Volume 4 Corporate Finance, Portfolio Management & Equity

Reading 35: Capital Budgeting

Lesson 1: Capital Budgeting

LOS39d: Describe how different types of cash flows affect a company's net daily cash position

Most companies prefer keeping a minimum cash balance to run their operations msoothly. if a company sets aside too much money, it will lose out on investment income (opportunity costs) -if a company sets aside too little, it will incur higher costs to raise funds quickly

NPV

NPV sum CFt/(1+r)^t - outlay CFt = after tax cash flow at time t r= required rate of return for the investmetn outlay = investmetn cash outflow at t=0 always invest in project if greater then zero

Reading 40: The Corporate Governance of Listed Companies: A manual for investors LOS40a: Define Corpoarte governance

corporate governance is the system of internal controls and procedures through which individuals companies are managed, defines rights, roles, and duites of management, board directors, and sharewoners. minimize and manage conflicts of interest between insiders and shareholders

Reading 36: Cost of Capital

cots of capital refers to rate of return supplilers of caipatl require to contribute capital to the firm. opp cost of funds for the providers of capital

LOS39f Evaluate a company's management of AR, inventor and accounts payable over time compared to peer companies

credit managers can use credit scoring modesl to evaluate customers' credit worthiness

Reading 39: Working Cpaital Management Lesson 1 Working capital management

working capital management deals with short term aspects of corporate finance activities. effective working capital management ensures that a compnay h as ready access to funds that are needed fro day to day expenses and that it invests its assets in the most productive and timely matter

Risks of Creditors and Owners

risk borne by creditors and owners differ because different rights and responsibilities creditor calims on assets are seniro to those of equity holders Legal Codes 2 types of Bankruptcies 1. Reorganizaiton (Chapter 11) - grants company temporary protection from crediotrs so it can reorganzie its capital structure and emerge from bankruptcy as a going concern 2. Liquidation (Chapter 7) - orderly settlement of creditors claims. orginal business ceases to exist companies with high operating leverage have less flexibility in making changes to their operating structures

Evaluating Trade Discounts

- company should review its evaluation of trade discounts periodically. -you should review an early payment discount to see if saviings are greater than the returns that could have been earned by investing funds instead or greater than the firms cost of borrowing implicit rate = cost of trade credit = (1+ (discount/(1-Discount))^ (365/number of days beyond discount period) -1 say temres are 2/10 net 30 and acount is paid on 15th and 25th this means you get a 2% discount if paid on or before 10th day so cost of trade crdit of 15th day = 337.02% 25th day = 63.49% so picking whether you should pay the discount if company's cost of funds or short term investment rate is less than the calculated rate, it offers a better return than the company's short term borrowing rate

6 Basic Assumptions of capital budgeting

1. Decisions are based on actual cash flows, only incremental cash flow is relevant and sunk costs are ignored 2. Timing of cash flows i crucial. Analysts try to predict exactly when cash flows will occur, as cash flows received later. 3. Cash flows are based on opportunity costs. (incremental cash flow 4. Cash flows are analyzed on an after-tax basis 5. Financing costs are ignored from calculations of operating cash flows. Therefore focus on operating cash flows and capture costs of capital in the discount rate (financing decision) 6. Accounting net income is not used as cash flows for capital budgeting, because accounting net income is subject to non cash expenses (depreciation)

LOS35c: Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and captial rationing

1. Ind vs mutually exclus projects. - independent means cahs flows are unrelated, mut excl means if project a and b are mutally exclusive the firm would only pick one 2. Project Sequencing - sometimes investing in one project allows for opportunites to invest in other projects in the future 3. Unlimited funds versus capital rationing - when company has no constraing on amount of cpaital it can raise, it will invest in all profitable projects to maximize shareholder wealth. the need for capital rationing arises when the projects exceeds the resources available to the company

Capital budgeting projects can usually be classified into the following categories

1. Replacement Projects: help in maintaining normal course of business, and usually do not require very thorough analysis. an obsolete piece of equipment 2. Expansion projects - these are projects that increase the size of the business. much more careful consideration since uncertainties involved 3. New products and services 4. Regulatory, safety and environmental projects 5. Other projects

Capital budgeting processes tell us two things about company management:

1. The extent to whcih management prusues the goal of shareholder wealth maximization. 2. Management's effectiveness in pursuit of this goal

LOS36d: Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget

A company's MCC marginal cost of capital, increases as it raises additional capital. this is because most firms must pay a higher cost to obtain increasing capital. For example, the more a company borrows, the greater the risk that it will be unable to repay its lenders, adn therefore, the higher the return required by investors. The profitability of a comapny's investment opps decerases as the company makes additional investments. Company prioritizes projects with highest IRRs. As more resources are invested in the most rewarding projects, remaing opportunites offer lower and lower IRRs. this fact is represented by an investment opportunity schedule (IOS), downard sloping. The optimal captial budget occurs at the point where ther marginal cost of capital intersects the investment opportunity schedule. Basic equilibrium pg 22

