B3 3.2 Leverage
A company has the following information in its financial records: Beginning balance // Ending balance Cash// 3,900//$3,000 Marketable securities//3,800//4,400 Accounts receivable//14,600//12,900 Total current assets //$22,300//$20,300 Net sales $103,200 Expenses 20,430 =Net income $82,770 What is the company's receivable turnover ratio? *A. 7.5* B. 8.0 C. 7.1 D. 6.0
(A) AR turnover = Net Sales / Avg A/R Beg A/R $14,600 End A/R 12,900 =27500 total /2 =13,750 average A/R Sales= 103,200 *103,200 Sales / 13,750 average A/R= 7.50*
A firm that designs its cost structure to include a higher degree of operating fixed costs than variable costs by electing to pay salaries instead of commissions, is magnifying the impact of each additional sales dollar using the concept of: a. combined leverage b. fixed leverage *c. operating leverage* d. financial leverage
(C) Operating Leverage
ABC Co. had debt with a market value of $1 million and an after-tax cost of financing of 8%. ABC also had equity with a market value of $2 million and a cost of equity capital of 9%. ABC's weighted-average cost of capital would be *A. 8.7%* B. 9.0% C. 8.5% D. 8.0%
(a) Debt 1,000,000 Equity 2,000,000 Total=3,000,000 Debt weight: 1,000,000 / 3,000,000 = 0.33 Equity weight: 2,000,000 / 3,000,000 = 0.67 =======//After-tax//wght//Product Debt//8%//0.33//2.64 Equity//9%//0.67//6.03 *WACC===========8.67% approx 8.7%*
*Lockbox service* A company has daily cash receipts of $150,000. The treasurer of the company has investigated a lockbox service whereby the bank that offers this service will reduce the company's collection time by four days at a monthly fee of $2,500. If money market rates average 4% during the year, the additional annual income (loss) from using the lockbox service would be: A. $6,000. *B. $(6,000).* C. $12,000. D. $(12,000).
(b) A company's decision to commit to a lockbox plan is an example of marginal analysis. In other words, do the marginal benefits exceed the marginal costs of the plan? Marginal revenue equals: Increase cash receipts available for investment $150,000 per day x 4 days collection reduced =$600,000 * Can be invested at 4% =$24,000 Marginal revenue Less marginal cost Mo Lockbox fee x 12 $2500 x 12= (30,000) =*(6000) loss on plan*
A company has total costs of $100,000, of which 40% is variable costs. What is the operating leverage? a. 2.5 *b. 1.5* c. .40 d .60
(b) A shortcut computation for operating leverage is the ratio of fixed costs to variable costs. If total cost is $100,000 and variable cost is 40% of total costs (or $40,000), then fixed costs must be 60% (or $60,000). Operating leverage calculated as: Fixed costs / Variable costs= Operating leverage =60,000 FC / 40,000 VC =*1.5*
The following selected data pertain to the Darwin Division of Beagle Co. for the current year: Sales 400k Operating income 40k Capital turnover 4 Imputed interest rate 10% What was Darwin's current year residual income? a. 0 *b. 30,000* c. 10,000 d. 4,000
(b) Capital turnover=Net sales / Avg capital 4=400,000/ Avg Capital 4Avg Capital=400,000 Avg Capital= 400,000/4 AVg Capital= 100,000 Residual Income = Net Income - Required Return on Investment =40,000 - (0.1 x 100,000) =40,000-10,000 *Residual income=30,000*
A divisional manager receives a bonus based on 20% of the residual income from the division. The results of the division include: Divisional revenues, $1,000,000; divisional expenses, $500,000; divisional assets, $2,000,000; and the required rate of return is 15%. What amount represents the manager's bonus? A. $100,000 *B. $ 40,000* C. $200,000 D. $140,000
(b) Residual Income = Income - Hurdle Income (Based on assets) *Income:* Rev: 1,000,000 Exp: (500,000) =*Income $500,000* *Hurdle Income:* Assets 2,000,000 Req return 15% =*Hurdle $300,000* Residual income=*Income $500,000* - *Hurdle $300,000* *Residual Income= $200,000* * 20% Bonus rate =Bonus amount $40,000
*Effective interest rate* Acorporation obtains a loan off $200 000 at an annual rate of 12. The corporation must keep a compensating balance of 20% of any amount borrowed on deposit at the bank, but normally does not have a cash balance account with the bank. What is the effective cost of the loan? a. 13.3% *b. 15.0%* c. 12.0% d. 16.0%
(b) The effective rate of interest or cost of financing arrangements is the amount paid on the loan divided by the net proceeds. The fact pattern tells us that interest is paid at 12% while cash available is reduced by a 20% compensating balance that was not otherwise required. The effective interest rate is, therefore: Interest paid ($200,000 x 12%) *$24,000* */* Net proceeds: $200,000 x 80% (100% - 20% compensating balance) *$160,000* = 15%
The stock of Fargo co. is selling for $85. The next annual dividend is expected to be $4.25 and is expected to grow at a rate of 7%. the corporate tax rate is 30%. What is the firm's cost of common equity? a. 5.0% *b. 12.0%* c. 7.0% d. 8.4%
(b) Under discounted cash flow (DCF) method, the cost of equity is computed as: Expected dividend / Current share price (+growth rate) D1 / P0 +g $4.25 Expected dividend / $85 Current share price = 0.05 0.05 + 0.07 growth rate = 0.12= 12% When expected dividend not given but current dividend we paid this period we can calculated the expected dividend using the following: D1=D0 x (1+g) Expected dividend = Current dividends per share x (1+Growth Rate)
Payment Discounts
-> When Company *gives payment discount* to their customer, it will be *"COST"* for the company. -> When Company *receives payment discount* from Vendor and company does NOT take it, that is an "*OPPORTUNITY COST*" for the company.
