BEC 3 - Financial Management & Capital Budgeting Flashcards
Financing Function
raising necessary capital to Fund a business
Capital Budgeting Function
Choosing the best long term projects to which to dedicate the firm’s resources, based on the projects expected risks and returns
Financial Management Function
- managing the business internal cash flows & capital structure (debt & equity mix)
- minimizing financial costs
- ensuring obligations can be paid when due
Corporate Governance Function
making sure that managerial behavior is ethical (toward all parties) & in the interest of the business’ owners
Risk Management Function
identifying and managing the business’s various types of risk
Managing Working Capital
- making sure the business has the net short term financial assets to meet short term obligations
- managing inventories and receivables
Working Capital Formula
Current Assets – Current Liabilities
Current Ratio
Current Asset / Current Liabilities
Quick Ratio (Acid Test)
Quick Assets / Current Liabilities
Quick Assets
Cash + Marketable Securities + Accounts Receivable
What does the Cash Conversion Cycle Measure?
of days from when a business pays for its INPUTS to when the business COLLECTS CASH from resulting sales of finished goods
What is the goal of the Cash Conversion Cycle
- to shorten the CCC to minimize the need for financing
- Therefore, lowers costs of financing & improves profitability
Cash Conversion Cycle Formula
ICP + RCP – PDP
- ICP: Inventory Conversion Period
- RCP: Receivable Collection Period
- PDP: Payable Deferral Period
Inventory Conversion Period Formula
ICP = Avg Inventory / COGS Per Day (OR Sales per day)
*avg # of days to convert inventory to sales
Accounts Receivable Collection Period
RCP = Avg AR / Avg CREDIT Sales per day
- avg # of days required to collect AR
Accounts Payable Deferral Period
PDP = Avg Payables / [Purchases per day (or COGS/365)]
- Avg # of days between buying inventory (including DM + DL for mfg entity) and paying for that inventory
Several Purposes for Keeping Cash Balances
- Operations
- Trade Discounts
- Compensating Balances
- Speculative Balances
- Precautionary Balances
Float
time it takes for checks to be mailed, processed, & cleared
Pay By Draft
customers pay by check for SLOWER processing (3rd Party Instrument)
Zero Balance Accounts
Banks offering these accounts notify their customer each day of checks presented for payment & transfer only the funds needed to cover them
Concentration Banking
- customers pay local branches instead of main offices so that the business gets funds quicker (REDUCING AR FLOAT)
- periodic wire transfers from local branches to main offices can be costly
Lock Box System
- customers send payments directly to the bank to speed up deposits & increase internal control over cash
- eliminates check processing float
Electronic Funds Transfer (EFT)
- Customers pay electronically for fastest processing
- eliminates float from both payments and receipts (AR & AP)
What is the purpose of managing marketable securities?
- to maximize earnings by using ST investments instead of cash (or 0% checking accounts)
- most important to consider LIQUIDITY & RISK (SAFETY)
Treasury Bills
- ST obligations of the US government with original maturities under 1 year
- use a ZERO-coupon format
- virtually ZERO risk of capital losses even if sold before maturities
Treasury Notes
- US government obligations with original maturities between 1 & 10 years
- pay coupons (interest payments) semi-annually
Treasury Bonds
- Same as Notes but with original maturities over 10 years
TIPS
- T-notes & T-bonds that pay a FIXED REAL RATE of interest by adjusting the principal semi-annually for inflation
Federal Agency Securities
- offerings that may or may not be backed by the full faith & credit of US government
- do not trade as actively as Treasury’s but pay slightly higher rates
Certificates of Deposits (CDs)
- Time deposits at Banks with Limited government insurance
- Interest yields are typically higher then US Govt Securities
Commercial Paper
promissory notes issues by corporations with lives up to 9 months
Bankers’ Acceptances
- drafts drawn on banks that are payable at a specific future due date (not on demand, as checks would be) usually 30-90 days after being drawn
- usually to pay or goods across international borders
- trade in secondary markets @ a discount prior to their due date
Money Market Mutual Funds
- invest in instruments with short maturities (<1 year)
- generally stable value
Short Term Bonds Mutual Funds
- invest in instruments with maturities of under 5 years
- generate higher returns than money market funds but with the potential for fluctuations in value
Stocks & Bonds
- individually offer substantially higher potential returns (also greater risk)
What does managing receivables include?
