BEC 3 - Financial Management & Capital Budgeting Flashcards
Financial Management involves what 5 main functions?
(Financing,Capital Budgeting,Financial Mgmt,Corp Governance,Risk-Mgmt)
An aspect of managing an entity that consists of 5 functions:
- Financing Function - raising of capital
- Capital Budgeting Function - choosing the best long term projects to invest in
- Financial Management Function - managing internal cash flows & capital structure, minimizing cost & ensuring obligations can be paid when due
- Corporate Governance Function - ensuring ethical behavior
- Risk-management Function - identifying & managing business risk
Working Capital
Current Ratio
Quick (Acid Test) Ratio
Working Capital = Current Asset - Current Liability
Current Ratio = CA / CL
Quick Ratio = (Cash+Securities+Net A/R) / CL
Cash Conversion Cycle (CCC)
What is Forumla & its parts?
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:
- Receive inputs
- Pay suppliers
- Sell Finished products on Credit
- Collect receivables.
- Businesses seek to shorten the CCC to minimize the need for financing.
- CCC = ICP + RCP - PDP
Inventory Conversion Period (ICP 1-3)
Accounts Receivable Collection Period (RCP 3-4)
RCP = “Average Collection Period”
Accounts Payable Deferral Period (PDP 1-2)
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)
Cash Management
Businesses keep cash balances for what 5 purposes?
(Operations,Compensating,Trade Discouts,Speculative,Precautionary)
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
Float
What are 5 ways to manage Floats?
(Pay by Draft,Zero Balance Accts,Concentration Banking,Lock Box,EFT)
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)
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
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
Managing Receivables
Businesses’ credit policies include what 4 key elements?
(Credit Period, Discounts, Credit Criteria, Collection Policies)
- Credit Period - the time buyers are give to make payments
- Discounts - price reductions for paying early
- Credit Criteria - financial strenght requirements for customers
- Collection Policies - methods emplyed to collect on receivables that are behind schedule
A/R Ratios
Accounts Receivable Turnover Ratio
&
Number of days of sales in A/R ratio
A/R Turnover = Net Credit Sales / Average A/R
Number of days of sales in A/R = 360 / A/R Turnover
What 3 methods may businesses use to convert A/R into Cash immediately?
(Pledging,Assignment,Factoring)
- Pledging - a business obtains a loan by offering the receivable as colateral.
- 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.
- Factoring w/o Recourse - Like selling the receivable, but buyer charges a percentage fee for accepting the uncollectibles risk.
Materials Requirements Planning (MRP)
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.
Reorder Point (RP)
What is the formula?
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
Economic Order Quantity (EOQ)
What is the formula?
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
Safety Stock (SS)
What is the formula?
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
Just-in-Time (JIT)
vs.
Backflush Approach
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.
Inventory Ratios
Inventory Turnover Ratio
&
Number of days of supply in average inventory
Inventory Turnover Ratio = COGS / Avg Invetory
Number of days of supply in avg Inv = 360 / Inv Turnover Ratio
What is Capital Budgeting?
What are the 4 techniques?
(Payback Period,IRR,ARR/ROI,NPV)
TESTED
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:
- Payback Period
- Internal Rate of Return (IRR)
- Accounting Rate of Return or (ROI)
- Net Present Value (NPV)
Payback Period
&
Discounted Payback Period
Formula? Disadvantages?
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.
Internal Rate of Return (IRR)
Formula?
Advantages/Disadvantages?
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.
- Calculate the PV Factor
- PV = Initial Inv / After Tax Annual Cash Flow
- 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
Accounting Rate of Return (ARR)
or
Return on Investment (ROI)
Formula?
Advantages/Disadvantages?
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.
Net Present Value (NPV)
Formula?
Advantages/Disadvantages?
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.
Private Debt (2)
vs.
Public Debt
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.
Debt Covenants
Positive (3)
vs.
Negative (4)
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
Variations on Bonds Interest
Zero-Coupon
Floating Rate
Registered
Junk
Foreign
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.
Managing Short-Term Debt Ratios
Annual Financing Cost (AFC)
vs.
Cost of the Loan (Comp Balances)
TESTED
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
Common Stock
Advantages
vs.
Disadvantages
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
Preferred Stock
What are some features? (6)
CCC-RPF
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
Preferred Stock
Advantages vs. Disadvantages
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
Degree of Operating Leverage (DOL)
Formula?
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
Degree of Financial Leverage (DFL)
Formula?
DFL - measures how much a business relies on debt financing.
DFL = % Change in EPS / % Change in EBIT
Cost of Debt Financing
2 Formulas?
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
Cost of Preferred Stock Financing
(TESTED)
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
What are the 4 techniques to calculate the Cost of Existing Common Stock?
Cost of Existing C/S financing represents the expected rate of returns common shareholders, and is difficult to estimate. Some techniques are:
- Capital Asset Pricing Model (CAPM)
- Arbitrage Pricing Model
- Bond Yield Plus
- Dividend Yield Plus Growth Rate
Capital Asset Pricing Model (CAPM)
Formula?
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.
Dividend Yield Plus Growth Rate
Formulas for both?
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
Cost of New Common Stock
Formula?
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
Weighted Average Cost of Capital
(WACC)
TESTED
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
Weighted Average Cost of Capital (WACC)
EXAMPLE
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%
What are the 3 types of Mergers?
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.
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
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
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.
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.
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.
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.
