CFA Level 1 - Corporate Finance
Debt with Optionlike Features
- debt can have features such as built-in options for either the borrower or the issuer that make the cost of debt more difficult to estimate - some of these features are call, conversion, or put provisions - these serve to either increase (call) or lower (conversion, put) the cost of debt from that of an option-free debt issue
Evaluating Inventory Management
- done through inventory turnover ratio and number of days of inventory - analysis should be done carefully as these numbers can change based on a variety of decisions in the business, such as product mix
Drags and Pulls on Liquidity
- drags on liquidity are situations in which cash comes into a company more slowly, while pulls on liquidity are situations involving cash being paid out too quickly
Evaluating Accounts Payable Management
# of Days of Payables = AP / Average Day's Purchaes Purchases = (EI - BI) + COGS
Nonelectronic (Lockbox) Systems
- involves the use of a post-office box to which the bank for a company has access - bank employees can thus collect and deposit checks for the specific company - collection typically happens once per day, amount deposited is available for business use the following day
Nonrated Debt
- "synthetic" debt costs can be calculated from financial ratios, but there are not accurate
Payback Period
- # of years it will take for a project's cash inflows to equal its initial outflow - ignores time value of money and the fact that cash flows come after the payback period
How CFOs Estimate the Cost of Capital
- CAPM is the most popular method - mos companies use a single cost of capital but adjust for risk on specific projects
Dividend Discount Model (DDM) Approach - Sustainable Growth Rate
- DDM equates the estimated future dividends to the current price by discounting each in a geometric series, which can be solved for the ROE r = (D1/P0) + G G = (1 - (D/EPS))ROE - the sustainable growth rate can be estimated with the payout ratio and the firm's ROE
DDM Model / Implied Risk Premium Approach
- DDM risk premium approach uses a firm's current dividend level and an assumed growth rate into the future for a stream of cash flows that are discounted at the rate of common equity to arrive at the stock price r = (D1/P0) + G - this estimated cost of equity minus the risk-free rate can be used as a risk premium in the CAPM
ESG Considerations: Market Overview
- ESG integration is the consideration of ESG issues when investing - ESG integration is synonymous with sustainable investing, responsible investing, and socially responsible investing - new organizations exist to facilitate consideration of ESG, and some institutional investors are considered "universal owners"
Multiple IRR Problem
- IRR calculation as a tool for comparison with a hurdle rate may not work as well when cash flows of a project change signs multiple times, possibly creating two or more IRRs for a project's cash flows
Marginal Cost of Capital Structure
- MCC schedule is a representation, usually graphic, which shows the WACC at various levels of capital - the MCC is upward-sloping, representing the increasing cost of finding additional funding sources
Popularity and Usage of Capital Budgeting Methods
- NPV/IRR are the most widely used capital budgeting methods - other techniques such as Payback Period are still popular - smaller firms are less likely to use NPV and IRR
Number of Days of Payables
= AP / Average Days Purchases - average number of days it takes a company to pay suppliers, vendors, and creditors
Short-Term Investment Instruments
- T Bills, federal securities, CDs, mutual funds, money market accounts - T Bills are least risky, guaranteed return
Investment Opportunity Schedule (IOS) and Optimal Investment Decision
- a firm's marginal cost of capital (MCC) is generally increasing as a potential investment projects can be lined up from the highest return to the lowest return - MCC and the IOS cross at a point of optimal investment
Accounts Receivable Turnover
- allows a business to see the ratio of sales on credit to its average annual accounts receivable balance - illustrates how often a company collects on its accounts receivables - the quicker it can collect on its accounts receivable, the more efficient the company = Credit Sales / AR
Investors, Rights and Risks
- analyst considerations of corporate governance should extend to the types of investors in a company, their concentration, and strength of their rights, and whether there is cross-shareholding and activist shareholders - also, investigate any patterns of fines, lawsuits, and investigations to see if a company is doing a relatively poor job of managing long-term risks related to personnel or the environment
Historical Equity Risk Premium Approach