DQZ Telecom is considering a project fro the coming year, which will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment. -Issue 15 million of 20 year bonds at a price of 101, with a coupon rate of 8 percent, and flotation costs of 2 percent of par. -Use 35 million of funds generated from (retained) earnings The *equity market is expected to earn 12 percent*. *U.S. treasury bonds are currently yielding 5 percent*. The *beta coefficient* of DQZ is estimated to be *0.60*. DQZ is subject to an effective corporate income tax rate of 40 percent. Assume that after-tax cost of debt is 7 percent and the cost of equity is 12 percent. Determine the weighted average cost of capital. *Compute DQZ's expected rate of return using the Capital Asset Pricing Model (CAPM). a. 12.20 percent *b. 9.20 percent* c. 7.20 percent d. 10.0 percent
(b) 9.20 percent CAPM formula: C = R + B (M-R) CAPM formula = Risk free rate + {beta x (Market return - Risk free rate)} C= cost of equity capital R= Risk free rate (treasury bond rate) B= Beta coefficient of comparable publicly traded stock M= Market rate of return = R + B (M-R) = .05 + 0.6 (.12 - .05) = .05 + .60 (.07) =.05 + .042 =.092 =9.20 percent
Spotech Co.'s budgeted sales and budgeted cost of sales for the coming year are $212,000,000 and $132,500,000 respectively. Short-term interest rates are expected to average 5 percent. If Spotech could increase inventory turnover from its current 8 times per year to 10 times per year, its expected cost savings in the current year would be: a. $331,250 b. $250,000 *c. $165,625* d. $81,812
(c) Cost savings by going from Inv turnover of 8 to 10? Inventory turnover= COGS / Avg inv *VERY IMPORTANT TO MEMORIZE INVENTORY TURNOVER FORMULA* *Inventory turnover ratio used to evaluate firms efficiency* *8* =132,500,000/ Avg inv 8Avg inv = 132,500,000 *Avg inv = 16,562,500* *10* =132,500,000/ Avg inv 10Avg inv = 132,500,000 *Avg inv = 13,250,000* 8: *Avg inv = 16,562,500* - 10: *Avg inv = 13,250,000* = 3,312,500 *Inventory Decrease* x 5% avg ST int rates = *$162,625 Cost savings*
A company with a combined federal and state tax rate of 30% has the following capital structure: *Weight//Instrument//Cost of capital* 40%//Bonds//10% 50%//Common stock//10% 10%//Preferred stock//20% What is the weighted-average after-tax cost of capital for this company? A. 8.2% B. 7.7% *C. 9.8%* D. 3.3%
(c) The weighted average cost of capital (WACC) is 9.8%. Computation of the weighted average cost of capital purely weights the cost of each form of capital financing wit its relative percentage of total financing. The cost used for the WACC is the *after-tax cost of capital.* The scenario above provides a number of capital financing instruments and their relative weight in the capital structure. *Debt costs are reduced by tax benefits while common and preferred equity costs are not* Debt cost is reduced by the tax shield...company gets interest deduction for tax purposes which reduces cost of debt...so we would only account the (1-tax rate) amount as the cost...while the tax rate amount is not considered as part of the cost. ===//Pre-tax//Tax//After-tax//wght//Product Debt//10%//* (1-.3)//=7%//*40%//=*2.8%* Com//10%//*N/A//=10%//*50%//=*5.0%* Pref//20%//*N/A//=20%//*10%//*2.0%* *WACC*======================*9.8%* Debt cost is 10%....we get tax shield of 30% which reduces the cost of debt by 30%....so .1 x .3= 0.03 amount debt reduced by...so original cost of debt is .1 - .03 reduction = .07 remaining cost of debt
A company has income after tax of $5.4 million, interest expense of $1 million for the year, depreciation expense of $1 million, and a 40% tax rate. What is the company's times interest- earned ratio? a. 5.4 b. 6.4 c. 7.4 *d. 10.0*
(d) *Compute pretax income* After tax income of 5.4 million = Pretax income x (1-40%) 5.4 million / 60% = Pretax income 9,000,000=Pretax income *Add interest to pretax income to arrive at EBIT* Pretax income + interest = EBIT 9,000,000 + 1,000,000 = $10,000,000 *Compute times interest earned* Times interest earned = 10,000,0000(EBIT) / 1,000,000(interest expense) *Times interest earned=10.0*
DQZ Telecom is considering a project for the coming year, which will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment. -Issue 15 million of 20 year bonds at a price of 101, with a coupon rate of 8 percent, and flotation costs of 2 percent of par. -Use 35 million of funds generated from (retained) earnings The equity market is expected to earn 12 percent. U.S. treasury bonds are currently yielding 5 percent. The beta coefficient of DQZ is estimated to be 0.60. DQZ is subject to an effective corporate income tax rate of 40 percent. Assume that after tax cost of debt is 7 percent and the cost of equity is 12 percent. Determine the weighted average cost of capital. a. 6.30 percent b. 9.5 percent c. 8.5 percent *d. 10.50 percent*
