Capital Structure Flashcards
What is capital structure
This is how a firm uses different sources of funds to finance its operations and growth
This is in a combination of debt and equity
What is the cost of capital
This is evaluating the opportunity cost of using capital in one project (or investment) versus another.
Example - you have 10M to spend - you can upgrade equipment or purchase bands.
You evaluate the expected returns on each to see which is the better use of the 10M
How do you calculate the Weighted Average Cost of Capital
It is taking the relative weighted costs of different capital sources to arrive at a single or weighted average cost of capital
Thi sis then used as a benchmark to evaluate future projects or investments:
Example: My capital cost is 9% - therefore any project or investment need to be greater than 9% for me to consider doing it
Asset Structure
This is how a business uses assets to generate earnings - usually ROA - Return on Assets
first thing management will decide is how to acquire assets : what blend of debt and equity financing should be used to get the capital that I need to then go out and buy the assets thatI need
The second issue is how can the business maximize the returns on the asset base
What is the formula ROA
Return on Assets = Net Income / Total Assets
What is the difference between asset structure and capital structure
Capital structure - is long term debt and equity
Asset Structure are the assets listed on the balance sheet
What is the difference between current assets and long term assets
Current Assets - provide the companies liquidity
Long Term assets are geared toward generating earnings
What type of long term assets a business holds depends on the businesses strategic goals and nature of its business, industry and markets it operated in
What are Loan covenants
These are restrictions/requirements places on a loan or a line of credit by the lender
If the lender is out of compliance - the loan is due immediately
What are examples of loan covenants
Meeting ratios - debt to equity ratios or working capital requirements
Limits on taking on additional debt
Collateral attached to a loan
What are growth ratios and examples
These are used to evaluate an entire business , their earnings or sale, expenses, or even entire economies
What are the measures of profitability: Profit Margin, Return on Assets, Return on Equity
Profit Margin: gross margin, Contribution Margin, operating margin Pretax margin, Net profit margin
Gross Margin
Revenue - COGS
Contribution Margin
Revenue - Variable Expenses
Operating Margin
Operating Income / Revenue
Pretax Margin
Earnings before Tax / Revenue
Net Profit margin
Net income / Revenue
What is financial leverage
This is the amount of debt a business uses to buy assets
It s really the ratio of debt to equity that business uses to acquire assets
Example: ABC buy equipment for 10K down and a loan of 90K. ABC earns 20K with the equipment. ROA is 20K / 10K = 200%
The rules on leverage and risk
the more leverage you use - the more risk
The more debt you take on the higher your chances that you wont or can’t pay it back
What business types make the risk of high leverage more risky
This risk is increased with cyclical businesses
Also veyr risky for businesses with low barriers to entry - because competition can make sales fluctuate
Best to be a business with steady and predictable revenue
What are the tax advantages of debt
Interest expense is deductible
But is a company increases their amount of debt - lenders will tighten their conditions
- they will charge higher interest rates, have more restrictive covenants
- This will result in increasing your risk of default
What is working capital
This is the difference between a firm’s current assets and its current liabilities
The point is that working capital is to meet the need of the company
Example - purchasing inventory and having enough cash to meet obligations when they come due
Current Assets - Current Liabilities
Liquidity Ratio:
Working Capital
Current Ratio
Quick Ratio
working capital - CA - CL
current ratio - CA / CL
Quick ration CA - inventory and prepaids / CL
times interest earned
(Net Income + Interest expense + Income Tax Expense) / Interest expense
This is the measure of the ability of current earnings to cover interest payment for a given period
average collections period
365 * Avg. A/R / credit sale sales
this measures how long it takes of rte business to receive payment owed from A/R
What is the cash conversion cycle
Days inventory outstanding + Days sales outstanding + Days payable outstanding
It measures how long it takes cash invested in inventory to return as cash received from customers
days inventory outstanding - # of days it takes to sell a batch of inventory
days sales outstanding - # of days needed to collect account receivable
days payable outstanding - # of days before the business needs to pay its own bills
why is it a good idea to not pay your bills soon
The longer you wait - the longer you can hold and invest cash
Inventory Turnover
COGS / Avg Inventory
Inventory turnover measures how many times inventory is cycled through in a period
It can help identify over and under stocking inventory, obsolete, or slow moving inventory
receivables turnover
net credit sales / Avg receivables
This measures how many times receivables are earned and collected in a period.
It indicates the effectiveness of the collections policies
What is the objective of inventory management
It is to determine ad maintain optimal amounts of all inventories
How do you decide what is the optimal level of inventory a company should maintain
The cost of inventory is directly related to how much inventory a company should keep on hand.
