Chapter 12: Corporate Finance Flashcards
What do we mean when we say that capital is tied up in a companies operations?
**Capital is tied up when financial resources are invested in the company’s activities before generating returns. **
This occurs due to the time lag between payments (e.g., for salaries, materials, machinery, etc.) and receipts (revenue from sales).
Examples include:
- Industrial Operations: Payments for raw materials, production, and machinery are made upfront, but returns are received over time through sales.
- Fixed Assets: Capital is invested in long-term assets like production plants, equipment, and buildings.
- Inventories: Retailers and wholesalers invest heavily in inventories to meet customer demands.
- Accounts Receivable: For consulting firms, capital may be tied up in client projects completed but not yet paid for.
This reflects the need for businesses to invest resources before receiving customer payments.
Describe the 3 common types of capital used in a company
- Fixed Asset Capital: Used to invest in long-term assets for permanent use, such as machinery, equipment, and real estate.
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Working Capital: Finances ongoing operations, including:
* Salaries.
* Purchases of raw materials, components, and consumables.
* Costs for inventory of finished goods.
* Products delivered but not yet paid for. - Safety Capital: Acts as a buffer for disruptions or unforeseen issues, often maintained as a liquidity reserve in cash or bank deposits.
Why is it, from a corporate finance point of view, important to keep the inventories as small as possible?
Small inventories reduce capital tied up in raw materials, WIP, finished goods, and goods in transit.
They lower the need for extra financing, as large inventories strain cash flow.
Delayed payments from customers (accounts receivable) further tie up capital, while smaller inventories improve liquidity and resource management.
Describe the typical difference of capital tied up in a:
- retail company
- manufacturing company
- service company
-
Retail Company:
* Most capital is tied up in finished goods inventory (products ready for sale), accounts receivable (credit sales), and other current assets.
* Strategies include reducing inventory through in-store stock or rapid sales turnover. -
Manufacturing Company:
* Capital is tied up in raw materials, work in progress (WIP), finished goods inventory, and accounts receivable.
* Focus on minimizing all inventory types and optimizing material flow, often using just-in-time production and transferring inventory responsibilities to suppliers. -
Service Company:
*Capital is tied up in accumulated project work (work completed but not yet billed), accounts receivable, and other current assets.
- Minimal inventory requirements but reliant on timely client payments.
Give examples of formulas for calculating the efficiency of capital use in a company
- Capital Turnover Rate (times/year) = sales (per year)/total capital (at years end)
- Inventory Turnover Rate (times/year) = turnover period (365 days) / average time in inventory (days)
- Average Credit Time to Clients (days) = ( AverageAccountsReceivable(SEK) * 365) / sales (per year)
- Average Credit Time from Suppliers (days) = (AverageAccountsPayable(SEK) * 365) / purchase costs (per year)
How is a companies working capital calculated?
Working capital is the capital tied up in operations that cannot be financed with short-term liabilities and must be covered by long-term debt or equity.
It is calculated as:
**working capital = current assets - current liabilities **
For a manufacturing company, working capital can be calculated using either:
- Time Method
capital tied up: (DaysMaterialStorage−SupplierCreditTime)+ProductionTime+FinishedGoodsStorageTime+CustomerCreditTime
- Calculate days for raw material (storage, production, credit time).
- Multiply days by unit cost and production volume for:
- Raw materials
- Work in progress (WIP)
- Finished goods
- ** Balance Method**
CapitalTiedUp=RawMaterialsInventory+WIP+FinishedGoodsInventory+CustomerCredit−SupplierCredit
- Include individual components:
- Raw materials inventory
- Subtract supplier credit
- Add WIP and finished goods inventory
- Include client credit
Draw the typical diagram for working capital tied up in a manufacturing companies operations and describe the different stages.
Raw Materials → Work in Progress (WIP) → Finished Goods → Sales → Accounts Receivable → Cash
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What is equity and why can equity be said the be the most expensive type of capital for a company?
**Equity **represents the owners’ stake in the company and includes share capital, retained profits, and untaxed reserves.
It is the most long-term source of financing, existing as long as the company operates.
