Module 44: Financial Management Flashcards
Arbitrage pricing model
Uses a series of systematic risk factors to develop a value that reflects the multiple dimensions of systematic risk
Cash discounts
Discounts for early payment of accounts
Compensating balance
Required minimum level of deposit based on loan agreement
Concentration banking
Payments from customers that are routed to local branch offices rather than firm headquarters. Reduces collection time.
Cost of capital
weighted-average cost of a firm;s debt and equity financing components
Debenture
A bond that is not secured by the pledge of specific property
Economic order quantity (EOQ)
An inventory technique that minimizes the sum of inventory ordering and carrying costs
Electronic funds transfer
The movement of funds electronically without use of a check
Factoring
The sale of receivables to a finance company
Financial leverage
Measures the extent to which the firm uses debt financing
Float
The time that elapses relating to mailing, processing, and clearing checks
Inventory conversion period
The average length of time required to convert materials into finished goods and sell the goods
Just-in-time production
A demand-pull system in which each component of a finished good is produced when needed by next stage of production
Just-in-time purchasing
A demand-pull inventory system in which raw materials arrive just as they are needed for production. Minimizes inventory holding costs
Lockbox system
A system in which customer payments are sent to a post office box that is maintained by a company’s bank. This reduces collection time and improves controls.
Mortgage bond
Bond secured with the pledge of specific property
Operating leverage
Measures the degree to which a firm builds fixed costs into its operations
Payables deferral period
Average length of time between the purchase of materials and labor and the payment of cash for them
Precautionary balances
Cash available for emergencies
Receivables collection period
Average length of time required to collection AR
Speculative balances
Cash available to take advantage of favorable business opportunities
Subordinated debenture
A bond with claims subordinated to other general creditors
Supply chain
Describes the processes involved in a good’s production and distribution
Warehousing
Inventory financing in which inventory is held in a public warehouse under the lender’s control
What is financial management?
Deal with the various types of monetary decisions that must be made by managers in a company, along with the tools and analyses used to make those decisions
Financing function
Raising capital to support the firm’s operations and investment programs
Capital budgeting function
Selecting the best projects in which to invest firm resources, based on a consideration of risks and return
Financial management function
Managing the firm’s internal cash flows and its capital structure (mix of debt and equity financing) to minimize the financing costs and ensure that the firm can pay its obligations when due
Corporate governance function
Developing an ownership and corporate governance aystem for the firm that will ensure that managers act ethically and in the best interest of stakeholders
Risk-management function
Managing the firm’s exposure to all types of risk
Working capital management
Involves managing and financing the current assets and current liabilities of the firm
Cash conversion cycle
Length of time between when the firm makes payments and when it receives cash inflows
How is the cash conversion cycle analyzed?
- Inventory conversion period
- Receivables collection period
- Payables deferral period
Inventory conversion period
Average time required to convert materials into finished goods and sell those goods
Inventory conversion period formula
Average inventory / cost of goods sold per day
*Divide by 365 days if given annual amount
Receivables collection period (DSO - days sales outstanding)
Average time required to collect accounts receivable
Receivables collection period formula (DSO)
Average receivables / credit sales per day
*Divide by 365 days if given annual amount
Payables deferral period
Average length of time between purchase of materials and labor and the payment of cash for them
Payables deferral period formula
Average payables / purchases per day
Average payables /(Cost of goods sold /365)
Cash conversion cycle formula
Inventory conversion period + receivables conversion period - payables deferral period
What is effective working capital management?
Involves shortening the cash conversion cycle as much as possible without harming operations
Why should management maintain a sufficient amount of cash?
- Take advantage of trade discounts
- Maintain its credit rating
- Meet unexpected needs
Why do firms hold cash?
- Transactions
- Compensation to financial institution
Compensating balance
Financial institutions requiring minimum balances
Why do firms prepare cash budgets?
- Take advantage of cash discounts
- Take advantage of business opportunities
- Meet emergencies, such as funds for strikes, natural disasters, and cyclical downturns
Speculative balances
Cash available for favorable business opportunities
Cash discounts
Usually provided by suppliers for early payment of invoices
Precautionary balances
Cash available for emergencies
Cash management: Float
The time that elapses relating to mailing, processing, and clearing checks
Float exists for both the firm’s payments to suppliers and the firm’s receipts from customers
What is effective cash management in regards to the float?
