BEC exam
Cost of common equity(RE)
(> cost of pref, as common stockholders are last in line and assume the most risk) Cost of equity = ROR required by stockholders, they use the calcs below to determine Re THREE COMMON METHODS OF Cost of RE/ CS = CAPM DCF BYRP re= can be the avg of all three models together
how to do an open ended question, last module to write open ended questions,
1) read the question twice bfore starting the asnwer 2)when writing answer= spelling counts, grammar counts, punctuation counts. write in complete sentances and paragrphs, no bullet list 3) do not use abbreviation until you define it first, the securities exchange commission (SEC) 4) structure= follow I E C a) introduction and issue , the reason you are writing this : intro -- "thank you for reaching out to us to explain ..." ; issue -- "we are going to explain why ..." b) explanation with details , 1- 3 paragraphs, c) conclusion and closing, wrap u= answer, draw con based on facts . One sentance closing
solvency ratios, to show imapct of cap structure on fin ratios
1) total debt ratio = if its higher, higher risk, higher |DFK , but NI / E = ROE will increase , reward for assuming more risk = total liab /total assets, increases w more debt 2) D to E = total liab / total equity Low liab = higher e = Risk decrease, ROE will decrease (NI/ e , e increases) 3) times interest earned = = earnings before interest exp and taxes / interest exp As debt increase, interest exp increase, = more debt , more risk, the ratio will go down, More interest exp = lower the times interest earned ratio
COSO objectives , components and principals
3 objectives (ORC) , 5 components (CRIME) , 17 principles, EBOCA SAFR OIE SoD CAT P coso is an integrated framework to assess IC effectiveness, PRINCIPAL based not rules based,
effective annual percentage rate
= EAR rate =( 1 + effective periodic rate in a decimal ) ^ (number of periods) - 1 =EAR It's the stated rate adjusted for number of COMPOUNDING periods Effective APR is compounding, normal ARP is non compounding 1) calc period rate= stated rate / periods 2) 1 + periodic rate , and raised to the periods 3) subtract by 1
Liquidity risk
= affects lender/ investor, the risk that if you want to sell your security but will not be able to do it in a timely manner, or you will need to make major price concessions Good example is real estate, you can't sell it that quick as its not publicly traded
Default risk
= affects lenders, the risk that the debtor will not pay their interest/ principal when it becomes due, US treasury = historically would be default free, they will always be paying you back
BYRP
= bond yield plus premium Re= pretax bond yield to maturity market risk premium = pretax bond yield + (market return - rfr)
current ratio
= current asset/ current liab , bigger spread, decrease risk, good way to measure st risk Deteriorating current ratio = greater risk Improving current ratio = less risk Limits = st liquidity isn't the best measure of the health of a business, as a smaller ratio might be normal for an industry Current ratio > 1
ROR
= from a lender = 0 sum gain , lenders required return = borrowers cost of borrowing (debtor) 1) nominal RFR (should just be the US treasury rate, don't usually need to calc) = real risk free rate + inflation 2) nominal rfr + risk premiums= returned return What are risk premiums? Maturity, risk increases the longer the term to maturity Inflation , used to calc the nominal risk free rate (if we need to use it) liquidity= risk that we can't sell on short notice, higher return if less liquid Default risk = risk that the borrower will fail to pay, increased return
Black scholes option pricing model
= how to value a model, Call option value= stock price- pv of strike price The higher the stock price, the higher the call price, We want the stock price to be greater than the strike price Pv of strike= strike / (1+r) Higher stock ,lower strike price, higher expiration , higher risk of underlying stock = HIGHER VALUE OF CALL BS assumptions= stock prices are random, we need to know the volatility and rfr that are constant, no taxes assumed, no div , Options are european style ( only exercised at maturity) limits= the assumption means it might be diff from the real price, can only use for a european option
Value intangibles (Patent, franchise) calc
= just ask MIC No physical form , but have future benefits Market approach = recent sales of a similar asset, (but intangibles are traded normally, could use a range, and could use the average or median value, or whatever similar assets) Income approach = discounted cash flow, discount the cash flow from the intangibles Cost approach = replacement cost, or reproduce it
Diversifiable risk (unsystematic/ firm specific )
= non market, based on the firm or industry that are specific to them, these risk can be eliminated through diversification **DUNS (diversifiable= unsystematic, non diversifiable= systematic risk
Value tangible assets (PPE) calc