Why is equity expensive?
* High Risk: Equity holders bear the highest risk in case of default, as they may lose their entire investment.
* High Return Expectation: To compensate for this risk, equity investors demand a higher return.
* Double Taxation: Company profits and shareholder dividends are taxed, increasing the overall cost.
* Cost of Capital: Compared to other financing options, equity has the highest cost due to these factors.
Describe the concept share capital
Share capital is the total value of a company’s issued shares, calculated as the sum of the quota value (nominal value) of all shares. It represents the owners’ equity invested in the company and is a key part of the company’s capital structure. All shares within the same class have the same quota value and rights.
What is the difference between a Class A share, and a Class B share?
The primary difference lies in voting rights:
Class A Share: Offers higher voting rights, typically up to 10 times more than Class B shares.
Class B Share: Offers lower voting rights but usually has the same financial rights, such as dividends, as Class A shares.
This structure allows companies to raise capital while enabling major shareholders to retain control.
Describe the capital structure of a company
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What is included in a companies risk capital?
A company’s risk capital consists of:
-
Equity:
- Owners’ stake in the company, including share capital and retained profits.
- The primary component of risk capital, as equity holders bear the highest risk in case of bankruptcy. -
Untaxed Reserves:
Reserves not yet taxed, included as part of the equity for financial stability. -
Subordinated Liabilities:
- Liabilities with lower priority than other debts in bankruptcy (e.g., convertible loans).
- Carry higher risk due to lower repayment priority, leading to higher required returns than regular loans but lower than equity.
Risk capital represents the financial resources at the greatest risk in the event of default but also provides the foundation for company control and operations.
What is the difference between risk capital and foreign capital?
Risk Capital:
* Consists of equity, untaxed reserves, and subordinated liabilities.
* Represents the owners’ investment and higher-risk financing (e.g., convertible loans).
* Prioritized last in repayment during bankruptcy.
* Carries the highest cost due to high return expectations and associated risks.
* Provides shareholders with control over the company.
Foreign Capital:
* Includes interest-bearing liabilities (e.g., bank loans) and operational liabilities (e.g., accounts payable).
* Prioritized for repayment before risk capital in bankruptcy.
* Usually less costly than risk capital, as lenders typically require lower returns than shareholders.
* Does not give lenders control over the company, though they may exert influence depending on loan terms.
The primary distinction lies in repayment priority, cost, and the control associated with each type of capital.
Explain the concepts:
- subordinated liabilities
- interest-bearing liabilities
- operational liabilities
Subordinated Liabilities:
* Liabilities that are repaid after all other debts in the event of bankruptcy.
* Examples include convertible loans, which can be converted into company shares under specific agreements.
* Higher risk for lenders leads to higher required returns compared to regular debts but lower than equity.
* Considered part of the company’s risk capital.
Interest-Bearing Liabilities:
* Loans or debts where the company pays interest as the cost of borrowing.
* Examples include bank loans, mortgage loans, and overdraft facilities.
* Often secured by collateral (e.g., property), reducing risk for lenders.
* Lower cost than equity but higher than operational liabilities.
Operational Liabilities:
* Short-term, non-interest-bearing debts, typically from supplier credits (e.g., accounts payable).
* The cheapest form of financing but has short maturity periods (weeks to months).
* Helps companies manage day-to-day cash flow efficiently.
* These liabilities play distinct roles in a company’s financing strategy, balancing cost, risk, and liquidity needs.
What does matching of assets and liabilities mean? Why is this important?
Matching of Assets and Liabilities:
Aligning the maturity dates of financing sources (liabilities) with the economic life of the financed assets.
- **Short-term assets **(e.g., cash, accounts receivable) should be financed by short-term liabilities (e.g., operational liabilities).
- ** Long-term assets** (e.g., fixed assets like machinery or buildings) should be financed by long-term liabilities, untaxed reserves, or equity.
Why is it important?
- Liquidity Management: Ensures the company can meet its short-term obligations, avoiding cash flow problems.
Liquid assets (current assets minus inventory and unfinished products) should exceed operational liabilities (acid test ratio > 1).
