B3: Financial Management Flashcards
Capital Budgeting
process for evaluating and selecting the LT investment projects of the firm
Cash Flow Effects
Cash Flows Related to Capital Budgeting
Direct Effect
- when a comp pays out cash, receives cash, or makes a cash commitment directly related to the capital investment
- has immediate effect on amt of cash available
Indirect Effect
- indirectly associated w a capital project, produces cash benefits or obligations
- net proceeds on sale of old reduces cost of new
- e.g. depreciation * tax rate = dollars saving
Net Effect
- total of direct and indirect effects
Stages of Cash Flows
Cash Flows Related to Capital Budgeting
cash flows exist through the life cycle of a capital investment project, there are 3 stages
- Inception of the Project
- today’s cost = initial outflow
- both direct and indirect cash flow effects occur at the time of the initial investment
- initial cash outlay is often the largest amt of cash outflow in the investment’s life
a) working capital: net CA, current assets - current liabs
- additional working capital: “buy” WC, cash outflow
- reduced working capital: “sell” WC, cash inflow
b) disposal of replaced asset
- book value is a sunk cost
- but gain or loss, net of tax, is inflow or outflow
- selling price is inflow - Operations
- future annual OCF = inflow
- pretax CF * (1-T)
- plus, depreciation tax shields: (depr. * T)
3. Disposal of the Project SP = inflow \+ decrease in WC = inflow - gain * T = outflow \+ loss * T = inflow = net inflow
- final year has 2 inflows:
1. last OCF
2. terminal year cash flow (step 3) TYCF
Calculation of Pretax and After-Tax Cash Flows
Cash Flows Related to Capital Budgeting
Pretax Cash Flows
- investment’s value is often based on PV of future cash flows
After-Tax Cash Flows
- pretax CF * (1-T) + (depr. * T) = annual OCF **
B3-5
Objective and Components of Disc. CF as used in Capital Budgeting
Discounted Cash Flows
DCF to focus the attention of mgmt on relevant cash flows appropriately discounted to present value
Rate of Return Desired for the project
- compensation for all risk assumed
- aka hurdle rate or discount rate
- mgmt may use a weighted avg cost of capital (WACC) method
- mgmt may assign a target for projects to meet
- mgmt may recommend the disc. rate be related to the risk specific to the project
Limitation of DCF
- they freq. use a simple constant growth (single interest rate) assumption
- this assumption is unrealistic bc actual interest rates may fluctuate
- NPV allows r to change, but IRR doesn’t
Net Present Value Method (NPV)*
Discounted Cash Flows
Objective
- used to screen capital projects for implementation
- focus decision makers on initial investment amt required to purchase a capital asset that will yield returns in excess of a mgmt-designated hurdle rate
- dollar amt of return, rather than % of years like others
Calculation of NPV
a) Estimate Cash Flows: 1. initial outflow 2. annual OCF 3. final year’s CF
- ignore depreciation, UNLESS tax shield
- use of accelerated depr. increases the PV of depr. tax shield
- ignore method of funding
- NPV uses hurdle rate to discount cash flows (WACC)
b) Discount the Cash Flows
- discount all CFs to PV using hurdle rate
- NPV method assumes CFs are reinvested at same rate used in analysis
- IRR assumes CFs reinvested at IRR
pass key summary B3-8
Interpreting the NPV Method**
Net Present Value Method (NPV)
Positive Result = Make Investment
- IRR > hurdle rate
- sum of PVFCF > cost, value added
Negative Result = Do Not Make Investment
- IRR < hurdle rate
- sum of PVFCF < cost, value down
Interest Rates Adjustments for Required Return
Net Present Value Method (NPV)
NPV analysis may incorporate many types of hurdle rates
- major advantage over IRR
Adjustments to Rate
- risk ^: rate ^, PVFCF v (disc. rates increased to factor differences in risk)
- inflation: rate ^ (loss of purchasing power, risk ^)
Differing Rates
- NPV considered superior to IRR bc flexible enough to handle uneven cash flows or inconsistent rates of return
Discount Rate Applied to Qualitatively Desirable or Non-optional Investments
- B3-9
Advantages and Limitations of NPV
Net Present Value Method (NPV)
Advantages
- flexible
- no constant rate of return required each year
Limitations
- does not provide true rate of return
- purely indicates whether an investment will earn the hurdle rate used in NPV calculation
Capital Rationing
Net Present Value Method (NPV)
describes how limited investment resources are considered as part of investment ranking and decisions
Unlimited Capital
- pursue all investments w positive NPV
Limited Capital
- makes investment choices mutually exclusive
- managers allocate capital to combo of projects w max NPV
- ranking is best accomplished using profitability index
Profitability Index
Net Present Value Method (NPV)
= PVFCF / cost
- aka excess PV index or PV index
- if PI > 1, means positive NPV thus profit
- measures CF return per dollar invested; the higher the PI, the more desirable
Internal Rate of Return
