401 - Exam 1

Question 1

1. Operating/working capital cycle

Answer 1

company’s operations and finances are integrally connected

movement of cash to inventory - to AR - and back to cash - cash conversion cycle

timing VERY imp.
–bc company can be profitable but if ex. gives customers long time to pay - loses control of AR and need cash quicker to pay off liabilities = or if it makes more inventory than it sells

insolvent - when comp. has insufficient cash to pay its maturing obligations

Question 2

Fin. Statents

Answer 2

BS - SNAPSHOT - shows company health over period
–income stmt. shows changes in owners equity by breaking down revenues and expenses (Explains changes in equity)

CFS - focuses on solvent - having enough cash to pay bills - looks at company’s changes in cash

• -Cash provided or consumed by operating (CFO)
• -cash from investing activities (CFI)
• -cash from financing (CFF)

Current A & L - listed in DECREASING LIQUIDITY - current if converted to cash within one year

Question 3

Earnings (NI)

Answer 3

measures the extent to which net sales generated during accounting period exceeded expenses incurred in producing the sales

• -earnings or profits
• -to measure earnings need to 1. identify rev. for the period and 2. match corresponding costs to revenues
• -rev. accounted for when sale generated…not when cash is received (time lag on incoming cash)
• -EX. if revenue was $5,020M and AR increased by 102M we assume taht cash received was (5020 - 102) $4,918M and still haven’t collected $102M

Question 4

EBIT vs. EBITDA

Answer 4

EBIT - measure of business’s income before divided among creditors, owners and taxman - used interchangeably with operating income

EBITDA - used in some industries, like broadcasting, where depreciation charges may overstate true economic deprecation

Question 5

sources and uses statement

Answer 5

1. take 2 balane sheets together and note all changes in accounts that occurred over the period
2. segregate changes into those that generated cash and those tha consumed cash

generates cash in 2 ways: REDUCING an asset or INC a liability

• -sale of equipment, liquidation of inventory, reduction of AR = source of cash
• -inc. in bank loan and sale of comon stock are sourse of cash

USES cash

• -inc. asset account or reduce liability account
• -add to inventories or AR, building plant - also repay loans so reduction in AP and operatingl osses all use cash

Total uses = total sources

Question 6

CFS

Answer 6

expands and rearranges the sources and uses stmt.

1. CFO
   - -rearrange fin. stmts. to eliminate effectsof accrual acc. on NI
   - -add all noncash charges (D and A( back to NI (bc no change in CF)
   - -then add changes in current assets and liabilities
   - -shows firm solvency bc shows extent to which oeprations are generating or consuming cash

Question 7

ROE

Answer 7

Earnings per $1 of invested capital

profit margin (NI/S) = How much $ in earnings is squeezed out of every 1$ in sales

asset turnover (S/A) - sales generated from each 1$ in assets - mgmt. efficiency - using resources req. to support sales

leverage (A/E) - amt. of equity used to finance assets

Question 8

1. Profit margin

Answer 8

measures fraction of each dollar of sales that goes through income stmt. to profits

• -imp. bc it shows operating managers company’s pricing strategy and its ability to control operating costs
• -“WHAT PERCENT OF SALES DO YOU GET TO KEEP”

usually varies inversely with AT (comp. with high profit margin tend to have lower asset turnover) - because offer a high value to customers to can demad a high profit margin…but to meet that demand themselves req. a lot of assets
–but Target and grocery stores have opposite - low profit margin bc add little value to product, just supply it, sell for cash and make customer leave with it - so low PM but high AT (so look at them together with ROA)

Question 9

ROA

Answer 9

NI/A –> PM * AT

basic measure of efficiency - shows how comapny allocates and manages its resources
–measures prodit as a % of money procided by owners and creditors…not just owners

JPM and Google have high ROA by high PM and low AT – but Target and Amazon have high ROA by low PM and high AT

Question 10

Gross margin

Answer 10

Gross profit / sales

• helps distinguish btwn variable and fixed costs
• -variable - change as sales vary
• -so most of COGS is variable costs

Gross margin - 55.6% means that 55.6% of sales dollars are available to pay for FIXED COSTS and profits – the other 44% is tied up in variable costs

also used to find breakeven point - if estimate fixed costs were 1,968M…and know that 56 cents of each sales dollar are available for fixed costs…then 1,968.,56 = 3,514M to breakeven
–so if sales are below 3,514M, comp. loses money and when above they have a real profit