- Cost Efficiency: Reduces financing costs by using the most appropriate type of funding for each asset type.
- Risk Mitigation: Prevents mismatches where short-term financing is used for long-term assets, which could lead to repayment difficulties.
- Operational Stability: Aligning asset financing with the company’s needs ensures smoother operations, particularly in capital-intensive industries requiring long-term planning.
Explain the difference between a share issue and a share dividend.
Share Issue:
A company issues new shares to raise additional financial capital.
* Investors purchase shares, and the company receives cash or non-cash assets.
* Examples include rights issues (offered to existing shareholders) and private placements (offered to specific investors).
* Used to expand operations, finance investments, or improve liquidity.
Share Dividend:
A company distributes additional shares to existing shareholders instead of cash dividends.
* Converts non-restricted equity (e.g., retained earnings) into restricted equity.
* Does not bring new financial capital into the company but changes the structure of equity.
* Often issued to meet lenders’ requirements for stronger financial stability.
Give 4 examples of off-balance-sheet financing.
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Factoring:
* Borrowing against invoices (accounts receivable) by using them as collateral.
* Provides immediate cash at a fee. -
Leasing:
* Renting production equipment or assets from a financial institution instead of purchasing them outright.
* Keeps the asset off the company’s balance sheet. -
Sale/Leaseback:
* Selling an asset (e.g., a building) to a financial institution and leasing it back.
* Transfers financial risk and potential value changes to the lessor. -
Outsourcing:
* Paying another company to manage specific operations or processes (e.g., manufacturing, cleaning).
* Reduces fixed assets and operational costs while focusing on core activities.
What is the purpose of a cash flow analysis?
- **Track Cash Movement: **Understand how financial capital flowed through the company during a specific period.
- **Analyze Financing: **Identify how the company was financed, distinguishing between internal (operating profit) and external (share issues, loans) sources of funds.
- Assess Liquidity: Determine changes in liquid assets and ensure the company can meet its financial obligations.
- Evaluate Capital Requirements: Identify working capital needs (e.g., raw materials, accounts receivable) and fixed asset requirements (e.g., machinery, buildings).
- Support Decision-Making: Inform future financial planning, such as borrowing needs or new share issues.
- Compliance: Meet regulatory requirements for large or listed companies to present cash flow analyses in annual reports.
Set up a cash flow analysis according to FAR´s recommendation
A cash flow analysis consists of the following steps:
-
Cash Flow from Operations:
* Start with Operating profit/loss before depreciation.
* Add financial revenues and costs.
* Add back depreciation, as it is a non-cash expense.
* Subtract taxes paid.
* Adjust for changes in working capital:
* Decrease in current liabilities = positive cash flow.
* Increase in current liabilities = negative cash flow.
* Decrease in inventories = positive cash flow.
* Increase in inventories = negative cash flow. -
Cash Flow from Investment Activities:
* Calculate changes in fixed assets (e.g., machinery, buildings).
* Ensure depreciation is excluded.
* Adjust for acquisitions and sales of assets:
* Asset purchases = negative cash flow.
* Asset sales = positive cash flow. - . Cash Flow from Financing Activities:
* Include changes in non-current liabilities (e.g., loans).
* Include capital contributions (e.g., new share issues).
* Subtract share dividends paid. -
Net Cash Flow for the Year:
* Add cash flows from operations, investment activities, and financing activities.
* Compare opening and closing liquid assets to confirm the change.
Explain the difference between operational risk and financial risk
Operational Risk (Business Risk):
- Arises from the company’s core operations and industry characteristics.
- Factors include:
- Nature of operations (e.g., cyclical demand, political sensitivity).
- Cost structure (fixed vs. variable costs).
- Capital tied up in assets.
- High operational risk often leads to fluctuating returns on total capital (ROT).
- Example: The pulp and paper industry faces operational risks due to environmental regulations, currency exchange rates, and export dependency.
Financial Risk
* Linked to how the company finances its operations.
* Factors include:
- Leverage risk: The use of debt increases exposure to default risk.