LOS36k: Describe the marginal cost of capital schedule, explain why it may be upward sloping and calculate and interpet its break points

A company's marginal cost of capital MCC increaess as additional capital is raised becase 1. company may have existing debt covenants that retrist it from issuing debt with simlilar seniority. subsequent rounds will be subordinated to the senior issue so will varry more risk. 2. due to economies of scale in rasiing a significant amount of ocmponent (debt or equity) of capital in one go frims may deviate from tehir optimal capital strucutre over the short term. these deviations may cause the margianal cost of capital to raise over time. remember WACC = MCC the margianl cost of capital schedule shows the WACC at different amounts of total captial break point = amount of capital at which a components cost of capital changes / proption of new capital raised from the component can be multiple break points chagnes in Cost of equity or After tax cost of debt if issuing debt or equity for example 0-300 in new equity is cost of equity of 6% while 300-600 new equity cost 7.8%

Liquidating Dividends

A dividend payment is known as a liquidating dividend when: -a company goes out of business and its net assets are distributed to shareholders -company sell off portion of business and distributes proceeds to shareholders

Stock Dividends

A stock dividend or bonus issue occurs when a comapmny isseus more common shares in the company instead of cash to shareholders pg 53 is a good example Observations ivnestor ends up with more shares, did not have to pay for company issues a dividend without spending any cahs -market value of the company does not change in responses to a stock dividend -invetor's avg cost per share falls, but the total cost remains unchanged. -also stock price fell slightly in this example but makes sense stock dividends are not taxable Advantages -broadens company's shareholder base by lowering price -stock dividends could bring to optimal ragne (20-80 for US companies), where ivnestors are attracted to the stock

Average Accounting Rate of Return (AAR)

AAR = avg net income/avg book value for avg net income add up all net incomes and divide by number of years for average book value use beginning and ending value over the period and divide by 2 for example a 150000 investment depreciated over 5 years so take (150000+0)/2 = 75000, the +0 is b/c the value at the end after it is depreciated is 0 Advantage - it is easy to understand and easy to calculate Drawbacks -it is based on accounting numbers not cash flow, which are susceptible to manipulation -does not account for time value of money -does not differentiate between profitable and unprofitable investmetns accurately, as there are no benchmarks for acceptable AARs

LOS38f: All else being equal, a share repurchase is equivalent to the payment of a cash divdend of an equal amount int terms of its effect on shareholder welath

All else being equal, a share repurchase is equivalent to the payment of a cash divdend of an equal amount int terms of its effect on shareholder welath pg 63 however this is assuming that -dividends are received as soon as shares go ex dividend -tax implications of dividends and repurchase are teh same -company must be repurchasing at the market price not at a premium Concluding remarks Many investors believe that on average share repurchases have a net postiive effect on shareholder wealth.

LOS 35 e: Explain NPV profile and compare NPV and IRR methods when evaluating independent and mutually exclusive projects, describe probles,

An NPV profile is a graphical illustration of a projects NPV at different discount rates NPV profiles are downward sloping becauese as the cost of capital increase the NPV of an investment falls pg 12 it using the discount rate as the x asix and the corresponding NPV on y axis. easy to compute on calculator You can plot the NPV profiles of both projects marked against a line that is the cost of capital %, the IRR of a project instersects the x axis. (1 for each project the crossover rate is where both projects intersect (1 total

Evaluating Management of Accounts Receivable

An aging scedule classifies accounts receivable according tot he length of time outsanding we can showcase in a chart as a percentage of what amount of funds are in what aging group we can better evaluate the firms ability to collect its receivables by calculating the weighted average collection period, which measures how long it takes a company to collect cash from customers irrespective of the changes in sales and the level of sales When a company's weighted average period has increased dramatically an anlayst should scrutiineze whether this is due to an extension of credit terms by the company to promote sales or because major customers are having trouble making payment to calculate calculate average days of collectin receivalbe in each groupings for example 91-120 days range average might be 95 collectibabiliaty. then multiply by the weighting from the aging schedule, and compare across years

Pure- Play

Analysts use the pure-play method to estimate beta of a company that is not publicly traded. this mthod required adjusting a comparable publicly listed company's beta for differences in financial leverage. 1. First we find a comparable company that faces simlar business risks. Betas vary with level of fiancnial risk in a company. highly leveraged companies have higher financial risk, which is reflectged in their high equity betas. 2. To remove all elements of financial risk we UNLEVER the beta. this unlevered beta reflects only the business risk of the comparable and is known as a ASSET BETA 3. THen we adjust the unlevered beta of the comparable company in the project or company under study. we include this comanpies financial risk so basically we take a comparable company unlever the beta, then we use that portion of the beta as the business risk beta in new project but keep financial beta also Basset = Bequity [ 1 / (1+((1-t)(d/e)) ] this reflects only the business risk of the comparable comany d/e = debt to equity ratio of comparable company t= marginal tax rate of the comparable company so plug in Basset to the follwoing equation to determine the entire beta Bproject = basset [ 1 + ((1-t)(D/E))] D/E= debt to equity ratio of the subject company t= marginal tax rate of the subject company