- establishing/updating credit approval mechanism
- monitoring the resulting receivables
Methods of generating immediate cash
- Pledging: Loan (AR = collateral)
- Assignment: Loan (interest & fee for the advance)
- Factoring without recourse: sell AR (interest & fee)
What does factoring AR usually do?
improves AR Turnover Ratio
Accounts Receivable Turnover Ratio
Net CREDIT Sales / Avg AR
Number of Days of Sales in Avg AR
360 / AR Turnover3
What is Inventory Management?
- budgeting for inventory purchase decisions
- when to place orders (or start production) to replace inventory
- how much to purchase (or to produce)
- requires weighing conflicting factors (carry costs, order costs, lead time, need)
What is Materials Requirement Planning
- MRP: computerized system that uses demand forecasts to manage the production of finished goods & the required inventory for ram materials
Reorder Point Formula
Avg Daily Demand x Avg Lead Time
Safety Stock Formula
Reorder Point(@ MAX lead time) – Reorder Point(@ NORMAL lead time)
Economic Order Quantity Formula
Sqrt(2AP/S)
- A: Annual usage of inventory
- P: Placing order costs
- S: Storage costs for carrying for 1 period (obsolesce cost)
Just-In-Time (JIT)
- to keep inventories low, order as LITTLE as possible & order as CLOSE to the time when their inventories are needed as possible
- goods are produced on demand rather than based on long-range forecasts of sales
- units in process for a relatively short period of time (efficient & high speed / mature JIT system)
When can Just In Time be used effectively?
- storage costs (non-value added operations) are HIGH
- lead times are LOW
- needs for safety stock are LOW (good relationship with reliable suppliers)
- costs per purchase order are LOW
When do companies usually use backflush costing?
- in a mature JIT system because tracking costs in WIP is NOT effective
Backflush Costing
- AKA Delayed or Endpoint Costing
- all mfg costs are charged DIRECTLY TO COGS
- @ end of the accounting period, the company determines if there are inventories
- If inventories exist, costs are allocated FROM COGS to INVENTORY accounts (such as finished goods using standard costs)
What is Cycle Counting?
- technique to manage & audit inventory
- focuses on counting small subsets of inventory in specific locations
Inventory Turnover Ratio
COGS / Avg Inventory
of Days in Avg Inventory
360 / AVG inventory
FV Factor Formula
1 / PV Factor
Convert PV Ordinary Annuity to Annuity Due
(PV of Ordinary Annuity Factor)x(1+Interest%) = PV Annuity Due Factor
Payback Period Formula
Initial Investment / After Tax Annual Net Cash Inflow
Disadvantages of the Payback Period Method
- does not consider the project’s total profitability
Payback Period
length of time it takes for an initial investment to be recovered in cash
Internal Rate of Return
- the discount rate at which NPV = 0
- the rate of interest that equates the PV Cash O/F = PV of Cash I/F
- can be used to compare alternative instruments
- could compare against Hurdle Rates
Internal Rate of Return Formula
Investment / Annual Cash Flows = PV Factor (for NPV=0)
Advantages of the Internal Rate of Return
- time value of money
- Hurdle Rates (similar risk)
- More readily understandable than NPV
Disadvantages of the Internal Rate of Return
- with different assumption = multiple IRRs
- some CF patterns may not have an IRR for which project’s NPV equates to zero
Accounting Rate of Return
computes approximate rate of return
Accounting Rate of Return Formula
Accounting Income / AVG (or Initial) Investment
Advantages of the Accounting Rate of Return
- easy to compute & understand
- used (often) to rate managerial performance (simple & intuitive)