= stay CALM Cost method = NBV = cost - dep Appraisal method Liquidation value = if we sod the asset today value Market value method = could be lower of the replacement cost or NRV (selling price- costs to sell)
Value debt instruments calc
= sum of PV of FCF, = C/ (1+R) + C+ (1+R) ^t .....+ C +par / (1+R)^ t Can use discount rate that is the same for all , or can use spot rates w different rates Coupon = fv of bond * interest rate Discount rate = market rate Market rate = coupon / price If current market rate is higher than our coupon rate, then it will be sold at a discount
ERM; Governance and culture and DOVES
= tone at the top, core values, culture Desired culture= how conservative or aggressive do we want to be, there is a spectrum to risk averse to risk neutral and risk aggressive, Risk averse= conservaitve Risk neutral = seek out highest return no matter what the return Risk aggressive= risk is so high that the return goes down Exercise board oversight= entity strategy , business objectives from the board Demonstrated commitment to core values = tone at the top, is there a code of conduct, Employes, attracts and developed capable indv= board will select the executive, HR will hire great employees with good skills, Establish operating structure= are we centralized or decentralized, how do you carry out your day to day operations
Simple interest amount
= total interest over the life of the loan = P *stated rate annual * number of years No regard to compounding,
ar turnover and days in ar
Ar turnover= net sales/ avg ar Days in sales in AR = ending AR / (sales/ 365) Collect quickly wout upsetting customers Tight credit policy = might sell slower, but collect faster
CAPM
Assume that cost of re is = rfr + risk premium Market risk = systematic/ non diversifiable risk with stock market Market risk premium = the extra amount of risk from investing in the stock market (market return) less the rfr beta= the volatility of stock relative to the overall stock market CAPM = Re= RFR + (B * (market return - RFR) )
annuity calc and assumptions,
Calc pv of annuity 0) PV factor = (1- ( 1/ (1+r)^t)) / r 1) annuity pv = C * (1- PV factor / r) Assumptions = Annuity is recurring, if payment increase, increase pv, Apr discount rate is dependent on risk, higher risk , lower pv More payments , = higher pv Timing of annuity, is it paid at bg of the period or the end
profitable project based on cash flows
Cash flows related to capital budgeting= select lt projects of the firm Look at CF effects: ACCEPT if its profitable Profitable project = sum of PV of CF > todays cost (net outflows) Outflow of cash when you enter the project, and inflows when we get the f cf Can also look at indirect effects, like dep allows us to have less taxes, and then in turn we can keep more cash like $ saved = dep * Trate Net effect of the project = sum of PV of FCF - todays cost
COSO 5 components (CRIME)
Control environment risk assessment info and comm monitoring existing control activities
fifo vs lifo vs wa vs moving average
FIFO = sell oldest, in rising price environment, COGS will be cheap , ending inventory is expensive LIFO = sell newest, if prices are rising, COGS is high , ending inventory is lower WA = COFASF/ # of units= avg costs, will use that to calc COGS and ending inventory, must be a periodic system, Moving average= need a perpetual system,
ERM 5 components GOPRO
Governance and culture Strategy and objective setting Performance Review and revision Info , com, and reporting-- ongoing
relative valuation model : summary
If target companies value < peers value, we are relatively undervalued If target > peers, could be overvalued, or maybe has higher growth Need to look at all mult together, PEG should be looked at with PE if we are "overvalued from PE
inventory on books as
LIFO at lower of cost or market, with FIFO/ wa is lower of market or net realizable value Market value= median value of : replacement cost, market ceiling or market floor ceiling= selling price- costs to complete floor= ceiling - normal profit margin Replacement cost= cost to purchase inventory Net realizable value = net selling price less costs to complete and dispose
Value of a leveraged firm:
Levered firm= when a company has any debt in its capital structure 1) value of an unlevered firm , given 2) PV of the interest tax savings = T x (R of debt interest x D) / R debt ( really saying = $ value of interest tax shield/ cost of debt ) 3) value of levered firm = value of unlevered firm + PV of the interest tax savings Firm that uses debt benefits from a TAX SAVINGS, this is the diff bw the value of a levered firm and unlevered firm
mission vs vision vs core values
Mission = objective, core purpose, why are we in business, vision= what's the strategy , how will you get there , high quality or low cost provider Core values= how are we going to get there, ethics, culture and values
COSO 3 objectives (ORC)
