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Summary Study notes on Finance concepts

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Summary Study Notes on Finance Concepts

1. Hedging and Risk

  • Hedging: Strategies used to reduce or eliminate financial risk, typically through derivatives like options, futures, or swaps.
  • Risk Management: Identifying, assessing, and prioritizing risks followed by coordinated efforts to minimize, monitor, and control the impact of those risks.

2. Capital Budgeting

  • Capital Budgeting: The process of planning and managing a firm's long-term investments. Key techniques include Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period.
  • NPV: Measures the profitability of an investment by comparing the present value of cash inflows to the present value of cash outflows.

3. EBIT vs. Price Earnings Ratio

  • EBIT (Earnings Before Interest and Taxes): A measure of a firm's profitability that excludes interest and income tax expenses.
  • Price Earnings Ratio (P/E Ratio): A valuation ratio, calculated by dividing the market price per share by the earnings per share (EPS). It indicates how much investors are willing to pay per dollar of earnings.

4. Accounting Figures vs. Finance (NPV)

  • Accounting Figures: Based on historical costs and may not reflect the current value or future cash flows of an asset.
  • Finance (NPV): Focuses on the present value of future cash flows to evaluate the profitability of an investment, offering a forward-looking perspective.

5. APV vs. NPV/WACC

  • Adjusted Present Value (APV): A valuation method that separates the impact of financing from the project’s operating value. It calculates NPV with and without financing and adjusts for the value of financing benefits.
  • NPV/WACC: Uses the Weighted Average Cost of Capital (WACC) as the discount rate for calculating NPV. It incorporates the cost of both equity and debt in a single rate.

6. Agency Problems

  • Agency Problem: Conflicts of interest between management (agents) and shareholders (principals). Management may pursue personal goals that do not align with shareholder interests.
  • Solutions: Implementing performance-based compensation, improving corporate governance, and increasing transparency.

7. Dividend Policies

  • Dividend Policy: The strategy a company uses to decide how much it will pay out to shareholders in dividends. Common policies include Stable Dividend, Constant Payout Ratio, and Residual Dividend.
  • Impact: Affects stock price, investor perception, and company cash flow.

8. Evaluation Projects

  • Project Evaluation: Assessing the potential financial performance of an investment project. Techniques include NPV, IRR, Payback Period, and profitability index.

9. Real Options

  • Real Options: The application of financial options theory to capital budgeting, allowing for the valuation of flexibility and strategic decision-making in investments.
  • Types: Includes options to expand, delay, or abandon a project. Provides a way to incorporate uncertainty and management flexibility into project valuation.

Key Concepts Recap:

  • Hedging and Risk: Managing financial risk with strategic tools.
  • Capital Budgeting: Evaluating long-term investment projects.
  • EBIT vs. P/E Ratio: Comparing profitability and valuation.
  • Accounting vs. Finance Figures: Historical costs vs. present value analysis.
  • APV vs. NPV/WACC: Valuation methods focusing on different aspects of financing.
  • Agency Problems: Conflicts between management and shareholders.
  • Dividend Policies: Strategies for distributing profits to shareholders.
  • Evaluation Projects: Methods for assessing investment viability.
  • Real Options: Valuing strategic flexibility in investments.

This summary provides a foundation for understanding key finance concepts essential for effective financial decision-making and analysis.

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