Finance Exam 3

Finding DSI

1. First find inv. turnover Inv. Turnover = COGS / Inv. 2. Next Find DSI 365 / (Inv. Turn)

Days sales in inventory (DSI)

shows how long the firm keeps its inventory before selling it, the ratio of the inventory balance to the daily cost of goods sold

Days Payables Outstanding (DPO)

tells how long a firm takes to pay off its suppliers for the cost of inventory

Issuing preferred stock with flotation costs

A company has preferred shares outstanding that pay an annual dividend of $4 per year and the current price of the shares is $50. If the cost to issue new shares is 5%, what is the cost of new preferred shares? k= D / P(1-F) k= $4/$50(1-0.05)

Example of Effective annual rate (EAR)

A company offers a 4% discount if the customer pays within 10 days; otherwise, net is due in 60 days. What is the implicit cost of the trade credit? EAR= (1+4/96)^(365/50) -1= 34.72%

Cost of preferred example

A share of preferred stock has a 5% dividend rate, $100 stated value and a price of $85. What would be the cost of issuing this preferred stock? D= $100*0.05 = $5 K= D/P = $5 / $85 =0.059 or 5.9%

Variable Costs

Cost that vary directly with the number of units sold

Accounting Break-even

Number of units that must be sold for accounting operating profit to equal $0. EBIT Break-even = (FC + D&A / Price - Unit VC)

Pretax operating cash flows break-even

Number of units that must be sold for pretax operating cash flows to equal $0. EBITDA Break-even = (FC / Price - Unit VC)

Flotation Costs

When a company issues new preferred stock or new common stock they also have to pay flotation costs (middlemen fees) to the underwriter This INCREASES the cost

Capitalized Expenditures

are expenditures that may provide benefits into the future and therefore are treated as capital outlays and not as expenses of the period in which they were incurred. Examples: Shipping and installation

A project with a higher proportion of fixed costs

will have cash flows and accounting profits that are more sensitive the changes in revenues

Example of terminal year, operating and non-operating cash flows, t=n

Operating cash flows 4,280,000 Return of NWC 1,000,000 Terminal Year 5,280,000

Constant-Growth Dividend Model

Po = D1/ (r-g) we can also rearrange this for the required rate of return

Terminal year non-operating cash flows; t=n

Proceeds from Sale or Salvage Value (-)+ (Tax if gain on sale) or Offsetting deduction if loss on sale + Return of NWC =Terminal Year Cash Flow

Three components of collection time

-Delivery -Processing -Float

Flexible Strategy

-Promotes a liberal trade credit policy for customers which results in high levels of accounts receivable -Perceived to be a low-risk and low-recur course of action for management. -The advantage of this policy is the large working capital balances the firm holds.

Basis points

If a loan quotes a fee of 69 basis points on an unused balance. This is equal to .69/100 or .0069 Multiply the unused balance by .0069 to calculate the amount of the commitment fee.

Free Cash Flow Calculation

Revenue -Op. Expense =EBITDA -D&A =EBIT x(1-t) =NOPAT +D&A =CF Ops. -Cap. Exp -Add. WIC =Free CF

Marginal tax rate

The amount of tax on each additional dollar of revenue

The Cost of Equity (Preferred Stock)

The characteristics of preferred stock allow us to use the perpetuity modulate estimate the cost of preferred equity. Just as with common stock, we can find the cost of preferred equity by rearranging the pricing equation for preferred shares: K = D / P

Working capital efficiency

length of time between when a working capital asset is acquired and when it is converted into cash.

Restrictive Strategy

-A high-risk high-return alternative to the flexible strategy. -The high risk comes in the form of shortage costs which can be either financial or operating. -Financial shortage costs arise mainly from illiquidity, shortage of cash, and a lack of marketable securities to sell for cash.

Working Capital management involves two key issues

1. What is the appropriate amount and mix of current assets? 2. How should these current assets be financed?

CAPM Cost of Equity

Assume the risk-free rate is 2.5%, the market risk premium is 6% and the firm's beta is 1.2. What is an estimate of the cost of common equity? 2.5% + 1.2(6%) = 9.7%

Break Even Analysis

Analysis that tells us how many units must be sold in order for a project to "break even" on a cash flow or accounting profit basis. Helps to understand the sensitivity of cash flows and accounting profits to changes in the number of units that will be sold.