Operations= effective and efficient operations, ensure assets are safeguarded Reporting= reporting needs to be reliable , timely and transparent, for external and internal users Compliance = comply w all laws and regulations when you do business ineffective controls can lead to not achieving ORC, and effective controls need reasonable assuranfce that ORC will be acheived, -> the 5 components adn 17 principals need to be present (designed) , and operating effeciently
periodic vs perpetual system
Periodic inventory = by physical count performed annually, not counted when we buy and sell Perpetual inventory= inventory balance is updated for each purchase and each sale Specific id = the cost of each item is tied to that item, it's the most precise
optimal capital structure w debt and equity
Ratio of debt to equity w lowest WACC Lowest wacc= lowest will make it easier to find projects w ROIC > WACC Y axis= cost of capital X axis= D/E ratio, goes from little debt to lots of debt No debt at all = higher WACC< Equity costs more than debt, so we will want to add debt Lowest wacc= D/E ratio of 4, As debt increases slowly, it will go down but if you have too much debt the WACC will go back up again
DCF model
Re= D1/ P0 + g D1= dividend from the end of year 1, D! = D today * (1+ gr) P0= current market value today
Risk preferences=
Risk indifferent = seek highest return , this is the exception, seeks the highest rate of turn, regardless of risk Risk averse = risk where we want to be comp with an increase in risk with a increase in return , most people Risk seeking= most unusual = increase in risk decreases required rate of return,
Binomial option pricing model:
Use when we have discrete time periods, also known as cox-ross- rubinstein model Useful for valuing american options (can be exercised early, not at expiration date_ This option value should be > = the european counterpart Asusmpt = there is a perfectly efficient market (stock prices are fair) , we can forecast where the stock price will be at a certain time Build a tree diagram Useful for american options and stocks that pay div
Credit risk
affects borrowers, as the risk increases, and cost of borrowing goes up , credit risk goes up when your credit rating goes down, aka they do not want to give you a loan as you are not credit worthy, if you have a high risk, the creditor will depend a higher rate of returns
Discounted cash flow analysis
based on the sum of the pv of the FCF, Choose the correct model: Can use DDM only can be used with div FCF model, only works if they have positive FCF Residual income model = ni - huddle rate,
Debt financing
fixed cost with interest exp payment risk, greater risk of not being able to pay the interest Higher risk , higher return on equity debt= liab ex: Commercial paper= unsecured, st debt finance current assets debentures= unsecured obligation of the company, general creditor Subordinated debenture = unsecured and ranks behind senior creditors in the event of issue liquidation Command higher interest rates Income bond= pay interest only if the company achieves a certain income level Junk bonds= high default risk , higher return Mortgage bonds= loan with real estate Leasing = don't borrow and buy, rent instead if lower cost. Both leases result in lessee to record a ROU asset, which is amort over the life of the lease by the amount of the lease liab
RISK ASSESSMENT and components SAFR
fs could be misstates, not efficient, breaking law 1) specific objectives, id and assess risks, will we or won't we comply, 2) assess changes in external env, what's happening in economy, external environment, business model, leadership (retirement) 3) fraud potential= always a risk , opportunities, pressure, attitudes 4) analyze risks, how are the risk managed This is relevant to ERM (ISEARAIM)
international translation exposure
if we have foreign subs, risk that the subs assets/liab will go up or down depending on the subs FC, Degree of F involvement= the exposure increases as the properiot of the F involvement in the sun increases Aka the sub does lots of business in F governments Locations of F investments= are they doing business in A more stable exchange rate country= less risk Volatile exchange rate = higher risk
APPLY IC FRAMEWORK
manage application, evaluate effectiveness, deficiency assertions, COSO framework document : COPS Need to document the IC assessment 1) Component evaluation 2) Overall assessment 3) principle evaluation 4) SUmmary of IC def
COSO limits/ risk
no guarantee, doesnt prevent bad decisions, inherent limits even w effective IC = human failure, faulty judgement, does not meet the suitability, external events, collusion, management override of IC risks include: Material omission= unintentional , risk can change over time, more complex, more risk Fraud= intentional, misappropriation and theft of assets, or intentional misrepresentation, risks increased with management bias, estimates and judgments or incentives for fraud Management override of controls= for personal gains, may lead to fraud Illegal acts= might not be intentional, need to abide by laws of all states you do business in, but there could be conflict bw laws , if there are any payments for unspecified services.
