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
Cash Conversion Cycle Analysis
Company should minimize the amount of time it takes to convert inventory to cash while maximizing the amount of time it takes to pay vendors
Lower the cash conversion cycle the better
Working Capital Turnover
= ___\_Sales
Average Working Capital
** Average working capital is beginning of period plus end of period working capital divided by 2
Measure of how effective a company is at generating sales based on funds used in operations
Higher working capital implies company is doing relatively well at converting its working capital into sales
Too low implies too much money is invested in current assets such as receivables
Too high implies there is not enough capital in place to continue to support operations
Option
Definition: a contract that entitles the owner (holder) to buy (call option) or sell (put option) a stock (or some other asset) at a given price with a stated period of time
American style options can be exercised at any time prior to their expiration
Euro style options can only be exercised at the expiration or maturity date of the option
Black-Scholes Model
Accountants use to value stock options when accounting for share-based payments
- Inputs into the Model (determinants of the call option value)
- Current price of the underlying stock (higher price -→ higher option value)
- Option exercise price
- Risk-free interest rate (higher rate -→ higher option value)
- Current time until expiration (longer time → higher call option value)
- Some measure of risk for underlying stock (higher risk → higher option value)
- Assumptions underlying
- Stock prices behave randomly
- Risk-Free rate and volatility of the stock prices are constant over the option’s life
- There are not taxes or transactions cost
- Stock pays no dividends, although model can be adopted
- Options are Euro-style
- Limitations
- Due to model assumptions, results generated may differ from real prices
- Assumes constant, cost-less trading, which is unrealistic
- Model tends to underestimate extreme price movements
- Model is not applicable to pricing American-style options
Binomial Model (Cox-Ross-Rubinstein Model)
Variation of Black-Scholes model
Considers underlying security over a period of time
Useful for valuing American-style options
- Assumptions
- Perfectly efficient stock market
- Underlying security price will move up or down at certain points in time (nodes) during the life of the option
- Benefits
- Can be used for stocks that pay dividends without modifying model
Valuing Debt Instruments
Value of bond is equal to the present value of its future cash flows (which consists of interest payments and the principal payment at maturity)
Valuing Tangible Assets
- Cost Method: value of assets is based on the original cost paid to acquire the asset
- adjustments can be made for depreciation in order to reduce value to reflect current utility
- Market Value Method:
- Requires similar assets be available in the marketplace
- Appraisal Method
- Professional appraiser determine the value of asset, assuming that the company can find an appraiser with knowledge and experience
- Liquidation Value
- Value of asset if sold today
Valuing Intangible Assets
- Market Approach :
- Approach requires similar markets be used in reference for asset to be valued
- Unique nature of intangibles and relative trading infrequency present challenges
- Income Approach
- Future expected cash flows over the estimated useful life of the intangible asset are discounted to present value using discount rates reflecting the level of risk (asset, industry and market) associated with income stream
- Cost Approach
- Used when there are no similar assets or transactions involving similar assets and no reasonable estimates of future income
- Includes replacement costs, reproduction costs
- Material, labor, overhead, legal and other fees, development cost, production cost and opportunity cost
Information Use in Accounting Estimates
- Historical Information
- Required by GAAP an allowance for uncollectible accounts be estimated using historical information regarding collectability
- Market Information
- information on the current value of inventory items should be used to determine the lower of cost or market and lower of cost and net realizable value
- Used to determine whether inventory should be written down or off (never up)
- Expected Usage
- Depreciation methods may be based on expected patterns of fixed-asset usage
- Estimates From Experts:
- attorneys are often used - ex cost of litigation
Capital Budgeting
Process for evaluating and selecting the long-term investment projects of the firm
crucial to success of organization
Net Effect = Cash Inflows - Cash Outflows (total of the direct and indirect effect of cash flows from capital investment)
Stages of Cash Flows
- Inception of the Project (Time Period Zero)
- Present Value = 1
- Initial cash outlay for project is often largest amount of cash outflow of investment’s life
- Operations
- cash flows generated from operations of an asset occur on a regular basis– may be the same amount every year (annuity) or differ
- Disposal of the Project
Additional Working Capital Requirements
