Study Session 11

What is the second principle of capital budgeting?

Cash flows are based on opportunity costs -opportunity costs are cash flows that a firm will lose by undertaking the project under analysis. include these in analysis.

Pro forma balance sheets and pro forma income statements

• forward-looking financial statements that are constructed based on specific assumptions about future business conditions and firm performance

Nonbank sources of short term funding

-dont have access to banks. more costly -large, creditworthy companies can issue commercial paper- the interest costs are slightly less than the rate they could get from a bank

bond equivalent yield (short term discount securities)

bond equivalent yield = (face value-price)/price x (365/days to maturity) = holding period yield x (365/days)

What is the fifth principle of capital budgeting?

-financing costs are reflected in the project's required rate of return -do not consider financing costs specific to project when estimating incremental cash flows

LOS 40.f: Evaluate a company's management of accounts receivable, inventory, and accounts payable over time and compared to peer companies

-first calculate the average days of receivables and compare this ratio to the firm's historical performance or to the avg ratios of comparale companies. can use an aging schedule to see how current they are. -can also look at the weighted average collection period- which indicates the average days outstanding per dollar of receivables

Independent vs. mutually exclusive projects

-independent projects are projects that are unrelated to each other and allow for each project to be evaluated on its own profitability -mutually exclusive means that only one project can be accepted

What is the capital budgeting process?

-it is the process of identifying and evaluating capital projects, that is, projects where the cash flow to the firm will be received over a period longer than a year. -Four administrative steps ‣ Step One: Idea Generation: most important. ‣ Step Two: Analyzing project proposals: cash flow forecast ‣ Step Three: Create the firm-wide capital budget: prioritize profitable projects. consider strategy ‣ Step Four: Monitoring decisions and conducting a post-audit:

LOS 39.e: Calculate the effect of a share repurchase on book value per share

BVPS will decrease if the repurchase price is greater than the original BVPS and increase if the repurchase price is less than the original BVPS

Calcuating a company's weighted average cost of capital

WACC = (Wd)(kd(1-t)) + w(ps)(kps)+(wce)(kce)

LOS 39.f: Explain why a cash dividend and a share repurchase of the same amount are equivalent in terms of the effect on shareholders' wealth, all else being equal

because shares are repurchased using a company's own cash, a share repurchase can be considered an alternative to a cash dividend as a way of distributing earnings to shareholders.

Cash Management Investment Policy

start with an investment policy statement that outlines the purpose and objective of the investment portfolio, guidelines about the strategy and types of securities to be used. make sure to not take on too much credit or liquidity risk.

What are the effects of stock dividends and stock splits?

they both increase the total number of shares outstanding, but because stock price and earnings per share are adjusted proportionally, the value of a shareholder's total shares is unchanged

Factors that influence a company's liquidity position

• factors that weaken a company's liquidity position are called drags and pulls on liquidity • drags on liquidity delay or reduce cash inflows, or increase borrowing costs. examples: uncollected receivables and bad debts, obsolete inventory and tight short-term credit due to economic conditions. • pulls on liquidity: accelerate cash outflows. Examples include paying vendors sooner than is optimal and changes in credit terms that require repayment of outstanding balances

The cost of Preferred Stock

-Kps = Dps / P -Where Dps = preferred dividends -P = market price of preferred

Bond yield plus risk premium approach

Kce = Bond yield + Risk Premium

Audit committee

• committee ensures that the financial information provided to shareholders is complete, accurate, reliable, relevant, and timely. investors must determine whether: -proper accounting and auditing procedures have been followed -the external auditor is free from management influence -any conflicts between the external auditor and the firm are resolved in a manner than favors the shareholder -independent auditors have authority over the audit of all the company's affiliates and divisions -all board members serving are independent -financial experts -vote on approval of board's selection of the external auditor -have authority to approve or reject any proposed non audit engagements with the external audit firm -the firm has provisions and procedures that specify to whom the internal auditor reports. -any discussions of questionable accounting rules, fraud and the like -audit committee control audit budget

Investors when analyzing the remuneration/compensation committee should determine whether:

• executive compensation is appropriate • firm has provided loans or use of property to board members • committee members regularly attend • policies in place • firm provided compensation details to public • terms and conditions of options granted are reasonable • any obligations regarding share-based compensation are met through issuance of new shares • the firm and the board are required to receive shareholder approval for any share-based remuneration plans, because these plans can create potential dilution issues. • senior executives from other firms have cross-directorship links with the firm or committee members. watch for situations where individuals may benefit directly from reciprocal decisions on board compensation.