Financial leverage
use of debt rather than equity, Reminder : Interest exp indp of sales- fixed costs (as it does not vary with sales) Look at how much EBIT we have to cover the interest exp , If we have lots of interest, we need lots of EBIT If you are highly leveraged, you are bankrupt , you might not be able to find new lenders as you already borrowed a lot, credit rating is down DFL (degree of fin leverage) = % change of EBT or EPS / % change in EBIT Increase liab, decreasee E = increased DFL % change in EBIT * DFL (max) = % change in earnings
Kanban inventory controls
visual signal that it's time to order,
Annual percentage rate (APR)
= effective rate * number of periods in the year, takes periodic rate * number of periods, to get the annual rate Non compounded 1) calc the effective period interest rate 2) multiply by the number of period
ap turnover and days of payable outstanding
= ending AP / (COGS / 365) Don't be later, but take full advantage of an interest free grace period, Only reason to pay faster is if given an incentive Ap turnover= COGS/ avg AP Don't want it to be too low, want it to be relatively lower
Market risk (systematic/ non diversifiable)
= fluctuations in value as a result of a certain economy, doesn't matter how much you diversify, there is still a risk , Risks factors- war, inflation, political risk,
quick ratio
(current asset - inventory - prepaid) - current assets More conservative, as it takes inventory out of the equation The higher the ratio the less risk we have
Cost of pref stock
(is > cost of debt as div are not tax deductible, and pref stockholders assume more risk = pref stock div/ net proceeds of pref stock , Pref stock div= par * rate Net proceeds= proceeds net of the flotation costs ( like issuance costs)
audit committee
, resp for hiring the public annc firm, Auditor reports to audit committee only Major role= resolve disputes bw auditor and management Audit comm members need to be on the board, but otherwise indp, and no other comp other than the board comp Establish procedures for whistleblowers and complains and how to address these
Price risk
,= affects investor, risk that the value of what the invest in will decline, price risk is diversifiable,
Preferred stock value calc
0 growth stock, perpetuities Pv of perpetuity= stock value per share = P = D/R = div / required return Div and ror must be specified
3 stages of new project cash flow, T0 inception
1) T0 = inception of the project, today's cost outflow to enter into the project Look at direct payment Indirect cash flows like shipping, training, installation Can offset initial outflows with initial proceeds on trade in Do we need to increase/ dec working capital to support new investment ? Additional working capital requirements (buy an asset) , is a cash outflow, Reduce working capital (Sell an asset) , cash inflow Disposal costs? Cash inflow , cash proceeds on sale of old , NET OF TAX, if you sell with a gain, you need to pay taxes on that Gain = selling price - NBV Taxes paid = gain * T Net proceeds = selling price- nbv - taxes paid If you have a loss, loss + tax, could be an inflow
how to create value when facing risk (ERM, CPER)
1) creation= benefit needs to be bigger than expense, rev > expense, ROIC > cost of capital, positive NPV, profitable, resources= people, capital , tech, brand 2) preservation= sustainable profit, to come from core business, customer satisfaction, profitable product lines 3) erosion= don't want the value to go down, - NPV investment, cost > benefit, stock price decreases, faulty strategy, 4) realization= investor will reap the benefits of the investment from capital gains or dividends, could be monetary or nonmonetary by being leader in the industry,
Safety stock
: cushion, to ensure manufacturing . customer supply is met Based on reliability of sales forecasts, More confident= smaller cushion Possibility of customer dissatisfaction resulting from back orders Stockout costs Lead time (how long does it take to get new inventory) , Seasonal demands Think about inventory turnover, safety stock , reorder point, economic order quantity, material requirement planning
Reorder point
: when do we call up to reorder, = safety stock + (lead time * sales during lead time) Be consistent with lead time, it needs to be in consistent units like days, weeks , months
Economic order quantity
: when i say "two" , you say "SOC" Trade Off be carrying costs and ordering costs ( like shipping, stocking) EOQ is minimizing total ordering and carrying costs = sqrt ( 2SO /C) s= sales in units O costs per purchase order C= carrying costs per unit Consistency in times
Compounding interest amount
= P * (1+ effective periodic rate in a decimal) ^ ( total number of periods) Total number of periods = number of years * total number of periods This is compounding
relative valuation model : price to cash flow ratio
= P0 /CF1 p0= competition ( p0/CF1) * CF1 Use as companies value is related to the company's ability to generate cash, harder to manipulate, more stable than PE
relative valuation model : price to book value
= P0/ BV0 of CS BV per share for today = A- L - PE = common equity / # common shares = BV per share BV is for today!, not forward looking BS is more cumulative so it is less volatile, usually positive, looking at today's BV per share p0=( others P0/B0) * B0
Debt covenants
= a way for the bank to protect the borrowers credit rating, so the bak can guarantee that you can pay them back , reduces the cost of borrowing, protects the lender's interest Positive cov = we want you to do this (ex: you need to provide us w a quarterly statements, maintenance of fin ratios, ) Negative cov = don't do this, ( ex: limit on addt debts, restrictions on payment of div, limit on the disposal of certain assets, limit on how the borrowed money can be used) If its violated: in technical default, and creditor could demand automatic repayment, but usually they get concessions
cash conversion cycle