Can incur indirect cash outflows that is recognized at the inception of the project because part of the working capital of the organization will be allocated to the investment project and will be unavailable for other uses in the organization
Disposal of the Replace Asset
- Asset Abandonment
- Net salvage value is treated as a reduction of the initial investment in the new asset
- Abandoned asset book value is considered a sunk cost -→ no relevant to decision making process
- but can be used for tax purposed as a deductible which reduced liability in year of abandonment
- Asset Sale
- Cash received for sale of new asset reduces the new investment’s value
Disposal of the Project
Produces both direct and indirect cashflows
Working capital commitment that was recognized as an indirect cash outflow at the inception of a project is recognized as an indirect cash inflow at the end of the project when the working capital commitment is released
Discount to present value
After Tax Cash Flow Methods
Method 1:
- Estimate net operating cash inflows (Inflows minus outflows)
- Subtract noncash tax deductible expenses to arrive at taxable income
- Compute income taxes related to a project’s income (or loss) for each year of the project’s useful life
- Subtract tax expense from net cash inflows to arrive at after-tax cash flows
Method 2:
- Multiply net operating cash inflows by (1 - tax rate)
- Add the tax shield associated with non cash expenses such as depreciation (depreciation multiplied by the tax rate)
- The sum of these two amounts will equal the after-tax cash flows
Discounted Cash Flow (DCF)
- Rate of Return Desired for Project
- Rate used to discount future cash flows set by management using WACC method, specific target rate assigned to new projects, or rate that related to the risk specific to the proposed project
- Limitations
- Frequently use a single interest rate assumption
Net Present Value Method (NPV) - most common
Objective: focus decision makers on the initial investment amount that is required to purchase (or invest) a capital asset that will yield returns in an amount in excess of a management-designated hurdle rate
Calculation:
- Estimated all direct and indirect cash flows related to investment
Ignore Depreciation (Unless a Tax Shield)
Ignore Interest Expense because discounting process itself deals with the cost of financing
- Discount Cash Flows
Discount to present value using appropriate discount factor based on hurdle rate and timing
- Compare
Interpreting: is NPV positive or negative
Positive = make investment
Negative = do not make investment
Adjustments to rates (usually increase) may be made for RISK or INFLATION
Advantages: flexible and can be used when there is no constant rate of return required
Disadvantages: does not provide the true rate of return, simply tells whether it will earn the hurdle rate
Capital Rationing
Definition: describes how limited investment resources are considered as part of investment ranking and selection decisions
Unlimited Capital: ideally, a company has unlimited resources at its disposal and should do every investment that meets the screening criteria
Investments are undertaken in order that they are ranked
Limited Capital: realistically, company had limited resources and investment choices mutually exclusive
Profitability Index
= ____Present Value of Cash Flows___\_
Cost (present value) of initial Investment
Application: measures cash-flow return per dollar invested
Higher the index the more desirable the project
Projects that meet screening criteria (Positive NPV) should be rank in descending order based on their Profitability Index
Financing Lease
analogous to lessee buying an asset and financing it with debt
meets criteria of NPV and Profitability Index
Operating Lease
Same as financing but does not meet criteria of NPV or Profitability Index
Operating Lease
Same as financing but does not meet criteria of NPV or Profitability Index
Financing Decision
- Discount cash flows specific to each financing option at the after-tax cost of debt
- Preferred financing option is that with the lowest NPV of cost
- Relevant cash flows to consider:
- Buy Asset
- Purchase cost or present value of lease payments
- tax saving from depreciation
- Scrap Proceeds
- Lease Asset
- Lease Payments
- Tax Savings on Leases Payments
- Buy Asset
*** If the PV of the cost of the best course of financing is less than the PV of the operating cash flows, then the project should be undertaken ***
Effects of Financial Statements of Lease-versus-Buy
- Borrow to Buy
- Bank loan recorded in non-current liabilities
- increase debt-to-equity ratio
- Interest on debt will reduce firm’s interest coverage ratio
- Finance Lease
- recognized on balance sheet
- increase debt-to-equity ratio
- liability is amortized over time
- Operating Lease
- leases expenses is recognized on income statement
Internal Rate of Return
Expected rate of return of a project (Time-Adjusted Rate of Return)
Objective: determines the present value factor (related interest rate) that yields an NPV equal to zero
Present Value of the after-tax net cash flows equals the initial investment of project
Focuses on percentages
Initial Investment = Net Cash Flows * PV Factor
or
PV Factor = _\_Initial Investment_\_
Net Cash Inflow
Interpretation: Hurdle rate is compared with IRR
Accept when IRR > Hurdle Rate