In evaluating management, investors should:

• verify that the firm has committed to an ethical framework and adopted a code of ethics • see if the firm permits board members or management to use firm assets for personal reasons • analyze executive compensation to assess whether it is commensurate with responsibilities and performance • look into the size, purpose, means of financing, and duration of any share repurchase programs.

For confidential voting, check whether:

•the firm uses a third party to tabulate votes • the third party or the firm retains voting records • the tabulation is subject to audit • shareholders are entitled to vote only if present

What are stock dividends?

-dividends paid out in new shares of stock rather than cash -results in more shares outstanding, but each one will be worth less -commonly expressed as a percentage -a 20% stock dividend means every shareholder gets 20% more stock

Percentage discount from face value:

% Discount = (Face Value - price) / Face Value

What is the opportunity cost of equity capital?

- It is the required rate of return on the firm's common stock -The firm could avoid part of the cost of common stock outstanding by using retained earnings to buy back shares of its own stock. -Cost of equity can be estimated using either CAPM, dividend discount model approach or bond yield plus risk premium approach

Money market yield

-(face value-price)/price x (360/days) = holding period yield x (360/days) -days = days to maturity -price= purchase price of the security

LOS 37.d: Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget

-A firm's WACC may increase as larger amounts of capital are raised. thus, its marginal cost of capital, the cost of raising additional capital, can increase as larger amounts are invested in new projects. this is the upward sloping marginal cost curve. rank IRRs to get investment opportunity schedule. -intersection is called the optimal capital budget. the firm should undertake all those projects with IRRs greater than the cost of funds

LOS 37.i: Calculate and Interpret the beta and cost of capital for a project

-A project's beta is a measure of its systematic or market risk. -Can use the pure play method-being with the beta of a company or group of companies that are purely engaged in a business similar to that of the project and are therefore comparable to that project. -Beta of a firm is function of business risk of projects and also financial structure... thus need to adjust the pureplay beta from a comparable companmy for the company's leverage and then adjust it based on the financial structure of the company evaluating the project. To get the asset beta for a publicly traded firm, we use the following formula: Βasset = βequity ( 1 /( 1+(1-t)D/E)) To get the equity beta for the project, we use the subject firm's tax rate and debt-to-equity ratio: βProject = βAsset (1+(1-t)D/E)

What are the several challenging issues involved in estimating the beta of the comparable company's equity?

-Beta is estimated using historical returns data. The estimate is sensitive to the length of time used and the frequency (daily, weekly, etc.) of the data -The estimate is affected by which index is chosen to represent the market return -Betas are believed to revert toward 1 over time, and the estimate may need to be adjusted for this tendency -Estimates of beta for small-capitalization firms may need to be adjusted upward to reflect risk inherent in small firms that is not captured by the usual estimation methods.

LOS 37.j: Explain the country equity risk premium in the estimation of the cost of equity for a company located in a developing market

-CAPM to estimate cost of equity is tough in developing countries because does not account for country risk -Country risk premium is added to marker risk premium -Look at the country's sovereign yield spread-the difference in yields between the developing country's government bonds (denominated in the developed market's currency) and treasury bonds of a similar maturity. -To estimate an equity risk premium for the country, adjust the sovereign yield spread by the ratio of volatility between the country's equity market and its government bond market (for bonds denominated in the developed market's currency). A more bolatile equity market increases the country risk premium, other things equal.

How do you calculate the country risk premium?

-CRP = Sovereign yield spread x (Annualized standard deviation of equity index of developing country/annualized standard deviation of sovereign bond market in terms of the developed market currency) -Sovereign yield spread = diff between the yields of gov't bonds in the developing country and treasury bonds of similar maturities

What are flotation costs?

