BEC 3 - Financial Management & Capital Budgeting

Question 1

Financial Management involves what 5 main functions?

_{(Financing,Capital Budgeting,Financial Mgmt,Corp Governance,Risk-Mgmt)}

Answer 1

An aspect of managing an entity that consists of 5 functions:

1. Financing Function - raising of capital
2. Capital Budgeting Function - choosing the best long term projects to invest in
3. Financial Management Function - managing internal cash flows & capital structure, minimizing cost & ensuring obligations can be paid when due
4. Corporate Governance Function - ensuring ethical behavior
5. Risk-management Function - identifying & managing business risk

Question 2

Working Capital

Current Ratio

Quick (Acid Test) Ratio

Answer 2

Working Capital = Current Asset - Current Liability

Current Ratio = CA / CL

Quick Ratio = (Cash+Securities+Net A/R) / CL

Question 3

Cash Conversion Cycle (CCC)

What is Forumla & its parts?

Answer 3

CCC - The average number of days from when a firm pays for purchases to the time it collects cash from the sale of goods. Also known as “Net Operating Cycle”

• There are four parts to the cycle:

1. Receive inputs
2. Pay suppliers
3. Sell Finished products on Credit
4. Collect receivables.

• Businesses seek to shorten the CCC to minimize the need for financing.
• CCC = ICP + RCP - PDP

Question 4

Inventory Conversion Period (ICP 1-3)

Accounts Receivable Collection Period (RCP 3-4)

RCP = “Average Collection Period”

Accounts Payable Deferral Period (PDP 1-2)

Answer 4

ICP (1-3 ) - Is the avg number of days required to convert inventory into sales.

• ICP = Avg Inv / COGS per pay (sales per day)
  
  • Avg Inv = (Beg + Ending) / 2

RCP (3-4) - Is the average number of days required to collect accounts receivable.

• RPC = Average A/R / Avg Credit Sales per day

PDP (1-2) - Is the average number of days between buying inventory & paying for that inventory.

• PDP = Avg Payables / Purchases per day (or COGS/365)

Question 5

Cash Management

Businesses keep cash balances for what 5 purposes?

_{(Operations,Compensating,Trade Discouts,Speculative,Precautionary)}

Answer 5

Making certain that there is adequate cash for serveral purposes:

• Operations - funds for ordinary expenses
• Compensating Balances - banks require to maintain a minimum (for loans, bank fees)
• Trade Discounts - for quick payments of bills that may result in early payment discounts
• Speculative Balance - to take advantage of business opportunities
• Precautionary Balance - funds for emergencies

Question 6

Float

What are 5 ways to manage Floats?

_{(Pay by Draft,Zero Balance Accts,Concentration Banking,Lock Box,EFT)}

Answer 6

Float - refers to the time it takes for checks to be mailed, processed, & cleared. Managing Cash involves maximizing float on payments (PDP) and minimizing float on receipts (RCP).

Different ways to manage float such as:

• Pay by Draft (3-party instrument) - pay by check
• Zero-balance Accounts - banks notify customers each day of checks presented for payments & so customers can transfer the funds only needed.
• Concentration Banking - customers pay local branches rather than main offices (walking check to a bank rathan mailing)
• Lock-box System - payments go directly to the bank
• Electronic Fund Transfers (EFT) - pay electronically (wire, ach)

Question 7

Types of Marketable Securities

Treasury Bills

Treasury Notes

Treasury Inflation-Indexed Securities (TIPS)

Federal Agency Securities

Certificate of Deposits

Commercial Paper

Banker’s Acceptance

Money Market Mutual Fund

Short-term Bond Mutual FUnds

Stocks & Bonds

Answer 7

To maximize earnings, businesses may choose to use various short-term investments like Marketable Securities. The most important consideration regarding Marketable Securities are liquidity & risk. Some examples of securities: (Based in low risk/interes to high)

• Treasury Bills - under 1 yr, “risk free”
• Treasury Notes - 1-10 yrs, semi-annually, US gov’t obligation
• Treasury Bonds - same as Notes, but over 10yr maturity
• Treasury Inflation-Indexed Securities (TIPS) - Treasury notes & bonds that pay a fixed real rate of interest by adjusting the principal semi-annualy for inflation.
• Federal Agency Securities - offerings that may or may not be backed by the full fait of US govt.
• Certificate of Deposits - time deposit at banks
• Comemercial Paper - promissory notes issued by corporation with lives up to 9 monts
• Banker’s Acceptance - drafts drawn on banks, 30-90 days
• Money Market Mutual Fund - investment in instruments with maturities under 1 yr
• Short-term Bond Mutual Funds - Investment in instruments with maturities under 5 yrs
• Stocks & Bonds

Question 8

Managing Receivables

Businesses’ credit policies include what 4 key elements?