(d) ================>//Debt//Equity//Total Investment Dollars//$15 mil//+ 35 mil // = $50mill Investment Structure//30%// +70% // = 100% Cost of investment//*x* 7%// *x* 12% // WACC // = 2.1% // + 8.4% // = *10.5%* *Investment structure 15 mil debt / 50 mil total = 30% 35 mil debt / 50 mil total = 70% *Investment structure 30% x Cost of investment 7% = 2.1%*
*Float*===> measures the number of days it takes a typical check to "clear" through the banking system. Assume that each day a company writes and receives checks totaling $10,000. If it takes five days for the checks to clear and be deducted from the company's account, and only four days for the deposits to clear, what is the float? a. $0 b. ($10,000) c. $25,000 *d. $10,000*
(d) Float is the difference between the balance of checks outstanding, which have not cleared the bank and deposits made but which have not cleared the bank hee. $10,000/day checks drawn but not cleared x 5 days= $50,000 Less $10,000/day deposits made but not cleared x 4 days = (40,000) = Positive "float" *$10,000*
The *theory underlying the cost of caital* is primarily concerned with the cost of:
* Any combination of old or new, short term or long term funds* The cost of capital considers the cost of all funds, whether they are short-term, long-term, new or old.
Which one of a firm's sources of new capital usually has the lowest after tax cost?
*Bonds* Because debt is a cheaper source of financing than equity, bonds will be the cheapest form of financing. In addition, the company issuing bonds *receives a tax deduction for interest paid.* This further reduces the cost of bond financing.
Cash discounts facts
-The cost of not taking a cash discount is generally *higher* than the cost of a bank loan. and higher than the prime rate
Corporate treasurer: Cash and short-term investments
-When managing cash and short-term investments, a corporate treasurer is primairly concerned with *liquidity and safety* -The board of directors and general management would be interested in *maximizing rate of return on company operations*
*Discounted Cash Flow (DCF) Example* Assume that a firm is a constant growth firm that just paid an annual common stock dividend of *$2.00* (D0), has a dividend growth rate of 7.5% and a current market price for common stock of $25.25 per share. Compute the cost of retained earnings using the discounted cash flow (DCF) method.
*Compute the dividend per share expected at the end of the year as follows* Since dividend for next period NOT given....We can use the expected dividend which would be the dividend paid this year times 1 plus the growth rate to arrive at dividend for next period D1=D0 x (1+g) D1= $2.00 x (1 + 0.075) D1= $2.00 x 1.075 D1=$2.15 *Cost of retained earnings using the Discounted Cash Flow (DCF) method* Cost of Retained Earnings =(D1/Po) + g =Dividend next period / Current Stock price + Growhth =($2.15 / $25.25) + 0.075 =0.0851 + 0.075 =0.1601 = 16.01
*Bond Yield + Risk Premium (BYRP) Example* Assume the a firm has estimated its market risk premium at 4.5% and has determined that the yield to maturity on its own bonds is 11.34%. Compute the cost of retained earnings using the bond yield plus risk premium (BYRP) method
*Cost of Retained earnings Using the Bond Yield Plus Risk Premium Method* Cost of retained earnings = Firm's own bond yield + Market risk premium = 0.1134 + 0.045 = 0.1584
The three elements needed to estimate the cost of equity capital for use in determining a firm's weighted average cost of capital are:
*Current dividends per share, expected growth rate in dividends per share, and current market price per share of common stock* D1 / P0 +g D1=D0 x (1+g) D0 = expected dividend or current dividends per share G= constant growth rate in divs P0=Current market price per share of CS
Capital investments require balancing risk and return. Managers have a responsibility to ensure that the investments that they make in their own firms increase shareholder value. Managers have met that responsiblity if the return on the capital investment:
*Exceeds the rate of return associated with the firm's beta factor* A capital investment whose rate exceeds the rate of return associated with the firm's beta factor will increase the value of the firm.