-Flotation costs are the fees charged by investment bankers when a company raises external equity capital. Flotation costs canbe substantial and often amount to between 2% to 7% of the total amount of equity capital raised, depending on the type of offering.

Capital components and their component costs

-Kd = the rate at which the firm can issue new debt. This is the yield to maturity on existing debt. This is also called the before-tax component cost of debt. -Kd (1-t) = the after-tax cost of debt. Here, t is the firm's marginal tax rate. The after-tax component cost of debt, kd(1-t), is used to calculate the WACC. -kps = the cost of preferred stock -kce = cost of common equity. it is the required rate of return on common stock and is generally difficult to estimate.

LOS 37.k: Describe the marginal cost of capital schedule, explain why it may be upward-sloping with respect to additional capital, and calculate and interpret its break-points

-Marginal cost of capital (MCC) is cost of the last new dollar of capital a firm raises. As raise more debt, cost of it increases. Also, issuing new equity is more expensive than using retained earnings due to flotation costs. Bottom line-raising additional capital results in an increase in the WACC -The marginal cost of capital schedule shows the WACC for different amounts of financing. Because different sources of financing become more expensive as the firm raises more capital, the MCC schedule typically has an upward slope. -Break points occur any time the cost of one of the components of the company's WACC changes. A break point is calculated as: Break point = amount of capital at which the component's cost of capital changes / weight of the component in the capital structure

Relationship of NPV and stock price

-NPV method is a direct measure of expected change in firm value from undertaking a capital project, it is also the criterion most related to stock prices -more complicated due to expectations

Profitability Index

-PV of a project's future cash flows divided by the initial cash outlay or 1 + NPV / initial cash flow -if NPV positive, PI will be greater than one -PI >1 accept, <1 reject

Explain the correct treatment of flotation costs

-So the incorrect method has flotation costs increasing WACC by a fixed percentage and will be a factor for the duration of the project because future project cash flows are discounted at the higher WACC to determine project NPV. -Problem with that approach is that flotation costs are not an ongoing expense for the firm. Outflow at initiation of porject and affect NPV by increasing the initial cash outflow. -Therefore, the correcy way is to adjust the initial project cost. Calculate the dollar amount of flotation costs attributableto the project and increase the initial cash outflow for the project.

What is the third principle of capital budgeting?

-The timing of cash flows is important -time value of money

Notes on breakeven

-a firm that chooses operating and financial structures that result in greater total fixed costs will have a higher breakeven quantity of sales -leverage of either type magnifies the effects of changes in sales on net income

LOS 39.d: Calculate and compare the effects of a share repurchase on earnings per share when 1) the repurchase is financed with the company's excess cash and 2) the company uses funded debt to finance the repurchase.

-a share repurchase will reduce the number of shares outstanding, which will tend to increase earnings per share -on other hand, purchasing shares with company funds will reduce interest income and earnings, and purchasing shares with borrowed funds incurs interest costs, which will reduce earnings directly by the after-tax cost of the borrowed funds. -the relation of the percentage decrease in earnings and the percentage decrease in number of shares used to calculate EPS will determine whether the effect of a stock repurchase on EPS will be positive or negative. -conclusion: share repurchase using borrowed funds will increase EPS if the after-tax cost of debt used to buy back shares is less than the earnings yield of the shares before the repurchase. It will decrease EPS if the cost of debt is greater than the earnings yield, and it will not change EPS if the two are equal.

When evaluating the qualifications of board members, consider whether board members:

-can make informed decisions about the firm's future -can act with care and competence as a result of their experience with: ‣ Technologies, products, and services which the firm offers ‣ financial operations and accounting and auditing topics ‣ legal issues ‣ strategies and planning ‣ business risks the firm faces -have made any public statements indicating their ethical stances -have had any legal or regulatory problems as a result of working for or serving on the firm's board or the board of another firm -have other board experience -regularly attend meetings -are committed to shareholders. Do they have significant stock positions? have they eliminated any conflicts of interest? -have necessary experience and qualifications -have served on the board for more than ten years. While this adds experience, these board members ma be too closely allied with management

What is the fourth principle of capital budgeting?

