Chapter 3 - Financial Management+CapitalBudgeting Flashcards
Five manin functions of financial management
Know these
Cash Conversion Cycle (2-4)
’s 2-4, which is the time from when a business pays for its inputs to the time it collects cash in the end. Goal is to SHORTEN CCC. Shortening CCC improves profitability. Longer CCC’s require busineses to use more financing rather than rely on cash flow
Inventory Conversion Period (1-3)
Stages 1-3, which is the time it takes for inventory to be purchased to the time it takes to be sold (NOT cash collection, just a sale).
Inventory Turnover = COGS/Average Inventory
Inventory Conversion Period = 365/Inventory Turnover
A/R Collection Period (3-4)
Stages 3-4. The time it takes from a sale to be collected into cash.
Accounts Receivable Turnover = Sales/Average Accounts Receivable
Receivables Collection Period (Days Sales Outstanding) = 365/Accounts Receivable Turnover
A/P Deferral Period (1-2)
Stages 1-2, measuring the time it takes from purchasing invy (and recording the payable) to paying suppliers for it.
Accounts Payable Turnover = Sales/Average Accounts Payable
Accounts Payable Deferral Period = 365/Accounts Payable Turnove
CCC=
Cash Conversion Cycle = Inventory Conversion Period + Receivables Collection Period – Payables Deferral Period
Float
The time it takes for checks to be mailed, processed, and cleared
How to manage float
Think about it: the longer the float the worse if it’s a receivable. We wouldn’t want our check to take long to convert.
And the opposite goes for if it’s a payable. We would rather have the money stay in our account as long as possible. Just be sure you don’t spend it all ;)
So:
MAXIMIZE float payment time
MINIMIZE float receivable time
Reorder point.
level of inventory which triggers replenishment that particular inventory stock
Reorder point calculation
Average Daily Demand
xAverage Lead Time
= Amount to reorder
+Safety Stock
Reorder point
- Average Lead Time is the # of days it takes a supplier to deliver the goods once an order is placed
- Safety stock - see seperate card
Safety Stock
An amount to reorder in additon to the reorder point of inventory. To be held just incase.
Calculated as the difference between Average Daily Demand Multiplied by the average and max lead time
EG:
- We sell 25 per day average
- Average lead time is 10 days
- Maximum lead time is 15 days
25 ADP x 10 days = 250
25ADP x 15 days = 375
375 - 250 = 125 Safety Stock
Economic Order Quantity
Economic order quantity (EOQ) is the order quantity that minimizes the total inventory holding costs and ordering costs
Economic order quantity (EOQ) Formula, and a disadv of it
EOQ = SQRT(2AP/S)
A = Annual (i.e., periodic) demand
P = cost to place an order,
S = cost to store inventory (carrying cost)
One problem with EOQ is that it assumes the periodic demand is known
Capital Budgeting
Techniques that, with the information availible, try to select the most profitable or best investment in a set of alternatives.
4 capital budgeting techniques BEC likes to test
- Payback Period
- Internal Rate of Return
- Accounting Rate of Return
- Net Present Value
PAyback Period
Tries to guesstimate the average time it might take for an investment to be recouped. It’s easy to understand and deals with cash flows,so people like it. But it does not take into account:
- Time Value of Money. Assumes each yearly cash flow are the same value - not PV’d
- Profitability - only tells time
Payback Period Formula
Initial investment or cash outflow
After-tax net cash inflows per year
IRR Formula
Initial investment or cash outflow
After-tax net cash inflows per year
Yes - same as payback period. Then:
(say the # is 6.4)
- Look at the PVOA table
- Go down to the # of years the project is
- Look across and find the closest value there is to that 6.4.
- Look up the interest rate it belongs to. That rate is the IRR
IRR
Internal Rate of Return. You can think of IRR as the rate of growth a project is expected to generate. It would be compared to other investments or to a hurdle rate
Hurdle Rate
Minimum acceptable rate of return. Can be whatever the company sets it to be, but its usually WACC or derived from market rates of return for similar projects.
Accept a project IF THE IRR IS HIGHER THAN THE HURDLE RATE.
Advantages and Disadvantages of IRR
ADV:
- Account for TVM
- more understandable then Net Present Value
DISADV:
- estimates can always be wrong, so cash flows can yield multiple IRRs.
Accounting Rate of Return (ARR)
Accounting Income
Average or Initial Investment
***Accounting Income is typically profits less depreciation
ARR disadvantages and advantages
ADV:
Easy to understand
Can rate managerial performance
DISADV:
No TVM taken into account
different depreciation methods obviously would yield different ARR’s
Net Present Value (NPV)
Excess of present value of inflows over outflow (initial investment)
NPV = PV of Future Cash Flows - Required Investment
NPV Advantages and Disadvantages
Advantages:
- Take into account for TVM
- May take into account risk and profitability
- ending result is a dollar amount
Disadvantages of NPV:
- Computation isn’t simple and intuitive
- Does not take into account that managers may not follow the estimated cash outflows
Discount and AFC
ALWAYS try to take the discount! May not seem like a lot of cash, but stretched over a year it’s a huge rate of return! In fact, to calculate the cost of NOT taking the discount (Annual Financing Costs of AFC):
Discount %
100% - Discount %
X
365 or 360 days
Total days in pay period - discount days***
*** eg: 3/15 net 45 would be the 45 days - 15 days
Compensating Balances
Demand Deposit balances lenders may require as a condition for receiving loans.