The imputed interest rate used in the *residual income approach* for perforance measurement and evaluation can *best* be characterized as the:
*Historical weighted average cost of capital for the company* Historical weighted average cost of capital is usally used as the target or hurdle rate in the residual income approach
The optimal capitalization for an organization usually can be determined by the:
*Lowest total weighted average cost of capital (WACC)* The optimal capitalization for an organization usually can be determined by the lowest total weighted average cost of capital (WACC). Capitalization serves to maximize shareholder's equity.
Lockbox system Which of the following effects would a lockbox most likely provide for receivables management?
*Minimized collection float* A lockbox system expedites cash inflows *(minimized collection float)* by having a bank receive payments from a company's customers directly, via mailboxes to which the bank has access. Payments that arrive in these mailboxes are deposited into the company's accounts immediately.
Vested, Inc. made some changes in operations and provided the following information: *=======================//Year 2//Year 3* Operating revenues//$ 900,000//$1,100,000 Operating expenses//650,000//700,000 Operating assets//1,200,000//2,000,000 What percentage represents the return on investment for year 3? a. 20.31% b. 20% c. 28.57% *d. 25%*
*ROI =>Net Income / Average Assets* Operating revenue (Year 3) $1,100,000 Operating expense (Year 3) (700,000) = Operating income $400,000 Operating assets (Year 2) 1,200,000 Operating assets (Year 3) 2,000,000 =Total 3,200,000 / 2 =avg op assets 1,600,000 ROI=Operating income $400,000 / avg op assets 1,600,000 *ROI = .25=25%*
Listed below is selected financial information for the Western Division of the Hinzel Company for last year. Amount ........................................Account (thousands) Average working capital........................ $ 625 General and administrative expenses .......75 Net sales............................................... 4,000 Average plant and equipment ................1,775 Cost of goods sold ..................................3,525 If Hinzel treats the Western Division as an investment center for performance measurement purposes, what is the before-tax return on investment (ROI) for last year? *a. 16.67 percent* b. 26.76 percent c. 19.79 percent d. 22.54 percent
*ROI =>Net Income/ Average PP&E + Average Working Capital* Net income: Sales: 4000 COGS: (3,525) G&A expense: (75) =$400 NI Investment: Avg working capital: 625 Avg Plant & equip: 1,775 = $2400 investment *ROI Formula= $400 income/$2,400 investment = 16.67%*
Which of the following rates is most commonly compared to the *internal rate of return* to evaluate whether to make an investment?
*Weighted average cost of capital* The weighted average cost of capital is frequently used as the hurdle rate within capital budgeting techniques. Investments that provide a return that exceeds the weighted average cost of capital should continuously add to the value of the firm.
*Leverage:* Leverage is the Use of Fixed Costs to amplify Risks assumed and Potential Returns.
*What is Operating Leverage?* Operating Leverage is the degree to which a company uses *Fixed Operating Costs rather than Variable Operating Costs* (*such as Depreciation or Rent, which is totally Independent of Sales "Fixed"*) Operating leverage is the presence of *fixed costs* in operations, which allows a small change in sales to produce a largeer relative change in profits
EOQ Equation: (*2 SOC*)
*^/*square root 2 x Annual *S*ales (units) x *O*rder cost / *C*arrying cost per unit *Note:* Sales can be used as either Annually or Monthly (In Units), it depend on the information you receive on the Exam.
Interpretation of Economic Value Added (EVA)
-> A Positive (*+*) EVA indicates the Performance is meeting standards (thus its performance is adding Value to the Stock and Stock goes UP) -> A Negative (*-*) EVA indicates that performance is Not meeting standards (thus its performance is Not adding value to the Stock and Stock goes Down)
ROI facts -Goal congruence is promoted through the use of *residual income approach. The *ROI approach* may cause segments that achieve high returns to reject investments that may benefit the company but lower the segment's rate of return.