Question 11

2. Asse turnover

Answer 11

Financial performance improves as asset turnover rises

• -measures sales generated per dollar of assets
• -HOW EFFICIENTLY/EFFECTIVELY ARE MY ASSETS GENERATING SALES

=.99 - means company generated 99 cents of sales for each dollar invested in assets

imp. to remember that if sales decline, a company’s investment in AR and inv. should fall too (use of cash) which frees up cash to be used elsewhere

when current assets are rising…loans will need to be taken to pay for them - and that during a downswing when current assets are falling…it willprovide cash to repay loans

control ratios - measuring the asset turnover for each individual asset on the balance sheet and comparing

ex. AR control ratio rising? - 1. bc sales have grown so AR grew or 2. bc mgmt. has slacked at collection efforts (then can realize where need to improve)

Question 12

inventory turnover

Answer 12

COGS / ending inventory

=5.8 times - means that inventory turned over 5.8 times per year
—or can do 365 / 5.8 = 63 days – DAYS INVENTORY OUTSTANDING - shows that the inventory sits abuot 63 days before being sod

Question 13

the collection period

Answer 13

AR / credit sales per day = 96
= has an everage of 96 days worth of credit sales tied up in AR
–or say that the average time lag btwn sale and recept of cash from sale is 96 days

CAREFUL WITH SEASONAL SALES - best way is to do credit sales per day based on prior 60-90 days

Question 14

days sales in cash

Answer 14

cash and securities / sales per day
=92.3 means has 93.2 days worth of sales in cash and securities
–if too low, dangerous bc illiquid - but if too high, shareholders could be disappointed bc assets are not being put to more productive and profitable uses

Question 15

Payables period

Answer 15

AP / credit purchases per day = (amt / (amt/365))

• -control ratio for liability
• -should use credit purchases but bc infrequently recorded just do COGS
• -diff. than COGS bc a lot of manufacturers add labor to COGS so it is larger than the credit purchases would be

52.4 - (but if used COGS) it is overstated so means that company’s suppliers are waiting a lot longer than 52.4 to receive pmt.

Question 16

fixed asset turnover

Answer 16

Sales / Net PP&E

• -for companies or industries with large investments in long assets to produce goods - called capital intensive and have lots of fixed assets
• -auto manufacturers and airlines

capital intensity - called operating leverage - concern to creditors specifically bc they want to see basic business risks faced by firm

fixed-asset turnover is. a measure of capital intensity - low turnover means high intensity

5020 / 267 = 18.8 times

Question 17

Days operating and cash conversion cycle

Answer 17

when comp. begins production cycle, uses cash to purchase inventory - when comp. sells the item, inventory turns into cash after customer pays and the AR is collected

operating cycle = days inventory outstanding + collection period

• -(sum of the # of days cash is tied up in inventory + the # of days it takes customers to pay)
• -in ex. = 63 + 96 = operating cycle of 159 days
• -cash is tied up btwn when it aquires inventory and when its customer pays for about 159 dayss on average

cash conversion cycle (CCC) = operating cycle - payable period
= days inventory outstanding + collection period - payables period

(TIMELINE IN NOTES)

Question 18

3. Financial leverage

Answer 18

firms with predictable and stable CFS can better face leverage risks vs. firms with market uncertainty who should have less leverage
–banks usually have diversified portfolios of readily salable, liquid asses can also use more financial leverage than typical businesses

inversely related with ROA - companies with Low ROA use more debt financing and high ROA use less

Question 19

debt to assets/ equity ratios

Answer 19

L/A = 63.4%

• -financial lev. used to cmopare book value of liaibilities to book value of its assets
• -says money to pay for 63.4% of the assets comes from creditors

L/E = 173.5%
–means creditors supply $1.73 to every 1$ in shareholder equity

Question 20

coverage ratios - times interest earned and times burden covered

Answer 20

times interest earned
= EBIT / interest expense = 807/97 = 8.3 times
–MEANS the company earned its interest obligation 8.3 times over in 2016 - EBIT was 8.3x as large as its interest
–assumes that the company will roll over its LTD as they mature (bc still have obligations and didn’t pay entire principal)

times burden covered
= EBIT / (interest + (principal repayment / 1-taxrate))
–includes debt principal repayments as well as interest - have to express principal as a before-tax comparable to interest and EBIT (bc they are before tax and numerator and denominator must be consistent)
–principal repayments are NOT a tax deductable expense (unlike interest)
–assumes they will pay principal to zero

both ratios compare income available for debt service in the numerator of some measure of annual financial obligation
–income available is EBIT - earnings of company that can be used to make interest pmts.