- arithmetic mean is a forward-looking measure, while geometric mean is an accurate backward-looking measure, showing the most meaningful historical return - measurement should be done for a country's own index, making sure that the average being used covers complete business cycles
Benefits of Effective Governance and Stakeholder Management
- benefits include operational efficiency through clarity of expectations, improved controls, lower default risk levels leading to lower costs of debt, and an overall improvement in financial performance due to these and other lower costs
Board, Audit, and Transparency
- board of directors is elected by shareholders to oversee the hiring of top management and several important functions of firm-wide oversight - this includes the retention of an auditor and the review of the auditor's report, reporting and transparency, as well as some policies meant to reduce conflicts of interest
Board Composition and Responsibilities
- board of directs vary greatly in size and structure - they can have one-tier or two-tier structure - some are staggered in terms of elections - board members have broad responsibilities including financials, operations, risk management, and major firm decisions - board members are to exercise a duty of care and a duty of loyalty
Bond Yield plus Risk Premium Approach
- bond yield plus risk premium approach estimates the cost of equity as the before-tax cost of debt and an estimated risk premium (ERP) - don't need to account for tax of bond yield when calculating cost of equity
Country Risk Premium
- calculated as the sovereign yield multiplied by the ratio of standard deviation of returns for the developing market's equity market and the developing market's sovereign bonds
Leases
- can be operating or capital in nature, although only capital leases are included as a liability on the company's balance sheet
Sources of Short-Term Financing
- companies obtain short-term financing from banks or from money market sources - bank sources can be uncommitted or committed lines of credit or revolving credit agreements - committed lines of credit and revolving credit agreements can be secured or unsecured - uncommitted lines of credit and revolving credit agreements are more common in the U.S.
Managing Short-Term Financing
- companies should establish an effective short-term borrowing strategy - short-term financing should focus on maintaining sufficient liquidity position and allow for a small degree of risk - smaller companies are typically short-term borrowers or short-term investors, but not both; large corporations can be both
Leverage and Company Risk
- company risk is linked with leverage; the more fixed costs, the riskier - increases volatility of company's earnings/cash flow DOL x DFL = DTL
Evaluating Short-Term Funds Management
- converting all securities to returns expressed as bond-equivalent yields and weighting items on the portfolio can simplify the evaluation of short-term funds
Cost of Common Equity
- cost of common equity is calculated as a percentage rate - cost is difficult to estimate - approaches to estimation include CAPM, Dividend Discount Model, or Adding a Risk Premium to the Bond Yield
Cost of Debt
- cost of debt is simply the interest rate a company must pay on new borrowing, either by issuing bonds or taking out a bank loan - taken from an investor's POV, it is the return required to take on the risk of buying the bond - taken from a creditor's POV, it is the return required in order to take on the risk of lending money
Cost of Debt - Debt-Rating Approach
- cost of debt used in calculating WACC represents the cost of a company's existing bonds or loans - bond-rating approach utilizes characteristics of similar companies, such as the same credit rating, to calculate the cost of debt when it is not possible to calculate a yield to maturity
Cost of Debt - YTM Approach
- cost of debt used in calculating a WACC represents the cots of a company's existing bonds or loans - 2 approaches: YTM and Bond Rating - YTM approach is used to calculate the cost of debt when the market price is KNOWN for a firm's debt
Types of Investment Risks and Safety Measures
- credit risk, market risk, liquidity risk - these can be mitigated by investing in safe securities or investing in securities with short maturities - foreign exchange risk, however, can be reduced by investing in domestic securities
Ownership, Control, and Board Representation
- dual-class structures of corporate shares can be set up as class B shares which each have several votes, or that elect a majority of board members - dual-class structures present greater risk to other shareholders - board representation is difficult to balance in terms of experience, expertise, and in avoidance of conflicts of interest
Costs of Different Sources of Capital
- each source of capital has a different cost due to unique attributes that include seniority within a firm's capital structure, contractual commitments, and the potential value as a tax shield - each of these factors needs to be considered, as they can have a marked impact on the return that a supplier of capital is willing to accept and on the true cost to the firm