-When the average age of assets differs substantially across segments of a business, the use of ROI may not be appropriate -The use of ROI may lead managers to reject capital investment projects that can be justified by using discounted cash flow models -The use of ROI can make it undesirable for a skillful manager to take on troubleshooting assignments such as those involving turning around unprofitable divisions -The primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investment center managers is that ROI may lead to rejecting projects that yield positive cash flows. Profitable investment center managers might be reluctant to invest in projects that might lower their ROI, even though those projects might generate positive cash flows for the company as a whole. This characteristic is often known as the *"disincentive to invest"* -ROI encourages shortsighted behavior that defers or avoids investment for the skae of current ROI performance. Short term benefits are emphasized over long term commitents -ROI is controlled or influenced by managers and can be manipulated
*Weighted Average Cost of Capital- Debt and Equity Example* Assume that the cost of equity capital for XYZ is 17.8%. Also assume a weighted average interest rate of 10% and a targeted capital structure composed of 75% equity and 25% debt. Finally, assume a tax rate of 30%. What is XYZ's WACC? *The optimal capital structure is the mix of financing instruments that produces the *LOWEST WACC* ====>Minimum weighted average cost of capital is consistent with a firm's target or optimal capital structure
1. Cost of debt (after tax): = Interest rate x (1-Tax Rate) =10% x (1-30%) =10% x 70% =7% 2. WACC= (75% equity x 17.8% cost of equity *given*) + (25% debt x 7% cost of debt)= (1.75) + (13.35) = 15.1% If XYZ is using its WACC as the *hurdle rate* then it should *invest in any project that will yield* a return higher than 15.1%
The following information regarding inventory policy was assembled by the JRJ Corporation. The company uses a 50-week year in all calculations. Sales 10,000 units per year Order quantity 2,000 units Safety stock 1,300 units Lead time 4 weeks The reorder point is:
10,000 unit sold in year / 50 weeks in a year = 200 units sold per week Reorder point= Safety stock + (Lead time x Sales during lead time) =1,300 safety stock + (4 weeks x 200 units sold per week) =1,300 safety stock + 800 units used during lead time *Reorder point= 2100 units*
Average collection period
A company's average collection period is used to evaluate the *liquidity* of the firm through the calculation of the cash conversion cycle. *Liquidity* measurements focus on the ability of the company to meet obligations as they come due.
*IMPORTANT MEMORIZE* How to calculate Annual Cost (APR), If the Discount (provided by supplier) is *NOT* taken by the Company?
APR of quick payment discount AKA Annual cost of not taking discount = *360 / (Total pay period - Discount period)* *X(multiply) *Discount% / (100% - Discount %)*
Receivable Collection Period: *Number of Days to Collect the Receivables*
Account receivable turnover = Sales / Avg A/R Rec collection pd=Days sales O/S (DSO) = 365/AR turnover
3. Payable Deferral Period: *Number of Days to pay the Payables*
Accounts payable turnover= COGS / AVG A/P Accounts payable deferral period = 365 / AP turnover
2. Receivable Collection Period: *Number of Days to Collect the Receivables*
Accounts receivable turnover= Sales / AVG A/R Receivables collection period= Days sales outstanding (DSO) = 365/AR turnover
*IMPORTANT MEMORIZE* If a retailer's terms of trade are 3/10, net 45 with a particular supplier, what is the cost on an annual basis of not taking the discount? Assume a 360-day year. a. 24.00% b. 37.11% c. 36.00% *d. 31.81%*
Annual cost of not taking discount = 360 / (Total pay period - Discount period) * Discount% / (100% - Discount %) = 360 / (45-10) * 3%/(100%-3%) =360/35 * 3%/97% =*31.81% annual cost of not taking the discount*
Asset Turnover Ratio
Asset Turnover => Sales / Average Total Assets
Working Capital
CA - CL = Working capital Working capital incr if CA incr or CL decr e.g., Exhanging account payable (CL) for a two year not payable (Long term liablity) would decrease CL and increase WC
What is Quick Ratio (Acid Test)? Used by management to evaluate short term liquidity
CA-Inv-Prepaids / CL or Cash+Marketable sec + Rec / CL
The cash conversion cycle is the sum of the inventory conversion cycle and receivable collection period minus the payables deferral period: *Decreasing inventory conversion and accounts receivable collection periods indicates cash is being collected faster from sales of product and speedy collections from accounts receivable* *The increasing deferral period on payables indicates that cash disbursements are being held as long as possible.* *We want Decreasing Inventory conversion period and Receivable collection period while we want Increasing Payable deferral period*
Cash conversion cycle = Inventory conversion period + Receivables collection period- Payables deferral period *Inventory conversion period + Receivables collection period* = # days to sell + % days to collect = Operating cycle* *Note:* The Lower the Operating cycle, the Better.