LOS 38e: Calcuclate the effect of a share repurchase on book value per share

Book value per share = book value of equity/number of shares oustanding When market price is greater than the book value per share, book value per share will decrease after the repurchase when market price is lower than the book value per share, book value per share will increase after the repurchase

More takeaways

Business risk is composed of operating ans sales risk, both of which are largely determined by the industry in which the company operaties. A company has more control over operating risk then sales risk. This is because cannot control numbe rof units it will sell, but can determine the production method it wasnt to employ indsutries that require higher initial invesment have higher poroprtion of fixed to variable costs thus have higher operatin leverage (example pharmaceuticals) retailers have relatively low operating leverage

Business Risk and FInancial Risk Business RiskD

Business risk refers to the risk associated with a companys operating earnings. Operating earnings are risky because total revenues and costs of sales are both uncertain. Therefore business risk can be broken down into sales risk and operating risk Sales Risk' - uncertainty associated with totatl revenue is sales risk. rev is affected by economic conditions, industry dynamics, government regulation and demographics pg 40 shows figures bar graphs of operating income simulation taken into account variailty of price and unites sold (standard deviation) Operating risk: the risk associated with a company's operating cost structure. a comapnny that a has a greater proportion of fixed costs in its cost structure has greater operating risk a company with greater fix costs relative to variable costs will find it more difficult to adjust its operating costs to cahgnes in sales and therefore more risky in order to examine company's sensitivity of operating income to changes in unit sales we use the degree of operating leverage (DOL). ratio of the percentage change in operating income to the percentage change in units sold DOL = percentage change in operating income/ percentage change in units sold example: 1.24 this is elasticity, so a 1% increase in percentage of units sold, results in a 1.24% increase in operating income this is the same as in economics however we are substituting out the sales risk and only dealing with the operating risk which is based on decisions whether to employ more fixed then variable costs can be expressed in basic elements DOL = Q x (P-V) ./ (Q x (P-V) - F) Q=units sold P = price per unit V = variable cost per unit F= fixed oeprating cost Q x (P - V) = contribution margin, amount that units sold contribute to covering fixed costs (P-V) = contribution per unit DOL is different at different levels of sales. Takeaways -DOL is negative when operating income is negative, and is postive when company earns operating profits -operating income is most sensitive to chagnes in sales around the point where the company makes zero operating income -DOL is undefined when operating income is zero

Share repurhcase methods

Buy in open market - nice because company can buy at a good price, no hoops to jump through for legaility buy back a fixed number of shares at a fixed price, knowb as a fixed tender offer. typically price is at a permium to the current market price if number of shares offered for sale exceeds amount of shares company desires to repurchase the company will repurchase a pro rata amount from each shareholder who offers her shares for sale. Dutch auction - everybody picks the number of shares and price they want to sell and the best offer wins and the company buys back their stocks repruchase by direct negotion - direct negotion with a majority shareholder examples -large shareholder wants to sell and company wants to prevent large block of shares from overhangin the market and depressing the share price -the company wants to buy out a large shareholder to prevent it from gaining representation on the company's board of directors

IRR

CFt/(1+IRR)^t -outlay = 0 or first part of equation = outlay IRR is the discount rate at which NPV = 0 so set NPV = 0 and solve

Differences between stock dividends and cash dividends

Cash dividends reduce net assets (cash) and shareholders' equity (retained earnings). So when company pays out liquidity ratios deterioate, leverage ratios (debt-assets, debt-equity ratios) also worsen. Stock dividends do not have any effect on company's capital structure but do transfer retained earning to contributed capital

LOS39b: Compare a company's liquidity measures with those of peer companies

Creditworthiness - ability of borrow to pay. Liquidity contributes to creditworthiness. Following liquidity ratios are used to evalueate a companies liquidity management current ratio = current assets/ current liabilities quick ratio - ratio of quick assets to current liabilities (exclude inventory ) accounts receivable turnover = credit sales / average receivables number of days of receivables - how many days it takes on average to collect from customers acts rec/ avg days sales on credit = acc reciev/(sales on credit/365) desirable to have ratios that are close to the industry average Invetnory turnover - how often inventory is created and sold over a period it = cost of gods sold/avg inventory number of days of inventory accounts payaples turnover measures how many times company theoretically pays off creditors over a period payables turnover = purchases/ avg trade payables number of days of payables= = accounts payable/ avgerage days purchases Purchases = ending inventory +COGS - beginning inventory