-cash flows are analyzed on an after-tax basis -the impact of taxes must be considered when analyzing all capital budgeting projects.

Degree of total leverage

-combines the degree of operating leverage and financial leverage. DTL measures the sensitivity of EPS to change in sales. DTL is computed as: DTL= %ΔEBIT/%ΔSales x %ΔEPS/%ΔEBIT = %ΔEPS/%ΔSales DTL = Q(P-V) / Q(P-V)-F-I DTL = S-TVC / S-TVC-F-I

Operating Breakeven quantity of sales

-consider only fixed operating costs and ignore fixed financing costs -Qobe = Fixed operating costs / price - variable cost per unit

LOS 42.a: Define corporate governance

-corporate governance is the set of internal controls, processes, and procedures by which firms are managed -it defines the rights, roles, and responsibilities of management, the board of directors, and shareholders within an organization. -it is the firm's checks and balances

Dividend payment language

-declaration date: the date the board of directors approves payment of the dividend -ex-dividend date: the first day a share of stock trades without the dividend. the ex-dividend date is also the cutoff date for receiving the dividend and occurs two business days before the holder-of-record date. if you buy the share on or after the ex-dividend date, you will not receive the dividend -holder-of-record date: the date on which the shareholders of record are designated to receive the dividend -payment date: the date the dividend checks are mailed out or when the payment is electornically transferred to shareholder accounts. -stocks prices fall on ex dividend date. because of taxes, drop in price may be closer to the after-tax value of dividends

Degree of operating leverage

-defined as the percentage change in operating income (EBIT) that results from a given percentage change in sales DOL = Percentage change in EBIT / Percentage change in sales DOL= ΔEBIT/EBIT /ΔQ/Q To calculate a firm's DOL for a particular level of unit sales, Q, DOL is: ‣ DOL = Q(P-v)/Q(P-V)-F ‣ Q = quantity of units sold, p = price per unit, v = variable cost per unit, f=fixed costs ‣ DOL = S-TVC / S-TVC-F..... denominator is operating earnings (EBIT) ‣ DOL is highest at low levels of sales and declines at higher levels of sales

LOS 38.a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk, and classify a risk, given a description

-leverage refers to the amount of fixed costs a firm has ‣ could be fixed operating expenses, fixed financing costs ‣ greater leverage leads to greater variability of the firm's after tax operating earnings and net income -business risk refers to the risk associated with a firm's operating income and is the result of uncertainty about a firm's revenues and expenditures necessary to produce those revenues. Business risk is the combination of sales risk and operating risk ‣ sales risk: uncertainty about the firm's sales ‣ operating risk: additional uncertainty about operating earnings caused by fixed operating costs. the greater proportion of fixed costs to variable costs, the greater a firm's operating risk -financial risk refers to the additional risk that the firm's common stockholders must bear when a firm uses fixed cost (debt) financing. when finance with debt, it takes on fixed payments. greater debt, greater financial risk.

The Relative Advantages and Disadvantages of the NPV and IRR Methods

-main disadvantage of NPV is it does not include any consideration of the size of the project -a key advantage of IRR is that it measures profitability as a percentage, showing the return on each dollar invested. we can tell how much below the IRR the actual project return could fall, in percentage terms, before the project becomes uneconomic (negative NPV) -disadvantage of IRR: the possibility of producing rankings of mutually exclusive projects different from those from NPV analysis and the possibility that a project has multiple IRRs or no IRR

Payback period

-measure of liquidity- for a firm with liquidity concerns, the shorter a project's payback period, the better. -main drawbacks: no time value of money or cash flows beyond payback period -discounted- just discounts the cash flows... must be greater than the payback period without discounting... still doesnt look at cash flows beyond period.

LOS 40.c: Evaluate working capital effectiveness of a company based on its operating and cash conversion cycles, and compare the company's effectiveness with that of peer companies.

-operating cycle is the avg number of days that it takes to turn raw materials into cash proceeds from sales ‣ operating cycle = days of inventory + days of receivables -cash conversion cycle or net operating cycle is length of time it takes to turn the firm's cash investment in inventory back into cash, in the form of collections from the sales of that inventory. ‣ cash conv. cycle = (avg days of receivables) + (avg days of inventory)-(avg days of payables) ‣ high cash conversion cycles are undesirable. too high implies that the company has an excessive amount of investment in working capital.