Salvage Value

If the salvage value is more than its book value, the firm must pay taxes on the difference. If the salvage value is less than its book value, the firm gets an offsetting tax deduction.

Which method should we use?

In practice, most people use the CAPM to estimate the cost of equity if the result is going to be used in the discount rate for evaluating a project.

Components of Capital

The "means" to make a company grow. Obtained from three primary sources. 1. long-term debt 2. Preferred Stock 3. Common Equity

Economic Order Quantity

The EOQ mathematically determines the minimum total inventory cast taking into account reorder costs and inventory carrying costs. The optimal order size strike the balance between these two costs.

Effective rate of loan

The effective rate of any financing arrangement is the ratio of the amount the firm must pay to the amount the firm can use. Eir= (interest expense + commitment fee) / (usable funds)

Component Cost of Debt

The firms 15-year, 12% semi-annual coupon bonds currently sell for $1,153.72, and its marginal tax rate is 40%. Find the yield to maturity or before-tax cost of debt, and then the after-tax cost of debt. Before tax cost of debt= 5% x 2 = 10% After tax cost is .10(1 - .4) = .06 N= 30, PV= -1153.72, PMT= 60, FV= 1000 CPT I/Y= 5 To find PMT do % times FV and if semi annual then divide by 2

The working capital trade-off

The optimal current assets investment strategy will depend on the relative magnitudes of carrying costs and shortage costs. This conflict is often referred to as the working capital trade-off. Financial managers needs to balance shortage costs against carrying costs to define an optimal strategy.

Capital Structure

The proportion of each component of capital. Example: 10% of all capital comes from debt 20% from preferred stock 70% from equity Adds up to 100% The proportions are based on market values!

The Cost of Equity (Common Stock)

Three alternative methods fir estimating the cost of common stock. Method 1: Ising the Capital Asset Pricing Model (CAPM) Method 2: Using the Constant-Growth Dividend Model Method 3: Using a Multistage-Growth Dividend Model Only cover the first two methods in class.

Weighted average cost of capital

WACC = XdKd(1-t) + XpsRK + XcsKcs The x's refer to the weights of the firms capital structure , the k's refer to the cost of each component

What is working capital and net working capital?

Working capital- funds invested in a company's cash account, accounts receivable, inventory, and other current assets (also called gross working capital) Net working capital (NWC)- the difference between current assets and current liabilities. NWC is important because it is a measure of liquidity and represents the net short-term investments the firm keeps in the business.

Finding DPO

1. First find accts. pay turnover a/p Turnover = COGS / Accts. Pay 2. Next Find DPO 365 / (A/P Turn)

Finding DSO

1. First find accts. rec. turnover a/r Turnover = Net Sales / Accts. Rec. 2. Next Find DSO 365 / (A/R Turn)

Goals of financial managers in managing the cycle

- To delay paying a/p without suffering any penalties - To maintain minimal raw material inventories without causing manufacturing delays. - To use as little labor as possible while maintaining quality. - To maintain minimal finished goods inventories without losing sales. - To offer customers the most attractive credit terms possible on trade credit to maximize sales while minimizing the risk of non-payment. - To collect cash payments on a/r as fast as possible.

Depreciation tax savings

-A non-cash expense that lowers taxable income The amount of taxes saved = depreciation expense * tax rate example in slides

Lockboxes

-Allows geographically dispersed customers to send their payments to a post office box close to them. -A post office box is replaced by a local branch which receives the mailings, processes the payments, and makes the deposits. -Either approach will reduce the collection time to an extent nut there is a cost associated with it.

Electronic Funds Transfer

-Another increasingly popular means of reducing cash collection time is through the use of electronic funds transfers. Such payments reduce cash collection times in every phase. -Eliminates mailing time -Reduces processing -Funds available immediately

Basic Principles to adhere to in estimating cash flows

-Assume annual, end of year Cash Flows -Dont ignore inflation -Include any net working capital requirements -Ignore Sunk cost -Consider opportunity cost -Consider externalities

Aging A/R

-Shows the breakdown of the firm's a/r by their date of sale; how long has the account not been paid in days. -Its purpose is to identify and then track delinquent accounts and to see that they are paid; good tool for analyzing quality of receivables. There is a chart in the slides****

Accounts Receivables- Terms of Sale

-Spells out the credit agreement between the buyer and seller. -Specifies when the cash payment is due and the amount of any discount if early payment is made. -Trade credit, which is a short-term financing, is typically made with a discount for early payment rather an explicit interest charge.