_{(Credit Period, Discounts, Credit Criteria, Collection Policies)}

Answer 8

1. Credit Period - the time buyers are give to make payments
2. Discounts - price reductions for paying early
3. Credit Criteria - financial strenght requirements for customers
4. Collection Policies - methods emplyed to collect on receivables that are behind schedule

Question 9

A/R Ratios

Accounts Receivable Turnover Ratio

&

Number of days of sales in A/R ratio

Answer 9

A/R Turnover = Net Credit Sales / Average A/R

Number of days of sales in A/R = 360 / A/R Turnover

Question 10

What 3 methods may businesses use to convert A/R into Cash immediately?

(Pledging,Assignment,Factoring)

Answer 10

1. Pledging - a business obtains a loan by offering the receivable as colateral.
2. Assignment of A/R - a lending agreeement whereby the borrower assigns an A/R for cash, but must pay interest & usually a service charge on the advance.
3. Factoring w/o Recourse - Like selling the receivable, but buyer charges a percentage fee for accepting the uncollectibles risk.

Question 11

Materials Requirements Planning (MRP)

Answer 11

Materials Requirements Planning (MRP) - is a computerized system that uses demand forecasts to manage the production of finished goods & the required inventory levels for various raw materials.

Question 12

Reorder Point (RP)

What is the formula?

Answer 12

Reorder Point - the minimum amount of inventory that should remain on hand when an order is placed. (when to order)

RP = (Avg Daily Demand* x Avg Lead Time**) + SS***

* Avg Daily Demand = “Usage per day”

** Average Lead Time - How long it takes from when order is placed to when order is received.

*** SS - Safety Stock

Question 13

Economic Order Quantity (EOQ)

What is the formula?

Answer 13

EOQ - is the amont of inventory that should be ordered each time a purchase is made to minimize the combined cost of placing orders for inventory, including the cost of placing the order, receving/processing, & storing.

EOQ = √ (2 x P x A) / S

A = Annual usage of inventory (demand)

P = Cost of Placing an order

S = Cost of Storing or carrying an individual unit of inventory for one perod

Question 14

Safety Stock (SS)

What is the formula?

Answer 14

The amont of inventory that will be included in the reorder point to protect the company from running out of inventory.

FORMULA:

+ (Max daily demand x Max lead time)

• (Avg daily demand x Avg lead time)

= Safety Stock

Question 15

Just-in-Time (JIT)

vs.

Backflush Approach

Answer 15

JIT - An inventory mgmt system consisting of orderdering as little inventory as possible & as late as possible to keep cost down, but requires an execellet relationship with supplier. Most effective when:

• Cost of storage is high
• Lead times is low
• Needs for safety stock is low
• Cost per purchase order is low

Backflush Approach - An inventory mgmt system appropriate when minimal inventories are maintained.

• All manufacturing costs/purchase directly to COGS. (DR: COGS, CR: Cash; Instead of Inventory)
• Inventory is recognized/determined on the FS date
• If inventories exist, cost are allocated from COGS to inventory accounts such as WIP, or Finished Goods account.

Question 16

Inventory Ratios

Inventory Turnover Ratio

&

Number of days of supply in average inventory

Answer 16

Inventory Turnover Ratio = COGS / Avg Invetory

Number of days of supply in avg Inv = 360 / Inv Turnover Ratio

Question 17

What is Capital Budgeting?

What are the 4 techniques?

_{(Payback Period,IRR,ARR/ROI,NPV)}

TESTED

Answer 17

Capital Budgeting - the process used to determine how & when the entity will use its cash for long-term purposes, such as making equipment purchases, acquiritng long-term investments, or entering into long-term projects. The 4 main techniques are:

1. Payback Period
2. Internal Rate of Return (IRR)
3. Accounting Rate of Return or (ROI)
4. Net Present Value (NPV)

Question 18

Payback Period

&

Discounted Payback Period

Formula? Disadvantages?