Effective cash management involves extending the float for disbursements and shortening the float for cash receipts
Zero-balance accounts
Maintaining a regional bank account to which just enough funds are transferred daily to pay the checks presented
Regional banks typically receive the checks drawn on their customers’ accounts in the morning from the Federal Reserve
Advantages of zero-balance accounts?
- checks take longer to clear at a regional bank, providing more float for cash disbursements
- Extra cash foes not have be deposited in the account for contingencies
How is a zero-balance account cost-effective?
Firm saves on interest costs from the longer float is adequate to cover any additional fees for account maintenance and cash transfers
Lockbox system
Customer payments are sent to a post office box that is maintained by a bank. Bank personnel retrieve the payments and deposit them into the firm’s bank account
Advantages of a lockbox system
- Increases the internal control over cash because firm personnel do not have access to cash receipts
- Provides for more timely deposit of receipts which reduces the need for cash for contingencies
Cost-effectiveness of a lockbox system
If the interest costs saved due to obtaining more timely deposits is sufficient to cover the net increase in costs of cash receipt processing (bank fees less internal costs saved from having the bank process receipts)
Concentration banking
Customers in an area make payments to a local branch office rather firm headquarters. The local branch makes deposits in an account at a local bank. Then, surplus funds are periodically transferred to the firm’s primary bank.
Float related to cash receipts is shortened.
Wire transfers can involve a significant fee.
Official bank checks
Slower but less expensive way of transferring funds. These are depository transfer checks) which are preprinted checks used to make transfers
Electronic funds transfer
Funds are moved electronically between accounts without the use of a check.
Take the float out of both the receipts and disbursements processes
International cash management
Can use various systems, including electronic systems to manage the cash accounts they hold in various countries.
Marketable securities management
Can be converted to cash very quickly
Advantage over cash in that they provide an investment return
Minimum investment required
Some investments, such as high-yield certificates of deposits, require larger investments
Safety
The risk to principal
Marketability (liquidity)
Relates to the speed with which the investment can be liquidated
Maturity
The length of time the funds are committed
Yield
The higher the yield the better. Also comes with higher risk or longer maturity
Short-term investments: Treasury bills (T-bills)
Short-term obligations of federal government. Any maturity date up to 182 days. The active market ensures liquidity.
Short-term investments: Treasury notes
Government obligations with maturities from one to ten years.
Short-term investments: Treasury Inflation Protected Securities (TIPS)
Government obligations that pay interest that equates to a real rate of return specified by the US Treasury, plus principal at maturity that is adjusted for inflation. These are useful to a firm that wants to minimize interest rate risk.
Short-term investments: Federal agency securities
Offerings of government agencies, such as the Federal Home Loan Bank. Offer security, liquidity, and pay slightly higher yields than treasury issues.
Short-term investments: Certificates of deposit (CD)
Savings deposits at financial institutions; two-tier market for CDs - small ( $500-10,000) with lower interest rates and large ($100,000) with higher interest rates
CDs are not as liquid or safe; normally insured up to $100,000 by the federal government
Short-term investments: Commercial paper
Large unsecured ST promissory notes issued to the public by large creditworthy corporations. Usually had a two-to nine-month maturity period and usually held to maturity by the investor because there is no active secondary market.
Short-term investments: Banker’s acceptance
A draft drawn on a bank for payment when presented to the bank.
Where do banker’s acceptances usually arise?
From payments for goods by corporations in foreign countries.
What is the process for a banker’s acceptance?
The corporation receiving the banker’s acceptance may have to wait 30-90 days to present the acceptance for payment. These instruments usually sell at a discount.
Short-term investments: Eurodollar certificate of deposit
US dollars held on deposit by foreign banks and in turn lent by the banks to anyone seeking dollars. To obtain dollars, foreign banks offer Eurodollar certificates of deposit. As an investment, Eurodollar certificates of deposit pay higher yields than T-bills or certificates of deposit at large US banks
Short-term investments: Money market funds
Shares in a fund that purchases higher-yielding bank CDs, commercial paper, and other large-denomination, higher-yielding securities
Short-term investments: Money market accounts
Similar to savings accounts, individual or business investors deposit idle funds in the accounts and the funds are used to invest in higher-yielding bank CDs, commercial paper
Short-term investments: Equity and debt securities
Investment in publicly traded stocks and bonds of other corporations. Greater risk than other ST investments, but also offer higher average LT returns.