Stakeholder Management
- effective shareholder management includes active communication - the main tools of voice communication for shareholders is voting and general meetings; there are annual or extraordinary, depending on the function - voting is done in person or by proxy, and can be a straight vote or cumulative vote, depending on many factors
Electronic Funds Transfer Systems
- enable the readiness of cash from credit card and debit card transactions - a point-of-sale system allows a business to capture the transaction at the location the sale is made - a direct debit program is an arranged routine payment collection
ESG Factors in Analysis and Implementation
- environmental factors of ESG include pollution, water conservation, and the risk of "stranded assets" - social concerns include safety, human rights, and community impact - implementation of ESG integration can include negative screening, positive screening, best-in-class, or thematic investing
Levering and Unlevering Betas
- equity beta = levered beta - asset beta = unlevered beta - unlevered beta represents the market risk of the company's assets Basset = Bequity / (1+(1-T)D/E)
Flotation Costs
- fees charged by investment bankers to assist companies raising capital; includes registration and legal fees - fees include: registration fees, underwriting fees, legal fees - equity issues can have substantial costs, as much as 6-8% , common stock has greatest cost
Connection between Financial Leverage and ROE
- financial leverage occurs when a company chooses to finance operations by issuing debt - degree of financial leverage (DFL) quantifies the effects of financial leverage on net income and shows that higher leverage means proportionally higher net income - since ROE is calculated by NI / SE, financing leverage should also magnify ROE
Reorganization (Chapter 11)
- first step for finally distressed companies that are insolvent - provides time to reorganize their capital structure and negotiate better terms on existing debts; companies can reemerge healthy
Issues in Estimating the Cost of Debt
- fixed vs. floating rates, option-like features, non-rated debt, leases
Fixed-Rate Debt vs. Floating-Rate Debt
- floating-rate debt sets interest payments based on a reference rate, which can change significantly in the future - floating-rate structure presents a significant challenge to accurately estimating a forward cost of debt
Incorporating Flotation Costs into the Cost of the Project
- flotation costs can be incorporated info a project valuation analysis as another cost of the project itself, and this is the preferred method of incorporating flotation costs - preferred method is deduct flotation costs as part of NPV (sometimes tax adjusted)
Ranking Conflicts between NPV & IRR
- for profitable projects, NPV > 0, IRR > discount rate
Managing the Cash Position
- goal is to avoid negative net cash at the end of each day - companies keep small balances with low returns and consider this an acceptable cost of doing business - managing cash is usually within the treasury function of the company
NPV Profile
- graphically displays the NPV of a project's cash flows for a variety of discount rates - can be used to quickly judge a project - two main points to focus on are where the line reaches zero NPV and where the line is when it reaches the required rate of return
Inventory Turnover
- how many times per fiscal year a company sells its inventory = COGS / Inventory - the higher the ratio, the more efficient the company is
Economics of Taking a Trade Discount
- if a company is going to use the trade discount, it is most economical to pay on the last day the discount is offered - if the company is not going to use the discount, it is most economical to pay on the latest due date
NPVs and Stock Prices
- if a firm takes on a positive NPV project, the stock price of that firm should increase - in practice, the market reaction is often either smaller or larger than the NPV of the project because there are other cash flow expectations at the same time
Market Factors Affecting Stakeholder Relationships
- include a company's attempts at shareholder engagement, the instances of shareholder activism on matters typically centered on profit maximization, and various takeover attempts such as proxy contexts, tender offers, and hostile takeovers
Corporate Governance Overview
- includes internal controls, and procedures by which a firm is managed, and the rules, rights, and responsibilities of various parties - no agreement of governance, and differences among countries - stakeholder theory broadens shareholder theory to include environmental, social, and governance (ESG) issues
Identifying Typical Cash Flows