if the costs of carrying inventory are rising - should keep as little as possible
If the costs of carrying inventory are falling then you should carry more inventory
What is JIT inventory
It reduces inventory on hand - thus reducing unnecessary costs
JIT depends on the following:
- more frequent deliveries by suppliers
- vendor’s will guarantee their products are free from defects - so do not need to be inspected by you when they are delivered
- It reduces inventory in hand and therefore is a higher risk of running out of inventory
- carrying costs are lower
Accounts Payable Management
The most important thing is that businesses pay their bills on time
- improves relationship with vendors and suppliers
- Will get better discounts and credit terms
- These better discounts will boost profitability
- Cashflow is essentail because you need enough of it on hand to take advantage of discounts
LOC - and debt covenants
LOC - nothing is owed until you charge against it
Debt convenants - these are with long term debt -
- They usually include stipulations on maintaining a certain level of working capital or staying above a working capital ratio
Cash Management
- This is trying to make sure a firm doesn’t have too much cash or not enough cash
What if you have too much cash or too little
- This is an inefficient use of resources
- Too little causes problems of liquidity
What is a lockbox system
- Customer spay directly to the bank in a lock box - bank employees are the only ones who deal with the cash
lots of key controls here - very safe
zero balance account
- This a cash management tool that removes any excess cash at the end of each day
- This is used for special purposes like paying payroll checks
Accounts receivable Management
- The goal here is to maximize profits
- If you grant credit too easily ( loosely) then you run the risk of increasing your bad debt because too many people are not credit worthy
- If your policies are too tight - you might turn down customer that would actually pay
What is with A/R turnover and how do you use it
- You want to turnover receivables as many times as possible during a year
- the more you do it - it shows you are efficient you are at collecting cash on credit sales
- This way fewer credit sales are written off
- a lower number is best
Why do you want to factor your receivable
Sell to a third party at a discount in order to get cash sooner than waiting for the customers to pay
Accepting credit cards is an example of factoring. you get cash from the credit card company in exchange for a fee - this way the risk that the customer does not pay is transferred to Visa - its their problem
Financial Valuation Methods
This is the process of assigning value to assets an liabilities
Three levels of determining fair value
I - highest and most reliable - - observable quoted market prices for identical assets/liabilities in an active market.
II - observable quotes for SIMILAR assets liabilities in an active market
III - These are unobservable - estimates based on judgements
Three Valuation approach sot develop fair value
Market - uses prices etc. generated by market transactions that are identical or comparable to those being valued
Income - converts future amounts to PV to see what the future amounts are worth
Cost approach - what would it cost to construct a replacement item
What is GAAP’s real about about valuation
It is based on exit price ( not replacement cost) It is the amount you would receive to sell an asset or be paid to transfer a liability
arms length transactions
BOTH location and conditions are taken into account when determining price
Options pricing - Black Scholes model - advantages and disadvantages
There are advantages and disadvantages to the Black Scholes model:
Limitations
- It assumes the stock does not pay dividends
- It assumes the risk-free rate of return for discounting remains constant
- It assumes the option can be exercised only at the expiration date
Advantages
- It discounts the exercise price
- It uses the probability that the option will be exercised
- It uses the probability that the price of the stock will pay off within the time of expiration
What is binomial Option Pricing
This is a pricing method for options where a price tree and probable values are calculated based on volatility,expiration dates, and probabilities
CAPM - Capital Asset Pricing Model
This is a model that evaluates the relationship between risk and expected return for assets, but usually stocks
it uses:
1) the risk-free rate of return
2) Beta
What is the risk free rate of return
Thi sis the hypothetical rate for return for “no-risk” and is based on the rate for a 3-month US treasury Bill
What is Beta
This is a measure of how volatile an investment is compared to the rest of the market
Beta of 1 = means its equal
Beta of .5 means its half as volatile as comparable items
Beta of 1.5 = means it is 1/2 MORE volatile than comparable items
What is the formula for CAPM
RRR - RFR = B (Err - RFR)
RRR - required rate of return
RFR - risk free rate of return
Beta - a measure of volatility
ERR - Expected rate of return
Dividend Discount Model
This model uses the predicted dividends of a company and discounts them back to PV
If the PV of the dividend of a per share basis > current share price = stock is undervalued and a good investment
If PV of dividend per share < current share price = stock is overvalued and is a bad investment
How do you value a business
Market approach - Your business is compared to other similar businesses with similar characteristics in the same market
Income Approach - A fair value is derived from the businesses’s income streams - use net PV or a discount cash flow
Asset Approach - The fair values of the individual assets of the business are added up and equal the value of the business - used when a business is liquidated to pay its debts
Comparing Investments: Payback period approach
The payback period approach determines how many years it will take to recover the initial investment cost
You take the upfront projected cost and divide it bytes expected annual cashflows
Its easy to use and understand
disadvantage - it ignores the time value of money, it ignores cashflow you will get after the payback period, and it doesn’t measure total project profitability
Comparing Investments: Net present value
It compares the present value of expected cash flows of the project to the initial cash investment in the project
If net present value is zero or positive - then the project is considered economically feasible
Comparing Investments: Economic Value Added
This is a metric to measure economic profit
It also is a form of measuring residual income
EVA = Net Operating Profit After Tax ( NOPAT) - (Invested Capital * Weighted average)
Comparing Investments: Discounted Cash Flows (DCF)
DCF is a method of discounting future cash flows of a business to present value on a per-share basis to compare to the current share price to see if a potential investment is under valued or overvalued by the market
Comparing Investments: Internal Rate of Return
This method determines the discount rate that would make the net present value of after-tax cashflows equal to zero . Then any potential investment or project that returns an IRR greater than zero would have a value