= days in inventory + days in sales in AR - days in payables outstanding Operating cycle= number of days to sell + number of days to collect We want this to be low Number of days to pay our bills, the best is to take your time, and have this be long, we want it to be high, Less than or equal to industry standard Number of days it takes to generate cash from core business Days in inventory = ending inventory / (COGS/ 365) This is part of the sale, avg inventory we want to be decreasing Inventory turnover= COGS/ average inventory Sell quickly without giving it away Minimize time to convert inventory , and maximize the amount if time it takes to pay the vendors, the lower the cycle the better
relative valuation model : price to sales ratio
=sales per share 1 = sales 1/ # common shares = P0/ S1 Price to sales is less subject to manipulation (can be volatile bc of leverage) , sales are always positive, sales are independent from leverage If given industry average * target companies sales y1 P0= (P0/S1 competition * S1
relative valuation model : PEG ratio
Allows to investigate if we are under or overvalued or is it just based on growth, A lower PEG ratio is more attractive to investors as they are seen as undervalued PEG =( P0 /E1) / G Low peg = high e, or high growth , BETTER, low = < peer PEG This includes the forward PE ratio P0 = PEG * E1 G If peg is less than peers, and PE is higher than peers, that means that they are relatively "overvalued" but it must likely be from sales
Supply chain management / integrated supply chain management
Coordinate with from and entire supply chain (supplier, producers, distributors, retailers, customers) Allows you to expect the demand of customers 1) understand the needs and preferences of customers If actual demand is met and excess supply isn't there, the firm will be minimizing cost and maximize profits 2) SCOR (PSMD) Model for supply chain management KNOW THE 4 Plan= plan the balance of demand and supply from sales forecasts, and the ability of suppliers to provide inventory Source = find vendors in time to meet the demand Make = turn raw mat into finished goods, the production process, manufacturer, test the product, package deliver= activities to get finished products into the hands of the ultimate consumers to meet their planned demand , manage transportation,
ERM components to manage risks and create value = CCPIS
Culture = core values collective thinking, shaping decisions, Capabilities= competitive advantage, and will exploit it, Practices= continually applied, to all levels of the entity, Integration with Strategy and Performance = why do you exist, what is your mission, what's your vision what's your strategy must remember to set reasomable expections, and value creation is dependent on risk assumed
How to control /mitigate fin risk =
Diversification of unsystematic risk = uncorrelated or inversely rated stocks value of a goes up with value of b goes down For interest rate risk = invest in floating rate debts, derivative like forward rate agreements, or interest rate swap , Ex: if you think rates are going up , enter a swap , were we will pay our fixed interest, and rec variable For market risk = non diversifiable , inherent in the economy, noy easy to mitigate, use derivatives, that provide gains when the market declines, short sellings, provides returns when market declines, For credit risk = how to reduce cost of borrowing, from borrower/debtor perspective, monitor ratios for economy, industry, cash flow, leverage, capital structure, liquidity, profitability For default risk : lender can left to borrowers will lower rates of default ( lend only to high credit rating borrowers, or adjust interest rate to affect the rate of each borrower For liquidity risk = allocate more investments that trade in active market For price risk = diversification, or hedge with shorts, Ie: buy put if p goes down , use profit to offset loss in value
Management of AR
Do not sell to customers unless they are credit worthy What is our credit policy? Credit period, don't want it to be too long or too short, Standards , who would be worthy , are you doing a credit check, are they financially strong, Collection policy, how stringent /law on collecting overdue balances, Can offer discounts, but very expensive to do , \ Methods to speed collections: Customer screens and credit policy Prompt billing Payment discounts, if we offer a customer 2/10 net /30 APR AR = (360 / (30-10) * 2% /(100-2%) ) Expedite deposits : do Benefit > cost Make sure what we collect is deposited and credited in our account quickly, Ask that they don't write a check, and can do EFT instead, to have timely payments, Lockbox system, held at the bank, cost from the bank, Concentration banking = deposit in a single bank , less bank recs,
AP management
GR = stretch it out , don't pay too quickly, Take credit from your vendors accrual s= book expense but having paid the bill yet, and can keep cash for longer discounts= do not stretch it out if you are given a discount , it must be a high cost if you don't take it (opportunity cost) Discount ARP = (30 / ( pay period - discount period ) * (discount ) /(100- discount %) Expensive to turn down from a vendor, or to offer to a customer (dont offer it) If 2/10 net 30 = discount periods = 10 , discount percentage ( 2%) Will you take a discount? Do you have enough cash (should you borrow the money? ) Company wants th cash for something else
international transaction risk exposure
If we export in a foreign land= AR in a foreign currency , risk that the FC goes down in value, then AR goes down in value so we have a loss If we import= we have an AP in a foreign currency, if the FC goes up in value, the PA goes up in value, we will have a loss Calc the net of FC assets and liab import= AP Export = AR Estimate the variability risk associated with the FC
Inventory management strategy
Sales forecast = important to determine the amount of inventory Lack of inventory = loss of sales Excessive inventor= high carrying costs Carrying costs= storage costs, insurance, opportunity costs, lost inventory due to obsolescence or spoilage Lowerer carrying cost = the risk of having a surplus isn't that high, then we are willing to carry more consider the optimal level of inventory with safety stock , reorder point and economic order quantity