- inflows and outflows help the cash manager to gather data, review variances, and present the information to management - inflows: cash receipts, transfers, collection of AR, tax refunds - outflows: payroll, supply payables, utility payments, purchasing investments, tax payments
Constructing a Marginal Cost of Capital Schedule
- involves calculating a WACC for every possible level of capital - for an MCC constructed with a constant capital structure ratio, this becomes a matter of finding the WACC at the break points and connecting those points
Cost of Preferred Stock
- its the preferred dividend the company has committed to pay the preferred stockholders as a share of the preferred stock value - cost varies with risk and specific features of the preferred issue
Defining Liquidity Management
- liquidity management involves developing, implementing, and maintaining the company's liquidity policy so the company can obtain cash when needed - the resources for cash are usually short-term assets - when even more cash is needed, long-term assets can be sold for cash, and long-term liabilities can be renegotiated to retain cash - however, these last two options may deteriorate the overall financial strength of the company
Cost of Capital Changes and Break Points
- marginal cost of capital curve (MCC) is not smooth in practice, and has discontinuous jumps, or break points, where abrupt changes in the weighted average cost of capital (WACC) take place
Secondary Sources of Liquidity
- may result in a change in the company's financial and operating positions, whereas a primary source would not - use of secondary sources of liquidity may signal a company's deteriorating health - includes: negotiating debt contracts, liquidating assets, filing for bankruptcy protection and reorganization
Calculating the Weighted Average Collection Period
- measure of how long it takes to collect from customers regardless of the level of sales
Operating Cycle
- measure of the operating efficiency and working-capital management of a company; time it takes to turn raw materials to cash = (365 / Purchases) x Average Inventories + (365 / Credit Sales) x Average AR
Managing Cash Disbursements
- method by which cash leaves a company's bank account - companies prefer to only have enough cash in the account to cover checks, to avoid check fraud, to pay electronically only when cost-effective, and to manage bank charges - banks help companies address some of these concerns by optimizing check funding and providing protections against check fraud
Measuring Liquidity Ratios
- more liquidity means that a company has more creditworthiness and can obtain better borrowing costs
Market Model Regression
- most common beta estimation for a publicly traded firm is a regression of the company's equity returns against the returns of a market index
Discounted Payback Period
- number of years it is expected that a project will take to return the initial investment, when discounting all cash flows to present values DPP = Years Until Full Recovery + (Unrecovered Cash Flow from Prior Year / Cash Flow from Given Year) - DOWNSIDE of this tool is that it does not consider all of the project's cash flows
Short-Term Borrowing Approaches
- objective is to have sufficient cash at all times - to meet these objectives, companies should use a variety of funding sources and have flexibility in their repayments - an active strategy can most efficiently help a company match needs and repayments, while a passive strategy depends more on routine borrowing from the same lenders
Cost of Capital - Introduction
- opportunity cost against which investment projects are compared - to add value, a company needs to invest in projects that produce returns that exceed the cost of its capital - cost of capital varies with the riskiness of the project and it is only an estimate
Factors to Consider for Efficient Accounts Payable Management
- payables management is affected by company structure such as the degree of centralization of the financial functions and the choice of inventory management - when determining an efficient payables process, a company should also consider vendor-related issues such as the number of vendors and trade credit options - finally, payables processing selection may be impacted by the use of checks to pay bills and the value of electronic payments
Risks of Poor Governance and Stakeholder Management
- poor governance can lead to undetected fraud from weak internal control systems, poor decision making by managers which are not in the best interests of shareholders, damage to firm reputation, legal problems, lawsuits, and higher risk of default and bankruptcy
Degree of Operating Leverage (DOL)
- quantitative measure of operating risk, specifically the risk arising from relatively higher fixed costs vs. variable costs DOL = %change in OI / %change in units sold DOL = (Q(p-v)) / (Q(p-v)) -F DOL = revenue before fixed costs / EBIT - if DOL greater than 1, then the company is utilizing operating leverage and will have magnified operating income gains and losses with changes in sales