Discounted Cash Flows
single discount rate that will set the PVFCF = today’s cost
- yield 0 NPV
- aka time-adjusted rate of return
Interpreting
- accept when IRR > hurdle rate
- reject when IRR < hurdle rate
Limitations
- CFs assumed to be reinvested at IRR, but if rates are wrong then inappropriate
- less reliable when alternating periods of cash inflows and outflows, it needs 1 outflow then only inflows after
- does not tell in dollars value added like NPV, just gives you a % rate of return
Payback Period Method
Discounted Cash Flows
time required for net after-tax cash inflows to recover the initial investment in a project
- focuses decision makers on liquidity and risk
- liquidity: time it will take to recover initial investment
- risk: longer time, greater risk
Calculation*
- payback period = net initial investment / increase in annual net after-tax cash flow
- lower payback period, less risk
- assumes annual annuity
CF Assumptions
- Uniform Cash Inflows: net cash inflows assumed to be constant each period, using after-tax cash flows. CFs involve following factors
- project evaluation
- asset evaluation
- depreciation tax shield - Non-uniform Cash Flows: use cumulative approach
Advantages and Limitations
- limitation: time value of money is ignored
- B3-17
Discounted Payback Method
Discounted Cash Flows
computes payback period using expected CFs that are discounted
- aka breakeven time method (BET)
Objective
- evaluate how quickly new ideas are converted into profitable ideas
1. Focus on Liquidity and Some Profit - up to when the investment is recovered
2. Evaluation Term - begins when project team is formed and ends when initial investment has been recovered
3. Common Projects Using Discounted Payback - new product development projects of comps that experience rapid technological changes
- they want to recoup their investment quickly before their products become obsolete
Advantages and Limitations
- same as payback method, except discount payback incorporates time value of money
- both focus on how quickly investment is recouped rather than overall profitability of the entire project
Leverage
use of fixed costs to amplify risk assumed and potential return
- sig. consideration as a factor in designing capital structure
- must consider both operating and financial leverage
- whether DOL or DFL, always put the larger % in the numerator bc must be greater than or equal to 1
Operating Leverage
Leverage
degree to which a company uses fixed operating costs rather than variable operating costs
- capital intensive industries have high operating leverage
- labor intensive industries have low operating leverage
Implications
- comp w high operating leverage must produce sufficient sales revenue to cover it’s high fixed-operating costs
- comps w high operating leverage will have greater risk but greater possible returns
- beyond the breakeven point, a comp w higher fixed costs will retain a higher % of add. revenues as operating income
Degree of Operating Leverage (DOL)
= % change in EBIT / % change in sales
- higher DOL, higher risk higher return
- vice versa for lower
% change in operating income = % change in sales * DOL
- if DOL goes up, so does operating income
Financial Leverage
Leverage
the degree to which a comp uses debt rather than equity to finance the company
- debt results in fixed interest costs
- equity do not increases fixed costs bc dividend payments are not required
DFL = % change in EPS / % change in EBIT DTL = DOL * DFL or % change in EPS / % change in sales
Implications
- a comp that issues debt must produce sufficient EBIT to cover its fixed interest costs
- once fixed interest costs are covered, add. EBIT will go straight to net income and EPS
- a higher degree of financial leverage implies a small change in EBIT will have a greater effect on profits and shareholder value
- companies that are highly leveraged may be at risk of bankruptcy if unable to make payments on debt
Weighted Average Cost of Capital
major link b/w long-term investment decisions associated w a corp’s capital structure and the wealth of a corp’s owners
- average cost of all forms of financing used by a comp
- WACC often used internally as a hurdle rate for capital investment decisions
- optimal capital structure is the mix of financing instruments that produces the lowest WACC
- value ^ if return on investment capital > WACC
Computing the WACC
Weighted Average Cost of Capital
WACC is average cost of debt and equity
Formula
- determined by weighing the cost of each specific type of capital by its proportion to the firm’s total capital structure
- = cost of equity multiplied by the % of equity in the capital structure + weighted avg cost of debt multiplied by the % of debt in capital structure
- after tax cost of debt*
Individual Capital Components
- include both LT and ST elements of a firm’s permanent financing mix
- After-Tax Cash Flows: cost of debt computed on an after-tax basis bc interest expense is tax deductible
- YTM * (1-T) = after tax cost of debt (relevant!)