Question 21

market value leverage ratios

Answer 21

market value of debt / mkt. value of equity = 33.3%
= (mkt. value debt / (# shares*price per share))

mkt. value of debt / mkt. value of assets = 25%
= (mkt. value of debt / (mkt. value of D + E))

mkt. values indicate the true worth of creditors and owners stakes in the business
- -mkt. values are based on investors expectations about FCFs

compares today’s value of expected future income to today’s value of future financial burdens
–good to startups bc may have BAD coverage ratios but creditors will still lend to them bc they believe FCF will be sufficient to service the debt

Question 22

liquidity ratios

Answer 22

current ratio

• -current assets / current liabilities = 2 times
• -compares assets that will turn to cash within a year to liabilities that must be paid in a year
• -if current ratio is low the company lacks liquidity - it cannot reduce its current assets for cash to meet maturing obligations - must rely on operating income and outside financing

ACID TEST
= Current assets - inventory / current liabilities = 1.8 times
–or quick ratio - inventory subtracted bc freq. illiquid

good but not perfect for 2 reasons

1. rolling over obligatiosn - AP invovles almost no insolvency risk if the company is proitable they will be able to roll over at maturity
2. cash generated from liquidating current assets cannot be used to reduce liabilities if the comp. intends to grow - it must be plowed back in to teh business to support cont. operations

Question 23

why ROE suffers as evidence of improved performance?

Answer 23

1. TIMING problem
   - -ROE looks backwards and focuses on a single year - a little skewed estimate
   - -ex. heavy startup costs will bring down an ROE
   - -ROE is based on one year of data so it fails to capture the impact of multiperiod decisions
2. RISK problem
   - -says nothing about the risks company had to generate to get it
   - -leverage makes ROE high but makes the company an uncertain enterprise
3. VALUE problem
   - -ROE measures return on shareholder’s investment but uses Book value of equity, not market value
   - -so ROE is a good maeasure of mgmt.s financial performance..it is not synonymous with high returns on investment to shareholders

Question 24

return on invested capital

Answer 24

use to circumvent the distorting effects of leverage on ROE and ROA
–return on invested capital or return on NET ASSETS

ROIC = EBIT*(1-tax rate) / interest-bearing debt + equity
=17.5%

numerator = earnings after tax comp. would report if it were all equity financed
denominator = sum of all sources of cash to the company on which a return must be earned (AP is a source but it is not included bc it carries no explicit cost)

ROIC = rate of return earned on the total capital invested in the business without regard for whether it is by debt or equity

look at returns on similar companies independent of capital structure differences (ROE and ROA fail at that)
–ROA is biased bc punishes A for debt and leaves comp. B unaffected

ROIC - shows the company’s earning power before it is confounded by differences in financing strategies

Question 25

Earnings yield and P/E ratio

Answer 25

EARNINGS YIELD = NI / mkt. value of shareholders equity
or (earnings per share / price per share) = 5.6%
—not a. good measure bc company’s stock price is very sensitive to expectations for the future - higher expectations more they are willing to pay

high stock price, bright future, and LOW earnings yield

• -high earnings yield is not a good indicator of superior performance
• -it is very susceptible to timing issues

PE ratio - price to earnings
Price per share / earnings per share = 17.9 times
–price of one dollar of earnings
–used to normalize stock prices for diff. earning levels across companies

PE ratio depends on: future earnings prospects and risk associated with those earnings

• -possible to show earnings falling but PE ratio rising - bc people assume that earnings are weak but it is only temporary
• -SO PE ratio shows little about CURRENT fin. performance but does indicate what investors believe about future prospects
• -but lots of ppl argue the best measure of fin. performance is the firm’s stock price (but diff. bc it depends on a lot of factors outside of the firm’s control, info. asymmetry of managers, and fact that diff. to determine how operating decisions affect stock price)

Question 26

using ratios to analyze

Answer 26

diagnostics - but are all relative to opinion and company goals
–one company could see a quick ratio as ineffective and another could see it as profitable strategy

best to use by:

1. compare ratios to rules of thumb
   - -but very dependent on analyst’s perspective and circumstances of firm
2. compare to industry averages
   - -see how measures up next to competitors
3. compare to changes in ratios over time
   - -trend analysis - best option! - can see how company has performed and changed over time

look at ratio chart in notes!!!
–start with ROE and dig deeper to understand problems and health status of firm

Question 27

external funding required

Answer 27

in % of sales method

= total assets - (L + E)

change in RE = RE year 0 + earnings after tax year 1 - dividends year 1
(RE is the bridge btwn a company’s balance sheet and income stmt.)

Question 28

% of sales method

Answer 28

look at past fin. stmts. to see which items have varied with sales in the past

• -then forecast sales
• -then see what percent of sales each variable item is and multiply that by the forecasted sales amt.

ex. inventory has been 20% of sales and next years sales are estimated at $10M - so expect inventory to be $2M

problems:
–circularity btwn interest expense and loan size - either use excel circular reference or use assumption from first-pass estimate - but so insignificant it is not a huge deal

seasonality - pro formas only focus on one specific date - nothing about before or after that date

LTD does NOT vary with sales!!!!

• -only spontaneous accounts vary with sales
• -non-spontaneous accouns are LTD, common stock and notes payable

Question 29

dealing with uncertainty in forecasting

Answer 29

1. sensitivity analysis
   - -“what if” tests - what of COGS was 84% and not 86% - helps us test a range of outcomes with different assumptions
   - -also enables managers to determine which assumptions most strongly affect the forecast and which are secondary
2. scenario analysis
   - -sensititivity analysis only focuses on 1 variable at a time - scenario broadens view to look at how a # of assumptions would change in response to a particular economic event (Sales drop…so inventory rise)
3. simulation
   - -computer assisted sensitivity analysis
   - -assign a probability distribution to each uncertain element in the forecast then have computer pick a random value for each uncertain variable with the probability distribution and create pro forma stmts.

Question 30

cash flow forcasts

Answer 30

project external funding required as the diff. btwn ancitipated sources and uses of cash over the forecast period

• -yield same external funding needed as pro forma projection with same assumptions
• -less informative than pro forma bc do not provide info. useful in evaluating how best to meet indivated need for financing

Question 31

cash budgets

Answer 31

project change in cash balance over the forecast period as diff. btwn anticipated cash receipts and disbursements

• -cash not accrual accounting
• -same external funding needed as other forecasting methods
• -used usually for short term (day to month) forecasts

Question 32

firm’s SGR

Answer 32

reminds managers that more growth is not always a blessing and that companies can literally “grow broke”

• -is the mAX rate at which a firm can increase sales w/o raising new equity or inc. financial leverage
• -assumes comp. Debt increases in proportion to equity

SGR = profit margin * retention ratio * asset turnover * financial leverage (use equity beg. period)
or = retention ratio * return on beg. period of equity

Question 33

actual sales growth above a firm’s SGR

Answer 33

• -causes one or more of defining ratios to change
• can be managed by:
• —INC financial leverage
• —REDUCING div. payout ratio
• –pruning away marginal activities, products or customers
• –outsourcing some or all of production
• -increasing prices
• –merging with “Cash cow”
• -selling new equity

Question 34

actual sales growth below SGR

Answer 34

produces excess cash that can enhancee a firm’s appeal as a takeover targer
–forces mgmt. to find productive uses for the excess cash (reducing fin. leverage, returning money to shareholders, cutting prices, “buying growth” by rapidly growing firms in needs of cash”

Question 35

new equity financing

Answer 35

has been a USE of cash to Am. companies for most of past 35 ryrs - firms have retired more equity than they have issued

• -it is an important source of cash to smaller, rapidly growing companies
• -seldom used bc - issue costs of equity are high relative to debt, new equity tends to reduce earnings per share, managers believe current share price is unreasonably low and can get better price by waiting

Question 36

Class notes - problems with ONLY using ROE to evaluate a company

Answer 36

1. completey ignores risk (have to ask yourself how much risk is company taking to generate those returns?)
2. uses book equity
3. timing problem - could be low bc of decision that year (building a new plant/building)

two companies A = ROE 15% and B = ROE 25% is B better?
–have to break down the ROE formula and see that they could just be amplifying return by taking on more risk

Question 37

sustainable growth rate - class notes

Answer 37

• -how fast can company grow without changing D/E ratio (keeping financial policies constant)
• -POINT: managing growth: does not mean it is optimal - just a measure of sustainability

dinancing policies

1. retention rate
2. debt ratio
3. NO new equity
   - -trying to see how fast the company can grow using only RE - if grow other ways it is ok but can see which policies need to be changed

SGR = change in equity / equity (beg. period!)