Primary Sources of Liquidity
- ready cash balances, short-term funds, cash flow management
Sales Risk
- refers to the possibility of a good or the quantity of a good sold can fall and cause a decline in OI, or even a loss - managers do not have much control over sales risk - can affect profitability for a company
Financial Risk
- refers to the risk of meeting financial obligations related to debt
Operating Risk
- risk attributed to the operating cost structure, which is made up of variable and fixed costs - the more the company relies on fixed costs, the greater the operating risk it is taking - companies have more control over operating risk than sales risk
Risk Premium Survey Approach
- risk premium survey approach uses a mean response from experts about their estimate of an appropriate equity risk premium to use in the CAPM - this average has fallen over time from between 7-8% to a recent level of close to 4%
Credit Management - Trade Granting Process
- sets a company's framework for sales, either restricting sales by rejecting credit or expanding business by loosening credit criteria - fundamental financial analysis is imperative in setting credit policies and issuing and managing credit
Principal-Agent and Other Relationships
- shareholders are the principal, managers are the agent - conflicts arise between the goals of profit maximization and executive compensation - risk tolerance, debt levels, liquidity goals all vary depending on the stakeholder, and relationships between these stakeholders suffer from conflicts which naturally arise from opposing goals
Non-Market Factors Affecting Stakeholder Relationships
- shareholders have generally more protection under common law systems, where judges set law by precedent more than in civil law systems, where written statute is primary - creditors' claim is generally stronger than that of shareholders - media and a concentrated corporate governance industry are two other non-market factors which can shape stakeholder relationships
Stakeholder Groups
- shareholders, Board of Directors, creditors, managers, employees, customers, suppliers, regulators
Managing Inventory
- since inventory does not produce cash for a company until it is sold, overages and shortages in inventory can be costly
Nonbank Sources
- sources for small or large companies - for small companies with weak credit, nonbank finance companies might be a source of short-term financing - based on the specific size and credit of these companies, there are base rate fees as well as service fees for this type of financing - on the other hand, the largest corporations can issue commercial paper, which has the lowest rates for short-term funds based on money market rates and commissions
Remuneration and Creditor Agreements
- stock options are popular remuneration for managers, but this aligns with incentives only in the short term - paying with stock that has sale restrictions may better solve the principal-agent problem - say on pay is shareholder voting on executive compensation - bond indentures use covenants and collateral to protect creditors interests
Capital Budgeting - Concepts
- sunk costs should be ignored, while an opportunity cost must be considered - if opportunity costs are determined correctly, then incremental cash flow is an effective way to make a decision - cash flow patters, inflows, and outflows must also be considered before selecting decision criteria Conventional Cash Flow - where you have a single investment, or outflow, followed by a series of cash inflows Nonconventional Cash Flow - cash inflows and outflows flip from positive to negative several times, such as when an initial investment requires a subsequent expansion
Classical Economic Order Quantity-Reorder Point (EOQ-ROP) Model
- tends to work best for smaller items that have fairly predictable demand - EOQ is based on estimated demand while the reorder point is based on ordering costs, carrying costs, and the lead time needed to receive the order - companies often increase their level of safety stock to avoid stock-out costs and anticipation stock for when demand may be higher than usual
Choosing the Best Estimate of the Cost of Preferred Equity
- the best estimate of the cost of preferred stock involves consideration of the current value of the company's preferred stock, or, equivalently, the preferred dividend the company would have to currently offer to issue the preferred stock at part value - this estimate incorporates the current and future risk of the firm and is therefore the most accurate in estimating the forward cost of preferred equity - if nothing outstanding, use comparable companies cost
Goal of an Efficient Accounts Payable Process
- to balance the lost trade credit cost of paying bills too late with the opportunity costs of paying bills too early - an effective process comes from rules that recognize volume with suppliers and creates consistency in the payment processing