Total Leverage

DOL looks at sensitivity of operating income to changes in units sold, while DFL looks at the sensitivity of net income to changes in operating income. The degree of total leverage (DTL) looks at the combined effect of operating and financial leverage (it measures sensitivity of net income to changes in units produced and sold) DTL = percentage change in net income / percentage change in number of units sold DTL =DOL X DFL DTL = (Qx(P-V) / [Q(P-V) - F - C] f = fixed operating cost c= fixed financial cost a DTL of 3.25 implies that a 1% change in the number of units sold will change net income by 3.25%

2. Dividend Discount Model Approach

Dividend discount model asserts taht the value of a stock equals the present value of its expected future dividends. We will use the constant growth discount model (also known as a Gordon growth model), in which divdends grow at a constant rate, to determine the cost of equity greater detail later but we need to know price of a stock assuming a constant growth rate in dividends P0= D1/ (re-g) P0= curretn market value of the security D1 = next year's dividend re= required rate of returnon common equity g=firms expected constant growth rate of dividends rearranging re= (D1/P0) + g The growth rate, g, is a very imporant variable in this model. two ways to determine 1. Use forecasted growth rate from a published source or vendor 2. Calculate a company's sustainable growth rate using the following formula g = ( 1 - D/EPS) x (ROE) (1-(D/EPS)) = earning retention rate

LOS36L: Explain and demonstrate the correct tr(atment of flotation costs

Flotation costs refer to the fee charged by investment bankers to assist a company in raising new capital. For debt and preferred stock, we do not usually incorporate flotation costs because amount is quit small often less then 1%, however for EQUITY ISSUES, floation costs are usually quite significant re = D1/(P0(1-f)]) + g f= flotation costs as a percentage of the issue price pg 35 so can determine what the cost of equity was before and when it issued new equity. after influence floataion costs are included in costs of equity however adjsutign the cost of capital for flotation costs is incorrect. Flotation costs are part of the intitial cash outlay for a project. basically everything above is incorrect and the below is how we should actually treat ***The correct way to account for floation costs is to adjust the cash flows used in the valuation. We add the estimated dollar amount of floation costs to the initial cost of the project

LOS35b: describe the basic principles of capital budgeting

Important concepts before moving on: sunk costs: costs that cannot be recovered once they have been incurred. capital budgeting ignroes sunk costs because it is based only on current and future cash flows. an example is market research costs incurred to evaluate whether a new product should be launched opportunity cost incremental cash flow - additional cash flow realized as a result of a decision. incremental cash flow equals cash flow with a decision minus cash flow without the dcusion. externality - effect of investment decision on things other than the investment itself. conventional cash flow stream - initial outflow followed by series of inflows. the sign of the cash flows changes only once for nonconventioanl flow stream, more than one sign siwthc back and forth

LOS 40g: Voting Rules

Proxy voting cumulative voting - enables sharhodlers to chst cumulative number of votes allocated to their shavors in favor of one or a limited number of board nominees, this ensures shareholders interest voting for toher changes, must be outlined

Cash Dividends

Regualr cash dividend - most payout on a regular schedule, typically quarterly. companies strive to maintain or increase cash dividend payouts consistent dividends over an extended period of time indicates that a company is consistently profitable -an increase in regular dividend, can have a positive effect on share price. very strong message out to investors Dividend Reinvestment plans (DRP) - system that allows investors to reinvest all or a portion of cash dividends received from a company in shares of the company. 3 types open market DRPs , comapny purhcases shares on behalf of plan participants from the open market -new issue DRPs or scrip dividend schemes, company issues additoanl shares new issue DRPs allow the company to raise equity capital without incurring floatation costs. advantages to shareholderes -can accumulate shares in the company using dolalr cost averaging - no transaction costs with obtaining. Disadvantages - where capital gains are taxed, mayb have to pay -may have to pay tax on money you did not get because it was reinvested back in with the DRP

LOS 36i: Calculate and interpret the beta and cost of capital for a project An analyst must estimate a stock's beta when using the CAPM apporach to estimate a company's cost of equity

Ri= a +bRmt a=estimate of the intercept b=slope of the regression (beta) Ri= company's stokc's returns Rmt= market returns over the given period Beta estimates are sensitive to many factors and issues that should be considered -beta estimates are based on historical returns, and therfore sensitive to length of the estimation period -smaller standard errors are found when betas are estimated using small return intervals (such as daily returns -betas sensitive to the choice of market index -smoothing techniquies may be required to adjust calculated betas, due to betas are believed to revert to 1 over time - small cap stocks have greater risks compared to large cap. some argue that betas of small companies should be adjusted upward to reflect greater risk

LOS35a: Describe Capital Budget process and distinguish among various categories of capital projects

Steps: 1. Generating Ideas: Good investment ideas is most important step in the process. 2. Analyzing individual proposals (ideas). - Collecting information to forecast cash flows of a particular project as accurately as possible. Cash flows then used to evaluate feasibility of the project 3. Planning the capital budget 4. Monitoring and post auditing

LOS 36e: Explain the marginal cost of capital's role in determining the net present value of a project