- Liquidity risk: The risk of insufficient cash to meet obligations.
- Interest rate and currency risks: Changes in rates or currency values can impact debt repayment or profitability.
Financial risk depends on the company’s debt levels and financing choices.
Set up a DuPont Chart and explain its components
The DuPont Chart breaks down the Return on Total Capital (ROT) into two primary factors:
-
Profit Margin:
Reflects how efficiently the company converts revenue into profit.
ProfitMargin = OperatingProfit(EBIT) / NetSales
-
Capital Turnover:
Measures how effectively the company uses its total capital to generate sales.
CapitalTurnover = NetSales / TotalCapital
Formula for ROT using DuPont Chart:
ReturnonTotalCapital(ROT) = ProfitMargin × CapitalTurnover
Purpose of the DuPont Chart:
* Helps identify the impact of cost structure and capital utilization on operational performance.
* Evaluates efficiency without considering financial funding (independent of liabilities).
* Useful for operational risk analysis and optimizing resource allocation.
Describe the concepts:
- leverage risk
- liquidity risk
- interest rate risk
- currency risk
Leverage Risk:
* Risk from using debt in the capital structure. * High D/E ratio increases returns if ROT > average interest rate, but amplifies losses if ROT < average interest rate.
* High leverage makes the company more vulnerable to downturns.
Liquidity Risk:
* Risk of failing to meet short-term liabilities like invoices and salaries.
* Measured by the acid-test ratio.
* Poor liquidity can lead to default or bankruptcy, even if the company is profitable.
* Managed by maintaining liquid assets and planning cash flow.
Interest Rate Risk:
* Risk from changes in borrowing costs due to interest rate fluctuations.
* Companies with variable-rate debt face unpredictable expenses, while fixed-rate loans offer stability.
Interest Rate Risk:
* Risk from changes in borrowing costs due to fluctuating interest rates.
* Variable-rate debt increases cost unpredictability; fixed-rate loans mitigate this but reduce flexibility.
Currency Risk:
* Risk from exchange rate fluctuations affecting cash flow and profits.
Explain why a company with large liabilities can achieve high return on equity (tip: the leverage equation)
A company with large liabilities can achieve high ROE due to the leverage effect described by the leverage equation:
ROE = ROT+(ROT−R)⋅(D/E)
ROE: Return on equity.
ROT: Return on total capital.
R: Average interest rate on liabilities.
D/E: Debt-to-equity ratio.
* Leverage Effect: If the ROT (return on total capital) is greater than the R (average interest rate), the company can use debt as a lever to increase the return for equity holders.
* Debt Amplification: A higher D/E ratio magnifies the difference between ROT and R, resulting in a higher ROE.
* Risk Factor: The leverage effect works only if ROT exceeds R. If ROT falls below R, the effect reverses, causing ROE to drop rapidly, potentially becoming negative.
Example:
* High D/E ratio and ROT > R → Increased returns for shareholders (high ROE).
* High D/E ratio and ROT < R → Greater risk, leading to potential losses.
Explain how the financing of a company is related to the control over the company and its operations.
-
Ownership and Control:
* Shareholders provide equity, which gives them ownership and voting rights, allowing them to influence the company’s direction and operations.
* Investors seeking control take on higher investment risks but have the potential for higher returns if the company succeeds. -
Financiers’ Influence:
* Lenders (e.g., banks) typically have no direct control over the company but can impose terms (e.g., collateral requirements, loan conditions) that indirectly influence operations. -
Balancing Risk and Control:
* Equity financing: Provides control to investors (shareholders) but dilutes ownership among existing shareholders.
* Debt financing: Avoids ownership dilution but increases financial risk due to obligations like interest payments. -
Financial Transparency:
* Companies seeking financing must provide detailed information to attract investors or lenders, fostering trust and accountability. -
Trade-Off:
* More equity financing reduces financial risk but increases external control through shareholder influence.
* More debt financing retains ownership control but heightens financial risk, requiring careful management of leverage and liquidity.
Summary: The choice of financing method determines the balance between operational control and financial risk, influencing who governs the company and how its strategies are implemented.