Country Spread - Sovereign Yield Spread
- to fully capture the risk of developing nations, the market risk premium is often augmented by a sovereign yield spread, the difference in yields between a developing country's government bond and a comparable bond of a developed nation, denominated in the currency of the developed nation
Using CAPM to Estimate the Cost of Equity
- use the yield on the government security that matches the length of the investment project it is meant to cover - gathering the necessary parameters for this calculation requires additional estimation of the appropriate risk-free rate (matching the yield curve term with the project) and the market premium (using a historical risk premium, a DDM estimate, or a survey)
Estimating Beta and Determining a Project Beta
- using the CAPM for estimating cost of equity for a firm or project requires the use of a beta estimate - this beta can be taken from a regression of a firm's value against a market index or by a "pure play" method of leveraged beta using a comparable company - this beta estimate can be affected by the business risk an financial risk of the firm or project
Accounts Receivable Aging Schedule
- usually, the aging schedule is shown for accounts current, those 1-30 days past due, those 31-60 days past due, and so on for as long as necessary to be helpful - if there are changes in the percent of accounts in each group, the company might need to review any changes in collection policy or investigate why customers are changing their payments
Bank Sources
- variety of bank sources of short-term financing - options for larger companies include uncommitted lines of credit, revolving credit agreements, and discounted receivables - smaller companies can obtain collateralized loans or factor their receivables while international companies look for banker's acceptances - companies of all sizes might be able to obtain regular lines of credit or overdraft lines; each of these sources may be available more in the U.S. or more overseas and each charges different fees
Projects and Their Interactions
- various project interactions add challenges to incremental cash flow analysis - Mutually Exclusive Projects must directly compete with each other - Independent Projects are based solely on their own cash flows - with Project Sequencing, decisions are based on the financial results of the first project before the second project is considered (and so on) - a company with fixed amounts of funds to invest must ration capital
Weights of the Weighted Average - Targeted Capital Structure
- weights for each component in calculating WACC should be chosen based on the market value of that capital component, and in the proportions of the target capital structure the firm is trying to achieve
Working Capital - Introduction
- working capital focuses on short-term aspects of corporate finance, and attempts to balance the need for cash to pay obligations with the business goal of investing assets as productively as possible - working capital managers need to monitor all short-term asset and credit accounts, while also creating cash forecasts and watching transactions and bank balances Cost of Trade Credit = (1 + Periodic Rate)^# of periods - 1 # of Periods = (365/Days after Discount Period)
Pure Play Method
1) find a comparable firm with same business risk 2) estimate the comparable's beta 3) unlever the equity beta 4) take comparable asset beta, lever beta for the project
Capital Budgeting Process - Steps
1) generating ideas 2) analyzing individual proposals 3) planning the capital budget 4) monitoring and post-auditing
Number of Days of Receivables
= AR / Average Days Sales on Credit - shorter # of days illustrates that a company can convert receivables to cash faster, making the company more efficient
Quick Ratio
= (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities - does NOT account for inventory in its current assets
Number of Days of Inventory
= 365 / Inventory Turnover
Float Factor Calculation
= Average Daily Float / Average Daily Deposit - amount of money in transit from the customer's bank account to the company's bank account - # of days this money is in float - if the float factor is growing, the company may need to work with both parties' banking institutions to find a more efficient method to transfer money *no impact on quick ratio
Current Ratio
= CA / CL
Average Accounting Rate of Return (AAR)
AAR = Average NI / Average Book Value - based on accounting numbers, such as net income, instead of cash flows and does not consider time value of money - average book value, can be calculated as half the difference between the initial investment and salvage value
Value and Costs of Stretching Payables