Optimal Capital Structure- Lowest WACC
- optimal cost of capital is ratio of debt to equity that produces the lowest WACC
Application to Capital Budgeting
- historic weighted avg cost of capital may not be appropriate for use as a discount rate for a new capital project unless it carries same risk as the corp and results in identical leveraging characteristics
Cost of Capital Components
cost of capital is the cost of borrowing (interest rates on debt) and the cost of equity (return required by investors in exchange for assumed risk)
Weighted Average Cost of Debt
Cost of Capital Components
weighted avg interest rate = effective annual interest payments / debt cash available
- outflow / net inflow
- use coupon rate if par, otherwise use YTM
Pretax Cost of Debt
- represents cost of debt before considering the tax shielding effects of the debt
After-Tax Cost of Debt
- bc interest on debt is tax deductible, the tax savings reduces the actual cost of debt
- after-tax cost of debt = pretax cost of debt * (1-T)
- the higher the tax rate, the greater the incentive to use debt financing (tax benefit)
pass key:
- debt carries the lowest cost of capital and is tax deductible
- the higher the tax rate, the greater the incentive to use debt financing
Cost of Preferred Stock
Cost of Capital Components
cost of preferred stock = preferred stock dividends / net proceeds of preferred stock
- after tax considerations are irrelevant w equity bc dividends are not tax deductible
- net proceeds can be calculated as gross proceeds net flotation costs (e.g. issuance costs)
Cost of Retained Earnings*
Cost of Capital Components
cost of equity capital obtained through RE is equal to the rate of return required by the firm’s common stockholders
- 3 Common Methods of Computing the Cost of RE
1. Capital assets pricing model (CAPM)
2. Discounted cash flow (DCF)
3. Bond yield plus risk premium (BYRP)
Capital Assets Pricing Model (CAPM)*
Cost of Retained Earnings
Cost of Capital Components
**cost of RE = risk-free rate + (beta * (market return - risk-free rate))
- cost of RE is equal to risk-free rate plus a risk premium
- risk premium is the systematic (nondiversifiable) risks associated w the overall stock market: beta * market risk premium
- market risk premium is market rate of return - risk-free rate
- beta coefficient is a numerical representation of the volatility (risk) of the stock relative to the volatility of the overall market (e.g. B > 1 is riskier than the market)
Discounted Cash Flow (DCF)
Cost of Retained Earnings
Cost of Capital Components
Assumptions
- stocks are in equilibrium relative to risk and return (fairly priced)
- est. expected rate of return will yield an est. required rate of return
- expected growth rate may be based on projections of past growth rates, a retention growth model, or analysts’ forecasts
cost of RE = future dividend / current market price + growth
- future dividend = dividend today * (1 + g)
Bond Yield Plus Risk Premium (BYRP)
Cost of Retained Earnings
Cost of Capital Components
Assumptions
- equity and debt security values are comparable before taxes
- risk premiums depend on nondiversifiable risk
cost of RE = pretax cost of LT debt + market risk premium
- pretax cost of LT debt = firm’s own bond yield
Comparison of CAPM, DCF, and BYRP
Cost of Retained Earnings
Cost of Capital Components
- all methods are valid for calculating cost of RE
- average of the 3 amts could be used as the estimate if RE if there is sufficient consistency in the results of the three methods
Return on Investment and ROA
assessment of a comp’s % return relative to its capital investment risk
- ideal performance measure for investment in SBUs
- per IS and BS (CF ignored)
- invest more in SBUs with higher ROIs
ROI = income / investment capital (D+E)
or = profit margin * investment turnover
= net income / sales * sales / avg investments (D+E or A)
the higher the % return, the better!