Market rate of interst on a *One Year U.S. Treasury bill*
Comprised of the *RISK FREE RATE OF RETURN and an INFLATION PREMIUM*
2. Discounted Cash Flow (DCF) // Cost of equity capital
Cost of retained earnings = *D1*Dividend per share expected at the end of one year / *P0*Current market value or prices of O/S CS + *g* Constant growth rate in dividends =================================== *DCF= D1 / P0 +g* *D1 also = D0 x (1+G)* D0 = expected dividend G= constant growth rate in divs *Note:* Only Multiply {Expected Dividend (D0 ) x (1 + Growth Rate (g)} IF Future Dividend (D1) is NOT Given
3. Bond Yield + Risk Premium (BYRP)
Cost of retained earnings = Pretax cost of long term debt + Market Risk premium
*There are 3 common methods of computing the Cost of Retained Earnings:* 1. *C*apital *A*sset *P*ricing *M*odel (CAPM) Cost of Retained Earnings Formula (CAPM)
Cost of retained earnings = Risk free rate + Risk premium =Risk free rate + (Beta x Market risk premium) *= Risk free rate + {beta x (Market return - Risk free rate)}* ===>MEMORIZE *beta coefficent*= % change in stock price / % change in market price The beta coefficient represents the measure of a particular stock's percentage change compare to the percentage change in the market over the same period. *Risk free rate= Risk free rate earned on U.S. Treasury bonds
Zig Corp. provides the following information: Pretax operating profit $300,000,000 Tax rate 40% Capital used to generate profits 50% debt, 50% equity $1,200,000,000 Cost of equity 15% Cost of debt 5% What of the following represent Zig's year-end economic value-added amount? a.$180,000,000 b. $120,000,000 c. $0 *d. $60,000,000*
EVA = Net Operating Profit After Taxes -Investment* WACC Pretax operating profit: 300,000,000 Less:taxes (40%) (120,000,000) =NOPAT *180,000,000* Less:Required return (*WACC*) Cost of equity .5 weight x 1,200,000,000 capital x .15 return = $90,000,000 Cost of debt .5 weight x 1,200,000,000 capital x .05 return = $30,000,000 Total required return: *$120,000,000* NOPAT *180,000,000* - Total required return: *$120,000,000* = EVA $60,000,000
What is Financial Leverage? *Financial leverage is the amount of debt used to finance an asset. Higher leverage= more debt*
Financial Leverage is the degree to which a company uses *debt rather than equity* to finance the company. When Entity *Incur Debt* ---> that is *Fixed* such as *Interest Expense* on Line of Credit (which is Independent of Sales) Financial Leverage => Average Total Assets / Equity
Gross margin ratio::: Evaluates company's profitability
Gross Margin / Net Sales
Just in time inventory JIT models were developed to reduce the lag time between inventory arrival and inventory use
In a just in time system, products are produced just in time to be sold. Therefore, JIT systems maintain a much smaller level of inventory when compared to traditional systems. Inventory turnover (COGS / AVG Inventory) increases (Denominator decrease so ratio increases) with a switch to JIT, and inventory as a percentage of total assets decreases
Working capital policy
Increase in the ratio of current asset to noncurrent asset= *More conservative* Increase in the ratio fo current liabilities to noncurrent liabilities= *More aggressive approach*
*What are the Elements of Cash Conversion Cycle?* 1. Inventory Conversion Period: *Number of Days to Sell the Inventory*
Inventory turnover = COGS / AVG Inventory Inventory coversion period = 365 / Inventory Turnover=====> # days to sell
Investment turnover ratio
Investment turnover ratio = Sales / Avg Assets
What is the advantage of Current Ratio? Used to evaluate a company's liquidity *Solvency* refers to an enterprise's capacity to meet its long-term financial commitments. *Liquidity* refers to an enterprise's ability to pay short-term obligations
It is a way of measuring company's *Short-Term* Solvency. Current ratio = CA / CL *Note:* High Current Ratio *means* High Working Capital (*thus company can easily meet short term Obligations*) *Note:* High Current Ratio is *Better* in terms of "*Risk Reduction*", but *NOT* on "*Higher Returns*".
What is "*Conservative*" Working Capital Management?
It means High Working Capital ---> High Current Ratio ----> Less Risk...more assets As a company become more conservative in its working capital policy, it would tend to have an increase in the ratio of current assets to units of output.
What is "*Aggressive*" Working Capital Management?
It means Less Working Capital ---> Less Current Ratio ----> High Risk.....less assets
The capital structure of a firm includes bonds with a coupon rate of 12% and an effective interest rate of 14%. The corporate tax rate is 30%. What is the firm's net cost of debt? *a. 9.8%* b. 8.4% c. 12.0% d. 14%
Net cost of debt = Effective interest rate debt net of tax Net cost of debt: Effective interest rate 14% x (1-30%) =14% x 70% =9.8%
Assume that preferred stock component of the weighted average cost of capital for the firm is 10% $100 par value preferred stock that was issued at par value with a flotation cost/cost of issuing stock of $5 per share. Compute the cost of preferred stock.
Preferred stock dividend:Dividend percentage time par value= 10% x $100=$10 Cost of preferred stock = Dividends / Net proceeds =$10/ $100 par -$5 cost =10/95 =0.10526 *When market price given for preferred stock...when calculating Net proceeds we would use selling price - cost to arrive at net proceeds*
Return on Assets (ROA) *Ratio of income to assets employed* ROA is a profitability measure that can be used to evaluate the *efficiency of asset usage* and management, and the effectiveness of business strategies to create profits.