Disadvantages of the Accounting Rate of Return
- no time value of money
- no differences in risk across investments (no project risk)
- using different depreciations methods = different ARR’s
Net Present Value (NPV)
- the excess of PV Of Cash I/F over the PV of Cash O/F
- the time value discount rate used is known as the HURDLE RATE of return (or cost of capital)
- most accepted approach to compare projects financially
Advantages of the NPV
- time value of money
- accounts for risk using high discount rates for riskier projects
- accounts for total profitability
- yield result in dollars which may be interpreted as the change in owners wealth if project is carried out
Disadvantages of the NPV
- more computations involved (not simple/intuitive)
- some audiences may understand less readily
- do NOT account that managers may not actually follow the originally scheduled investments (or expenses)
Excess of PV Index (or Profitability Index)
- used to choose which projects to carry out first when faced with several potential projects with positive NPVs
- if the ratio > 1.0… NPV Is positive
Profitability Index Ratio
PV of Annual Aftertax Cash Flows / Original Cash Invested in the Project
Interpolations
using available data to “fill in the gaps” in data relevant to a business
Extrapolation
using available data to make projections outside for which there is available data
When do forecasts tend to be the most accurate?
when economic conditions are most stable
Momentum
short term trends will continue (‘rally’)
Mean Reversion
deviations from Long Term patterns will eventually be corrected (‘Correction’)
Existing forecasting systems are very from?
being able to determine when mean reversions will take place
Cost of Not Taking discount (AFC – Annual Financing Cost) Forumla
AFC = [Discount% / (100%-Discount%)] * [365/(Total Pay Period – Discount Period)]
What do compensating balances affect?
Increases the effective interest rate paid on the net part of the loan that borrowers get to use
Effective Cost of The Loan Formula
Cost of the Loan = Interest Paid/(Net Funds Available)
*Net Funds Available=Principal – Compensating Balance
LIBOR
London Interbank Offered Rate: common base rate for many business and consumer loans abroad and in the US
- computes rates for many short term maturities and currencies including the USD
Positive Covenant
what the borrower MUST DO
Negative Covenant
what the borrower MAY NOT DO
Income Bonds
make interest payments only if the business has earnings in excess of some preset level.
Private Debt (Var. Interest)
business obligations that may not be readily resold to general public
Public Debt (Fixed Interest)
business obligations that MAY BE readily sold to the general public in markets that the SEC regulates
- Eurobonds are included
Euro Bonds
bonds denominated in USD that are sold abroad – not only Europe
Callable Bonds
force to redeem at the BORROWER’s demand before maturity date
Redeemable Bonds
BONDHOLDER may demand repayment in advance of the normal maturity date should certain events occur (i.e. company buyout)
Current Yield
Annual Interest Paid / Current Bond Market Price = Current Yield
- at Discount: CY>Stated Rate
- at Premium: CY
Yield to Maturity
effective rate
- interest rate at which the PV of Cfs of interest and Principal will equal the current selling price of the bond
- at Discount: YTM>CY
- at Premium: YTM>CY
Effective Annual Interest Rate (EAR) Formula
EAR = (1+ r/m)^3 - 1
- r: stated interest rate
- m: compounding frequency
Yield Curve
Illustrates the relationship between short & long term interest rates
- important in determining whether to use LT FIXED or VAR rate financing
What does the price of a bond depend on?
