CMA Part II Flashcards
Prospective Financial Statements
These are financial statements that are based on a set of assumptions and cover a future period. Whenever prospective financial statements are prepared, the significant accounting policies and significant assumptions that were made need to be disclosed.
Accounts receivable turnover will normally decrease as a result of?
Accounts receivable turnover is calculated as annual credit sales divided by the average accounts receivable. It measures the number of times the accounts receivable “turn over”
during a year’s time. Therefore, this number will decrease if there is a decrease in credit sales or an increase in the average receivables. If the company lengthens the period for cash discounts, more companies will take longer to pay their bills, which will increase the average receivables. This will, in turn, decrease the accounts receivable turnover ratio. A decrease in the accounts receivable turnover ratio means the accounts turn over less frequently; and in this case, that is because the level of accounts receivable is higher.
Times Interest Earned
The times interest earned ratio (interest coverage ratio) is EBIT(operating profit) / Interest Expense.
The Amortization of Bond Premium
The amortization of bond premium is like the amortization of a deferred gain. Since this is a noncash transaction, however, this “gain” needs to be taken out of net income and this is done by subtracting it from net income under the indirect method.
Degree of Financial Leverage
Degree of Financial Leverage is EBIT (operating profit) divided by EBT (Earnings Before Interest & Taxes + Earnings Before Taxes).
Everything else being equal, a (A) highly leveraged firm will have (B) earnings per share.
In firms that are less highly leveraged, the company has lower fixed costs. Because fixed costs are lower, profits as a percentage of sales fluctuate less as the level of sales changes than would be the case for a more highly leveraged firm. This will lead to less volatile, more stable earnings per share.
The P/E Ratio
The P/E ratio is measured as the market price of the share divided by diluted earnings per share (DEPS).
GAAP Income Statement ON TIDE N OC
O = Operating
N = Non Operating Income
T = Taxes (current and deferred)
I = Income from Continuing Operations
D = Discontinued Operations
E = Extra Ordinary Gain /(Losses)
N = Net Income
O = Other Comprehensive Income (DENT)
D= Derivatives
E= Excess adj. of Pension PBO& FV Plan
N= Net unrealized gain or loss on AFS security
T= Translation Adjustment
C = Comprehensive IncomeWhich one of the following factors indicates that a foreign affiliate’s functional currency is the U.S. dollar?
Sales prices are responsive to short-term changes in exchange rates and worldwide competition.
The definition of a foreign entity’s functional currency is that it is normally the currency in which the entity generates and expends cash. If a company generates and expends cash in one currency only, then its purchases and its sales will not be subject to exchange rate risk. Furthermore, a company that operates only in the currency of its own economy will find that its selling prices are determined by its local market or its local government’s regulations. In this case, the entity’s functional currency should be the currency it buys and sells in, and that will be its local currency.
On the other hand, if the entity’s sales prices are determined more by worldwide competition or by international prices, that is an indication that it may be buying and selling goods in currencies other than its own currency. And when the foreign entity is buying and selling goods in currencies other than its own currency, then the FASB Accounting Standards Codification recommends that its functional currency be designated as the U.S. parent’s currency and not the foreign entity’s local currency.
Vertical, Common-Size Analysis
Vertical, common-size analysis creates financial statements in which each component is measured as a percentage of another element of the financial statements for that same period. For example, all items on the balance sheet are measured as a percentage of total assets and all income statement items are measured as a percentage of total sales.
Advertising expense being 2% of sales is such an example of vertical, common-size analysis.
The Degree of Operating Leverage (DOL)
The degree of operating leverage (DOL) is a measure of the change in net operating income associated with a given change in sales volume. For a particular level of output,
Degree of Operating Leverage is calculated as follows:
% Change in Operating Profit (EBIT) /
% Change in Revenue
Degree of operating leverage is calculated as Contribution Margin divided by Operating Income. Because bad debt expense is a percentage of sales, it is a variable expense.
The Direct Method (Reconciliation)
Only the direct method of preparing the Statement of Cash Flows requires a reconciliation between net income and net cash flows from operating activities. This reconciliation is exactly the same as the net cash flows from operating activities as it is presented under the indirect method.