ROA => Net Income / Average Total Assets OR ROA => Net Profit Margin x Assets Turnover which is: (Net Income / Sales ) x (Sales / Total Average Assets) which ends up to: Net Income / Total Average Assets
Select Co. had the following current-year financial statement relationships: Asset turnover 5 Profit margin on sales 0.02 What was Select's current-year percentage return on assets? A. 0.1% b.0.4% C.2.5% *D. 10.0%*
ROA => Net Profit Margin x Assets Turnover (Net Income / Sales ) x (Sales / Total Average Assets) =0.02 x 5 =10%
Wexford Co. has a subunit that reported the following data for Year 1: Asset (investment) turnover 1.5 times Sales $750,000 Return on sales 8% The imputed interest rate is 12%. What is the division residual income for Year 1? a. $60,000 b. $30,000 c. $20,000 d. $0
Residual Income = Income - Hurdle Income Return on Sales = Net Income / Sales 8%=Net Income/750,000 Net income=(8%)(750,000) *Net income=60,000* Asset Turnover = Sales / Avg Total Assets (Division's Investment) 1.5=750,000/Avg Total assets 1.5Avg Total Assets=750,000 Avg Total Assets= 750,000 / 1.5 Avg Total Assets = 500,000 Required return= Assets x imputed rate Required return=500,000 x .12 *Required return=60,000* Residual Income = Net Income - Required Return on Investment Resiudual income = $60,000 - $60,000 *Residual income=$0*
James is the manager of Industrial Division, and his performance is measured using the residual income method. James is reviewing the following forecasted info for his division next year. Working Capital- $1,800,000 Revenue - $30,000,000 Plant and Equip - $17,200,000 If the imputed interest charge is 15% and Webb wants to achieve a residual income target of $2 mill, what will costs have to be in order to achieve the target? a. 23,620,000 *b. 25, 150,000* c. 25,690,000 d. 10,800,000
Residual Income = Income - Hurdle Income (Based on assets) Income = Revenue - Cost Given: Residual income = 2,000,000 Hurdle income= 1,800,000 working capital + 17,200,000 P&E * .15 =19,000,000 * .15 *Hurdle income=2,850,000* Residual Income = Income - Hurdle Income Residual Income = (Revenue -Cost)- Hurdle Income 2,000,000=(30,000,000-Cost) - 2,850,000 Cost=30,000,000 -2,000,000 - 2,850,000 *Cost=25,150,000*
What is Return on Investment (ROI)? *Ratio of income earned to the investment* *Note:* The Higher the Percentage (%) Return, the "Better". Numerator / Denominator = % *N = Direct relationship with %* Incr N = Incr % Decr N = Decr % D= Invesrse relationship with %* Incr D = Decr % Decr D = Incr %
Return on Investment (ROI) is analyzed per *Income Statement* and *Balance Sheet* (*Cash Flow is Ignored*). ROI provides the assessment of a company's *% Return* relative to its Capital Investment Risk. ROI can be calculated in many ways, but it depend on which information you may get on exam to calculate it: ROI => Net Income / Investment Capital (Debt + Equity) //*Operating profit/Investment* *Income = Revenue - COGS - Genderal & administrative expense - Variable costs - Traceable Fixed costs* OR *ROI =>Net Income / Average Assets* OR *ROI =>Net Income/ Average PP&E + Average Working Capital* OR ROI =>Profit Margin x Investment Turnover OR ROI =>(Net Income / Sales) x (Sales / Average Assets) *Note :* Net Income/Sales is same as Profit Margin. and, Sales / Assets is same as Investment Turnover=====> Investment and Asset same so: Profit Margin = ROI/ Investment turnover
Instafab Manufacturing has an investment in its southeast regional plant with an investment of $300,000 after adjustments for capitalization of research and development costs and revaluation of certain assets. The company's cost of capital is 12 percent and their division produces a net operating profit after taxes of $50,000 after adjustments for current year research and development, asset revaluations, and other accounting considerations. Calculate the economic value added.
Solution: NOPAT (EBIT x (1-T)) *$50,000* Investment (Debt and Equity) $300,000 Cost of capital x 12% WACC Required return (in dollars) *(36,000)* *Economic Value added $14,000 (in dollars)* Instafab's economic value added is positive. Instafab has added to shareholder value.
What is Cash Conversion Cycle?
The Cash Conversion cycle (aka "*Net Operating Cycle*") is the length of time from the date of the initial expenditure for production to the date cash is collected from the customers and the vendors are paid for the initial expenditure.
What is Economic Value Added (EVA)? Formula: EVA = NOPAT - $WACC Represents the residual income that remains after the cost of all capital, including equity capital has been deducted = *Economic value added*=====> represents the residual (excess) income of project earnings in excess of the cost of capital (including cost of equity) associated with the invested capital
The EVA is similar to "*Residual Income*", Residual Income method computes Return based on a *Hurdle Rate determined by management* (which is Subjective, that means management can Choose any Hurdle Rate), whereas *EVA Rate* is determined by *WACC* (Can't choose just any Rate, it has to be WACC). EVA does not Uses Net Income, but it uses NOPAT (Net Operating Profit After Taxes), which is Profit Before Interest But After Taxes.