Answer 18

Payback Period - a method for evaluating a capital budgeting opportunity by determining the length of time it takes for an initial cash outlay for the investment to be recovered in cash.

PP = Initial Investment / After Tax Annual Cash Flows

Disadvantages of Payback Period:

• Does not take into account project’s profitability.
• Does not take into account time value of money.

Discounted Payback Period - uses the present value of each individual annual net cash flow.

Question 19

Internal Rate of Return (IRR)

Formula?

Advantages/Disadvantages?

Answer 19

A method for evaluating a capital budgeting opportunity by determining the effective rate of return & comparing it to the hurdle rates, measured in a two step process. IRR is the discount rate at which the NPV is zero.

1. Calculate the PV Factor
   
   • PV = Initial Inv / After Tax Annual Cash Flow
2. Find the PV Factor in the PV tables to determine the interest rate.

Advantages:

• Time value of money is taken into account
• Hurdle rates may take into account rates of return on investment w/ similar risk
• IRRs more readily understandable than NPV

Disadvantages:

• Under different assumptions, some cash flow patters may yield different IRRs
• Some cash flow patterns may not have an IRR

Question 20

Accounting Rate of Return (ARR)

or

Return on Investment (ROI)

Formula?

Advantages/Disadvantages?

Answer 20

The rate of return earned on a capital budgeting opportunity calculated on the basis of changes in accounting net income* (Cash inflow less all expenses, including depreciation & income taxes in any) rather than cash flows & compared to guidelines established by the entity. ARR is calculated by dividing accounting income by the investment.

ARR = *Accounting Income / Average Investment

*Accounting Income = Cash Flow - Depreciation

ROI = Operating Profit / Average Asset

Advantages:

• Easy to compute & understand
• Often used to rate managerial performance

Disadvantages:

• ARR does NOT take time value of money into account
• ARRs does not take into account different risks
• Using different depreciation methods yeilds differnt ARRs

The accounting rate of return is equal to the increase in annual operating income divided by either the initial investment or the average investment.

Question 21

Net Present Value (NPV)

Formula?

Advantages/Disadvantages?

Answer 21

The excess of the PV of all cash flows from investment over the PV of investment/cash outflow. A project that earns the hurdle rate of return has a NPV = 0; NPV > 0 means project earns more than the hurdle rate.

NPV = PV of future cash flow - Current cash outflow

Advantages:

• Most accepted approach to compare projects
• Time value of money is taken into account
• Risk are taken into account by using higher discount rates for risker projects
• Project profitability is taken into account
• NPVs yield results in dollars

Disadvantages:

• NPVs require more compuations; less simple
• Some audiences may not undersand NPV
• NPVs do not take into account that managers may not actually follow the originally scheduled investments.

NOTE: Depreciation is considered as an increase in cash inflow because of the income saved as a tax savings.

Question 22

Private Debt (2)

vs.

Public Debt

Answer 22

Private Debt (variable interest) - debt that’s not liquid to the general public. Largely loans from banks.

• Prime Rate - rate to the most credithworthy customers
• London Interbank Offered Rate (LIBOR) - interest in different currencies

Public Debt (fixed interest) - debt that’s liquid. Public debt largely includes bonds.

Question 23

Debt Covenants

Positive (3)

vs.

Negative (4)

Answer 23

Debt Covenants - Provisions of a loan agreement, intended to provide more security to the lender, that places restrictions on the borrower.

• Positive Covenants specify what the borrower must do:
  
  • Providing annual audited FS to lender
  • Maintaining a minimum ratio of CA to CL
  • Maintaining life insurance policies for key officers (in case of death)
• Negative Covenants specify what the borrower must NOT do:
  
  • Not borrowing additional sums during the time period from other lenders
  • Not selling various listed assets of the business
  • Not exceeding certain level of dividend pmts
  • Not exceeding certain compensation limits for executives

Question 24

Variations on Bonds Interest

Zero-Coupon

Floating Rate

Registered

Junk

Foreign

Answer 24

Zero-coupon Bonds - Example are US Treasury Bonds. These bonds usually sell at a discount.