ERM: performance and VAPIR
a)evaluate, id and respond to risk using ARTS VAPIR= look at responses to risks and priortieis of risks 1) Develop portfolio view= parent level, high level, looking at risk at parent level , 2) Assess severity of risk= helps to prioritize risk, - Look at multiple levels, risk that are severe at the operating level may not devastated at the entity level, - if one fails you will still be okay: a) Inherent risk= if your business cyclical, of demographics (you sell baby toys and there are no kids ) , b) Target residual risk= we want to assume this specific risk, will take on fixed cost of depreciations to buy a machine , c) Actual residual risk = risk after management has taken action, which is the risks from decisions you had made - Company should id triggers to see if there is an increase to risks 3) Prioritize risk= 4) Identified risk= inventory of risks, big picture of all types of risks, 5) Implements risk response = using ARTS, a) High frequency , high severity of risk = AVOID (jump out of plane w no parachute) Leave this product line, risk is too high and frequency b) High frequency, low severity= REDUCE , (Can add derivatives and hedges, we can manage this risk) c) Low frequency , high severity = TRANSFER (share risk with insurance company, risk transferred to insurance) Hedge this , reduce the risk, calls and forwards d)Low frequency , .low severity= SELF INSURE (accept this risk, it's a given risk with the industry, need to accept this)= Is in our level of risk tolerance, we know it can happen and we accept it, E) Pursue risk? We might increase risks to achieve improved performance, pursuit of risk is appropriate when management understands the nature and extent of the risk, so they make the decision so they can increase return
interset rate risk
as interest rates go up , the value of fixed income goes down ; If we have a fixed coupon, and want to call the value of the FCF = coupon / (1+r) ^ t If the rate of return goes up (market demands higher rate of return) , the lower the value of the FCF
relationship bw leverage and risk
as level goes up risk goes up expected return goes up leverage= amplifier of risk and return Operating leverage= fixed costs idnp of sales = rent, dep , insurance As fixed costs increased, degree of operating lev goes up Not good to have a high amount, they need a high It's the degree in which company uses fixed costs rather than variable operating costs These are fixed costs, so the more sales you have is better, Company w higher operating leverage will have greater risk but greater returns DOL = % change in EBIT/ % change in sales When sales go down , its bad, % of change in sales * DOL = % of change in EBIT A higher DOL is riskier
ERM: review and revision and SIR
assess substantial changes to risk, pursue improvements Assess substantial changes to risks,= could be internal if ceo quits, or external of there is a threat to a substitute product, Pursue improvement in ERM= always look for new opportunities and stratified to improve efficiency , Reviews risk and performance = how did we do w managing risk, did we property hedge the risk , was the hedge effective, looking after the fact, to see if it was the best way to reduce the risk
Constant growth div discount model (DDM)
assumes div of the payments are going to grow forever, Common stock value = pv of expected future div Gordon growth constant growth model (GGM) = p0 = D1 ( 1+G) / (r-g) P today = div 1 year in the future / (r-g) P year 1 = div in year 2 / (r- G Div 1 = div 0 *(1+g) Determine ror = ROR = rfr + B (market return - rfr) Assume div from next year must be used, How to get div in the future = div year 4 = div today *( 1+g)^4 Our ROR must be greater than the growth rate, r>g
ERM framework
companys strategy to balance risk and return, assists orgs in developing a comprehensive response to risk management
Growth rate
increase, value increases Growth rate = (ROE x retention rate) / (1- (ROA x retention rate) Payout rate = Div PS/ Earn PS Retention rate = 1- payout rate Increase ROE x increased ret = increased growth rate Increase ROA, x increase degree of fin leverage = increases ROE Influence on cap structure= increased debt , increased risk assumed, but ROE and growth rate increases, Assume more risk = higher growth rate
mitigate international transaction risk
decrease risk from imports and exports in FC) 1) determine the net transaction exposure Ar > ap = net assets, risk that decrease in FC AP > AP , net liab, risk that increase th FC Selective hedging, 2) with future hedged futures= exchange traded, more liquid, its standardized, in smaller transaction Net liab = AP , imports are greater than export, if FC goes up we have the risk of a loss BUY calls, futures : if AC goes up in value, we can use the profit on the derivative to offset losses futures= buy FC< so if it goes up in value, we can mitigate the risk of our loss Net rec= AR, exports are greater than imports, risk is that FC goes down in value BUY puts, SELL futures : if FC decrease, use profits on der to offset losses, Risk if domestic currency strengthens Futures hedge to sell the FC< will mitigate the risk of the strengthening domestic currency, as FC goes down, assets go down so there's a loss 3) Mitigate with forwards = Forward = private exchange, customized, similar to futures, for larger transactions, For AP = net import, risk of CF increase, BUY call, BUY forward/ future For AR= net exports, risk of FC decreases BUY put, SELL forward/ future 4) Mitigate with money markets = Use domestic currency to purchase FC at the current rate (sport rate) , will invest the FC in securities which will mature at the same time as the payables For payables (excess cash) , risk that FC increases, Firms with excess cash use money market to lock in the exchange rate with FC to satisfy the payable when they become due 1) determine the AP amount 2) determine the interest + principles , aka the PV of the liab denominated in FC 3) purchase the amount of FC equal to the net investment requires the deposit in money market, If we don't have excess cash , you can borrow funds, borrow domestically and investment them internationally to satisfy payable 5) Mitigate with currency option hedgers = Buy call = cap on cost ( for imports/ AP ) If value of FC goes up , use profit to offset higher ap Only exercise if price > strike , Buy contract (AP_ Forward 9large) / future (if small transaction Buy put= floor on rev (export / AR) If value of FC decrease, use the profit to offset the lower AR Only exercise if price < strike Sell the forward/ future Break even point in call = strike + cost Break even input = strike - cost of contract