- Economy-wide risk-free interest rate
& - The credit risk involved in that bond (bond agencies)
PV of the Proceeds of a Bond formula
(FacePV lump sum @ Effective%) + (FaceStated%*Time)
Variations of Bond Interest
- Zero Coupon Bonds
- Floating Rate Bonds (& Reverse Floaters)
- Registered Bonds
- Junk Bonds
- Foreign Bonds
Registered Bonds
- use a register in which the borrower has the names & addresses of bond holders so that payments can be sent directly to the bondholder (not a broker)
- actual bond certificate will NOT be issued
Foreign Bonds
- interest and face value in another currency
Advantages of Debt Financing
- interest is tax-deductible
- for fixed rate, the obligation is fixed for better planning
- no ownership dilution (vs. equity financing)
- excess earnings accrue to owners (not debt holders)
- less costly (vs. equity financing)
- during inflationary periods, debt is paid back with less valuable dollars
Disadvantages of Debt Financing
- must make payments, regardless of earnings
- effectively forgo control by agreeing to terms of loan and bond covenants
- high levels of debt can increases risk of business failure & wipe out owners claims
- May reduce stock prices (despite positive effects on returns on equity)
Benefits of Leasing (as a Lessee)
- if unable to obtain credit, may lease instead
- terms often less strict than in bond indentures
- do not often involve down payment
- during bankruptcy, creditors have weaker rights over leased assets
- reduced costs if lessor’s tax benefits are transferred over to lessee
- under operating leases, do not have to recognize asset or liability (only rent expense)
Advantages of Using Common Stock to Finance
- Dividend payments are NOT fixed (depend on performance)
- Less risk to lender if rely on equity more (therefore reduces borrowing costs)
- attracts investors because of entitled future profit growth
Disadvantages of Using Common Stock for financing
- Higher cost of issuance than debt issue costs
- Higher cost of capital
- ownership dilution (new issuance of c/s)
- dividends are NOT tax deductible
Possible features of Preferred Stock
- Cumulative dividends
- Redeemability
- Callability (business’s decision)
- Convertibility
- Participation
- Floating Rate
Advantages of Preferred Stock
- flexibility of being able to skip dividends
- less risk to lenders if rely more on equity (reduces borrowing costs)
- no ownership dilution
- more earnings does not mean P/S holders receive them
Disadvantages of Preferred Stock
- high costs of issuing
- higher cost of capital (Dividend Rates > Interest Rates)
- Dividends are NOT tax deductible
- Accumulating skipped dividend payments may be difficult to reduce the backlog AND/OR find new sources of funding
What must you take into account to make appropriate financing decisions?
- Leverage & Cost of Capital
Explain Degree of Operating Leverage
DOL: measures how the size of a business’s FIXED COSTS (relative to total costs) affects its performance when revenues change
- higher fixed costs exposes a larger business risk (measured by DOL)
Degree of Operating Leverage Forumla
Percentage Change in EBIT / Percentage Change in Sales Volume
Increases in Revenue for businesses with HIGH FIXED COSTS (ie high DOL) reults in?
Proportionately larger increases in Return on Equity
Increases in revenue having lower variable costs results in?
Proportionately larger increases in Profit
Degree of Financial Leverage
- extension of DOL focusing only on debt financing (interest costs)
Degree of Financial Leverage Formula
Percentage Change in EPS / Percentage Change in EBIT
Leveraged Buyout (LBO)
- a method of financing the acquisition of all or a voting majority of O/S shares of a company
- financed primarily with debt secured by the assets of the target company
Cost of Debt Financing Formula
A) YTM*(1-Effective Tax Rate%)
Or
B) (Interest Expense – Tax Deduction for Interest) / CV of Debt
Cost of P/S Financing
Stipulated Dividend / Net Issue Price
Methods to Estimate the Cost of Existing C/S Financing
- CAPM
- Arbitrage Pricing Model
- Bond Yield Plus Method
- Dividend Yield Plush Growth Rate Method
CAPM Formula
Risk-Free Rate + [(Expected Rate of Return – Risk-Free Rate)*Beta]
Beta Coefficient
the correlation between changes in the stock price & changes in the price of the overall market (volatility)
i.e. Market Increases by 5% & Individual Stock Price increases by 10%
(B=2.0)
Arbitrage Pricing Model
more detailed version of CAPM that uses separate excess returns & Betas for various factors contributing to a stock performance
Bond Yield Plus Method
based on the historical relationship between equities and debt (simply adds 3%-5% to interest rate on the businesses long term debt)
Dividend Yield Plus Growth Rate Formula
(Next Expected Dividend/Current Stock Price) + Expected growth in earnings
Cost of New C/S vs. Cost of Existing C/S
costs are higher than existing stock since the business must recover the cost of issuing the new shares (selling or floatation costs)
Cost of New C/S Formula
[Next Expected Dividend / (Current Stock Price-Floatation Costs)] + Expected growth in earnings
- similar to Dividend Yield Plus Growth Rate
Businesses seek capital structures that ________ their WACC. Why?