Should purchase a balanced portfolio to diversify away the unsystematic risk (e.g. default risk) of the individual investments
What does effective inventory management start with?
Effective forecasting of sales and coordination of purchasing and production
What are the two goals of inventory management?
- To ensure adequate inventories to sustain operations
- Minimize inventory costs, including carrying costs, ordering and receiving costs, and cost of running out of stock
Seasonal production
Involves increasing production during periods of peak demand and reducing production during slow sales periods. Usually has additional operating costs for such things as overtime wages and maintenance
Level production
Working at a consistent level of effort to manufacture the annual forecasted amount of inventory. Results in inventory buildups during slow sales period.
Inventory and inflation
Price instability occurs in a number of markets; can be hedged partially by controlled holding low levels of inventory
How to hedge risk of inventory and inflation?
Hedge the price movement with a futures contract to sell silver at a specified price in the future
Supply chain
Describes a good’s production and distribution. Illustrates the flow of goods, services, and information from acquisition of basic raw materials through the manufacturing and distribution process to delivery of the product to the consumer.
What is a key aspect of supply chain management?
Sharing of key information from the point of sale to the final consumer back to the manufacturer, to the manufacturer’s suppliers, and to suppliers’ suppliers
Economic order quanitity (EOQ)
Minimizes the sum of the ordering and carrying costs
Carrying costs
Increases with order size
Ordering costs
Decreases with order size
EOQ formula
Square root 2aD / k
a = cost of placing one order D = annual demand in units k = cost of carrying one unit of inventory for one year
Stockouts
Inventory is no longer in stock
Safety stock
Used to guard against stockouts; maintained by increasing the lead time
Lead time
The time that elapses from order placement until order arrival
Examples of carrying costs of safety stock (and inventory)
- Storage
- Interest
- Spoilage
- Insurance
- Property taxes
Examples of stockout costs
- Profit on lost sales
- Customer ill will
- Idle equipment
- Work stoppages
What is the most common approach to setting the optimum safety-stock level?
To examine previous lead time periods to determine the probabilities of running out of stock (stockout)
Materials requirements planning (MRP)
Computerized system that manufactures finished goods based on demand forecasts
What is a key weakness of an MRP system?
Push through system - whether they are needed or not.
MRP II
Extension of MRP and features an automated closed loop system; uses technology to integrate the functional areas of a manufacturing company
JIT (Just-in-time) purchasing
Demand-pull inventory system which may be applied to purchasing so that raw material arrives just as it is needed for production
Primary benefit of JIT purchasing?
- Reduction of inventories ideally to zero
* most important aspect is relationship with suppliers
JIT production
Demand pull system in which each component of a finished good is produced when needed by the next production stage
How to accomplish JIT production?
- Emphasize reducing production cycle time (manufacturing lead time) and setup time
- Emphasize production flexibility
- Emphasize solving production problems immediately
- Focus on simplifying production activities
Manufacturing cells
Produce a product or type of product with the workers being able to operate a number of the different machines
What does JIT reduce?
Scrap and rework
Advantages of JIT?
- Lower investments in inventories and in space to store inventory
- Lower inventory carrying and handling costs
- Reduced risk of defective and obsolete inventory
- Reduced manufacturing costs
- Luxury of dealing with a reduced number of reliable, quality-oriented suppliers
Backflush costing
Simplified costing system. Lack of inventories in a JIT system makes choices about cost-flow unimportant - all manufacturing costs run through COGS
How can JIT systems breakdown?
- Suppliers for not provide timely delivery of quality materials
- Employers are not well trained or supervised
- Technology and equipment are not reliable
Enterprise Resource Planning Systems (ERP)
Enterprise-wide computerized information systems that connect all functional areas within an organization
What does effective receivables management involve?
Involves systems for deciding whether or not to grant credit and for monitoring the receivables.
Management should establish consistent credit evaluation procedures that balance the costs of lost sales with the costs of credit losses (uncollectible accounts)
What should a firm’s credit policy consist of?
- Credit period: length of time buyers are given to pay for their purchases
- Discounts - % provided and period allowed for discount for early payment
- Credit criteria - required financial strength of acceptable credit customers; use credit scoring to evaluate a potential customer
- Collection policy: diligence used to collect slow-paying accounts
Dun & Bradstreet Information Services
Source for credit information; makes available its Business Information Report (BIR)
Days sales outstanding (DSO)
DSO = Receivables / Sales per day
Why do current assets fluctuate from month to month?