The WACC or MCC (same thing) reflects the average risk of the company. When we choose MCC as the discount rate to evalueate a particular project we assume that: -the project udner consideration is an average risk project - the project will have a constant capital structure throughout its life If the risk of the project under consideration is above or below the average risk of the company's current portfolio of projects, an adjustment is made to the WACC -greater risk = greater marginal cost of capital

LOS 36h: Calculate and interpret the cost of equity capital using the capital asset pricing model approach, the dividend discount model approach and the bond yield plus risk premium approach

The cost of equity is the rate of return required by the holdrs of a company's common stock. Estimating the cost of equity is difficult due to the uncertainty of future cash flows that common stock holders will receive in terms of their amount and timing. Three Approaches are commonly used to determine the cost of equity

LOS36f: Calculate and interpret the cost of debt captial using the yield to maturiyt approach and the debt rating approach

The cost of fixed rate captial is the cost of debt financing when a company issues a bond or takes a bank loan. We will discuss two approaches to estimate the before tax cost of debt (rd) 1. Yield to Maturity Approach -The bond's yield to maturity (YTM) is a measure of the return on the bond assuming that it is purchased at the current market price and held till maturity. Yield that equiates the PV of bond's expected future cash flows to its current market price P0 = [sum of( PMTt/ (1+rd/2)^t)] + FV / (1 +rd/2)^n **THis equations assumes we are consdiering semiannual-pay coupon bond so the interim chas flows are discounted at rd/2 pg 23 P0= current market price of the bond PMTt = interest payment in period t rd= Yield to maturity on BEY basis n=number of periods remaing to maturity FV=par or maturity value of the bond

LOS36c: Describe the use of target capital structure in estimating WACC and how traget captial structure weights may be determined

The target capital structure is the capital structure that the company aims to maintain. THe weights used in the calculation of the WACC are the poroprtions of debt, preferred stock, adn equity a firm hopes to achieve and maintain in its structure over time so take debt to euiqty ratio, a simple way to tranform into a weight is to divide the ratio by (1+D/E) so (D/E)/(1+D/E) = wd and wd + we = 1 if information about the target capital structure is not easily available, we can use the weights in the company's current capital structure. The weights of the various components should be based on market values. an analyst may also use the average weights of comparable companies' captial strucutres as the target strucutre for the company

Extra or Special Dividends

a dividend from a company that does not usually pay dividends, usually given out in strong earnings years

Reading 38: Dividends and Share Repurchases: Basics Lesson 1: Dividends

There are two ways that a company can distribute cash to its shareholders. dividends, and share repurchases. dividend payments are at the company's discretion. dividends and share repurchases rep a payout. payouts important because are an important component of total retur, particularly when stock price volatility is high

LOS36g: Calculate and interpret the cost of noncallable, nonconvertible preferred stock

a company promised to pay dividends at a specific rate to its preferred stock holders. when preferred stock is noncallable, nonconvertible, has no maturity date, and pays dividends at a fixed rate, the value of the preferred stock can be calculated using the perpetuity formula Vp=Dp/rp Vp= current price of preferred stock Dp preferred stock dividend per share rp=cost of preferred stock so rp = Dp/Vp for rp is hte cost of prefered stock

LOS37d: Calculate the breakeven quantity of sales and determine the company's net income at various sales levels LOS37e: calculate and interpret the operating breakeven quantity of sales *** key total revenue = variable costs (quantity) + fixed operating costs + fixed financial costs this is how we transfer this to economic theroy, it is essentially the same thing but breaks fixed costs into operating and financial csots

a company's breakeven point occurs at the number of units produced and sold at which its net income = 0. breakeven occurs at PQ = VQ + F +C total revenue = variable costs (quantity) + fixed operating costs + fixed financial costs similar to econ only breaks fixed costs into operating and financial costs Operating breakeven point - specified in terms of operating profit. revenues equal operating costs PQobe = F / P-V obe is subscript and stands for operating break even point the frather unit sales are from the breakoven point the greater magnifying effet of leverage

Beta (continued

a companys or projects beta is exposed to following systematic (nondiversifiable risks) business risk - sales risk and operating risk financial risk - uncertrainity of profits and cash flows because of fixed cost financing sources such as debt and leases. the greater the use of debt financing the greater financial risk of the firm

Stock Splits are similar to stock dividends in that they increase the total number of shares outstanding and have no economic effect on the company. However one important difference ->

a stock dividend results in transfer of retained earning to contributed capital, whereas a stock split has no impact on any shareholder equity accounts both stock split and reverse stock split are simple to bring the price into a more marketable range

Describe responsibilities of Audit, compensation, and nominations committees

audit commitee esnures financial information is complete, accurate, relaiable, relevant, and timely renumeration comittee - variatous form s of compensation offered to exectuties is in line nominations committee - recruiting new board members