Two reasons for holding cash

1. Facilitates transactions with suppliers, customers, and employees. 2. Most banks require firms to hold minimum cash balances in exchange for the services they provide.

Two measures of operating leverage

1. Degree of pretax cash flow operating leverage 2. Degree of accounting operating leverage

Salvage value- firm sells an asset for LESS than book value

A firm purchased an asset for 100,000, of which 70% has been depreciated. Tax rate = 40% If the firm sells the asset for 10,000 calculate the firms offsetting deduction and find the after-tax salvage value of the asset. book value= 100,000 - 70,000 =30,000 if the firm sells the asset for 10,000 the firm has offsetting deduction of (10,000-30,000)(.4)= -8000 after tax salvage value = 10,000 + 8000 = $18,000 BV= 30,000 now get tax credit Sale 10,000 + tax credit 8,000 = 18,000

Salvage value- firm sells an asset for MORE than book value

A firm purchased an asset for 100,000, of which 70% has been depreciated. Tax rate = 40% If the firm sells the asset for 40,000 calculate the firms tax bill and find the after-tax salvage value of the asset. book value= 100,000 - 70,000 =30,000 if the firm sells the asset for 40,000 the firm has tax liability of (40,000-30,000)(.4)= 4000 after tax salvage value = proceeds minus taxes = 40000 - 4000 = $36,000

Scenario analysis

An analytical method concerned with how the results from a financial analysis will change under alternative scenarios. An analysts who wants to examine how the results from a financial analysis will change under alternative scenarios performs a scenario analysis

Cash conversion cycle formula

DSI + DSO - DPO Operating Cycle - DPO

DOL - Pre-tax Operating Cash Flow EBITDA Degree of accounting operating leverage

Degree of accounting operating leverage -Measures the sensitivity of accounting operating profits, EBIT, to changes in revenue. Accounting DOL= 1+ (Fixed Charges/Accounting operating profits) 1+(FC + D&A / EBITDA - D&A) or EBIT

DOL - Pre-tax Operating Cash Flow EBITDA Degree of pretax cash flow operating leverage

Degree of pretax cash flow operating leverage -Measures the sensitivity of pre-tax operating cash flows (EBITDA) to changes in revenue -It changes with the level of revenue; the sensitivity of operating cash flows are not the same for all levels of revenue. Cash Flow DOL= 1+(Fixed Costs / Pretax operating cash flows) = 1+(FC / EBITDA)

When does the cash conversion cycle start?

Does not start until the firm actually pays for its inventory. It represents the length of time between the cash outflow for materials and the cash inflow from sales.

Per-unit Contribution break-even analysis

Dollar amount that is left over from the sale of a single unit after all the variable costs associated with that unit have been paid. Amount that is available to help cover fixed costs for the project. Price - Unit VC = Unit Contribution

EOQ Formula

EOQ = square root(2 x reorder costs x sales per period / carrying costs)

The Cost of Debt

Estimating the current cost of a bond or an outstanding loan--- The current cost of debt for a publicly traded bond is derived from its yield to maturity calculation. -Since the interest payments are a tax deductible expense, use the after-tax cost of debt. -After-tax cost of debt equals the pretax cost times 1 minus the tax rate.

Just-in-time inventory management

Exact day to day, or even hour by hour raw material needs are delivered by the suppliers, who deliver the goods "just in time" for them to be used on the production line. Advantages: no raw material inventory costs and no chance of obsolescence or loss to theft; however, if the supplier fails to make the needed deliveries, then production shuts down. Disadvantages: lost sales

Risk Analysis

Financial analysts must often resort to different types of risk analysis to obtain a better understanding of how errors in forecasting these factors affect the attractiveness of a project.

