Financial_Management 2

Question 1

How is Net Working Capital calculated?

Answer 1

NWC : Current Assets - Current Liabilities

An aggressive working capital policy would

• focus on high profitability potential, despite the cost of high risk and low liquidity.
• work to reduce current assets, in relation to current liabilities.

Question 2

Sharpe measure formula

Answer 2

The formula for the Sharpe measure for portfolio performance is

= (Portfolio return - Risk free rate) ÷ Standard deviation.

Question 3

What is Economic Order Quantity?

Answer 3

EOQ = Square root of (2aD/k)
Where
a = cost of placing one order
D = annual demand in units
k = cost of carrying one unit of inventory for one year.

Economic order quantity (EOQ) is the quantity of inventory that should be ordered at one time in order to minimize the associated costs of carrying and ordering inventory, such as purchase-order processing, transportation, and insurance

Assumptions of economic order quantity analysis include the following:

• Periodic demand for the good is known.
• Total carrying costs vary with quantity ordered.
• Costs of placing an order are unaffected by quantity ordered.
• Purchase costs per unit are not affected by quantity discounts.

Question 4

Inventory Turnover Ratio

Answer 4

The Inventory Turnover Ratio measures the speed with which inventory can be converted into sales. In other words, the control that management has over inventory is assessed. The quality of the inventory is determined by the company’s ability to use and dispose of inventory without a loss.

Cost of Goods Sold

Inventory Turnover = —————————–
Average Inventory

A very high inventory turnover could be the result of very low inventory levels. If this is the case, a serious risk of stockouts could exist. Management should certainly check this situation out.

Question 5

Economic value added (EVA)

Answer 5

EVA = After tax operating income - [WACC × (Total assets - Current liabilities)]

Economic value added (EVA) is after-tax operating income less the weighted average cost of capital (after tax) multiplied by the total assets minus current liabilities.

Economic value added (EVA) measures surplus or excess value created by an enterprise’s investments. EVA is calculated as return on capital minus cost of capital multiplied by invested capital. It is similar to net present value and, specifically, to residual income. Shortcomings of EVA include the focus on past, rather than future performance, and its complexity restricts its use to larger businesses.

Question 6

The formulas for portfolio performance :

• Sharpe measure,
• Treynor index
• Jesen measure

Answer 6

The formula for the Sharpe measure for portfolio performance is (Portfolio return - Risk-free rate) ÷ Standard deviation.

The formula for the Treynor index for portfolio performance is (Portfolio return - Risk-free rate) ÷ Beta.

The formula for the Jensen measure of portfolio performance measure of return on portfolio is Risk-free rate + ((Return on market index - Risk-free rate) × Beta).

Question 7

A compensating balance

Answer 7

A compensating balance is a cash balance left on account with the bank in exchange for a loan. It is usually a specified percentage of the amount of the loan, and is often required as collateral or to secure a more desirable stated interest rate. The actual effect is to decrease the actual balance borrowed and to increase the effective interest rate (the cost to the borrower). The compensating balance must be disclosed.

Example
Business A borrows $100,000 at 8%. Compensating balance is 20%.

Thus, Business A receives $80,000 and $20,000 (20% × $100,000) remains “on deposit” with the bank as the compensating balance until repaid.

Business A repays $108,000 ($100,000 face value plus 8% × $100,000 = $8,000 interest). However, the $8,000 interest on the $80,000 that Business A had available to it represents a 10% effective interest rate.

Question 8

Poison put clause and Affirmative covenant

Answer 8

• A poison put clause is a covenant that obliges the borrower to repay the bonds if a large quantity of common stock is held by a single investor and the bond rating is downgraded. This type of bond covenant is used as a defensive strategy to prevent hostile takeovers.
• An affirmative covenant is a covenant that requires a corporation to maintain, at all times, some minimum level of working capital.

Question 9

Materials requirements planning (MRP)

Answer 9

Materials requirements planning (MRP) is a computerized system that manufactures finished goods based on demand forecasts. Demand forecasts are used to develop bills of materials that outline the materials, components, and subassemblies that go into the final products. Finally, a master production schedule is developed that specifies the quantity and timing of production of goods, taking into account the lead time required to purchase materials and to manufacture the various components of finished products. A key weakness of MRP is that it is a “push through” system

(a) Meets forecasted sales demands by balancing existing production capacity and raw materials needs. (b) Since goods are produced based on sales forecasts, it is often referred to as push manufacturing.

.

Question 10

The beta coefficient in the capital asset pricing model (CAPM)

Answer 10

The beta coefficient in the capital asset pricing model (CAPM) measures the market risk of a security relative to other securities.

In the CAPM equation, ke = Rf + b(Km - Rf), the beta coefficient is the term “b”.

The other terms in the equation are:

• *ke:** the required return on the security on the part of investors,
• *Km:** the average return in the market on all securities, and
• *Rf:** the risk-free rate of return, usually measured as the present return on Treasury bills.

