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DSST Principles of Finance Study Guide

Updated: Feb 13



DSST Principles of Finance Exam Outline


Are you preparing for the DSST Principles of Finance Exam and looking for a comprehensive study guide?


Our study guide provides in-depth coverage of all the essential topics, ensuring you're fully prepared and confident when taking the exam.



 


Table of Contents




 


1. Financial Statements and Planning


Woman organizing her finances.
Financial Statements and Planning – 20%

Fundamentals of Financial Statements


Financial statements are essential tools for understanding a company's financial health.


For example, the balance sheet provides a snapshot of a company's assets, liabilities, and equity at a specific time.


The income statement shows a company's revenues, expenses, and profits over time, indicating its ability to generate profit.


The statement of cash flows reveals how cash flows in and out of a company during a specific period, highlighting its liquidity and ability to meet financial obligations.


Lastly, the owner's equity statement details equity changes over a period, reflecting the company's financial health.


 

Ratio Analysis


Ratio analysis involves using various financial ratios to assess a company's performance and financial health.


For instance, liquidity ratios like the current and quick ratios measure a company's ability to meet short-term obligations.


Solvency ratios such as the debt-to-equity ratio indicate a company's ability to meet long-term debt obligations.


Profitability ratios like the net profit margin assess how efficiently a company generates profit from its operations.


The DuPont analysis breaks down return on equity into components to analyze what is driving a company's profitability.


 

Taxes


Understanding tax concepts is crucial for financial planning and decision-making.


For example, knowing the difference between average and marginal tax rates helps individuals and businesses understand how taxes affect their income at different levels.


Corporate tax rates determine the amount of tax a corporation owes based on its taxable income.


Understanding these rates helps businesses plan their finances and make strategic decisions to minimize tax liabilities.


 


DSST Principles of Finance Trivia Question # 436




 


2. Time Value of Money


Dollars and cypto currency.
Time Value of Money – 20%

Present Value (lump sum and annuity):


Understanding present value is crucial for evaluating investment opportunities.


For instance, if you are considering investing in a project that promises to pay you $1,000 in one year, you would want to know how much that $1,000 is worth to you today.


This calculation uses an appropriate discount rate to discount the future cash flow back to its present value.


 

Future Value (lump sum and annuity):


Future value calculations help individuals and businesses understand the value of investments over time.


For example, if you invest $1,000 today at an annual interest rate of 5%, you would want to know how much that investment will be worth in five years.


This calculation involves compounding the initial investment over the specified period at the interest rate.


 

Annuity Due Versus Ordinary Annuity


An ordinary annuity is a series of equal payments made at the end of each period. In contrast, an annuity due is a series of equal payments made at the beginning of each period.


Understanding the difference is essential because it affects the timing of cash flows and, consequently, the present and future value of the annuity.


 

Interest Rate Calculations (Equivalent Annual Rate (EAR) and Annualized Percentage Rate (APR)):


The Equivalent Annual Rate (EAR) is the annual interest rate that accounts for the effects of compounding over a given period.


The Annualized Percentage Rate (APR) is the annual rate charged for borrowing or earned through an investment, expressed as a percentage.


Understanding these rates helps individuals and businesses compare different financial products and make informed decisions about borrowing or investing.


 

3. Working Capital Management


Currency of US dollars printing from a machine.
Working Capital Management – 10%

Short-Term Sources of Funds


Short-term financing options such as lines of credit, trade credit, and commercial paper are essential for businesses to meet their immediate cash needs.


For example, a company might use a line of credit to cover payroll expenses during a slow month or utilize trade credit to purchase inventory without immediate payment.


 

Management of Short-Term Assets and Liabilities (e.g., inventory, account receivables, accounts payable, short-term investments):


Managing short-term assets and liabilities effectively is crucial for maintaining liquidity and operational efficiency.


For instance, a business must carefully manage its inventory levels to avoid stockouts while minimizing holding costs.


Similarly, managing accounts receivable and accounts payable ensures the company maintains healthy cash flow and relationships with suppliers and customers.


 

Cash Budget


A cash budget is crucial for businesses to plan and control their cash flows.


It helps forecast cash inflows and outflows, allowing businesses to anticipate and address potential cash shortages or surpluses.


For example, a company might use a cash budget to plan for significant upcoming expenses or identify opportunities to invest excess cash.


 

4. Valuation and Characteristics of Stocks and Bonds


Man trading stocks.
Valuation and Characteristics of Stocks and Bonds – 8%

Bonds (e.g., debenture, sinking funds, coupon):


Bonds are debt securities issued by corporations or governments to raise capital.


They come in various types, including debentures and unsecured bonds backed only by the issuer's creditworthiness.


Sinking funds are provisions in bond agreements that require the issuer to set aside funds periodically to repay the bond at maturity.


Coupons are interest payments made to bondholders. Understanding bond types and valuation is crucial for investors making informed investment decisions.


 

Common Stock and Preferred Stock (i.e., dividend):


Common stock represents ownership in a corporation and typically comes with voting rights at shareholder meetings.


Preferred stock, conversely, usually does not have voting rights but has a higher claim on assets and earnings than common stock.


Dividends are payments made to shareholders, usually from the company's profits.


Preferred stockholders often receive fixed dividends, while common stock dividends can vary.


Understanding these concepts is essential for investors evaluating different types of stocks for their portfolios.


 


5. Capital Budgeting


Woman doing her finances.
Capital Budgeting – 12%

Capital Asset (e.g., building and equipment):


Capital assets are long-term assets businesses use to generate income, such as buildings and machinery.