An increase in an asset account must be subtracted from net income because it represents cash paid out that is not on the income statement. Therefore, the increase in prepaid expenses will be a deduction from net income to reconcile net income to cash flow from operating activities. The amortization of premium on bonds payable reduces interest expense and thus it increases net income without increasing cash. Therefore, it will also need to be deducted from net income in the reconciliation.
The ratio that measures a firm’s ability to generate earnings from its resources is?
Asset turnover is calculated as sales divided by total assets and is a measure of the company’s ability to generate earnings from all of its resources.
FIFO = COGS (LISH)
If cost are going up: LISH = Last In Still Here COGS - Understated NI- Overstated Ending Inventory is okay
LIFO= COGS (FISH)
If Costs are going up: FISH = First In Still Here Profits OK- Income statement is fair Ending Inventory - Understated Income Statement is OK but Balance Sheet is not.
Average Number of Days to sell inventory for the current year?
The average number of days to sell inventory is calculated as 365 divided by the inventory turnover ratio. Inventory turnover is calculated as the cost of goods sold (COGS) divided by average inventory. Cost of goods sold was $4,380,000 and average inventory was $870,000 (the average of the beginning and ending balances). This gives an inventory turnover of 5.03. Dividing 365 by 5.03 gives us 72.5 days as the average number of days to sell inventory.
The average number of days to collect receivables
The average number of days to collect receivables is calculated as 365 divided by the receivables turnover ratio. Receivables turnover is calculated as net annual credit sales divided by average receivables. Credit sales were $6,205,000 and average receivables were $335,000 (the average of the beginning and ending balances). This gives a
receivables turnover ratio of 18.52. Dividing 365 by 18.52 gives us 19.71 days as the number of days to collect receivables.
Horizontal Common-Size Analysis
Horizontal common-size analysis occurs when the financial information is presented as a percentage of the company’s financial information from a previous period. The current year amounts are stated in comparison to the base period for that company, which is given a value of 100%.
Systematic Risk
Systematic risk is risk that all investments are subject to. It is caused by factors that affect all assets. Examples would be inflation, macroeconomic instability such as recessions, major political upheavals and wars. Systematic risk cannot be diversified away, and so it remains even in a fully diversified portfolio.
Covariance
Covariance is a measure of the strength of the correlation between two (or more) sets of random variables. Those two random variables could be the historical returns of two securities; or they could be the historical returns of an individual security and the historical returns of the market portfolio.
If an individual security’s return moves with the return to the market or moves with the return to another individual security – both increasing at the same time and both decreasing at the same time – the covariance between the security and the other security or between the security and the market will be greater than zero. If one decreases when the other increases or increases when the other decreases, their covariance will be less than zero. If there is no correlation at all between the two, their covariance will be zero.
The Coefficient of Variation:(The risk of different investments)
The risk of different investments is measured using the coefficient of variation. The Coefficient of Variation is calculated as the standard deviation divided by the expected return. The higher this value, the more risky the stock. The coefficient of variation for stock A is .75 (15%/20%). The coefficient of variation for Stock B is .9 (9%/10%). Therefore, the investment in Stock B is riskier because it has a higher coefficient of variation.
The risk premium for an individual security:
The risk premium for an individual security is its beta times the difference between the return to the market and the risk-free rate. Thus, the security’s risk premium is .5(.09 - .04), which is .025 or 2.5%.
The expected risk premium for a stock (or a portfolio)
The expected risk premium for a stock (or a portfolio) is the difference between the expected return on the market and the risk-free rate multiplied by the stock’s (or portfolio’s) beta. The expected return on the market minus the risk-free rate multiplied by the beta is 1.2 x (.11 - .02), which is equal to .108 or 10.8%.
The formula for Arbitrage Pricing Theory is:
r = rf + B1k1 +B2k2 + B3k3
Risk Factor Est. Risk Premium
Interest rate changes +0.5% (k1)
Inflation +1.0% (k2)
Real GNP Changes +1.5% (k3)
Int. Rate Inflation Real GNP Chrgs. BCD Appliance +1.2 +1.8 +1.9
r =.05 +(1.2 x .005)+ (1.8 x .01) + (1.9 x .015)
r =.05 +.006 + .018+.0285 = .1025 or 10.25%
The optimal capital budget is determined by:
Calculating the point at which marginal cost of capital meets the projected rate of return, assuming that the most profitable projects are accepted first.