= (ret. rate)*NI / (equity beg. of period!) – bc need to see growth!

SGR = PRA*T^. (T hat)

ex. to analyze
- -if P decreases…then less profit retained so RE goes down and SGR goes down
- -if A increases then using assets more efficieny and don’t need more assets or financing

Question 38

rapid growth?

Answer 38

what if growing too fast and cant sustain it?
--can grow self to death
OPTIONS:
--decrease payout rate
--increase profit margin
--increase price
--merge with another company
--issue new equity
--increase debt
---outsource (use assets more efficiently by using other companies assets)

IMP. growth must be planned and sustained - doesn’t have to be SGR but must ave plan - if keep issuing debt and can’t handle it and meet obligations then sales are bad

Question 39

IRR

Answer 39

Internal rate of return

• -metric used in capital budgeting to estimate the profitability of potential investments
• -discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero
• -higher a project’s internal rate of return, the more desirable it is to undertake
• -To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount rate (r), which is the IRR

Question 40

NPV

Answer 40

• -difference between the present value of cash inflows and the present value of cash outflows over a period of time
• -used in capital budgeting to analyze the profitability of a projected investment or project
• -ositive net present value indicates that the projected earnings generated by a project or investment (in present dollars) exceeds the anticipated costs

Question 41

impicit interest rate - 2/10 net 30

Answer 41

2% discount of pay within 10 days…otherwise pay in 30

1000 - 20 = 980 ($20 implicit cost (interest rate) if fail to pay - or 2% interest rate bc bill is not actually $1000)

(20 / 980) * (365 / 20) = 37.2%
–ANNUALIZING the interest rate - seeing how many 20 day periods are in a year

in Clarkson case - his payables period was 48 days so his implicit interest rate is
(20 / 980) * (365 / 48) = 15.5%

now check if have to keep taking out bank loans at 11% bc does not meet obligations and needs to keep financing…we need to see which is a better decision - financing without the discount or the 11% bank rate

(20 / 980) * (365 / x) = .11
x = 68 days
add 10 (bc this interest comes if do NOT make the 10 day discount period)
68 + 10 = 78 days
–if he stretched AP payment to 78 days he would be indifferent

options: - Clarkson
- -tighten AR
- -increase price
- -get bank loan and more - temporary fix then repay
- -merge with another comp.
- -cut inventory
- -issue equity

Question 42

2 BOND RULES!!

Answer 42

1. Bond prices move INVERSELY with market interest rates
2. Price of a longer maturity bond is more sensitive to change in interest rates than the price of a shorter maturity bond

Question 43

banks and specialization

Answer 43

banks vs. pooling money ourselves and giving out loans?

• -banks beter at screening (to discern who is credit worthy)
• banks monitor
• -liquidity - access to your $ when you ened it

institutional investors are the most IMP - bc have ALL the money

• -pension funds, insurance comp., endowments
• -but they can’t invest in entrepreneur/start up directly bc they don’t hve the specialization expertise

Question 44

Public firms vs. private firms

Answer 44

public
–IPO to raise capital for firm - then as grow was to cont. to INC. capital/funds through public equity
–why public? bc quick access to capital
COSTS
–disclose info. to competitors - issuing equity is expensive and SEC filing is costly and time consuming
BENEFIT
–quick access to capital

private
COSTS
--harder to find capital
--PE/VC charge high rates
--BENEFITS
--don't have to do public filings

PE owns HUGE portion of US economy - PE firms also buy public comp. and turn them private

Question 45

3 ways PE firm generates returns

Answer 45

1. financial engineering (leveraging with debt)
2. multiple expansion (buy low sell high - buy 5x sell 7x)
3. operational efficiency (increase EBITDA)