Degree of financial leverage (DFL)

-ratio of the percentage change in net income (or EPS) to the percentage change in EBIT -DFL = Percentage change in EPS / percentage change in EBIT -DFL = EBIT / EBIT - Interest (for a particular level of operating earnings) -note: if no fixed costs, DOL is equal to one, no interest costs, DFL is equal to one

What are the six different types of capital budgeting projects?

-replacement projects to maintain the business -replacement projects for cost reduction -expansion projects -new product or market development -mandatory projects (safety or government related) -other projects

What are a firm's primary sources of liquidity?

-sources of cash it uses in its normal day to day operations. The company's cash balances result from selling goods and services, collecting receivables, and generating cash from other sources such as short term investments -typical short term funding include trade credit from vendors and lines of credit from banks -effective cash flow management of a firm's collections and payments can also be a source of liquidity for a company.

Some firms use stock splits and dividends to keep stock prices within a perceived optimal trading range of 20 to 90 dollars per share. what does research have to say about this?

-stock prices tend to rise after a split or stock dividend -price increses appear to occur because stock splits are taken as a positive signal from management about future earnings -if a report of good earnings does not follow a stock split, prices tend to revert to their original (split adjusted) levels -stock splits and dividends tend to reduce liquidity due to higher percentage brokerage fees on lower-priced stocks. -thus, stock splits and dividends create more shares but don't increase shareholder value

What are stock splits?

-stock splits divide existing share into multiple shares, thus creating more shares -there are now more shares, but the price of each share will drop correspondingly to the number of shares created, so there is no change in the owner's wealth -splits are expressed as a ratio -in a 3-1 stock split, each old share is split into three new shares

LOS 37.f: Calculate and interpret the cost of fixed rate debt capital using the yield-to-maturity approach and the debt-rating approach

-the after tax cost of debt, kd(1-t) is used in computing the WACC. It is the interest rate at which firms can issue new debt (kd) net of the tax savings from the tax deductibility of interest, kd(t) -after-tax cost of debt = interest rate - tax savings = kd - kd(t) = kd(1-t) -after tax cost of debt = kd(1-t) -use yield to maturity not coupon rate!

Good corporate governance practices seek to ensure that:

-the board of directors protects shareholder interests -the firm acts lawfully and ethically in dealings with shareholders -the rights of shareholders are protected and shareholders have a voice in governance -the board acts independently from management -proper procedures and controls cover management's day-to-day operations -the firm's financial, operating, and governance activities are reported to shareholders in a fair, accurate, and timely manner.

LOS 38.e: Calculate and interpret the operating breakeven quantity of sales

-the breakeven quantity of sales is the quantity of sales for which revenues equal total costs, so that net income is zero. we can then calculate the breakeven quantity by simply determining how many units must be sold to just cover total fixed costs. -for each unit sold, the contribution margin - the diff between price and variable cost per unit, is available to help cover fixed costs. -breakeven quantity of sales: ‣ QBE = Fixed operating costs + fixed financing costs / price - variable cost per unit

To be considered independent, a board member must not have any material business or other relationship with:

-the firm and its subsidiaries, including former employees, executives, and their families -individuals or groups, such as a shareholder(s) with a controlling interest, which can influence the firm's management -executive management and their families -the firm's advisers, auditors, and their families -any entity which has a cross directorship with the firm

LOS 40.b: Compare a company's liquidity measures with those of peer companies

-the higher the current ratio, the more likely it is that the company will be able to pay its short-term bills. A current ratio of less than one means that the company has negative working capital and is probably facing a liquidity crisis. -the higher the quick ratio, the more likely it is the company will be able to pay its short term bills -the current and quick ratio differ only in assumed liquidity of the current assets -it is considered desirable to have a collection period close to industry norm. too high collection period might mean customers are slow paying bills, too much capital tied up in assets. too low may indicate that policy is too rigorous, which might hamper sales -desirable to have an inventory processing period close to the industry norm

LOS 38.c: Describe the effect of financial leverage on a company's net income and return on equity

-the interest expense associated with using debt represents a fixed cost that reduces net income. However, lower net income is spread over a smaller base of shareholder's equity, serving to magnify the ROE. ROE is higher using leverage than it is without leverage -financial leverage not only increase the level of ROE, it also increase the rate of change for ROE. ROE is more volatile. -Financial leverage increases the risk of default but also increases the potential return for equity holders.