Because firms have seasonal fluctuations in the demand for products and services
How are assets financed?
With current liabilities such as AP, commercial bank loans, commercial paper
Permanent current assets
Required to operate business in even the slowest periods of the year
How should permanent current assets be financed?
Financed with long-term financing, such as stock or bonds
Temporary current assets
Inventory, accounts receivable; accumulated during periods of higher production and sales
Aggressive financing
Using extensive amounts of short-term debt to finance current assets
How is interest expense affected by aggressive financing?
Amount of interest expense over time will be more volatile because the firm has not locked in an interest rate on a long-term basis
Conservative financing
Financing some current assets with long-term debt which involves a more stable interest rate
Advantage of conservative financing?
More stable interest rate
Disadvantages of long-term financing?
Provisions or covenants generally constrain the firm’s future actions; prepayment penalties may make early repayment of long-term debt an expensive proposition
Maturity matching/self-liquidating approach
Financing assets involves matching asset and liability maturities; strategy minimizes the risk that the firm will be unable to pay its maturing obligations aka hedging approach
Trade credit (AP)
Significant source of short-term funding
Major advantage of trade credit
Arises in the normal course of conducting business and bears no interest cost, providing it is paid on time
What does terms of 2/10, net 30 mean?
Means that payment is due in thirty days and a 2% discount is allowed for payment within 10 days
What is the approximate cost of not taking the discount?
Discount % / 100% - Discount % times 365 days / Total Pay Period - Discount Period
What does the nominal rate not take into consideration?
The effects of compounding
What is the second most important source of short-term funds?
Notes payable to commercial banks
Maturity
Majority of lending has maturity date of one year or less; typically 90 days
Promissory note
Notes are executed using a signed promissory note; specifies terms of agreement
Interest
Rate for short-term bank loans; can fluctuate with changes in short-term interest rates
Prime rate
Rate a bank charges its most creditworthy customers; rate increases for customers with more credit risk
What is one basis point equal to?
Equal to one hundredth of one percent (0.01%)
London Interbank Offered Rate (LIBOR)
Availability of dollars for loan on the international market
Compensating balances
Loan agreements may require the borrower to maintain an average demand deposit balance equal to some percentage of the face amount of the loan; this increases the effective interest rate of the loan because full amount of loan does not get to be used
How to calculate the effective interest rate on a loan
Principal available = Principal Amount - (Comp. balance % * Principal)
Interest for # of days = Principal * Interest rate * (# days/360 days)
Effective interest rate = Interest paid/Principal available * (360 days/90 days)
Informal line of credit
An informal specification of the maximum amount that the bank will lend the borrower
Revolving credit agreements
A line of credit in which the bank is formally committed to lend the firm a specified maximum amount. The bank typically receives a commitment fee as part of the agreement (usually used for intermediate-term financing)
Letter of credit
Instrument that facilitates international trade; usually issued by importer’s bank, that promises the bank will pay for the imported merchandise when delivered; designed to reduce the risk of nonpayment by the importer
Commercial paper
Form of unsecured promissory note issued by large, creditworthy firms; maturity dates from 1-9 months; favorable for corporations with the financial strength to issue it; rate is often 2 to 3% less than the prime rate and no compensating balances
Disadvantage to commercial paper
Market is less predictable than bank financing
Pledging of receivables
Committing the receivables as collateral for a loan from a financial institution; interest rate will depend on the financial strength of the firm and the quality of the receivables; financial institution will typically lend 60-80% of the receivables
Disadvantage of pledging of receivables
Interest is computed based on the outstanding loan balance and tends to be quite hight
Advantage for small companies for pledging receivables
Interest rate will be less than for unsecured loans
Factoring
Accounts receivable are sold outright to a finance company, who is directly involved in credit decisions
Finance company generally paid a fee of 1 to 3% of the invoices accepted; finance company also receives the interest rate for advancing the funds
Example of factoring:
Finance company charges a 2% fee and a 12% interest rate for factoring firm’s receivables which are payable in 30 days. Calculate effective interest rate.