Floating Rate Bonds - does not have a fixed coupon rate, payments instead fluctuate with some general index of interest rates.

Registered Bonds - use a register, such that borrowers may send payments directly to bondholders. An actual bond certificate is not actually issued.

Junk Bonds - bonds issued by companies that credit rating agencies asess as more likely to default.

Foreign Bonds - bonds that have interest & face value payments in another currency.

Question 25

Managing Short-Term Debt Ratios

Annual Financing Cost (AFC)

vs.

Cost of the Loan (Comp Balances)

TESTED

Answer 25

Businesses may obtain short-term financing by purchasing goods on Trade Credit. To calculate the cost of NOT taking the discount: (Annual Financing Costs)

AFC = (%Discount / 100%-Discount%) x (360 / Total Pay Period-Discount Period)

Compensating Balances - Demand deposit balances (set as a percentage of loans) that lenders may require as a condition for receiving loans. Having to maintain compensating balances in theory increases the effective interest paid on the loan.

Cost of Loan = Interest Paid / Net Funds Available*

*Net Funds = Principal - Compensating Balance

Question 26

Common Stock

Advantages

vs.

Disadvantages

Answer 26

Advantages:

• Flexibility of dividend payments are not fixed like interest
• More equity means less risk to lenders which reduces borrowing costs
• C/S are attractive to investors

Disadvantages:

• Cost of issuing C/S is more expensive than debt
• New stock issuance can dilute ownership
• Common dividends are not tax deductible
• Higher cost of capital

Question 27

Preferred Stock

What are some features? (6)

CCC-RPF

Answer 27

Preferred Stock holders must be paid a preset dividend before any dividends may be paid to common stockholders.

Some possible features of preferred stock:

• Cumulative Dividends - accumulates
• Callability
• Convertibility
• Redeemability - stockholders may demand repayment of face value at specific date
• Participation - preferred stock holders recieve higher dividends when common dividends are increased
• Floating Rate - dividends vary depending on interest or inflation index

Question 28

Preferred Stock

Advantages vs. Disadvantages

Answer 28

Advantages:

• Flexibility to skip preferred dividends
• More equity equals less risk to lenders equals less borrowing costs
• Doesn’t affect common holder’s control
• Positive company earnings means preferred holders profit more

Disadvantages:

• Cost of issuance is higher
• Preferred dividends are not taxable
• Difficult to pay dividends in arrears

Question 29

Degree of Operating Leverage (DOL)

Formula?

Answer 29

DOL - measures how the size of a business’s fixed costs affects its performance when revenues change.

DOL = % Change in EBIT* / % Change in Sales Vol

*EBIT - Earning before income taxes

Question 30

Degree of Financial Leverage (DFL)

Formula?

Answer 30

DFL - measures how much a business relies on debt financing.

DFL = % Change in EPS / % Change in EBIT

Question 31

Cost of Debt Financing

2 Formulas?

Answer 31

Cost of Debt financing is always after-tax cost of interest payments as measured by yields to maturity. It can be calculated in two ways:

• = Yield to Maturity x (1 - Effective Tax Rate)
• = (Int Exp - Tax Deduction for Int) / CV of Debt

Question 32

Cost of Preferred Stock Financing

(TESTED)

Answer 32

Cost of Preferred stock financing is the stipulated dividend divided by the net issue price of the stock.

Cost of Preferred = Dividend / Net Issue Price*

*Net Issue Price = Issuance Price less Issuance Costs

*Dividend - Based on % times the par value of P/S

Question 33

What are the 4 techniques to calculate the Cost of Existing Common Stock?

Answer 33

Cost of Existing C/S financing represents the expected rate of returns common shareholders, and is difficult to estimate. Some techniques are:

1. Capital Asset Pricing Model (CAPM)
2. Arbitrage Pricing Model
3. Bond Yield Plus
4. Dividend Yield Plus Growth Rate

Question 34

Capital Asset Pricing Model (CAPM)

Formula?

Answer 34

CAPM - assumes that the expected return of a particular stock depends on its volatility relative to the overall stock market (beta).