In economics, a basic principle is that a firm should increase output until marginal cost equals marginal revenue. Similarly, the optimal capital budget is determined by calculating the point at which marginal cost of capital (which increases as capital requirements increase) and the marginal efficiency of investment (which decreases if the most profitable projects are accepted first) intersect
The total cost of the safety stock
The total cost of the safety stock is the carrying cost plus the expected stock-out cost.
If the company carries 100 units of safety stock, the cost of carrying the safety stock will be $1,000 for the year. This is calculated as 20% of the value of the safety stock. The average inventory investment per unit is $50.
For 100 units, the carrying cost is $50 * 100 * .20, or $1,000.
The stock-out cost is $5 per unit. At a safety stock level of 100 units, if a stock-out occurs, the number of units the company would be short would be 100 units (from the “Stock-out” column). Therefore, the cost of one stock-out would be 100 * $5, or $500.
The company orders inventory an average of 10 times per year. The probability of a stock-out occurring at a safety stock level of 100 units is 15%. Therefore, during a year’s time, the expected number of stock-outs is 10 * .15, or 1.5 times. At a cost of $500 per stock-out, this is an expected annual cost of $750 ($500 * 1.5).
Since the total cost of the safety stock is the carrying cost plus the expected stock-out cost, the total cost of the safety stock on an annual basis with a safety stock level of 100 units is $1,000 carrying costs plus $750 stock-out costs, or $1,750.
The cost of retained earnings, Using the Capital Assets Pricing Model (CAPM)
The beta coefficient for a stock is 1.15, the risk-free rate of interest is 8.5%, and the market return is estimated at 12.4%. If a new issue of common stock were used in this model, the flotation costs would be 7%.
Asset Pricing Model (CAPM) equation:
R = Rf + B(Rm - Rf) R= Rate Rf = Risk Free Rate B= Beta Rm = Market Return This gives us: 8.5% + [1.15(12.4% - 8.5%)] = 12.99% as the cost of retained earnings
Commercial paper:
Commercial paper:
1) Usually only sold through investment banking
dealers.
2) Has an interest rate lower than Treasury bills.
3) Has a maturity date greater than 1 year.
4) Ordinarily has an active secondary market.
A Zero-Balance Account:
A zero-balance account reduces the cost of cash management because it reduces the:
1) time that managers need to spend transferring funds from one account to another to cover checks written. The bank does charge for the service, but the bank’s fee is lower than the cost to the company would be to make the calculations and then to make the transfers manually.
2) A zero-balance account reduces excess bank balances, because the company needs to monitor the balance in only one account. The other accounts are maintained at zero balances, so the company does not have to leave excess funds in those accounts to make sure they do not get overdrawn.
The amount of safety stock that a company is required to hold will be affected by:
The amount of safety stock that a company is required to hold will be affected by:
1) the variability of the lead time,
2) the variability of the demand for the product,
3) the cost of stock-out.
The more variable either of the first two items, the more safety stock the company will need to guard against stock-outs in the case of an unusually high demand or an unusually long lead time. If these items are more consistent and predictable, the company can reduce the amount of its safety stock because there is a smaller chance of needing so many items in stock. The greater the cost of a stock-out, the more safety stock the company will need to keep because the potential loss from a stock-out is higher.
The optimal amount of cash to be raised by selling securities is:
The amount of cash that should be obtained through the sale of marketable securities is calculated in order to balance the cost of the conversion and the lost return by having the assets as cash instead of invested in a higher-return investment.
When two things are inversely related, when one increases, the other decreases and vice versa. The higher the return is on marketable securities, the lower will be the amount in cash that will be converted from securities at any one time, in order to keep as much money as possible working and earning a return for as long as possible.
When two things are directly related, when one increases, the other also increases and vice versa. The higher the cost is for a transaction, the larger will be the amount (in cash) of marketable securities that will be converted each time a conversion is made, in order to minimize the overall transaction costs.
