Chapter 2 Flashcards
Working Capital Turnover Formula
_____Sales______
Average Working Capital
* Average Working Capital =
( Beginning-of- Period Capital + End-of-period Working Capital ) / 2
Interpretation: Measures how effective a company is at generating sales based on funds used in operations
Analysis:
Higher ratio implies that company is doing a relatively good job at converting its working capital into sales
- Lower ratios implies that too much money invested in current assets such as receivables and inventory relative to the
amount of sales a company is generating from that capital
- Too high of a ratio implies that there may not be enough capital in place to continue to support operations and sales
Debt Financing
- Short & Long Term Debt in their Capital Structures
- Examples:
- Commercial Papers: unsecured short-term debt instrument
- Matures in 270 days or less
- Muse be used to finance current assets such as account receivables or inventory to meet short term obligations
- Debentures: unsecured obligation of the issuing company
- Risk can be mitigated by a negative-pledge clause that stops a company from pledging assets to additional debt
- Income Bonds: securities that pay interest only upon achievement of target income levels
- risky and only used in reorganizations
- Junk Bonds: high default risk and high return
- Non-investments grade bonds
- Often used to raise capital for acquisitions and leverage buyouts
- Commercial Papers: unsecured short-term debt instrument
Equity Financing
- Involves the issuance of equity (stock) securities that represent different forms of ownership in the company
- Types:
- Preferred Stock
- Cumulative Dividends: may require that unpaid dividends in arrears on preferred stock from a prior period be paid prior to the distribution of common stock dividends
- Participating Feature: may participate in declared dividends along with common shareholders to the extent that undistributed dividends exist after satisfying both preferred dividends requirements and common shareholder requirements at the preferred dividend rate
- Voting Rights: rare, for preferred shareholders
- Common Stock
- Basic ownership equity in a corporation
- Includes voting rights
- Issued at par value
- Lowest claim to firm’s assets in liquidation
- Preferred Stock
Characteristics of Debt & Equity Financing
Weighted Average Cost of Capital
WACC
- Serves as a major link between long-term investment decisions associated with a corporation’s capital structure and the wealth of a corporation’s owners
- Average cost of all forms of financing used by a company
- Used internally as a Hurdle Rate for capital investment decisions
- Optimal capital structure has the lowest WACC
- Mixture of debt and equity financing that produces the lowest WACC maximizes the value of the firm
WACC Formula
= (E / V)( Re) + (P / V)(Rp) + (D / V){ Rd (1 - T)}
- V = summed market values of the individual components of the firm’s capital structure
- E = Equity Stock
- P = Preferred Stock Equity
- D = Debt
- R = required rate of return (also known as “cost”) of the various components
- T = Corporate Tax Rate (only applies to debt b/c its is tax deductible)
Explanation: weighted average cost of capital is determined by weighting the cost of each specific type of capital by its proportion to the firm’s total capital structure
Percentage equity and percentage debt in the capital structure is calculated using market values of outstanding debt and equity
Individual Capital Components
- Long-Term Elements: long-term debt, preferred stock, common stock, and retained earnings
- Short-Term Elements: short-term interest-bearing debt
- After Tax Cash Flows: most relevant/ cost of debt is computed on an after-tax basis b/c interest expense is tax deductible
=Weighted Average Cost of Debt Formula
Weighted Average Interest Rate = Effective Annual Interest Payments
Debt Outstanding
- relevant cost of long-term debt is the after-tax cost of raising long-term funds through borrowing
- Include issuance of bonds or long-term loans
- Cost usually stated as interest rates of the debt instruments
- Calculated by dividing a company’s total interest obligations on an annual basis by the debt outstanding
After Tax Cost of Debt Formula
= Pretax Cost of Debt * (1 - Tax Rate)
Debt carries the lowest cost of capital and the interest is tax deductible
The higher the tac rate, the more incentive exists to use dent financing
Cost of Preferred Stock Formula (P)
= Preferred Stock Dividends
Net Proceeds of Preferred Stock
Cost is the dividends paid to preferred stockholders
After tax considerations are irrelevant with equity securities because dividends are not tax deductible
Preferred Stock Dividends
- Can be stated in Dollars or Percentage
Net Proceeds of Preferred Stocks
- Can be calculated as the proceeds net of flotation costs (issuance costs)
Example =
Weighted Average Cost of Capital to Firm = 10%
$100 Par Value Stock
Flotation Cost = $5
So….