2% fee; 1% interest for 1 month (12% annual/12); 3% monthly x 12 = 36% annual rate
Asset-backed public offerings
e.g. bonds
Collateralized by the firm’s AR. Securities generally have high credit ratings even though issuing firm may have a lower credit rating
aka securitization of assets
Inventory financing
Firm may borrow funds using inventory as collateral; extent of feasibility depends on the marketability of the inventory
e.g. lumber, metals and grains are easily used as collateral
Blanket inventory lien
Legal document that establishes the inventory as collateral for the loan; no physical control over inventory is involved
Trust receipt
Instrument that acknowledges that the borrower holds the inventory and that proceeds from sale will be put in a trust for lender; each item tagged and controlled by serial number; when inventory is sold, funds are transferred to the lender and trust receipt is cancelled
aka floor planning
Warehousing
Most secure form of inventory financing; inventory is stored in public warehouse or under control of public warehouse personnel
Private Debt
Two principal types
- loans from financial institutions; almost have universal floating interest rate that is tied to a base rate, usually LIBOR or prime rate
- Private placement of unregistered bonds sold directly to accredited investors (often pension funds or insurance companies); less expensive to issue than public debt
Public long-term debt
Selling SEC registered bonds directly to investors; bond agreement specifies the par value, coupon rate, and maturity date of debt
Par value
face amount of bond; most corporate bonds have $1,000 face amount
Coupon rate
Interest rate paid on face amount of bond; market value of the bond fluctuates with changes in the market interest rate
Maturity date
Final date on which repayment of the bond principal is due
Public LT debt example:
Issued $500,000 in 6% bonds, maturing in 20 years; interest paid semi-annually
Coupon rate is paid in installments of $30 (3% x $1,000) every 6 month for each $1,000 bond
Annual interest is $30,000 ($500,000 x 6%)
What happens if market rate of interest increases to 7% after the bonds are issued?
-Mrkt value of bonds will decline to an amount that will allow a new purchaser to realize a 7% yield to maturity
What happens if market rate of interest decreases to 5%?
-Market price of bons will increase to an amount that will allow the new purchaser to earn only a 5% YTM
Eurobond
Bond payable in the borrower’s currency but sold outside the borrower’s country
E.g. bond of US firm, payable in US dollars, might be sold in Germany, London and Japan through an international syndicate of investment bankers
Advantages of Eurobonds
Registration and disclosure requirements for Eurobonds are less stringent than those of the SEC for US issued bonds; cost of issuance is less
Debt covenants
Restrictions to private and public debt agreements; allow investors (lenders) to monitor and control the activities of the firm
Examples of negative debt covenants
- Sale of certain assets
- Incurrence of additional debt
- Payment of dividends
- Compensation of top management
Examples of positive debt covenants
- Provide audited financial statements each year
- Maintain certain minimum financial ratios
- Maintain life insurance on key employees
Secured debt
One in which specific assets of the firm are pledged to the bondholders in the event of default
Mortgage bond
Bond secured with pledge of specific property
Collateral trust bond
Bond secured by financial assets of the firm
Debenture
Bond that is not secured by the pledge of specific property; general obligation of firm; can only be issued by firms with highest credit rating; higher yield than mortgage bonds and other secured debt
Subordinated debenture
Bond with claims subordinated to other general creditors in the event of bankruptcy of the firm; bondholders receive distributions only after general creditors and senior debt holders have been paid
Income bond
Bond with interest payments that are contingent on the firm’s earnings; higher degree of risk and carry even higher yields; associated with firms undergoing restructuring
Serial payments (serial bonds)
Paid off in installments over the life of issue; desirable to bondholders because they can choose their maturity date
Sinking fund provisions
Firm makes payment sinto a sinking fund which is used to retire bonds by purchase
Conversion
Bonds may be convertible into common stock and this may provide the method of payment
Redeemable
Bondholder may have right to redeem the bonds for cash under certain circumstances (e.g. if firm is acquired by another firm)
A call feature
Bonds may have call provision allowing firm to force bondholders to redeem bonds before maturity; these typically call for payment of a 5 to 10% premium over par value to redeem the bonds
Why don’t investors like call features?
They may be used to force them to liquidate their investment
What are the three different yields relevant to bonds?
- Coupon rate
- Current yield
- Yield to maturity (YTM)
What is the price of a bond dependent upon?
Current risk-free interest rate and the credit risk of the particular bond
E.g. Moody’s Investor Service
Current yield formula
Interest payment / Current price of the bond
YTM formula
NUMERATOR
Annual interest payment + (principal payment - bond price)/# years to maturity
Denominator
0.6 (price of bond) + 0.4(principal payment)