ROA, similar to ROI, except uses avg total assets in denominator instead of invested capital
- ROA = net income / avg total assets
- the higher the denominator, the lower the return
ROI/ROA Issues
- Variations on Asset Valuation
- asset valuations used in ROI/ROA affects the results
- the appropriate asset valuation depends on the strategic objectives of the comp
a. net book value: GAAP, depreciation affects NBV
b. gross book value: ignores depreciation
c. replacement cost: approximates FMV
d. liquidation value: selling price of productive assets - Limitations of ROI
- residual income may be superior bc it’s in $s rather than % like ROI
- can inadvertently focus managers purely on maximizing ST results (bc ROA = NI / A so if A v then ROA ^)
- Investment Myopia: overemphasis of managers on investment balances gives disincentive to invest bc it takes time for assets to produce sales
Return on Equity and Dupont Model
Return on Equity
- stockholder perspective vs ROA/ROI is return to all investors (stockholders and creditors)
- measure for determining a comp’s effectiveness
- ROE = NI / total equity
- goal: ROE > cost of equity (CAPM)
- simple to compute, but add. breakouts of components provide mgmt w a clearer picture of efficiencies and leverage of operations
Dupont Analysis
- breaks ROE into 3 distinct components
DuPont ROE = Net Profit Margin * Asset Turnover * Financial Leverage
- NPM * AT = ROA
1. NPM = net income / sales
2. Asset Turnover = sales / avg total assets
3. Financial Leverage = avg total assets / equity
Extended DuPont Model
- breaks out net profit margin into 3 components
extended DuPont ROE = tax burden * interest burden * operating income margin * asset turnover * financial leverage
1. Tax Burden = NI / pretax income
2. Interest Burden = Pretax income / EBIT
3. Operating Income Margin = EBIT / sales
- for all 3, the higher the better
Residual Income
residual income measures excess of actual income earned by an investment over the return required by the company
- ROI provides % measurement, RI provides a $ amount
- like ROI, a performance measure for investments in SBUs
RI = NI (from IS) - required return (in $s)
- required return = NBV (equity) * hurdle rate
RI issues
- Benefits
- realistic target rates in dollars, set by mgmt
- focus on target return and amts in dollars, encourages managers to invest in projects rather than ROA investment myopia - Weaknesses
- reduced comparability: use of an absolute amt to compute performance distorts comparison of units w unequal size
- target rates require judgement, thus it’s subjective
Economic Value Added
ver similar to RI method, except uses WACC
- and uses NOPAT, profit before interest but after tax
EVA = NOPAT - $WACC
step 1: calculate req. amt of return and income after taxes
- investment (D+E) * cost of capital (WACC) = required return
step 2: compare income to required return
- NOPAT (EBIT * (1-T)) - required return = EVA
- return to all providers of capital, rather than just stockholders (E) like RI
Interpretation
- positive EVA: meeting standards, stock price up
- negative EVA: not meeting standards, stock price down
Value Added Component Issues
- EVA can be refined by adjusting income, more flexible than RI
1. capitalization of research and development: NI ^
2. current valuation of BS: FMV of assets approximates invested capital
3. income may be adjusted creating a nearly cash basis IS - adjs. to BS affect the IS
- deferred taxes are ignored
Debt to Total Capital Ratio
Effectiveness of LT Financing
Debt to Total Capital Ratio = total debt / total capital (D+E)
- increases risk, but higher debt means lower equity thus since ROE = NI / E, lower equity means higher ROE
- lower ratio, greater level of solvency and greater ability to pay debt, implies greater equity so lower ROE
Debt to Assets Ratio
Effectiveness of LT Financing
Debt to Assets Raio = total debt / total assets
- indicates LT debt paying ability
- lower the ratio, the better protection afforded to creditors
- some analysis adjust the DTA ratio to exclude certain items from the denom. as basis for refining the amt truly available to liquidate debt
Debt to Equity Ratio
Effectiveness of LT Financing
comprehensive ratios provide insights to overall solvency, relationships b/w elements of capital structure provide more refined views of solvency
DTE ratio = total debt / total shareholders’ equity
- DFL = 1 + D/E
- DuPont: DFL = A / E
Interpretation
- indicates degree of leverage used