Describe dividend payment chronology, inclduing the significanc of declaration, holder of record, ex dividend, and payment dates

declaration date - comapny announces a particular dividend ex dividend date - first day that share trades without the dividend any investor who oholds stock on or before is entiteld to the dividend holder of record date- date at which a shareholder listed in the company's records will be entitled to recieve the upcoming dividend. lenght of period between holder of record date and ex dividend date depends on the trade settlement cycle of the particular exchange. for example in the US trade settle 3 days after execution (T+3 settlement) there is a 2 day gap between the ex dividend date and the holder of record date payment date

Evaluating Management of Accounts Payable

important part of working capital managemtn as AP can be a source of working capital for the firm. by paying too early a company loses out on interest income. if pays late company risks reputation and relationship with suppliers. plus possible penalties and interest rate charges Guidelines trade credit and cost of borrowing or alternative cost - the standardization of comapny's payables is dependent on the importance of credit to the company and its ability to evaluate trade credit opportunities -the disbursement float - allwos comapnies to use their funds longer, if they fill chekcing account on the day the checks were mailed

we can evaluate a company's inventory management by analyzing the invertory turnover ratio and number of days inventory

inventory turnover = COGS/avg inventory Number of days of inventory = Inventory/avg days cost of goods sold = inventory / cost of golds sold/365 or 365/inventory turnover

LOS36b: Describe how taxes affect the cost of capital from different capital sources (Tax shield)

let's assume company pasy 50000 interest in a given year, the 50,000 is an expense that the company is allowed to recognize for tax purposes to reduce taxable income. Interest expense reduces profits before tax by 50,000 and assuming a 30% tax rate reduces profits after tax by only 35,000 that is because interest expense provides a tax shield of 15,000. tax shield is calcualted as interest expense multipled by the tax rate tax savings are only realized on payments to holders of debt instrumeents. preferred and ocmmon stock holders are not expensed on the income statment and do not result in tax savings (duh) essentially you get to pay back your debtors or loans with pre tax money

LOS37a: definte and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk 37b: calculate adn interpret the degree of operating leverage, the degree of financial leverage and the degree of total leverage 37c: analyze the effect of financial leverage on a company's net income and return on equity

leverage refers to a companys use of fixed costs in conducting business, fixed costs include: operating costs ( examples rent and depreciation) fianancial costs (examples interest expense) fixed costs are referred to as leverage because they support a companys activiites and earnings It is important for analysts for three reasons -Leverage increases the volatility of a companyes earning and cash flows, increasing risk borne by investorys - more signficiant use of leverage more risky it is, and therefore higher discount rate taht must be used to value the company -a company that is highly leveraged risks significant lsoses during economic downturns Leverage is affected by a companys cost structure -Variable costs, and fixed costs pg 38 **Really important, so if a company uses more fixed costs to produce the same net income then a higher fluctuation in sales will result in a larger fluction of net income, thus results in higher earnings volatility, Why leverage is important Graphing net income (y) and number of units produced and sold (x) can visualize this. the company with the steeper the slope of the net income curve illustrates a greater degree of leverage for a company

LOS39a: Describe primary and secondary sources of liquidity and factors that influence a comapny's liquidity position

liquidity management - ability of a company to gerate cash when reqiried primary sources - readily available such as cash balances and short term funds secondary sources, provide liquidity at a higher cost than primary sources, include negotiatiing debt contracts, liquidating assets, or filing bankruptcy protection using primary sources usually does not result in a change in a company's operations a drag on liquidity occurs when there is a delay in cash coming into the company Major drags on liquidity include: -uncollected receivables -obsolete inventory -tight credit - adverse economic conditions a pull on liquidity occurs when cash leaves the company too quickly Major pulls: -making payments early -reduced credit limits (as a result of not being able to make payments on time -limits on short term lines of credit -low existing levels of liquidity

Nonbank sources of short term fianance

nonbank finance companies, small weak borrowers, weak credits, prime +++ rate commercial paper - largest corporations, money market sets rate

Can evaluate a company's management of payable through its number of days of payables

number of days of payables = accounts payable/ avg days purchas =accounts payable/ (purchases/365) = 365/ payables turnover this ratio indicates the number of days on average it takes a company to pay its suplliers. number of days must be compared to the credit terms offered to the company

LOS39c: evaluate working capital effectiveness of a company based on its operating and cash conversion cycles and compare company's effectiveness to peer companies

opeerating cycles measures time needed to convert raw materials intoc ash from sales operating cycle = number of days of inventory + number of days of receivables Net opearatin cycle, or cash conversion cycle is length of period from paying suppliers for materials to collecfting cash from sales to customers net operating cylce = number of days of inventory + number of days of receivables - number of days payable a conversion cycle that is too long suggests that a company has too much invested in working capital

Survey s have studied the relatie popularity of various capital budgeting techniques and have found that: the payback method is very popular in european countries -larger companies prefer NPV and IRR over payback

pg 16 if a company invests in a positive NPV project, the expected addition to shareholder wealth should lead to an increase in the stock price however not as simple as pg 16 since stock price already takes into account expected growth. Also if a project opens the possibility for further projects may increase stock price by more than proportional increase in NPV