What is Economic Order Quantity (EOQ)? Approaches orders at the point where carrying costs equate nearest to restocking costs in order to minimize total inventory cost
The Economic Order Quantity (EOQ) inventory model attempts to minimize both ordering and carrying cost (*thus Balancing Inventory, Not Ordering too Less and Not Ordering too High*) *EOQ assumes that demand* is known and is constant throughout the year, so EOQ does NOT consider Stockout costs nor does it account for costs of Safety Stock. When the EOQ model is used for a firm that *manufactures its own inventory,* ordering costs consist primarily of *production set-up*
Working capital management Net working capital = CA -CL Cash collection of accounts receivable has *no effect* on working capital as cash increases (CA) by the amount that AR (CA) decreases===> cancel each other out *Refinancing a short-term payable (CL)* with a *two-year note payable (Long term liability)* would increase the working capital of a firms as the amount of this currently liability is transferred to long-term liability
The Goal of Working Capital Management is to "Maximize Shareholder's Wealth". Appropriate working capital management matches the maturity life of each asset with the length of the financial instrument used to finance that asset Determining the appropriate level of working capital for a firm requires offsetting the benefit of current assets and current liabilities against the probability of technical insolvency
What is Reorder Point?
The Reorder Point is the Inventory Level at which a company should order or manufacture additional inventory to meet demand and to avert (prevent) incurring Stockout Costs. *Reorder Point can be calculated as:* Reorder point= Safety stock + (Lead time x Sales during lead time)
Residual Income = Net Income (from I/S) - Required return (Based on assets) ===> Residual income is defined as *INCOME* in excess of a desired minimum return *Note:* Required Return => Hurdle Rate x Equity (or Investment)
The Residual Income method measures the *EXCESS* of Actual Income Earned by an Investment over the return required by the company. Residual income is the segment margin of an investment center after deduction the imputed interest (hurdle rate) on the assets used by the investment center. The *optimal imputed interest rate* used in the residual income approach can best be described as the *target return on investment set by management.*
Super Sets, Inc. manufactures and sells television sets. All sales are finalized on credit with terms of 2/10, n/30. Seventy percent of Super Set customers take discounts and pay on day 10, while the remaining 30% pay on day 30. What is the average collection period in days? A. 10 *B. 16* C. 40 D. 24
The average collection period represents the weighted average of the periods that accounts receivable are outstanding and is computed as follows: Customers paying on day 10 x 70% = 7 Customers paying on day 30 x 30%= 9 *Average collection period in days = 16*
Cost of Preferred Stock
The cost of Preferred Stock is the Dividend paid to Preferred Stockholders. Cost of preferred stock = Preferred stock dividends / Net proceeds of Preferred stock *Preferred stock dividends:* Par x Percentage % {outflows} Net proceeds of preferred stock: {Net Inflows} Preferred Stock Dividend ‐‐‐‐‐> Dividends Paid {OutFlows} Net Proceeds of Preferred ‐‐‐‐‐> Selling Price ‐ Flotation Cost Stock {Inflows}
The working capital financing policy that subjects the firm to the greatest risk of being unable to meet the firm's maturing obligations is the policy that finances: a. Fluctuating current assets with short-term debt b. Permanent current assets with long-term debt *c. Permanent current assets with short-term debt* d. Fluctuating current assets with long-term debt
The working capital financing policy that finances permanent current assets with short-term debt subjects the firm to the greatest risk of being unable to meet the firm's obligations. The use of long-term debt financing produces the smallest risk of being unable to meet maturing demands.===> Since debt is long term we have more time to pay it off..so less chance that it will come due and we will not be able to pay it anytime soon
Times interest earned ratio
Times interest earned = Earnings before interest and taxes (EBIT) / Total interest expense
Cost of Preferred Stock *>* Cost of Debt
Why is Cost of Preferred Stock is Greater than Cost of Debt? -> Because Dividend are *NOT* Tax Deductible.
Maximus Company incurs carrying costs of $50/month and each order cost the firm $5,625. If Maximus goes through 100 units of inventory monthly, what is Maximus' economic order quantiy
^/2*S**O*/*C*arry Cost per unit ^/2 x 100 x 5625 / 50 ^/1,125,000/50 ^/22,500 EOQ=150 units When Maximus orders inventory, it should order 150 units in order to minimize both ordering costs and carrying costs
Floatation Costs:
are those costs that are associated with the Issuance of Stock such as pay to Underwriters, CPA's, etc which reduces the Proceeds to the Company
Material Requirements Planning (MRP)
is an Inventory Management Technique that *Projects and Plan* Inventory levels in order to control the usage of raw material in the production process. *MRP* primarily applies to Work In Process (WIP) and Raw Material.