The beta coefficient is calculated by using a regression analysis of a firm’s historical total return each year, regressed against the market’s historical average return in the same years.

A beta of 1.0 indicates that the security has the same (systematic or market) risk as the average security in the market. A beta greater than 1.0 indicates that the security fluctuates more than the average security over the business cycle, and is thus riskier. Investors will require a higher-than-average return on this security. A beta smaller than 1.0 indicates that the security fluctuates less than the average security over the business cycle, and thus investors will accept a lower rate of return on the security. Securities with high betas are typically those in firms producing luxury goods or services, where sales and profits expand and contract a great deal in response to the state of the economy over the business cycle. Securities with low betas are typically those from firms that sell necessities; thus, public utilities have betas less than 1.0. Some securities, such as stocks, usually fluctuate with changes in the business cycle. Other securities, like short-term government securities, do not fluctuate directly with the business cycle, and thus have a beta of “0.”

Large investment firms publish beta coefficient for commonly traded stocks. There are slightly different ways to calculate a beta, and some betas are adjusted for the additional risk posed by the firm’s level of debt (leverage).

Question 11

A rational approach to capital budgeting

Answer 11

A rational approach to capital budgeting requires that for an investment to be undertaken, it should at a minimum produce a return that equals or exceeds the firm’s cost of capital.

Question 12

Market Risk

Answer 12

Market risk is the risk associated with a security that cannot be eliminated by diversification. This includes such things as recessions, inflation, and changing interest rates that affect all firms. This is also known as systematic risk.

Question 13

Operating leverage

Answer 13

Operating leverage is the impact on operating income resulting from a change in sales. The change in operating income is affected by the relative amounts of fixed and variable costs within total costs. The higher the fixed costs in relation to variable costs (due to such things as large investments in automation, etc.), the greater the impact on operating income from a change in sales.

The degree of operating leverage is calculated from the ratio of the operating income change divided by the change in sales.

A high degree of operating leverage indicates a firm’s profits will be more sensitive to changes in sales.

% Change in Net
Operating Income Contribution Margin
DOL = ——————————– = ———————————
% Change in Sales Contribution Margin - Fixed Costs

Question 14

Financial Leverage

Answer 14

a. Financial Leverage refers to the extent to which debt and preferred stock (fixed-income securities) are used in the capital structure. The larger the percentage of debt and preferred stock that is used for financing, the greater the risk that the company will not earn enough to cover the fixed interest and preferred dividend payments. The more leverage, the greater the risk, and the higher the cost of capital.
b. Degree of Financial Leverage is the percentage change in earnings available to common stockholders related to a given percentage change in EBIT.
% Change in Net Income EBIT
DFL = —————————————— = —————
% Change in Net Operating Income EBIT - Interest

Question 15

The hedging approach to financing

Answer 15

Under the hedging approach, the length of financing term is matched to the life or duration of assets financed. Long-term assets are financed with long-term debt and short-term assets (such as current assets) are financed with short-term debt.

Question 16

The quick ratio

Answer 16

The computation is Quick assets ÷ Current liabilities OR (Cash + MES + AR) ÷ Current liabilities.

The quick ratio is a liquidity ratio that measures the firm’s ability to discharge currently maturing obligations from most liquid (quick) current assets, cash, marketable equity securities (MES), and accounts receivable (AR). It is more precise than the current ratio because only highly liquid assets are used (i.e., inventories—less liquid and more likely to incur losses in the event of liquidation—and prepaid assets are excluded). It measures immediate liquidity.

Question 17

Average gross receivable balance

Answer 17

= Average daily sales × Average collection period

Question 18

Gross Margin Ratio

Answer 18

a. The Gross Margin Ratio compares the gross margin (gross profit) generated by the net sales revenue. In other words, what percentage of the sales dollars were used to cover the cost of goods sold? The remaining amount is left to cover the general and administrative expenses as well as to provide a profit. This is also known as the gross profit ratio.
Gross Margin
Gross Margin in Ratio = ——————————-
Net Sales Revenue
b. This ratio is generally more useful to management than to creditors or investors since the data necessary to analyze why changes occurred in the ratio are only available internally. Changes are caused by one of the following elements or a combination of the following items.

1. Increase/decrease in unit sales price
2. Increase/decrease in cost per unit

c. Gross margin ratio evaluates a company’s profitability. Profitability is the ability of an enterprise to maintain a satisfactory dividend policy while at the same time steadily increasing ownership equity.

Question 19

Cost of Goods Sold

Answer 19

The cost of goods sold is all costs that were included in the value of the units of finished product sold during the period.

Beginning finished goods inventory

+ Cost of goods manufactured

= Cost of goods available for sale

- Ending finished goods inventory

= Cost of goods sold

Question 20

What is inventory reorder point?

Answer 20

How low inventory should get before it should be re-ordered. IOP :

Average Daily Demand (Usage per day) x Average Lead Time.