Reverse Stock Splits

-the opposite of stock splits -after a reverse split, there are fewer shares outstanding but a higher stock price -these offset one another so shareholder wealth is unchanged -a company that is in financial distress whose stock has fallen dramatically may declare a reverse stock split to increase the stock price

What is the effect of a cash dividend?

-the payment of a cash dividend reduces a company's assets and the market value of its equity -this means that right after a dividend is paid, the price of the stock should drop by the amount of the dividend. -stock price is $25 per share and issue a $1 per share dividend, the price should drop to $24 to account for the lower asset and equity values of the firm.

Sources of short term funding from banks Lines of credit are used primarily by large, financially sound companies

-uncommitted line of credit: bank extends an offer of credit for a certain amount but may refuse to lend if circumstances change -committed (regular) line of credit: more reliable than above. the charge a fee. usually for periods less than a year -revolving line of credit: more reliable, longer terms.can be verified and listed on financial statements in footnotes as source of liquidity. -banker's acceptances are used by firms that export goods- guarantee from bank of the firm that has ordered the goods stating that a payment will be made upon receipt of the goods. exporting company can sell this acceptance at a discount in order to generate immediate funds -factoring refers to the actual sale of receivables at a discount from their face values. the "factor" (buyer of receivables) takes on the responsibility for collecting receivables and the credit risk of the receivables portfolio.

What are the three methods of share repurchase?

1. buy in the open market: at market price. share repurchase is authorized by board of directors for a certain number of shares. Buying in the open market gives the company the flexibility to choose the timing of the transaction. 2. Buy a fixed number of shares at a fixed price: make a tender offer to repurchase a specific number of shares at a price that is usually at a premium to the current market price. shareholders may tender their shares according to the terms of the offer. 3. repurchase by direct negotiation: large shareholder. if the firm pays more than market value for shares, the result is an increase in wealth for the seller and equal decrease in wealth for remaining firm shareholders.

What are the three forms of cash dividends?

1. regular dividends - occur when a co. pays out a portion of profits on a consistent schedule (quarterly). A long-term record of stable or increasing dividends is widely viewed by investors as a sign of a company's financial stability. 2. special dividends- used when favorable circumstances allow the firm to make a one-time cash payment to shareholders, in addition to any regular dividends the firm pays. 3. liquidating dividends- goes out of business and distributes the proceeds to shareholders. for tax- it is treated as a return of capital and amounts over the investor's tax basis are taxed as capital gains.

What is the 1st principle of capital budgeting?

Decisions are based on cash flows, not accounting income: -incremental cash flows, the changes in cash flows that will occur if the project is undertaken -sunk costs are costs that cannot be avoided, even if the project is not undertaken. do not include in analysis -externalities are the effects the acceptance of a project may have on other firm cash flows. Example: cannibalization - occurs when new project takes sales from an existing product. -conventional cash flows: sign on the cash flows changes only once. -unconventional is when more than one sign change.

Explain incorrect treatment of flotation costs

Do not incorporate flotation costs directly into the cost of capital by increasing the cost of external equity.

The dividend discount model approach

If dividends are expected to grow at a constant rate, g, then the current value of the stock is given by the dividend growth model: i. Po = D1 / Kce-g ii. D1 = next years dividend, Kce = required rate of return on common equity and g = firm's expected constant growth rate iii. Can rearrange to solve for Kce: 1) Kce = (D1 / Po) + g 2) To estimate the growth rate g, you can use the growth rate as projected by security analysts or use the following equation: G = (retention rate)(return on equity) = (1-payout rate)(ROE)

Investors should consider whether the firm (shareowners perspective)

Investors should consider whether the firm: • limits the ability to vote shares by requiring attendance at the annual meeting • groups its meetings to be held the same day as other companies in the same region and also requires attendance to cast votes • allows proxy voting by some remote mechanism • is allowed under its governance code to use share blocking, a mechanism that prevents investors who wish to vote their shares from trading their shares during a period prior to the annual meeting.