PE firms do add value - even though take on leverage sometimes, PE firms can work efficiently to double EBITDA, or sell high or make positive changes
–also give LPs access to entrepreneurs when they don’t have the specialization or expertise to tap in to that market effictecely - gives entrepreneurs a chance to sell their ideas and increases innovation and opportunity

Question 46

1. Financial enginnering

Answer 46

pension funds (LP) giving money to the GP (PE firm) who manages $1B from several diff. pension funds

Jake has company with EBITDA - $20M

• -PE firm buys at 5x EBITDA ($100M)
• -S&D determine price - bc lots of other PE shops compete for it
• -we talk about price as a multiple of EBITDA just like house mkt. talkes about price in terms of p/sq ft. - or like ceramics…EBITDA is amt. of clay investors have to work with - makes bigger pottery if have more clay - take 2.5x debt bc company generates high EBITDA and will be able to repay

Jake buys for 5x EBITDA ($100M)
D = $50M (2.5x EBITDA) and E = $50M

5 years go by - all that has changed is that he paid off his debt

5 years = $100M = doubled equity investment

• -to GP –> $100M - $50M = $50M * .2 (what they get…the CARRY - 20%) = $10M
• -mgmt. fee = (.02)*(50M) = $1M * 5 years (ann. mgmt. fee - the 2% carry 20) = $5M in mgmt. fees from pension fund
• -GP (PE firm) gets = 10M + 5m = 15m!!!

LP gets $35 —> return = 50*(1 + x)^5 = 85 (85 = 25 + 50 returning their original investment)

• -solve for x = (85/50)^1/5 - 1 = 11.2% return to LP
• -reason is leverage! bc amplifies treturns
• -did not add a lot of value by taking on risk
• -high returns bc of risk!

Question 47

2. Multiple expansion

Answer 47

EBITDA = $20M
value of comp. 5*20 = $100M
D=50, E=50

sell for 7x EBITDA = 720 = $140M
to GP = (140 - 50)20 = $18M (this 50 is equity owed to pension fund investors)
.02 * 50 * 5 = $5M mgmt. fee (this $50 is equity inv.)
= 23M to GP

to LP = 140 - 23 = 117
50 * (1 + x)^5 = 117
(117/50)^1/5) - 1 = 18.5 return to LP

GP took small Equity investment but bigreturns bc bought LOW and sold HIGH

• -added value
• -can do this without adding value? maybe buy low during recession and sell high when mkt. is good
• -or PE firm that buys a bunch of local dentist practices at 4x then finds bigger PE shop to buy whole thing for 6x

Question 48

3. Operational efficiency

Answer 48

buy Jakes comp. @ 20 EBITDA
pay 5x EBITDA = $199M
D = 50, E = 50

sell for 7x EBITDA but now have 40M in EBITDA, not 20 (EBITDA grew!!)
7(40) = $280
–PE firms can do bc business experts - know how to run effectively

to GP = (280 - 50).2 = $46M (take out 50 bc repay pension fund investors)
.0250*5 years = $5M mgmt. fee
–$51M

to LP = (280 - 51) = 229
return, 229 = 50*(1 + x)^5
= 35.6%

229 / 50 = 4.5x return - another way to say

Question 49

human beings are risk averse

Answer 49

a loss hurts utility more than a gain enhances utility
–bad outcome more harmful to you than a good outcome is good to you

in ex. - PG 195 book - req. more compensation bc take on risk

• -if have higher returns ask question, “at what level of risk?”
• Sharpes ratio – helps us understand risk in terms of a SR

Question 50

solving for ROIC

Answer 50

know leverage AMPLIFIES ROE
–want to know what portion of ROE is coming from leverage and what portion is from the productive assets
ROE = productive assets + leverage
–helps us know if lev. is increasing or dec. ROE

ROE = (EBIT - iD)*(1-t) / E
–the iD is interest expense
ahh just look on notes

but ROIC = EBIT * (1-t) / D+E
–EBI / D+E = EBI / A (ignores effects of leverage - also called “Return on net assets” - it is the return I am getting on assets withou effects of leverage

Question 51

ROE to see what portion of ROE is coming from leverage and what from productive assets

Answer 51

ROE = (EBIT - iD)*(1-t) / E
–the iD is interest expense
ahh just look on notes

end formula
ROE = ROIC + (ROIC - i’(D/E))
i’ = after tax interest rate - bc get tax savings for having debt so have to include the benefits when calc.
ROIC - i’ = sshows if return on assets is more than interest on your debt - VERY imp. bc if negative…your interest to use debt to finance is more expensie than your earning using it
–this formula tells me if leverage is giving an inc. or dec. in ROE

summary

• -when a company earns more on borrowed money than it pays in interest, then ROE will rise
• -if it earns less on borrowed money than it pay in interest, then ROE will fall

Question 52

Miller and Midigliani

Answer 52

does capital structure impact firm value?