Cost of a loan:
Interest Paid
Net funds Availible (Principal - Compensating Balance)
Debt covenants
To influence investors to lend, borrowers often agree on restrictions, or debt covenants.
- Positive Covenant - stipulate what borrower MUST do (eg audited stmtns/ratios/life insurance)
- Negative Covenant - state what borrower MUST NOT do (eg - borrow from others, exceed certain amounts of compensation, etc)
How to calculate current yield on bonds
Annual Interest Paid
Bond Market Price
Proceeds of a bond:
Sum of:
- PVlumpsum of Face using effective interest rate
- PVOA of Interest Pmts (Face X Stated X Time)
Advantages of using DEBT financing
- Interest on Bonds IS tax-deductible (its not for C/S dividends)
- Obligation is fixed - we are certain with what it will be
- no control given (unlike with C/S. Also earnings are not shared)
- Cost of capital generally lower than C/S bc debt is less costly
- Debt is usually paid back for less valuable dollars because of inflation
Disadvantages of Debt Financing
- We must make those fixed obligations no matter how good or bad our performance
- Though no control given up, there still are debt convenants
- High debt would increase risk business can fail and wipe out owners claims. Thus, sometimes high debt can reduce stock prices - even if it has positive effects on ROE!
some benefits of leases
- Businesses unable to obtain enough credit to purchase may be able to lease
- Terms in lease agreements often less strict then bond indentures
- No down payments
- In bankruptcy, creditors have weaker rights over leased assets
Advantages and Disadv of Common Stock
ADV
- Payments are flexible; not fixed. Business can pay dividends when they want
- If the company has a significant amount of equity, it poses as less risk for lenders of debt should the comoany seek financing that way. It thus reduces borrowing costs
DISADV
- Costs of issuing the C/S tend to be larger than that for debt
- Current owners dilute their ownership and control each time new stock issued
- Dividends are NOT tax deductible. They are paid out through after-tax earnings (Retained Earnings)
- higher cost of capital
Other than OTC, the two markets C/S is issued in are
- Primary Markets - New issues market (IPOs and initial price offerings
- Secondary market - where already outstanding shares are sold
Advantages of Preferred Shares
- Dividend payments are flexible - preferred dividend payments can be skipped even if those dividends have to be paid later when the business wants to pay common dividends
- More equity poses less risks to lenders, so lest borrowing costs for us
- Issuing more preferred shares means less common shareholders that could have more power in decision-making
- Preferred stockholders typically don’t have a share in earnings
Disadvantages of Preferred Shares
- Cost of issuing is alrger than debt. Also the dividend rates paid on interest are higher than the rates for bonds
- not tax deductible like debt
- Over-accumulated of skipped dividends on arrears can pose a problem in reducing that backlog. Also will make it harder to find further funding
Cost of Debt Financing calculated by:
- Yield to Maturity x (1-effective tax rate)
or - (Interest expense - tax deduction for interest)/Carrying value of debt
Cost of Preferred Stock
Dividend/Net Issue Price
To find C/S
CAPM:
Risk Free Rate + [(Expected market rate - risk free rate) x Beta]
cost of NEW common stock
(Next expected dividend/Current stock price - floatation costs) + expected growth in earnings
When calculating WACC, what is multiplied by 100% less tax rate before being multiplied by the weight?
Cost of DEBT
Profitability Index
is the ratio of payoff to investment of a proposed project. Useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.
See Question 3s-1
Limitation: it uses estiamted future cash flows - could be uncertain of course. (3s-38)
Days sales outstanding measures what? (3s-4)
Net Credit Sales
Average A/R x 360
This describes the average collection period, which measures liquidity (3s-21)
if want to improve A/R turnover ratio (3s-7)
Try to LOWER THE DISCOUNT TIME (not make it longer- these will be incorrect answers)
or
Enter into a FACTORING AGREEMENT.
***NOT a pledge agreement. Pledges still use the A/R as COLLATERAL for the loan. Thus, the A/R balance is still there unaffected.
(3s-13) Why would we agree to debt convenants?
To get those people to lend to us - and ultimately - at the LOWEST INTEREST RATE POSSIBLE
Business Risk
Risk that prfits will fall short of expectations. So if a company was only using equity financing, this would be the inherent in a firm’s operations (3s-16)
the optimat capitaliztion of an organization can usually be determined by what?
LOWEST WACC.
NOT:
- DFL
- DTL
- (3s-17)
Economic rate of returnn on C/S
Economic rate of returnn on C/S is the benefit derived from ownership. This would include both dividends and appreciatiom, divided by the intiial investment:
(Dividends + Change in Price)
Beginning Price
How to calculate profitabiltiy index (3s-30)
Pv of annual after tax cash flows
Investment
If your current ratio is better than a comeptitor’s, are you more or less liquid than them?
MORE. A company is more liquid when it has mroe assets to cover its liabilities
If inventory is very risky in terms of obsolescence, a company would want which type of ratio?
the highest QUICK RATIO or INVY TURNOVER ratio.
Quick ratio bc creditors like this more than current ratio. But, a high quick ratio would be the answer if the high invy turnover was not a choise.
Which of the following items represents a business risk in capital structure decisions?
Cash Flow
Business risk is the risk that profits may be lower than anticipated
Which of the following factors is inherent in a firm’s operations if it utilizes only equity financing
Operations would have to do with business risk. You thought it was financial risk, which is associated with defaulting on debt.
Business risk is risk that profits will be lower than estimated. That clearly is associated with operations