Reject with IRR < Hurdle Rate
Limitation:
Unreasonable Reinvestment Assumptions
Inflexible Cash Flow Assumptions (less reliable than NPV)
Evaluated Alternative Based Entirely on Interest Rates
Payback Period Method (easiest)
Time required for the net after-tax operating cash inflows to recover the initial investment in a project
Objective: focuses on both liquidity and risk
Calculation:
Payback Period = ____Net Initial Investment__\_
Average Incremental Cash Flows**
** Where cash flow per period id even
Assumptions:
Uniform Cash Inflows
Factors:
- Project Evaluation: Net annual cash inflows would be the net cash receipts associated with the project
- Asset Evaluation: net annual cash inflows will be the savings generated by use of new equipment
- Depreciation Tax Shield: not considered except to the extent that it is a tax shield
Advantages:
Easy to Use and Understand
Emphasis on Liquidity
Limitations:
Time value of money is ignored
Project cash flows occurring after initial investment is covered are not considered
Reinvestment of cash flows is not considered
Total project profitability is neglected
Discounted Payback Method (Breakeven Time Method BET)
Computes payback period using expected cash flows that are discounted by the project’s cost of capital
Objective:
evaluate how quickly new ideas are converted into profitable ideas
- Focuses on Liquidity and Profit
- Evaluation Term: computation begins when project team is formed and ends when initial investment has been recovered
- Using Discounted Payback: used in environments of rapid technological changes and company wants to recoup investment quickly
Advantages
Same as Payback Method
Disadvantages
Same as Payback Method
Inventory Management
Inventory represents the most significant current noncash resource of an organization
Types of Inventory:
- Raw Materials
- Work-in-Process
- Finished Goods
Inventory Valuation
- Generally accounted for at cost
- When value falls below original cost, inventory must be restated to the lower of market value or net realizable value
- LIFO or Retail Inventory Method is measured at lower of cost or market
- Any other methods is measured at lower of cost or net realizable value
Market Value of Inventory
Represents the median value of the item’s replacement cost, the market ceiling, and the market floor
- Replacement Cost: equal to the cost to purchase he inventory on the valuation date
- Market Ceiling: net selling price less the costs to complete and dispose of inventory
- Market Floor: equal to the market ceiling less a normal profit market
Net Realizable Value
Equal to the net selling price less costs to complete and dispose
Also known as Market Ceiling
Cost Flow Assumptions in Inventory Management
Specific Identification Method
cost of each item in inventory is uniquely identified to that item
cost follows the physical flow of the item in and out of inventory to COGS
FIFO Method
the first costs inventoried are the first costs transferred to COGS
Ending inventory on balance sheet includes most recent incurred costs and thus approximates replacement cost
Can use Periodic or Perpetual
Balance Sheet Happy
Income Statement Sad (may be over stated)
LIFO
Last cost inventoried are the first costs transferred to COGS
Ending inventory does not approximate replacement costs
Can Use Periodic or Perpetual
Balance Sheet sad
Income Statement Happy
Weighted Average Method
Calculates average cost per items at the end of the period by dividing the total costs of inventory available by the total number of units available
Used for both inventory and COGS
Requires Perpetual
Moving Average Method
Computes weighted average cost of inventory after each purchased by dividing the total cost of inventory available after each purchase by the total units available after each purchase
Requires Perpetual
Inventory Management Strategies
Factors Influencing Inventory Levels:
- Storage Costs
- Insurance Costs
- Opportunity costs
- Lost inventory due to obsolescence or spoilage
** Lower carrying cost of inventory the more inventory a company is willing to carry
Optimal Levels of Inventory
- Inventory Turnover
- Safety Stock
- Reorder Point
- Economic Order Quantity
- Materials Requirement Planning
Safety Stock
- Reliability of sales forecast
- Possibility of customer dissatisfaction resulting from back orders
- OOS costs
- Lead time
- Seasonal Demands on Inventory
Reorder Point
= Safety Stock + (Lead Time * Sales during Lead Time)
Economic Order Quantities
Helps with tradeoff between carrying costs and ordering costs
Attempts to minimize total ordering and carrying costs
Assumptions:
- the demand is known and is constant throughout the year
- does not consider OOS costs
- Does not account for cost of safety stock
- carrying costs and ordering costs per unit are fixed
Equation:
E = Square Root of (2SO/ C)
Order Size (EOQ)
Annual Sales (in units)
Cost per Purchase Order
Annual Carrying Cost per unit
Just-In-Time Inventory Model
Reduces lag time between inventory arrival and use
reduces need to carry large inventories
requires considerable degree of coordination between manufacture and supplier
Kanban Inventory Control
gives visual signals that a component required in production must be replenished
prevents oversupply or interruptions resulting from lacking component