Depreciation is the gradual decrease in the value of these assets over time, which is recorded on financial statements to reflect their reduced value accurately.


 

Project Cash Flow Forecasting and Analysis (e.g., incremental, total, pro format):


Forecasting cash flows is essential for evaluating the financial viability of a project.


Incremental cash flows are the additional cash flows generated by a project, while total cash flows include all cash flows related to the project.


Pro forma financial statements are projected financial statements that estimate future performance based on current or proposed financial conditions.


 

Financial Analysis Tools (e.g., Present Net Value, payback, Accounting Rate of Return (ARR), Internal Rate of Return (IRR)):


Financial analysis tools such as NPV, payback period, ARR, and IRR help assess the profitability and feasibility of capital investment projects.


NPV calculates the present value of future cash flows, while IRR is the discount rate that makes the NPV of a project zero.


The payback period measures the time it takes to recover the initial investment, and ARR calculates the average annual profit as a percentage of the initial investment.


 

Break-Even and Sensitivity Analysis


Break-even analysis determines the point at which revenues equal costs, indicating the level of sales needed to cover all expenses.


Sensitivity analysis assesses how changes in variables such as sales volume, costs, or interest rates affect the project's profitability, helping managers make informed decisions about project risks.


 


DSST Principles of Finance Trivia Question # 715




 


6. Cost of Capital


Gas station and prices.
Cost of Capital – 11%

Cost of Debt


The cost of debt is the effective rate a company pays on its borrowed funds.


It's usually calculated as the interest rate on debt multiplied by one minus the marginal tax rate, as interest payments are tax-deductible.


Understanding the cost of debt is crucial as it influences a company's decision on whether to use debt or equity financing.


 

Cost of Equity (e.g., common and preferred stock):


The equity cost represents the return investors require to compensate for the risk they undertake by investing in a company's stock.


It can be calculated using the Capital Asset Pricing Model (CAPM) or the Dividend Discount Model (DDM).


The cost of equity is essential as it helps companies determine their overall cost of capital and influences their investment decisions.


 

The Weighted Average Cost of Capital (WACC):


The WACC is the average rate of return that a company is expected to pay to all its security holders to finance its assets.


It's calculated by multiplying the cost of each capital component by its proportional weight and summing the results.


The WACC is a crucial metric in capital budgeting decisions. It represents the minimum return a company must earn on its existing assets to satisfy its creditors, shareholders, and other capital providers.


 


7. Risk and Return


Man shuffeling a deck of cards.
Risk and Return – 12%

Expected Return on an Asset and a Portfolio


The expected return on an asset or portfolio is the anticipated gain or loss from an investment, calculated as the weighted average of all possible outcomes, each multiplied by its probability of occurrence.


For example, if an investment has a 70% chance of returning 5% and a 30% chance of returning 10%, the expected return would be (0.70 5%) + (0.30 10%) = 6.5%.


 

Measures of Risk (e.g., standard deviation, beta):


Risk in investing refers to the uncertainty of returns. Standard deviation measures the volatility of returns around the average.


Beta measures an asset's sensitivity to market movements; a beta of 1 indicates the asset moves with the market, while below 1 is less volatile, and above 1 is more volatile.


 

Determinants of Interest Rates (e.g., real and nominal):


Several factors influence interest rates, including inflation expectations, the Federal Reserve's monetary policy, economic conditions, and investment risk.


Real interest rates are adjusted for inflation, while nominal rates are not.


 

Capital Asset Pricing Model (CAPM) and Security Market Line (SML):


CAPM is a model used to determine the expected return on an investment based on its risk and the market's return.


The SML is a graphical representation of the CAPM, showing the relationship between an asset's risk (beta) and its expected return.


 

Diversification (e.g., market risk, company-specific risk, portfolio risk):


Diversification is a risk management strategy that spreads investments across different assets to reduce exposure to any asset or risk.


Market risk is the risk of an entire market declining, while company-specific risk is associated with a particular company's performance.


Portfolio risk is a portfolio's overall risk, considering each asset's individual risks and their correlations.


 


8. International Financial Management


Image of currency.
International Financial Management – 7%

Impact of Exchange Rates on International Financial Markets


Exchange rates play a crucial role in international financial markets, affecting trade balances, investment flows, and the competitiveness of industries.


For example, a solid domestic currency can make exports more expensive, leading to a decrease in exports and a potential impact on the economy.


 

Currency Risk and Political Risk


Currency risk refers to the risk of financial loss due to changes in exchange rates.


Political risk, on the other hand, is the risk of financial loss due to political instability or changes in government policy.


For example, a sudden change in government policy can lead to currency devaluation, resulting in financial losses for businesses operating in that country.


 

Tools (e.g., Spot vs. Forwarding, Hedging):


Currency hedging is a strategy used to reduce the risk of loss due to fluctuations in exchange rates.


It involves using financial instruments such as forward contracts or options to offset the risk of adverse currency movements.


For example, a company may use a forward contract to lock in a specific exchange rate for a future transaction, thereby protecting itself from adverse currency movements.


 


9. Conclusion


Man holding saving jar with coins.

DSST Principles of Finance


In conclusion, the DSST Principles of Finance Exam is a comprehensive test that evaluates a student's understanding of financial concepts and their practical application.


Given the exam's challenging nature, thorough preparation is essential.


Are you ready to test your knowledge further?


Try our free practice test to enhance your readiness and excel in your DSST Principles of Finance exam.


Best of luck and happy testing!


 


10. Student Resources


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