- the lower the ratio, the lower the risk involved
Variations
- some analysts use the reciprocal (total shareholders’ equity / total debt) to measure amt of equity backing up every dollar of debt
- ROA * DFL = ROE
- B3-38
Times Interest Earned Ratio
Effectiveness of LT Financing
shows # of times the interest charges are covered by net operating income
times interest earned = EBIT / interest expense
- higher times interest earned means lower risk, but debt v so E ^ and ROE v
Interpretation
- ability of comp to pay its interest charges as they come due
- LT solvency
Working Capital Ratios
working capital management involves managing cash so that a comp can meet its ST obligations, and include all aspects of administration of CA and CL
- goal: shareholder wealth maximization
Working Capital = CA - CL
Balancing Profitability and Risk
- cash and marketable securities: lower risk, lower return
- LT investments: higher risk, higher return
- adequate WC reserves is a balance that mitigates risk
- aggressive WC mgmt: lower WC, lower current ratio, higher risk
- conservative WC mgmt: higher WC, higher current ratio, lower risk
Current Ratio
Working Capital Ratios
= CA / CL
- measures short-term solvency
- higher ratio is better for lowering risk
- deteriorating CR implies WC decrease and risk increase
- improving CR implies WC increase and risk decrease
Limitations
- can be misleading as a measure of health of a business
Quick Ratio (Acid Test)
Working Capital Ratios
= (cash + receivables + marketable securities) / CL
- CA - inventory - prepaid
- more rigorous test of liquidity
- the higher, the better
Variations
- some analysts include prepaid assets in numerator, but excluding is more conservative
Working Capital and Risk
Working Capital Ratios
less working capital increases risk by:
- likelihood of failure to meet current obligations
- may reduce firm’s ability to obtain additional ST financing, bc creditors dont like less WC
Advantages and Disadvantages of Holding Cash
Mgmt of Cash and Cash Equivalents
- too little, risk increases
- too much, ROA decreases
Motives for Holding Cash
- transaction motive: to meet payments in ordinary course of business
- speculative motive: take advantage of temp opportunities that may arise
- precautionary motive: safety cushion for unexpected needs
Disadvantages of High Cash Levels
- ROA decreases
- “negative arbitrage” effect: interest obligations exceed interest income from cash reserves
- increased attractiveness as a takeover target
- investor dissatisfaction w allocation of assets
Primary Methods of Increasing Cash Levels
Mgmt of Cash and Cash Equivalents
reducing the operating cycle
- either speeding up cash inflows or slowing down cash outflows increases cash balances
- objective of financial managers is to shorten the operating cycle
Methods to Speed Collections
- Customer Screening and Credit Policy
- extend credit to more responsible customers who are morel likely to pay bills promptly - Prompt Billing
- Payment Discounts*
- APR of quick payment discount = 360/(pay period - discount period) * discount/(100 - discount %)
- give to customer: cost
- receive from vendor and don’t take: opportunity cost - Expedite Deposits
- not only collect timely but also deposit
a) Electronic Fund Transfer
b) Lockbox System
- good if add. interest income > bank fees - Concentration Banking
- designation of single bank as centra depository - Factoring AR
- good if benefit > cost
Methods to Defer Disbursements
- Defer Payments
- take full advantage of grace period, pay on last day - Drafts
- dont pay cash - Line of Credit
- Zero-Balance Account
- helps to slow cash disbursements bc a disbursement is made only when there is a demand for it
Other Cash Mgmt Techniques
- Managing Float
- more cash earning interest in bank longer
- bank balance > book balance - Overdraft Protection
- good if benefits > cost - Compensating Balances
- reduces fees, does not increase cash
- maintaining a min. balance at bank
Cash Conversion Cycle
Mgmt of Cash and Cash Equivalents
aka net operating cycle
cash conversion cycle = inventory conversion period + receivables collection period - payables deferral period
Elements of Cash Conversion Cycle
- inventory turnover: COGS / avg inventory; in days: 365 / inventory turnover
- AR turnover: sales / avg AR; in days: 365 / AR turnover
- AP turnover: COGS / avg AP; in days: 365 / AP turnover
- want low inventory conversion and receivables collection period, but high payables deferral period