MONITORING and SoD
effectiveness of IC and reporting any deficiency 1) ongoing and sep evaluations of control components, frequency of testing is dedicated by the risk 2) comm of deficiencies= how to report the def, in a timely manner and there is corrective action being taken
Title IV
enhanced financial disclosures= internal controls and audit committee disclosures , which includes additional details, Enhanced disclosures= Material correcting adjustments id by auditors All material off balance sheet transactions like operating leases, contingent obligations like lawsuits, relationships with unconsolidated subs, Conflicts of internal provisions= issues a prohibited from making personal loans to directors or executive officers Disclosure of transactions from management to stockholders, as this is a related party transactions, w/ any stockholder with more than 10% Management assessment of IC = referred to as section 404, each annual report is required to constrain a report that includes the following, a statement that management is respon for establishing and obtaining IC, effectiveness of IC, auditor needs to attest to management assessment of IC<
WA cost of debt
lenders required return dictates to borrow the cost of borrowing 1) We need the pretax cost of debt (WTM , Market rate) If not we need to do this fiste WA interest rate= effective annual interest payments / debt outstanding, 2) After tax cost of debt =pre tax cost of debt * (1_TR) If tax rate increases, incentive to get more debt as it will decrease the cost of debt Increase in tax rate is a good thing
relative valuation model : PE ratio
look at comparable stocks, to determine fv, look at multiples to see if the stocks in undervalued / overvalued, by looking at price multiples 1) PE , most widely used, P/E ratio= STOCK p0 / e1 , since we use e1, it's a "forward PE" Price 0 = PE in the industry * E1 This is the general rule e1= ni 1 / # of CS outstanding If target companies PE < avg peers , they are undervalued, If our PE > avg peers, it could be overvalued, or they have more growth , 2) trailing / forward PE E in the PE ratio could be past earnings or expected future earnings Trailing PE = P0/ E0
ERM: Strategy and objective setting and SOAR
mission , vision, define the risk appetite Alternative strategies= whats the vision, do you want more equity( less debt) , or less equity ( less risk but less return) , Formulated business objectives= why do we exist- mission, objectives need to be realistic given the risks assumes should be specific , measurable, observable and attainable, the objectives= fin performance, customer satisfaction, efficiency Analyze business context= internal and external context Define risk appetite= this if risk in qualitative terms, this is goals based, i need to get this done, its critical, i will do this, or quantitative risk, and will look at the stand dev of risk , there will be ranges , ceilings floors for risk
ceo/cfo
must sign representations in writings for annual and quarterly report, so they have fairly states the financials, the reviewed the report, They are respon for the internal controls = that they are designed, they are effective, and their conclusion on the effectiveness, Must disclose any deficiencies, andy frua Must cooperate with the auditors, have the duty to cooperate Will forfeit their bonuses and profiles if the company is required to restate the fiancnials, and the ceo/cfo must give money back on any bonuses, incentive based payments
should you enter into st financing or lt financing
optimal to have a mix St financing= adv= rates are lower, increases profitability, decrease fin cost Dis = require current assets levels to be sufficient to meet st demands , not locking in the lt rate, interest rate risk (the risk that interest rates will increase in the future) , decreased capital availability, maybe our credit worthiness will change Lt financing= lt debt or equity, Adv = lt financing increases in leverage, locked in the lt rate, decreased interest rate risk ( we locked in the rate today) , increased capital availability (debt guarantees financing over a longer period ) Dis = higher rates bc the bank is taking a higher risk , decreased profitability, increased financing cost , if you lock in a rate that is not beneficial to you
Effective interest rate=
periodic rate, depends on when you get your payments = interest paid per period / net proceeds of the loan Interest paid per period= (P *stated annual rate ) / number of periods Number of periods = 1 annual, 2 semi, 4 quarterly Net process of loan = reduced for proceeds charged , like compensating balances , Effective rate is always higher than stated rate, as stated rate looks at the assumption of gross proceeds
EXISTING CONTROL ACTIVITY and CAT p
policies and procedures to mitigate any risks Entity policies and procedures, to mitigate risk that we won't reach our 3 objectives , could be detective or preventive like seg of duties, 1) control activities= mitigate risks 2) tech controls= achievement of objectives 3) policies and procedures= put policies into actions
Just in time inventory methods
pull approach, if you want this we can make it for you , reduces the lag time bw inventory arrival and inventory use, reduces the need of manufacturer and suppliers
international currency trade risks
