rate Factor = 1 + rf
• Discount Factor =
(1 + rf )
4.1 The Timeline (4 of 4)
• Assume that you are lending $10,000 today and that the loan
will be repaid in two annual $6,000 payments.
• The first cash flow at date 0 (today) is represented as a
negative sum because it is an outflow.
• Timelines can represent cash flows that take place at the end
of any time period – a month, a week, a day, etc.
Table 4.1 the Three Rules of Time Travel
Only values at the same point in
time can be compared or combined
To move a cash flow forward in
time,you must compound it.
Future value of a Cash flow
To move a cash flow backward in
time, you must discount it.
Present value of a Cash flow
F V sub F V sub n = C times, 1 + r, to the power of nn = C times, 1 + r, to
the power of n.
FVn = C × (1+ r )n
P V = C dividP V = C divided by, 1 + r, to the power of n = C over, 1 + r, to
the power of n.ed by, 1 + r, to the power of n = C over, 1 + r, to the
PV = C ÷ (1+ r )n =
power of n.
(1+ r )n
Using a Financial Calculator: The Basics (1 of 2)
• TI BA II Plus
• Future Value
‒ Present Value
‒ I/Y
• Interest Rate per Year / month
• Cash flows moving in opposite directions
must have opposite signs.
• Interest is entered as a percent, not a
• For 10%, enter 10, NOT .10
4.3 Valuing a Stream of Cash Flows (2 of 2)
• Present Value of a Cash Flow Stream
4.4 Calculating the Net Present Value
• Calculating the NPV of future cash flows allows us to evaluate an
investment decision.
• Net Present Value compares the present value of cash inflows
(benefits) to the present value of cash outflows (costs).
Textbook Example 4.6 (1 of 3)
Net Present Value of an Investment Opportunity
you have been offered the following investment opportunity:
if you invest $1000 today, you will receive $500 at the end of
each of the next three years. If you could otherwise earn 10%
per year on your money, should you undertake the
investment opportunity?
Textbook Example 4.6 (2 of 3)
As always, we start with a timeline. We denote the upfront
investment as a negative cash flow (because it is money we need to
spend) and the money we receive as a positive cash flow.
To decide whether we should accept this opportunity, we compute
the NPV by computing the present value of the stream:
NPV = 1000 +
= $243.43
1.10 1.10 1.10
Textbook Example 4.6: Financial Calculator
4.5 Perpetuities andAnnuities
• Annuities
• When a constant cash flow will occur at regular intervals for
a finite number of N periods, it is called an annuity.
• Present Value of an Annuity
(1 r )
(1 r )2
(1 r )3
(1 r )N
Video clips for page 2-3:
Textbook Example 4.8(1 of 3)
Present Value of a Lottery Prize Annuity
• Problem
– You are the lucky winner of the $30 million state lottery. You can
take your prize money either as (a) 30 payments of $1 million per
year (starting today), or (b) $15 million paid today. If the interest
rate is 8%, which option should you take?
Video clips for page 4-7:
Textbook Example 4.8: FinancialCalculator Solution (2 of
• Then
11.16 million
• $15 million > $12.16 million, so take the lump sum.
Textbook Example 4.9(1 of 4)
Retirement Savings Plan Annuity
• Problem
– Ellen is 35 years old, and she has decided it is time to plan
seriously for her retirement. At the end of each year until she is
65, she will save$10,000 in a retirement account. If the account
earns 10% per year, how much will Ellen have saved at age 65?
Video clips for page 9-11:
Textbook Example 4.9: FinancialCalculator Solution (2 of
• Then
4.5 Perpetuities and Annuities(1 of 2)
• Perpetuities
• When a constant cash flow will occur at regular intervals
forever it is called a perpetuity.
Video clips for page 12-13:
Textbook Example 4.7(1 of 2)
Endowing a Perpetuity
• Problem
– You want to endow an annual MBA graduation party at your alma
mater. You want the event to be a memorable one, so you budget
$30,000 per year forever for the party. If the university earns 8%
per year on its investments, and if the first party is in one year’s
time, how much will you need to donate to endow the party?
Video clips for page 14-15:
Textbook Example 4.7(2 of 2)
• The timeline of the cash flows you want to provide is
• This is a standard perpetuity of $30,000 per year. The funding you
would need to give the university in perpetuity is the present value
of this cash flow stream. From the formula,
PV = Clr =
= $375,000 today
• If you donate $375,000 today, and if the university invests it at 8%
per year forever, then the MBAs will have $30,000 every year for
their graduation party.
Growing Cash Flows(1 of 2)
• Growing Perpetuity
• Assume you expect the amount of your perpetual payment
to increase at a constant rate, g.
• Present Value of a Growing Perpetuity
PV (growingperpetuity) =
Video clips for page 18:
Textbook Example 4.10(1 of 2)
Endowing a Growing Perpetuity
Video clips for page 19-20:
In example 4.7, you planned to donate money to your alma mater
to fund an annual $30,000 MBA graduation party. Given an interest
rate of 8% per year , the required donation was the present value of
PV =
= $375,000 today
Before accepting the money, however, the MBA student association
has asked that you increase the donation to account for the effect of
inflation on the cost of the party in future years. Although $30,000 is
adequate for next year’s party, the students estimate that the party’s
cost will rise by 4% per year thereafter. To satisfy their request, how
much do you need to donate now?
Textbook Example 4.10(2 of 2)
The cost of the party next year is $30,000, and the cost then
increases 4% per year forever. From the timeline, we recognize the
form of a growing perpetuity. To finance the growing cost, you
need to provide the present value today of
PV =
= $750,000 today
0.08 −0.04
You need to double the size of your gift!