The payment of a stock
dividend
The payment of a stock dividend is accounted for by reducing retained earnings by a portion of the stock dividend’s value and increasing common stock (or common stock and additional paid-in
capital), Thus, a stock dividend would reduce retained earnings - though it would not reduce total equity - while a stock split would not.
Cash dividends are also accounted for by reducing retained earnings. A cash dividend cannot be paid if there is an insufficient balance in the retained earnings account.
Therefore, payment of a stock dividend could limit the company’s ability to pay future cash dividends, whereas a stock split would not.
What is the optimal plan to implement?
To answer this question, we calculate the net income after tax generated by each of the four plans. We will include the cost of capital to carry the accounts receivable and inventory last, after we have calculated the Operating Income After Tax, since the cost of capital given in the problem is an after-tax cost.
To calculate the cost of capital for each of the four proposed plans, we will multiply the average accounts receivable by 80% (the variable cost of the sales that the company has invested and needs to finance), add the average inventory to it, and multiply the total by the after-tax cost of capital to calculate the after-tax interest expense that will be required to carry the costs in the average accounts receivable and average inventory for one year.
Plan A: (($20,000 * .8) + $40,000) x .15 = $8,400
Plan B: (($40,000 * .8) + $50,000) * .15 = $12,300
Plan C: (($60,000 * .8) + $60,000) * .15 = $16,200
Plan D: (($80,000 * .8) + $70,000) x .15 = $20,100
Net income calculations:
Plan A:($200,000 *.20) - $1,000 - $1,000 = $38,000 net operating income before tax.
Net operating income aftertax = $38,000 *.70 = $26,600. $26,000 - $8,400 after-tax cost of capital = net income of $18,200.
Plan B: ($250,000 *.20)-$3,000-$2,000 = $45,000 net operating income before tax.
Net operating income aftertax=$45,000 *.70 = $31,500. $31,500 - $12,300 after-tax cost of capital = net income of $19,200.
Plan C: ($300,000 *.20)-$6,000 - $5,000 = $49,000 net operating income before tax.
Net operating income aftertax = $49,000 *.70 = $34,300. $34,300 - $16,200 after-tax cost of capital = net income of $18,100.
Plan D: ($350,000 *.20)-$12,000-$8,000 = $50,000 net operating income before tax.
Net operating income aftertax = $50,000 *.70 = $35,000. $35,000 - $20,100 after-tax cost of capital = net income of $14,900.
On a graph of the Security Market Line, betas:
The return to the market is the market return at the point where beta is 1.0. On a graph of the Security Market Line, betas are on the horizontal axis and expected returns are on the vertical axis.
Unsystematic risk is:
Unsystematic risk is risk that affects only one company or one industry and that is separate from economic or political factors that affect all securities systematically. Unsystematic risk can be eliminated in a portfolio through proper diversification.
Systematic risk, or market risk, is:
Systematic risk, or market risk, is the risk that changes in a security’s price will result from changes that affect all firms. Systematic risk, or market risk, cannot be eliminated by diversification in a portfolio. Investors will always be exposed to the uncertainties of the market, no matter how many stocks they hold.
Amount Received from Factoring:
The amount that is going to be received is going to be calculated by starting with the amount of the receivable itself, $100,000. This will be reduced by the reserve and the commission, both of which are calculated from the $100,000 amount. In total, this is 7% and reduces the amount to $93,000. This is the amount on which the interest will be charged. The interest rate is 10% and this gives an annual interest of $9,300. However, the time period before the receivable is due to be collected is only 3 months, so only ¼ of the annual interest will be charged. This is $2,325. This is also withheld from the amount received and brings the amount received down to $90,675.
Receivable =$100,000
Reserve = 6,000 (.06x100,000)
Commission = 1,000 (.01x100,000)
Subtotal = 93,000
Interest calc. = 10% (93000) x .25(90 days)
Interest total = 2,325
Total Received = 90,675
The company increases sales by $100,000 what is the profit after tax:
Sales $100,000 Selling expenses by 70% $ 70,000 Gross Margin $ 30,000 Bad debt expense 15% $ 15,000 Collection expense 5% $ 5,000 Subtotal $ 10,000 Tax rate is 40% $ 4,000 Total $ 6,000
A poison pill:
A poison pill is a defense in which the shareholders of the company have the option to buy the shares of the merged company at a reduced price. Because of this potential dilution of ownership through this discounted sale of shares, an acquiring company will be less likely to buy the company.