EAR------A/R- Terms of Sale

Financial managers must realize that trade credit is a loan from the supplier and it is usually a very costly form of credit. We can find the effective annual rate (EAR) for trade credit using the following formula: EAR= 1+(discount / discount price)^365/days credit

Financial managers use two types of strategies for current assets investments:

Flexible and Restrictive

Including Flotation Costs of new common stock

Flotation costs are incurred and one way to reflect this cost is to increase the cost of capital. Assume a company paid a dividend of $4.19 (Do) on its common stock currently selling for $50/share (Po), and this dividend is expected to grow at a constant rate of 5%. What is an estimate of the cost of common equity? R = ( Do(1+g) / Po(1-F) ) +g ( $4.19(1.05) / $50(1-0.15) ) + .05 = 15.4%

Depreciable Basis

In tax accounting, the fully installed cost of an asset. This is the amount that, by law, may be written off over time for tax purposes. Depreciable Basis = Cost of Asset + Capitalized Expenditures

Break-even analysis crossover level of unit sales (CO)

Level of unit sales at which cash flows or profitability for one project alternative switches from being lower than that of another alternative to being higher. (FC alternative 1 - FC alternative 2 / Unit contribution alt 1 - Unit contribution alt 2)

Depreciation tax savings

Instead of subtracting depreciation, calculating taxes and then adding back depreciation, one can simply add depreciation tax savings. Depreciation tax savings= (depreciation expense * tax rate)

Sensitivity analysis

Involves examination of the sensitivity of the results from a financial analysis to changes in individual assumptions. An analyst might examine how a projects NPV changes if there is a decrease in the value of individual cash inflow assumptions or an increase in the value of individual cash outflow assumptions.

Calculating Operating Leverage

Is a measure of the relative amounts of fixed and variable costa in a project's cost structure; it will be higher with more fixed costs.

Two ways to raise equity

Issue new shares of common stock - called external source of equity. Re Use Retained Earnings by not paying out all earnings as dividends- called an internal source of equity. Rs

What is the COST of Capital

Its a discount rate; an opportunity cost. Its a companys "hurdle rate" Its the required rate of return a company must earn on its projects. A company can increase its values if it invests in projects that have a higher return than its cost of capital

Net Working Capital Example: A new project will require an increase in inventory of $7,000 plus an increase in accounts payable of $2,000. What is the net working capital required for the project? NWC = CA - CL *****notes payable would not be considered because it includes interest.

NWC = CA - CL 7000-2000=5000 Note: 5000 would be an outflow in time 0, but an inflow at the end of the life of the project

Investment outlays at t=0 example

The performing arts center is evaluating a project to increase the number of seats by building some new box seating areas and adding seats. The initial capital expenditure is 10 million and the investment in working capital is 1 million. 10,000,000 (capital expenditure) 0 +1,000,000 (NWC) =11,000,000 (initial cash outflow)

When does the operating cycle begin?

When the firm uses its cash to purchase raw materials and ends when the firm collects cash payments on its credit sales.

Simulation analysis

Uses a computer to quickly examine a large number of scenarios and obtain probability estimates for various values in a financial analysis A computer program repeatedly draws numbers for the distributions for various assumptions, plugs them into the cash flow model, and computes the annual cash flows and NPV.

Investment Outlays at t=0

cost of "new" asset +capitalized expindatures +(-) Increase (decrease) NWC =Projected Cash outflow Note: The cost + Capitalized expenditures = depreciable basis

Days sales outstanding (DSO)

estimates how long it takes on average for the firm to collect its outstanding a/r balances; also called the Average Collection Period (ACP)

Fixed Costs

in contrast, do not vary with unit sales - at least int he short run

Net Working Capital

include any additional investments in net working capital NWC = any increases in current assets minus any increases in current liabilities Note: At time 0, NWC is a cost (outflow). In the terminal year, NWC is recovered (inflow).

Working capital management

involves the decisions regarding uses and sources of CA

Inventory Management

is a function of operations management Manufacturing companies generally carry three types of inventory; raw materials, work in process, and finished goods. Capital invested in inventory provides no direct return. On the other hand, running out of raw materials can cause manufacturing to shut down at a greater cost to the firm, as shortage of finished goods can mean lost sales.

Liquidity

is the ability of a company to convert assets- real or financial- into cash quickly without suffering a financial loss.

Float

is the time between when a customer makes a payment and when the cash becomes available to the firm

Progressive tax system

the progressive to marginal tax system used in the United States is one in which the proportion of income paid as taxes increases as the amount of taxable income increases

Using Discounted Cash Flow

to estimate the cost of common equity A firm recently paid a dividend of $4.19 (Do) on its common stock currently selling for $50/share (Po), and this dividend is expected to grow at a constant rate of 5%. What is an estimate of the cost of common equity? D1= 4.19(1+.05) = 4.3995 D1=D0(1+g) K= (D1 / Po) + g ($4.40 / $50) + 0.05 = 13.8%