The reorder point (RP) is the inventory level at which an order for the economic order quantity (EOQ) is placed. It is the level of inventory equal to (or less than) the units of demand during lead-time (DLT) plus any required safety stock (SS).

The formula for the reorder point is RP = DLT + SS, where DLT is average demand during the lead-time period and SS is safety stock.

Question 21

Average collection period

Answer 21

Average collection period is an activity ratio that measures the average number of days needed to collect trade accounts receivable. It measures how rapidly the firm’s credit sales are being collected (the lower the ratio, the more efficient the collection).

Computation:

• 365 ÷ AR Turnover, or
• 365 ÷ (Net Credit Sales ÷ Average AR), or
• Average AR ÷ Average Daily Sales, or
• Average AR ÷ (Net Credit Sales ÷ 365).

Limitations on use of this ratio: The ratio should be computed on credit sales only (otherwise a shift in the percentage of credit sales to cash sales will affect the ratio)—use of total sales will affect the ratio. Average accounts receivable should be used, net of the allowance for doubtful accounts.

Question 22

Cost of Trade Credit

Cost on an annual basis of not taking the discount

Answer 22

The return on taking discount can also be calculated using the following formula:
` 360 Percentage of Discount————————————- x —————————–Total Credit Period - Discount Period 100% - Percentage of Discount`

Exemple Terms of trade credit of 3/10, net 45 means a 3% discount may be taken if the bill is paid in 10 days or the full amount must be paid in 45 days. If a retailer’s payment terms of trade are 3/10, net 45 with a particular supplier, for every $100 the retailer pays in 10 days, he only has to pay $97.

Therefore, the actual interest rate for the period is derived by calculating .03 ÷ .97 or 3.093%. This interest rate is charged over a time period of 35 days (45 days minus 10 days). There are 10.286 35-day periods in 360 (360 ÷ 35). Therefore, the cost of not taking the discount on an annual basis is 10.286 × 3.093% or 31.81%.

Question 23

Accounts receivable turnover

Answer 23

a. The Accounts Receivable Turnover Ratiomeasures both the quality and liquidity of the accounts receivable.
` Net Credit Sales Accounts Receivable Turnover = ————————— Average Accounts Receivable` b. The quality of the receivables is defined as collection without losses. It is assumed that the longer that receivables are outstanding, the more likely it is that they will not be collected. c. The turnover is an indicator of the age of the receivables. It indicates how many times, on average, the receivables are generated and collected during the year.

Question 24

Depository Transfer Checks

Answer 24

Depository Transfer Checks (DTCs) are official bank checks that provide a means of moving funds from one account to another within the banking system. A DTC is payable to a particular account in a particular bank.

1. The payer prepares and mails a DTC. 2. The DTC is deposited by the payee (often through the use of a lockbox). 3. The DTC is sent to a concentration bank that serves as a clearing house for funds within the banking system. Often the lockbox is located at the concentration bank as a means of speeding up the collection process. 4. The concentration bank begins the clearing process by sending the check to the central bank. 5. Ultimately, the funds are deducted from the payer’s account when the payer’s bank is notified of the funds transfer.

Question 25

The differences between fair market value and fair value

Answer 25

The differences between fair market value and fair value are quite substantial:

• Fair market value implies a willing buyer and seller, whereas the buyer and seller under fair value are not necessarily willing.
• Fair market value defines the seller as hypothetical, whereas there is a specific seller when using fair value.
• Fair market value takes advantage of an unrestricted market, whereas fair value uses the principal or most advantageous market.

Question 26

There are three basic valuation approaches:

Answer 26

There are three basic valuation approaches:

The cost approach
The market approach
The income approach

• The market approach to determining fair value uses market comparisons of identical or comparable items. A comparable item is one that has reasonable and justifiable similarity to the item being valued, be that a single asset or an entire business.
• The cost approach to determining fair value is an example of the economic substitution principle. In other words, what would it cost to replace the item in question with an asset of like function and capacity?
• The income approach to determining fair value focuses on the company’s ability to create earnings or some other benefit stream, such as cash inflows, and the risk related to that investment. An investor will approach any investment from the perspective of the expected future benefit streams, and the requirement that those future benefit streams need to cover not only the cost of the initial investment but also a return commensurate with its risk.

Question 27

Control Precision and Control Sufficiency

Answer 27

Two important definitions related to the internal control process are control precision and control sufficiency:

• Control precision is the alignment between a risk and the control activity designed to mitigate that risk. In other words, a control activity that has a direct influence on the achievement of a stated objective is considered to be more precise than one that only has an indirect influence.
• Control sufficiency is a group of controls with a variety of degrees of precision necessary to achieve a control objective. For example, there would potentially be a number of control activities such as segregation of duties, reconciliation of bank statements, and daily deposits of receipts in order to protect all incoming receivable payments from theft or fraud.