What is the revised CAPM equation for country risk?

Kce = Rf +β(E(Rmkt) -Rf + CRP)

What are the steps involved in constructing sales-driven pro forma financial statements?

Step 1: Estimate the relation between changes in sales and the changes in sales driven income statement and balance sheet items Step 2: Estimate the future tax rate, interest rates on debt, lease payments, etc. Step 3: Forecast sales for the period of interest Step 4: estimate fixed operating costs and fixed financial costs Step 5: Integrate these estimates into pro forma financial statements for the period of interest

Capital Asset Pricing Model Approach

Step One: Estimate the risk-free rate, RFR. Yields on default risk free debt such as U.S. Treasury notes are usually used. The most appropriate maturity to choose is one that is close to the useful life of the project. Step Two: Estimate the stock's beta, β. Stock's risk measure Step Three: Estimate the expected rate of return on the market, E(Rmkt) Step Four: Use the Capital Asset pricing model (CAPM) equation to estimate the required rate of return Kce = RFR + β(E(Rm) -RFR)

Accounts Payable management

The cost to the company of not taking the discount for early payment can be evaluated as an annualized rate: ‣ Cost of trade credit = (1+ % discount / (1-% discount) ^ 365/days past discount -1 ‣ where days past discount = number of days after the end of the discount period -also look at number of days of payables = accounts payable / AVG days' purchases -avg days purchases = annual purchases / 365

Discount-basis yield (bank discount yield or BDY) is:

discount-basis yield = (face value - price/ face value)(360/days) = % discount x (360/days)

LOS 40.d: Explain the effect of different types of cash flows on a company's net daily cash position

don't want cash just sitting around, invest in short term securities to earn interest: ‣ us treasury bills ‣ short term federal agency securities ‣ bank certificates of deposit ‣ banker's acceptances ‣ time deposits ‣ repurchase agreements ‣ commercial paper ‣ money market mutual funds ‣ adjustable rate preferred stock

Unlimited funds vs. capital rationing

firm has too many profitable investments, have to ration.

Project Sequencing

first one is profitable, so have money to invest in second one

Inventory management

increasing avg days inventory or a decreasing inventory turnover ratio can both indicate that inventory is too large.

What are secondary sources of liquidity?

liquidating short-term or long-lived assets, negotiating debt agreements, or filing for bankruptcy and reorganizing the company. may signal that the financial position is deteriorating

Capital budgeting methods vary according to four general criteria:

• location: europe tend to use payback period • size of company: larger, most likely use NPV and IRR • public vs. private: private companies use the payback period more often than public companies. public companies tended to prefer discounted cash flow methods • management education: the higher the level of education, the more likely to use discounted cash flow techniques

When analyzing ethics codes, these are items to consider:

• make sure the board of directors receives relevant corporate information in a timely manner • ethics codes should be in compliance with the corporate governance laws of the location country and with the governance requirements set forth by the local stock exchange. Firms should disclose whether they adhered to their own ethical code, including any reasons for failure. • the ethical code should prohibit advantages to the firm's insiders that are not offered to shareowners. • a person should be designated to be responsible for corporate governance • if selected management personnel receive waivers from the ethics code, reasons should be given. • if any provisions of the ethics code were waived recently, the firm shuld explain why. • the firm's ethics code should be audited and improved periodically.

Effects on Financial Ratios

• paying a cash dividend decreases assets and shareholder's equity (retained earnings). the decrease in cash will decrease a company's liquidity ratios and increase its debt-to-assets ratio, while the decrease in shareholder's equity will increase its debt-to-equity ratio • stock dividends, stock splits, and reverse stock splits have no effect on a company's leverage ratios or liquidity ratios.

The nominations board is reponsible for:

• recruiting qualified board members • regularly reviewing performance, independence, skills, and experience of existing board members • creating nomination procedures and policies • preparing an executive management succession plan