Computerized Inventory Control
establishing real-time communication links between cashier and stock room
purchases recognized instantaneously
Integrated Supply Chain Management
exists when firm and entire supply chain are able to reasonably predict the expected demand of consumers for a product and plan accounting
Goal is to Understand Needs and preferences of Customers
Steps:
- Plan
- Source
- Make
- Deliver
Benefits:
- Reduce cost in inventory management
- Reduced cost in warehousing
- Optimization of the distribution network
- Enhance revenues
- Improved service times
- Strategic shipment sonsolidation
- Reduced cost in packaging
- Improved delivery time
Discounts in Accounts Payable Management
can be effective in preserving cash balances and financing current operations
Calculation:
APR of Quick Payment Discount = _____360____\_* ___Discount__\_
Pay Period - Discount Period 100 - Discount %
Accounts Receivable Turnover
= _______Sales (Net)_______\_
Average Accounts Receivables (net)
Methods to Speed Collections
- Customer Screening and Credit Policy
- Prompt Billing
- Payment Discounts
- Expedite Deposits
- EFT
- Lockbox System (bank access to mail box for deposit purposes)
- Concentration Banking (central depository)
Factoring
Entails turning over the collection of accounts receivables to a third party in exchange for short-term loan
Letter of Credit
represents third party guarantee, generally by a bank, of financial obligations incurred by the company
External credit enhancement used by company issuing otherwise unsecured debt to enhance its credit
Line of Credit
represents a revolving loan with a bank that is up to a specific $ amount for a defined term and is renewable upon the maturity date
Debt Covenants
Used to protect lenders
Examples:
- Limitation on issues additional debt
- restrictions on payments of dividends
- limitations on disposal of certain assets
- Limitations on how the borrowed money can be used
- Minimum working capital requirements
- Maintenance of specific ratios
- Providing financial statements
Short-Term Financing
Generally classified as current and will mature in a year
rates tend to be lower and presume greater liquidity
classified as current liability and decreases working capital
Advantages:
increased profitability and improved liquidity
Decrease in financing cost
Disadvantages:
Increased Interest Rate Risk (can change quickly)
Decrease Capital Availability
Long-Term Financing
Generally classified as non-current and will mature after one year
Interest Rates tend to be higher
Effect ON working Capital → increases financial leverage
Advantages:
Decreased Interest Rate Risk
Increased capital availability
Disadvantages:
Decreased Profitability due to higher financing costs
Increased Financing Costs
Beta Coefficient
- Measures the volatility of risk inherent in an investment by computing the ratio of percentage changes in stock’s price to percentage changes in overall market values during same period
Optimal capitalization of an organization
determined by the lowest of weighted-average cost of capital (WACC)
Capital Asset Pricing Model
R = RF + Beta (RM - RF)
R = Required rate of return
RF = Risk-free rate earned on U.S. Treasury Bonds
Beta = Beta Coefficient
RM = Expected market return (earnings)
Cost of Debt
Measured as actual interest rate minus tax savings
Elements in Cost of Equity Capital for Weighted-Average Cost of Capital
- Current Dividends per Share (D)
- Expected Growth Rate in Dividends (g)
- Current Market Price per Share of Common Stock (P)
R = (D1/ Po) + g
Bonds
- Callable Bonds: fluctuate in value/ Advantages to the issuer is the ability to call or ,effectively, refinance the bonds if interest rates become more favorable
- Convertible Bonds: fluctuate in value/ Advantages to investor (and potentially issuer) in relation to convertible bonds is the ability to convert, or swap the bonds for equity if market conditions become favorable (equity returns exceed fixed return on debt)
- Floating-Rate Bond: automatically adjust the return on a financial instrument to produce a constant market value for that instrument/ no premium or discount would be required since market changes would be accounted for through the interest rate
- Zero-Coupon Bond: have fixed stated rate of return that would require assignment of a premium or discount to the underlying security to produce a market rate of interest if that market yield is different from the stated rate
Constant Growth Dividend Discount Model
Stock price will grow at the same rate as the dividend
Value Estimation Technique
Price Sales Ratio- used sales per share as a basis for valuation and can be used in start-up situations or under conditions where earnings data is not meaningful
Zero Growth Model
P = D/R
R = Desired Rate of Return
D = Dividend
Price-Earnings Ratio
= Stock Price / Earnings Per Share
PEG Ratio
PEG Ratio=EPS Growth Price/EPS
where: EPS = The earnings per share
Weighted Average Method for Equivalent Units
Units Completed + Ending WIP(% Complete)
Weighted Average Method for Equivalent Units
Units Completed + Ending WIP(% Complete)
Growth
= ROE * Retention
ROE = ROA * DFL(degree of financial leverage)
1 - payout = Retention
Payout = DPS / EPS
Growth Rate = (Return on assets * Retention) / (1 - (ROA * Retention)