Preferred Stock Dividend = Dividend percentage Par Value (10% $100) = $10
= $10/ ($100 - $5)
= $10/ $95
= 10.53%
Cost of Retained Earnings
Cost of equity capital obtained through retained earnings is equal to the rate of return required by the firm’s common stockholders
Firm should earn at least as much on any earnings retained and reinvested in the business as stockholder could have earned on alternative investments
After tax considerations are irrelevant
Methods for Computing the Cost of Retained Earnings
- Capital Asset Pricing Model (CAPM)
- Discounted Cash Flow (DCF)
- Bond Yield Plus Risk Premium (BYRP)
*** Average of the three costs amounts could be used as the estimate of the cost of retained earnings if there is sufficient consistency in the results of the three methods
Capital Asset Pricing Model (CAPM)
Assumptions:
- Cost of Retained earning is equal to the risk-free rate plus a risk premium
- Market Risk premium is equal to the systematic (non-diversifiable) risks associated with the overall stock market
- Beta Coefficient is a numerical representation of the volatility (risk) of the stock relative to the volatility of the overall market
- Beta = 1 (stock is as volatile as the market)
- Beta > 1 (stock is more volatile than the market)
- Beta < 1 (stock is less volatile than the market)
Formula
Cost of Retained Earnings = Risk-free Rate + Risk Premium
= Risk- Free Rate + ( Beta * Market Risk Premium)
= Risk- Free Rate + { Beta * (Market Return - Risk- Free Rate)}
Discounted Cash Flow (DCF)
Assumptions:
- Stocks are normally in equilibrium relative to risk and return
- Estimated expected rate of return will yield an estimated required rate of return
- Expected growth rate make be based on projections of past growth rates, a retention growth model, or analysts’ forecasts
Formula
Cost of Retained Earnings (Do) = D1 + g
Po
Po = Current Market Value or Price of the outstanding common stock
D1 = Dividend per share expected at the end of one year
= Do * (1 + g)
g = Constant rate of growth in dividends
Do = annual common stock dividend
Bond Yield Plus Risk Premium (BYRP)
Assumptions:
- Equity and Debt security values are comparable before taxes
- Risks are associated with both the individual firm and the state of the economy. Risk premiums depend on non- diversifiable risk
- Risk Estimation can be derived by using market analysts’ survey approach or by subtracting the yield on an average (A-rated) corporate long-term bond from an estimate of the return on the equity market
Formula
Cost of Retained Earnings = Pretax cost of long-term debt + Market Risk Premium
Optimal Cost of Capital
Ratio of Debt to Equity that produces the lowest WACC
New projects are funded by sources of capital that maintain the optimum capital structure and meet or exceed the hurdle rate implied by its cost
Loan Covenants & Capital Structure
- Lenders use loan covenants to protect their investments by limiting or prohibiting the actions of borrowers that might negatively affect the position of the lenders
- If firm’s capital structure is weighted towards equity, its financial leverage will be low and its fixed obligations associated with debt with will relatively minimal
- If firm’s capital position has significant outstanding debt relative to equity, loan covenants will typically increase and become more stringent
- often disclosed in financial statements
Growth Rate Formula
g = Return on Assets * Retention
1 - (Return on Assets * Retention)
Retention: is equal to the addition to retained earnings divided by net income
the portion of net income not paid out in the form of dividends to stockholders
Return on Sales (ROS)
= Income before Interest Expense, Interest Income & Taxes
Sales- Net (Sales - Returns - Discounts)
Return on Investment (ROI)
= Net Income
Average Invested Capital
Return on Assets (ROA)
= Net Income
Average Total Assets
Return on Equity (ROE)
= Net Income
Average Total Equity
Operating Leverage
Definition: degree to which a company uses fixed operating costs rather than variable operating costs
Companies with capital intensive structures have high operating leverage
Labor intensive companies have low operating leverage
Implications: Company with high operating leverage will must produce sufficient sales revenue to cover it high fixed operating costs. Beneficial when sales revenue is high. Indicates high contribution margin. Greater risk but greater possible return. Beyond the breakeven point, companies with high operating leverage will retain a higher percentage of revenues as operating income
Financial Leverage
Definition: the degree to which a company uses debt rather than equity to finance the company