LOS38d: Calculate and compare the effect of a share repurchase on earnings per share when 1. repurchase if inanced with company's excess cash and 2 company uses debt to finance the repruchase

pg 60 Share repurchases may increase, decrease or have no effect on EPS -if funds used to finance repurchase are generated internally, a repurchyase will increase EPS only if funds would not have earned the company's cost of capital if they were retained by the company (no better options to invest in) -if borrowed funds are used to finance, and the after tax cost of borrowing is greater than the company's earnings yield, EPS will fall if money is more expensive than the company's earning yield, EPS will rise Earnings yield = EPS / Stock Price 5/80 = 6.25% *** Total return of stock is composed of capital gains (price increase) and dividends **so Bear in mind that it would be incorrect to infer that an increase in EPS indicates an increase in shareholder wealth. the cash used to finance the repurchase could as easily have been distributed as a cash dividend. any capital gains resuluting from an increase in EPS (stock price goes up) may be offset by a decrease in the stock's dividend yield

Investing short term funds

pg 70 shows list of what companies dow ith excess cash T-bills federal agency securities bank CDs Bankers acceptances BAs many more and more details on pg 70 when firm needs to borrow over the short term, they typically rely on bank overdrafts and commercial paper to meet their needs pg 72 determining yields of differnt short term investments (i skipped but may need to do)

LOS39g: Evaluate the choices of short term funding available to a company and recommend a financing method

pg 81 . Bank Sources uncommitted line, large corporations, compensation none, mainly in the US; limited liabilty a bank offers a line of credit to a company for a certain period of time, but resrerves right to refuse to lend. weakest and least realiable form of borrowing, but does not require compensaiton other than interest committed lines (regular lines of credit) - require formal commitment form the bank revolving credit agreements - strongest form of short term borrowing, ujnlike regulaar lines, they are in affect for multiple years

Capital Budgeting

process companies use for making long term investment decisioins, (acquiring new machingery, replacing, launching new products, R&D. Capital budgeting is important because: -capital is typically tied up in long term projects, need these investments to be successful -the valuation principles used in capital budgeting are also applied in security analysis and portfolio managemnet -sound capital budgeting decisions maximize shareholder wealth

Financial Risk

risk refers to how company chooses to finance its operations. if compnay chooses to issue debt(get a loan) or acquire assets on long term leases. it is obligated to make regular payments. so by taking these fixed obligations the comapny increases its financial risk. hwoever if it uses retained erainings or issues shares to finance operations, company does not require fixed obligations. higher amount of fixed financial costs taken by a comany, the greater its financial risk degree of financial leverage DFL = percentage change in net income/ percentang echange in operating income the higher the use of fixed fianancing the greater the sensitivity of net income to changes in operating income and therefore the higher financial risk of the company. note that the degree of financial leverage is different at different levels of operating income the degree of fianancial leverage is usally determined by the companys management. DFL = (Q(P-V)-F)/ (Q(P-V)-F-C) stable revenue streams and assets tha can be used as collateral make lenders more comfortable in extending credit the larger proportion of debt in a comapnys capital strucutre the greater the sensitivy of net income to changes in operating income, and therefore the greater the companys financial risk. bear in mind that taking on more debt also magnificies earnings upward if the company is performing well. illustrated by higher ROEs in scenario B

Lesson 2 LOS38c Compare share repurchases method

shares that are repurchased by the comapny are known as treasury shares and once repurchased are not considered fro dividends, voting, or calculating earnings per share Share repruchases versus cash dividends - just because a company authorizes a share repurhcase, does not necessarily mean that the company is obligated to go through with it. -cash dividends are distributed to shareholders in proprtion to their ownership percent. repurchases gernally do not distrubtue in such a manner. Arguments for -send out signal to market that managment believes stock is udnrvalued -tax advantage to distrubuting cash through repruchases in markets where capital gains are taxed at a lower rate than dividends

aproaches to short term borrowing

some companies take secured short term loans, which are known as asset based loans (loans collaterized usually by receivables and inventory) Computing the costs of borrowing line of credit cost =( interest + commitment fee)/loan amount cost of banker's acceptacnce = Interest/net proceeds = interest/ (loan amount - interest) cost of commercial paper = interest + dealer's commision + backup cost ) / (loan amount - interest)

Problems wit the IRR

sometimes cash flow streams have no IRR (there is no discount rate that results in zero NPV) NPV profile for a project with multiple IRRs more than one sign change in the cash flow stream

LOS36j: Describe uses of country risk premiums in estimating cost of equity

stocks beta captures the country risk of a stock accurately only in developed markets. to deal with this the CAPM equation for stocks in developing coutnries is modified to add a country spread (aslo called country equity premium) re = Rf + B [E(Rm) - Rf + CRP] CRP is cacluated as product of soverigh yiedl spread and the ratio of volatility of the developing country's equity market to the voaltility of the sovereign bond market denomitnated in terms of the currency of a developed country country risk premium = soverign yield spread x (annualized standard deviation of equity index/ annualized standard deviation of sovereighn bond market in terms of developed market currency)