Preemptive Rights:
Preemptive rights allow the existing shareholders to purchase the same percentage of a new issuance that they owned of the outstanding shares prior to the issuance. Before the new issue of stock, there were 1,000,000 common shares outstanding ($5,000,000 divided by $5 par value per share). This shareholder held 1 % of the outstanding shares (10,000 shares divided by 1,000,000 shares) before the issuance, so they have the right to purchase 1%, or 2,000 shares, of the new issue.
The Optimum Capital Structure
Financial structure is the composition of the financing sources of the assets of a firm. Traditionally, the financial structure consists of current liabilities, long-term debt, retained earnings, and stock. For most firms, the optimum structure includes a combination of debt and equity. Debt is cheaper than equity, but excessive use of debt increases the firm’s risk and drives up the weighted-average cost of capital.
Factoring Receivables:
In the process of factoring the receivables, the company will save $18,000 per year. However, there will also be some costs associated with this. Of the amount sold, the company will lose 2% of the amount of receivables. This is $24,000 per year ($100,000 * 12 * .02), giving a net cost of $6,000 per year. Additionally, they will need to pay 10% interest on the amount that is advanced to them connected to the factoring. They will receive 80% of the monthly amount of receivables, or $80,000 and because this will be done each month we can treat this as if there is always $80,000 outstanding during the year. The annual interest on this is $8,000 and adding this to the $6,000 net cost gives a total cost of $14,000 to receive a loan of $80,000. Therefore the cost is 17.5% ($14,000 / $80,000).
What is the value of one right?
A stockholder owns 10 shares of S Corporation common stock at a current market price of $10 per share. The corporation will allow each shareholder to buy proportional new shares of stock at $9 per share. Currently, there are 5,000 shares outstanding and 500 new shares will be issued. What is the value of one right.
In order to determine the value of the right when it is selling rights-on. This is done using the following formula
Po-Pn Vr = \_\_\_\_\_\_\_\_\_\_\_\_\_
r+1
Where:
Po = The value of a share with the rights still attached
Pn = The subscription (sales) price of a share
r = The number of rights needed to buy a new share
Vr = The value of the right
Since 5,000 shares are outstanding and 500 new shares will be issued, 10 shares will be required to buy a new share (5,000 / 500).
Putting the values into the formula, we calculate that the value of one right is
10-9
Vr = _____________ =.0909
10+1
If an importer worries that the U.S. dollar
may depreciate sharply against the British pound in the short term, it would be well advised to:
By purchasing pounds now, the American importer is able to determine now the amount of dollars that will be required to settle that invoice when it comes due. As such, they are protected against the situation in which the dollar depreciates against the pound. If the dollar were to depreciate and the importer had not entered into this agreement, they would need to spend more dollars in order to settle the invoice.
Weighted marginal cost of capital:
The cost of the bonds equals the interest rate times one minus the tax rate, or 5.4% [9% x (100% - 40%)]. The cost of preferred stock equals the preferred dividend amount divided by the net issuance price. No tax adjustment is necessary because preferred dividends paid are not tax deductible. The cost of the preferred stock is therefore 6% of the par value of the preferred stock {[$4,800,000 net issuance price / (100% - 4% flotation cost)] = $5,000,000 par value} divided by the net issuance price, or 6.25% [(6% x $5,000,000) / $4,800,000]. The cost of the common stock is given as 15%.
So the weighted average is as follows:
Weighted
Weight Cost Average
Bonds 40% x 5.40% = 2.160%
Preferred Stock 10% x 6.25% = 0.625%
Common Stock 50% x 15.00% = 7.500%
=10.285
U.S. multinational corporation’s use the foreign currency market:
The foreign currency markets will not enable the company to improve the return on the investment of a foreign subsidiary as the foreign currency markets can be used only to protect against losses due to fluctuations of the exchange rate. Assuming that the foreign subsidiary’s return on investments would involve cash inflows and outflows in the foreign subsidiary’s currency only, those cash flows would not be subject to exchange rate risk.
One of those reasons is to reduce the risk of devaluation of dividend payments as a result of
fluctuations of the exchange rate.