• -argue value found from CFs - from assets on firm, not from how it is financed
• -same size pizza - doesn’t matter if you have 4 or 8 slices
• -VA of firm is independent of capital structure…in a world with:
  1. no taxes
  2. no bankruptcy costs
  3. perfect capital markets
  4. no agency costs
  5. no assymmetric info. mkts.
• -structure is irrevelant…but this world does exist!!!!
• -this tells us what questions to ask! - and points in the direction to launch other theories!!!

Question 53

1. trade-off theory

Answer 53

btwn tax shield and bankruptcy costs

• -x axis - debt, y axis - firm value
• -creates a parabola where the optimal valueof debt is at the high peak
• -trade off bc measures the benefit of tax shields against the risk of bankruptcy

optimal value = marginal benefit of taxshielf = marginal expected costs of bankruptcy

ANN tax shield (if assume debt is held in perpetuity)
DTR = D*T

Vafirm (under trade-offtheory) = PV(Tax shields) - expected costs of financial distress

• -PV tax shields = DTR (debt amt.tax rateint. rate)
• -exp. costs of fin. distress = P(D) * L.G.D. = Prob. default (find by bond rating) * loss given default (conditional and really hard to determine)
• -for credit rating look at AAA, AA, A, BBB or if private look for comparable company’s times int. earned and compare

bankruptcy is NOT death - every car or airline has experienced it before
For L.G.D. - think about:
1. direct costs of bankruptcy (fees - IB, lawyer)
2. indirect costs of bankruptcy
–trust in the company

Question 54

trade-off theory case questions

Answer 54

Va firm = PV(tax shield) - P(D)*L.G.D
–what part of equation is related:

1. Does company benefit from a tax shield?
   - -PV(tax shield) - if don’t pay taxes they do not benefit - or if have really small tax rate - LESS DEBT
2. If it is in a highly volatile industry
   - -P(D) is going to be higher bc of dramatic changes - LESS DEBT
3. if it is dependent critically on external funds for investments
   - -L.G.D. - bc it will be harmful to the company to survive - NEED inventory then big loss if default - LESS DEBT
4. if there is a severe competitive threat
   - -L.G.D - competition takes over with cheaper prices (gas station example) - or P(D) bc competition always watching - LESS DEBT
5. company has tangible assets that can be used to generate cash? - MORE DEBT bc P(D) less risky bc so many assets to meet obligations

tax rate inc. so the debt ratio inc.

Question 55

Pecking order theory

Answer 55

Assymetric info. word (Dating ex.)
–CEO knows more than investors
1. ex. issue equity bc signals to mkt. that stock os overvalued and price drops
2. if buyback shares at low price, P increases
(buy low sell high)
–what kind of firms have high assymmetric info problems?
–pharmaceuticals, FDA approval - TECH. dont know what they’re working on
–retail has little AI problem

pecking order theory
–argues different financing decisions will send diff. signals

options:

1. retained earnings (least amt. of signals possible)
2. debt
3. equity

Question 56

theory of financial flexibilities

Answer 56

if live in a world where capital markets are not perfect

–firms are hoarding cash bc ensures they do not have to rely on capital markets

Question 57

agency theory of debt

Answer 57

deals with AGENCY COST problems

• -CEO salary tied to size of comp. - want to get big quick
• -debt can DISCIPLINE managers away from wasting money on bad projects (bc need to make huge debtpmt…can’t buy corporate jet)
• -CEO should be motivared to MAX shareholders wealth

Question 58

Suppose you constructed a pro forma balance sheet and cash budget for company for same time period and external financing required from pro forma forecast exceeded cash deficit estimated on cash budget. How would you interpret this result?

Answer 58

There was an error - forecasts should always be =

–maybe were too generous with sales growth assumptions or the % of sales calcuations were inaccurate

Question 59

irrelevance proposition

Answer 59

unless leverage affects an investment’s cash flows, it should not affect its value