relative rates of inflation, when inflation is high, the value of your currency goes down, Currency with higher inflation uses value, the demand for that currency goes down, its losing purchasing power Lower inflation = higher purchasing power, Relative income levels Increased demand when the economy is increasing, as demand goes up value goes up Government controls vs freely fluctuating equilibrium, does the gov control and suppress the natural forces of supply and demand, if they reduce the demand or increase the supply, the value will go down Relative rates and capital flows = with supply and demand,of the currency with the higher interest rates is more attractive, and then higher demand in that country , and higher value of the currency ,
international economic risk exposure
risk that the PV of cash flows can go up or down 1) Effect of US dollar currency appreciation (goes up) If FC goes down in value, the AR will go down PV of cash goes down, so we have a loss If FC goes down, the AP goes down, PV of cash out goes down, so we have a gain If Domestic goods are relatively more expensive now (the us dollar value increases) than the export value will go down , but import values will become inexpensive, so Decrease exports, increase imports 2) Effect of US currency depreciation (goes down) If out value goes down, the FC value will go up FC increases AS increases, cash in increases, we have a gain If C increases, AP increases, cash out increates, we have a loss So domestic goods are relatively less expensive, export values will go up and import values will now be expensive Increase exports, decrease imports
profitability ratios
success of the company Higher profit ratios the better 1) ROS (return on sales) = income before interest income, interest exp and taxes / sales (net) Numerator = net income - interest income + interest exp + tax expense 2) Return on investment = net income/ average invested capital Avg invested capital = (A- operating liab) 3) ROA = net income/ avg total assets Avg total assets could be bv of fmv 4) ROE = net income Avg total equity= (A-L)
ERM: info , com and reporting thats ongoing, TIP
this is IT , risk info, and reporting on performance, should use relevant info so we can properly manage it Leverage info and technology = info needs to be relevant so we can provide a competitive advantage, fair, accurate, complete and timely, FACT, Effective data management is integral to risk aware decisions, Communicates risk and information= communication of risk to internal external stakeholders in MDA, will discuss how we are handing risk, Reports on risk, culture, and performance = talk about in MDA, will discuss the portfolio view of risk at the entity level and looking at risk at diff levels in the entity , at the produce level, how they communicate the types of risk views
CONTROL ENVIRONMENT and its principals (EBOCA)
tone at the top / ethics, 1) ethics = standards of conduct, like a code of conduct, 2) board independence, knowledgeable of the business, oversight resp 3) org structure = 4) competence= hire develop and retain competent employees 5) accountability= how we measure performance , no excessive pressures on employees
Management of cash
too little cash = risk that we are not liquid enough Too much = roa will go down, can't get any return if it's just sitting there Motives to hold cash: Pay bills when they become due We could lose an investment opportunity Keep a safety cushion to meet unexpected needs Disadv of high cash - No return on assets Negative arbitrage, the interest obligation exceeds interest income, take the cash to pay down a higher interest obligation More attractive if someone wants to takeover yall Investor dissatisfaction ( not payment div) How to increase cash levels: Sell quickly , collect quickly Slow down outflows
Working capital turnover
turnover assets = measure of activity= efficiency, the higher the better = sales / avg working capital Measures the effectiveness at generating sales based on operations funds Greater than or = to standard,
Equity financing
variable cost w no maturity, higher equity, less risk, no risk of distress as there are no payments to be made, higher credit worthiness, lower ROE, need higher rate of return as we are less likely to get our money back Pref stock =hybrid equity, has features for debt and equity, Fixed div like a bond, equity like as the payment is of the discretion of the board, Common stock = basic equity ownership , voting rights, div payments are optional , par value, lowest claim in liquidation
Weighted avg cost of capital
we want the lowest WACC, the the cost of all forms of financing We want to it to be < ROIC as the NPV value increases The ideal capital structure is lowest wacc and diversified structure CALC = = (common equity/ total) + (equity rate ) + (pref stock /total ) ( pref rate) + (d/ total) * (debt rate* (1-T)) We will need A = L + PE + CE We will invest in any project with a ROR that is greater than WACC
Net working capital
we want to be able to pay st obligations as they become due and manage shareholder wealth = current asset - current liab Balance profitability and risk Increased WC, decreased risk, decrease ROA< as we have more cash on hand Lower WC, assume more risk , higher ROA, less short term assets on hand Need adequate working capital to mitigate risks, Less wc increases risk as you may not be able to pay your bills as they become due
INFORMATION AND COMM and OIE
what we report must be fair accurate complete and timely 1) obtain and use info= how do we get relevant high quality info 2) internal comm info, in the org , like internal audit, and how they all communicate w each other 3) external party communication= there is a two way comm channel, like cpa firms, consultants, duty to cooperative, cannot hinder each other
risk appetite
willingness to assume risk, it's based on your personality, think of the industry, why are you in business, what is your strategy , risk appetite varies on mission and vision and varies bw business, Risk appetite and value are directly related