The order of priority of the claims against the assets are as follows in a liquidation:
- Secured bonds
- Court/trustee costs
- Credit from suppliers since filing
- Wages payable
- Taxes owed
- Senior unsecured debt
- Junior unsecured debt
- Preferred shares (at par)
- Common shares (at par)
Country R’s currency would tend to depreciate relative to Country T’s currency when
If real interest rates are higher in Country T than in Country R, more people will want to invest in Country T. This will cause the demand for Country T’s currency to increase, and that will lead to appreciation of Country T’s currency relative to Country R’s currency. When Country T’s currency appreciates relative to Country R’s currency, Country R’s currency depreciates relative to Country T’s currency.
Residual Dividend Theory
Under the residual dividend theory it is assumed that the profits of the company should be distributed as dividends only if that is the best use of the money. If the company has investment opportunity that is better than what the shareholders are able to earn, the money should be reinvested and not paid as dividends. When there are no options that provide a higher return than the shareholders earn, the company should pay dividends and let the shareholders make the best investment available to them.
The following economic policies would not tend to correct a balance of payments deficit in the U.S.
An increase in the value of U.S. currency will raise the comparative price of US products. This will reduce the number of U.S. exports and increase imports as the relative price of U.S. goods increases, thus the balance of payments deficit will increase, not decrease, if the value of the US currency increases.
The slope of the Security Market Line.
The slope of the Security Market Line is the market risk premium. The market risk premium is the difference between the return to the market and the risk-free rate. It is also the amount by which the expected return for an individual security or portfolio increases for each 1 unit increase in the security’s or portfolio’s beta, graphed horizontally. For a beta of 0.5, the expected return is 7.5%. For a beta of 1.5 (1.0 greater), the expected return is 16.5%. The difference, 9%, is the slope of the Security Market Line.
Calculate the cost of capital by:
To calculate the cost of capital for each of the four proposed plans, we will multiply the average accounts receivable by 80% (the variable cost of the sales that the company has invested and needs to finance), add the average inventory to it, and multiply the total by the cost of capital to calculate the interest expense that will be required to carry the costs in the average accounts receivable and average inventory for one year.
Plan A: (($1,500 * .8) + $2,000) * .10 = $320
Plan B: (($2,000 * .8) + $2,300) * .10 = $390
Plan C: (($3,500 * .8) + $2,500) * .10 = $530
Plan D: (($5,000 * .8) + $2,500) * .10 = $650
Net income calculations:
Plan A: ($12,000 x .20) - $100 - $100 - $320 + 0 = $1,880 net operating income before tax.
Plan B: ($13,000 x .20) - $125 - $125 - $390 + 0 = $1,960 net operating income before tax.
Plan C: ($14,000 x .20) minus; $300 - $250 - $530 + 0 = $1,720 net operating income before tax.
Plan D: ($14,000 x .20) - $400 - $350 - $650 + $500 = $1,900 net operating income before tax.
The standard deviation:
The standard deviation from the mean of the possible annual returns is within the range of the 68% confidence interval about the mean. The 68% confidence interval represents the range from one standard deviation on the left side of the mean to one standard deviation on the right side of the mean. The mean is 4%, and the range of possible results about the mean that falls within the 68% confidence interval is between 2% and 6%. 2% is 2% below the mean of 4%, and 6% is 2% above the mean of 4%. Thus, the standard deviation must be 2% (equal to the difference between 4% and 2% and also to the difference between 4% and 6%).
A hazard risk :
A hazard risk is the type of risk that can be insured against. For example, the risk of a natural disaster such as a fire or flood can be managed with property insurance; the risk of the death of a key employee can be managed with key person life insurance; and the risk of a person getting injured on the premises can be managed with liability insurance.
Risk assessment:
Risk assessment is the process of analyzing and considering risks from two perspectives: (1) the likelihood of the risk’s occurring and (2) the potential impact of the event if it does occur.
Factoring Formula:
Face amount of the receivables
- Reserve (calculated face amount of receivables)
- Factor’s fee (calculated from the face amount)
= Amount the seller needs to pay interest on
- Interest for time period before collection rec’bles
= Cash Received Now