Management of AR
balance AR o/s and amt of bad debts and converting AR into cash quickly enough to meet ST obligations
Credit Policy
- if strict, # of days to collect decreases but # of days to sell increases
- goal: lower OC
- typically established by a committee of senior company executives
- definitions B3-45
Factoring
- selling AR for speeding cash collections
- ex B3-46
Management of AP
Trade Credit
- provide largest source of ST credit for small firms
Discounts
- opportunity cost
- APR of quick payment discount = 360/(pay period - discount period) * discount/(100 - discount %)
Accruals
- form of ST credit
- don’t pay employees everyday, pay them every 2 weeks, accrue payments
Management of Inventory
inventories represent most significant noncash resource of an organization
- too little: lost sales
- too much: carrying cost increases, profit decreases
Factors Influencing Inventory Levels
- primary: accuracy of sales forecasts
- others: storage costs, insurance costs, opportunity costs of inventory investment, lost inventory due to obsolescence or spoilage
- the lower the carrying costs of inventory, the more inventory companies are willing to carry
Factors that Influence Optimal Levels of Inventory
- inventory turnover
- safety stock
- reorder point
- economic order quantity
- materials requirements planning
Safety Stock
- to ensure manufacturing or customer supply requirements are met
- determination of safety stock depends on various factors B3-47, including reliability of sales forecasts
Reorder Point* = safety stock + (lead time * sales during lead time)
- inventory lvl at which a comp should order or manufacture add. inventory to meet demand and avert stockout costs
- stockout costs are incurred when customer orders can not be fulfilled
Economic Order Quantity* (EOQ) = (2SO/C)^(1/2)
- square root of 2SO/C
- E: order size, S: annual sales in units, O: cost per purchase order, C: carrying cost per unit
- trade off b/w carrying costs and ordering costs
- assumptions: assumes demand is known and constant throughout the year
Other Inventory Mgmt Issues
- Just in Time Inventory Models
- pull approach
- to reduce lag time b/w inventory arrival and inventory use
- don’t manufacture until ordered - Kanban Inventory Control
- visual signals that a component required in production must be replenished - Computerized Inventory Control
- establishes real-time communication links b/w cashier and stock room
- computers programmed to alert inventory managers when to reorder
- some cases computer automatically reorders, eliminating human element - Materials Requirements Planning
- extend idea of computerized inventory control
- designed to control use of raw materials and WIP in the production process
Management of Marketable Securities
marketable securities typically provide lower returns than operating assets but higher returns than cash
Common Marketable Securities (from least risk to most)
- US Treasury Bills (T-bills)
- proxy for CAPM “risk-free rate”
- safest securities on the market - Negotiable CDs
- relatively safe, there’s an active secondary market for CDs
- risk and return at low levels, possibly bank defaults give CD higher return for slight add. risk - Banker’s Acceptances
- ST IOUs guaranteed by commercial banks
- risks and yields are slightly higher than CDs - Commercial Paper
- notes and drafts - Equity Securities of Public Companies
- risky bc volatility of stock market
Eurodollars: US dollars deposited in banks outside of the US
Factors Influencing Level of Marketable Securities
- companies hold marketable securities for the same reason they hold cash, Liquidity, but they also yield higher returns than cash so preferable
- Credit Hedge: precaution against possible shortage of bank credit in times of need
Strategies for Holding Marketable Securities
- periods of low rates: cash holdings are preferable
- periods of high rates: marketable securities are advised
requirements for additional working capital are treated
as immediate cash outflows that are recovered as cash inflows at the end of the investment’s life
for capital budgeting purposes
market rate of interest on T bill
risk free rate + inflation premium
- doesn’t include default risk premium, liquidity premium, or maturity risk premium
working capital policy more conservative
as an increasing portion of an org’s LT assets, permanent current assets, and temporary current assets are funded by LT financing