“MINIMIZE” their WACC
- lower WACC results in lower required rates of return (hurdle rates) & are more likely to find projects that add to shareholder wealth
Optimal Capital Structure involves are trade off between
- Higher costs of equity
- Higher debt-to-asset ratios result in higher interest rates
- Must find a Debt-to-Asset Ratio that minimizes WACC
- At very LOW debt-to-asset ratios: business reduce their WACC by relying more on debt
- At very HIGH debt-to-asset ratios: businesses reduce their WACC by relying less on debt
What are the use of valuations?
- evaluate investments
- financial reporting
- mergers & acquisition
- capital budgeting
- tax reporting
- Litigation
What are the 3 Major Approaches to Valuation?
- Using Actual Prices for IDENTICAL assets traded in liquid markets
- Using the prices of SIMILAR assets traded in liquid markets
- Using Valuation Models (used if neither 1 and 2 are traded in liquid markets)
Horizontal Merger
Same Market (Ie competitors)
Veritical Mergers
in the same supply chain
Conglomerate Mergers
unrelated markets
Discount Cash Flow Analysis
- method for valuing potential merger targets
- determine the PV of Expected Cash Flows from the acquisition, discounted at COST OF EQUITY CAPITAL
Market Multiple Method
- method for valuing potential merger targets
Current Earnings*Price-Earnings Ratio
Methods for valuing potential merger targets
- Discounted Cash Flow Analysis
2. Market Multiple Method
Gross Margin Formula
Gross Profit / Net Sales
Operating Profit Margin
Operating Profit / Net Sales
Free Cash Flow
NOPAT + Depreciation + Amortization – Capital Expenditures – Net Increase in Working Capital
Residual Income
Operating Profit – Interest on Investment
- Interest on investment = Invested Capital*Required Rate of Return
Economic Value Added (EVA)
NOPAT - (total assets - current liabilities)*WACC
Cost of Financing
(Total Assets – Current Liabilities)*WACC
Economic Rate of Return on C/S
(Dividends + Change in Price)/Beginning Price
Return on Investments (based on Assets)
Net Income / Total Assets (or avg invested capital)
DuPont ROI Analysis
Return on Sales*Total Assets
Return on Sales = Net Income / Sales
Asset TO = Sales / Total Assets
Return on Assets
Net Income / Average Total Assets
Return on Equity
Net Income / Average CS holders Equity
- Average CS Holders equity = Stockholders Equity – PS Liquidation Value
Total Assets Turnover Ratio
Sales / Average Total Assets
Fixed Asset Turnover Ratio
Sales / Average Net Fixed Assets (after subtraction of Accum. Dep)
Debt to Total Assets Ratio
Total Liabilities / Total Assets
Debt to Equity Ratio
Total Debt / Total Equity
Times Interest Earned Ratio
EBIT / Interest Expense
Market Capitalization Ratio
CS Price per Share * CS outstanding
Market Book Ratio
2 Methods
- CS Price per share * BV per share
- Market Capitalization / CS holders equity
Book Value Per Share Ratio
CS Holders Equity / CS outstanding
Price Earnings (PE) Ratio
CS price per share / EPS
What does sales to Cash flow ratio measure?
financial strength
Investment Turnover Ratio
Sales / BV (or Net Worth)