1. Capital Asset Pricing Model (CAPM)

the CAPM states that the expected rate of return from a stock equals the risk free interest rate plus a premium for bearing risk. re = Rf + B(E(Rm)-Rf) where (E(Rm) - Rf )= equity risk premium RM = expected return on the market B= Beta of stock, beta measures the sensitivity of the stocks returns to changes in market returns RF= risk free rate re = expected retuen on stock (cost of equity) The equity market risk premium (Rm-Rf) can be estimated using a survey approach where the average of the forecasts of financial experts is adjusted for the specific stock's systemaitic (nondiversifiable) risk.

3. Bond Yield Plus Risk Premium Approach

the bond yield plus risk premium approach is baed on the assumption that the cost of capital for riskier cash flows is higher than that of less risky cash flows. therefore calculte ROE by adding a risk premium to the before tax cost of debt re = rd + risk premium

Evaluating Inventory Management

the main goal of inventory management is to maintain a level of inventory that smooths delivery of sales without having more than necessary invested in inventory high level of inventory is undesirable as it inflates storage costs, what are axioms storage costs what benefits do attorneys receive on the beach a shortage of inventory can hurt sales as the company loses on potential customers companies may have variety of motives for holding inventory: transactin motive: kept for planned manufacturing activity precautionary mothive: inventory is kept to avoid any stock out losses speculative motive: inventory is kept because believe prices are expected to icnrease need to avoid costs of holding excessive inventory, and at the same time ensure that they hold sufficient stock to avoid hampering sales. However companies need to strike a balance avoid costs of holding excessive inventory. Two basic approaches to managing inventory levels are economic order quantity and just in time economic order quantity - order quanitity for ivnentory that minimzies its total ordering and holding costs EOQ-ROP method, ordering point for invetnory is determined on the basis of costs of ordering and carrying invetnory. this method relies on expected demand, which makes it imperative that short term foreceasts are reliable the just in time method, the reoirder point is primarily determined on the basis of historical demand

Profitability Index

the profitability index of an investment equals the present value (PV) of a projects future cash flows divided by the initial investment PI =PV of future cash flows/initial investment = 1 + (NPV/intial investment) PI equals ratio of discounted future cash flows to the initial investment NPV equals the difference between discounted future cash flows and the initial investment PI indicates the value in exchange we receive for unit of currency investsed. it is also known as the "benefit cost ratio" Decision rules, company should invest if its PI is greater than 1

Payback period

the time it takes for the initial investment for a projected to be recoved through after tax cash flows from a project at what year do we become pofitable Advantages - it is simple to cacluate and explain-it can also be an indicator of liquidity Drawbacks it ingores risk of the project, as in cash flows are not discounted at the projects required rate of return -it ignores cash flow that occur after the payback period is reached -it is not a mearue of profitability

Discounted Pyaback period

this payback period equals the number of years it takes for cumulative DISCOUNTED cash flow to equal intial investmetn outlay. essentially the rate of return is subtracted off risk (discount rate) it is taking away one of the drawbacks from basic payback period pg 10 Advantage - it accounts for the time value of money and risks associated with projects cash flows draw back - it ignores cash flows that occur after the payback period is reached.

LOS36a: Calculate and interpret the weighted avg cost of capital (WACC) of a company

to raise capital, a company can either issue equity or debt (some instrumetns may have both features of debt and quity) -an instrument that is used to obtain financing is called a COMPONENT and each component has a different required rate of return, which is known as the component cost of capital. the weighted average costs of the various compnents used by the company to finance its operations is known as (WACC) or the marginal cost of capital (MCC) WACC = (wd)(rd)(1-t) + (wp)(rp)+(we)(re) wd = proprtion of debt that company uses when it raises new funds rd= before tax marginal cost of debt t=marginal tax rate wp=proprtion of preferred stock that the company uses when it raises new funds rp = marginal cost of prefferred stock we=proprtion of equity that company uses when it raises new funds re= marginal cost of equity ********This equation breaks up the marginal cost of capital relative to preferred stock, debt, or equity

2. Debt Rating Apprach

when reliable current market price for the company's debt is not avilable, the before tax cost of debt can be estimated using the yield on similarly rated bonds that also have smilar terms to maturity as the companys existing debt Issues in Estimating Cost of Debt -Fixed rate versus floating rate debt - cost of floating rate is reset periodically based on the LIBOR, and is more difficult to estimate, analysts may use current term structure, adn term structure theory to estimate cost of debt -debt with option like features -nonrated debt - if a compnay does not have debt outstanding -if a company uses leases as a source of finance, the cost of these leases should be included in its cost of capital