CAPM = Risk Free Rate + [(expected mkt - risk free rate) x Beta]

NOTE: The Beta coefficient of an individual stock is the correlation between changes in the stock’s price & changes in the price of the overall market. If for example, the market goes up 5% & the individual stock’s price goes up 10%, the stock’s beta coefficient is 2.0.

Question 35

Dividend Yield Plus Growth Rate

Formulas for both?

Answer 35

Dividend Yield Plus Growth Rate - adds the current divident (as a percentage of stock price) & the expected growth rate in earnings.

DYP = (Net Expected Dividend / Current Stock Price) + Expected Growth in Earnings

Question 36

Cost of New Common Stock

Formula?

Answer 36

Cost New Common Stock is a little higher than that of existing stock, since the business must recover the cost of issuing the new shares.

+ (Next Expected Div / [Current Stock Price - Floatation Cost])

+ Expected Growth in Earnings

= Cost of New C/S

Question 37

Weighted Average Cost of Capital

(WACC)

TESTED

Answer 37

WACC - An entity’s effective cost of capital based on the returns paid to creditors, preferred stockholders, & common stockholders, weighted by the portion of financing each component.

• A low total WACC tends to reduce risk as an investment would require a lower return to equal or exceed the WACC.
• A company with a high WACC indicates higher risk; therefore it won’t be as attractive to potential shareholders.
• A decrease to WACC will increase the value of a company, not an increase.
• WACC includes the borrowing rate and the cost of equity.
• Optimal Capitalization = Lowest WACC

Question 38

Weighted Average Cost of Capital (WACC)

EXAMPLE

Answer 38

For example: If 40% of capital was obtained through a LT debt at an effective cost of 6%, then 10% of capital was obtained by issuing preferred stock with an effective cost of 8%, and 50% of capital was obtained by issuing common stock expected to return 11% to shareholders, the WACC is:

= (40% x 6%) + (10% x 8%) + (50% x 11%)

= 2.4% + 0.8% + 5.5%

= 8.7%

Question 39

What are the 3 types of Mergers?

Answer 39

Horizontal Merger - involves a business that are in the same market (competitors).

Vertical Mergers - involves businesses aquiring others in the same supply chain.

Conglomerate Mergers - involves businesses acquiring others in unrelated markets.

Question 40

Profitability Ratios:

Gross Margin

Operating Profit Margin

Free Cash Flow

Residual Income

Economic Value Added

Economic Rate of Return on Common Stock

Return on Investment

DuPont ROI Analysis

Return on Assets

Return on Equity

Investment Turnover

Answer 40

Gross Margin = Gross Profit / Net Sales

Operating Profit Margin = Operating Profit / Net Sales

Free Cash Flow = NOPAT+Depr+Amort - Capital Expenditures - Net increase in working capital

Residual Income = Operating Profit - Interest on Investment

Economic Value Added = NOPAT - Cost of financing

Cost of Financing = (total asset - current liabilities) x WACC

Economic Rt of Rtrn on CS = (Divs + Change in Price) / Beg Price

Return on Investment = Net income / Total Assets Invested

Return on equity = Net Income / Avg common stock equity

Investment Turnover = Sales / Average Investment

Question 41

Which of the following methods should be used if capital rationing needs to be considered when comparing capital projects?

a. Net present value.
b. Internal rate of return.
c. Return on investment.
d. Profitability index.

Answer 41

You answered correctly

Correct! The profitability index divides net present value of an investment by the initial net investment and can be used to compare the relative profitability of investments. When resources are scarce, those with the highest profitability index will be selected since they represent the highest rate of return relative to the amount invested. Although the net present value method allows a comparison of which investments are most profitable, in terms of the present value of dollars, it does not take into account that a slightly larger net present value may require a substantially greater initial investment, an important factor when resources are scarce. Although both the internal rate of return approach and the return on investment approach allow for the determination of which investments will provide the highest return, neither takes into account the size of investment that may be required to earn the higher investment.

Question 42

Net present value as used in investment decision-making is stated in terms of which of the following options?

a. Net income.
b. Earnings before interest, taxes, and depreciation.
c. Earnings before interest and taxes.
d. Cash flow.

Answer 42

You answered correctly

Correct! Present value calculations are based on cash flows. In most situations, this will consist of net income from the investment plus depreciation or revenues less expenses, excluding depreciation, and income tax.