Implications: a company that issues debt much produce sufficient operating income (EBIT) to cover its fixed interest costs. However, once fixed costs are covered, additional EBIT will go straight to net income and earnings per share
higher degree of financial leverage implies that a relatively small change in earnings before interest an tax will have a greater effect on profits and shareholder value
Benefit: interest costs are tax deductible
Highly leverage companies may be at risk of bankruptcy and may be unable to find new lenders in the future
Value of a Levered Firm
Definition: company that has debt in its capital structure as apposed to equity
Formula:
= Tx (r * D)
r
T = Corporate Tax Rate
r = Interest rate on debt
D = Amount of Debt
Implications: firm that used debt benefits from the tax deductibility of interest payments
Total Debt Ratio
= Total Liabilities
Total Assets
Interpretation: indicates long term debt-paying ability/ lower ratio means greater levels of solvency
Can exclude certain items in denominator such as reserves, deferred taxes, minority shareholder interests redeemable preferred stock
Debt-to-Equity Ratio
= Total Liabilities
Total Equity
Related two major categories of capital structure to each other and indicates the degree of leverage used
Lower ratios means lower risk
Equity Multiplier
= Total Assets
Total Equity
greater percentage of debt utilized by the firms results in more assets allocated to debt relative to equity and a higher equity multiplier
Times Interest Earned Ratio
= Earnings before Interest Expense and Taxes (EBIT)
Interest Expense
Measures the ability of the company to pay its interest charges as they come due
Measure of long term solvency
Working Capital Management Goal
Maximize shareholder wealth with the optimal mix of current assets and liabilities which depends on the nature of the business and industry
Net Working Capital
The difference between current assets and current liabilities
Must be balanced with long-term or short-term debt or stockholder’s equity
Helps to mitigate risk and increase profitability
Working Capital metrics should be evaluated regularly
Ratios include: Current Ratio, Quick Ratio, Cash Conversion Cycle, Inventory Turnover, Days in Inventory, Account Receivable Turnover, Accounts Payable Turnover, Working Capital Turnover
Current Ratio
= Current Assets
Current Liabilities
Measures the number of times current assets exceed current liabilities
Way of measuring short-term solvency Demonstrates firm’s ability to generate cash to meet short-term obligations
Deteriorating: Decline in the current ratio implies a reduced ability to generate cash and can be attributed to increases in short-term debt, decreases in current assets or combo
Improving: increase implies an increased ability to pay off current liabilities and can be attributed to long-term borrowing to repay short-term debt
Limitation: short-term liquidity must be a relevant issue
Quick Ratio (Acid Test)
= (Cash/ Cash Equivalents) + (Short-Term Marketable Securities) + (Receivables-net)
Current Liabilities
** Do not include prepaids or inventory and subtract allowance for doubtful accounts **
More rigorous test of liquidity than current ratio because inventory is excluded. Ability to meet current obligations without liquidating inventory is important
The higher the better
Cash Conversion Cycle (Net Operating Cycle)
= (Days in Inventory) + (Days Sale in Accounts Receivables) - (Days of Payables Outstanding)
Length of time from the date of initial expenditure for production to the date cash is collected from customers offset by length of time it take to pay vendors
Inventory Turnoverr
= Cost of Goods Sold
Average Inventory
Days in Inventory
= Ending Inventory
Cost of Goods Sold/ 365
Analysis: company is doing well when it quickly converts inventory into sales
More days in inventory more opportunity for shrink, obsolesce and sunk costs
Too few days in inventory, company could run out of inventory and miss sales
Days in Accounts Receivable Ratios
Accounts Receivable Turnover = Sales (net)
Average Accounts Receivables
Days Sales in Accounts Receivables = Ending Accounts Receivable (net)
Sales (net)/ 365
Measures the effectiveness of a company’s credit policy
The fewer days is more ideal
Days Payables Outstanding Ratios
Accounts payable Turnover = Cost of Good Sold
Average Accounts Payable
Days Payables Outstanding = Ending Accounts Payable
Cost of Goods Sold/ 365
Measure of the effectiveness of a company’s attempt to delay payment to creditors
Too short presents the risk of not fully utilizing cash to the advantage of the company
Too long may strain relationships with vendors