Amount Earned from Stretch = (Annual Rate / 365) x Days x Bill Amount - involves waiting to pay a bill until the end of grace period - advantage is keeping cash lower and investing during stretch time - disadvantage is potential negative reflection of company's credit-worthiness
Audit, Governance, and Compensation Committees
Audit Committee - looks at the firm's internal controls, recommends an external auditor, and examines the auditor's report before the full board Governance Committee - ensures that the code of ethics and other policies and standards are current, and in line with legal requirements Compensation Committee - recommends payment packages for executives and some HR policies
Computing Bond Equivalent Yields
BEY = (Face Value - Purchase Price) / (Purchase Price) x (365 / Days to Maturity)
Calculating Breakeven Point
Break even Quantity = PQ = VQ + F + C p = price, q = quantity, v = variable costs, f = fixed costs, c = fixed financial costs - quantity of product that is produced and sold where revenues equal costs and the company makes $0 profit Q = (F+C) / (P-V) Operating Breakeven = F / (P - V)
Business Risk and Its Components
Business Risk - risk associated with operating earnings that end up being less than projected by the company Sales Risk - uncertainty related to price per unit and quantity of goods sold Operating Risk - risk attributed to the use of fixed costs relative to variable costs in the cost structure (operating leverage) *the more fixed costs relative to variable costs, the greater the risk
Contribution Margin
Contribution Margin Per Unit = (P-V), or the amount that goes towards fixed costs after variable costs are paid Contribution Margin = (P-V) x Q - the more direct method of calculating DOL uses contribution margin...DOL = Contribution Margin / (Contribution Margin - Fixed Costs) - at positions just below or just above the point where operating income is $0, DOL will be a much larger number
Computing the Cost of Borrowing
Cost of Borrowing = (all costs of borrowing) / (net proceeds) - costs must include all interest, even for all-inclusive interest rates, as well as all fees charged - if the loan is for less than one year, the cost must be annualized *all inclusive - commitment fees are included
Taxes and the Cost of Capital
Cost of Debt = Yield (1-T)
Incorporating Flotation Costs into the Cost of Capital
Cost of Equity = (D / (P0 - F)) + G Cost of Equity = (D / P0(1-F)) + G - to account for flotation costs for an equity offering, incorporate them into the cost of equity, which is used in the WACC
Computing the Cost of Trade Credit Financing
Cost of Trade Credit = (1 + (Discount/1-Discount))^(365/# of days beyond discount period) - 1 - the longer a company waits to pay the bill, the lower the cost of forgoing the discount
Degree of Financial Leverage (DFL)
DFL = %change in NI / %change in OI DFL = OI / (OI - Interest) *in either case, higher financial leverage, or interest expense, magnifies net income
Degree of Total Leverage (DTL)
DTL = %change in NI / %change # units sold - measures sensitivity of NI changes in the number of units produced and sold DTL = DOL x DFL DTL = Contribution Margin / (Contribution Margin - Fixed Operating Costs - Interest) - in case of operating leverage, the greater the fixed cost relative to variable costs, the more sensitive operating income changes is to changes in sales - in case of financial leverage, the more debt used - such as leases/bonds - the more sensitive net income is to changes in operating income
Discount Securities vs. Computing Yields on Short-Term Investmetns
Discount Securities - T-Bills, notes, bonds (less risky); investor receives face value at time of maturity Interest-Bearing Investments - banking accounts, CDs, other fixed- and variable-interest accruing deposits; investor pays face value and the investment accrues interest
Computing Investment Yields
Discount-Basis Yield = (Face Value - Purchase Price) / (Face Value) x (360 / # of days to maturity)
Forecasting Short-Term Cash Flows
Helps: - identify potential shortfalls or overages in cash balances and asset accounts - make sure payables can be paid timely - identify customers who are behind on payments
Internal Rate of Return
IRR = Sum (CF / (1+IRR^t) ) - Outlay = 0
Scope of Working Capital Management
Includes: - all transactions involving working capital - relations with outside organizations such as banks and suppliers - analysis for the development of working capital strategies - a focus on liquidity
Just-in-Time (JIT) and Manufacturing Resource Planning (MRP) Models
JIT - focuses on minimizing inventory at all stages of production; materials are ordered at their individual order points; production is determined by historical or actual demand MRP - incorporates production planning; based on expected demand, materials are ordered for the expected production, creating a materials ordering schedule as well as production schedule
Computing Money Market Yields
MMY = (Face Value - Purchase Price) / (Purchase Price) x (360 / Days to Maturity) Purchase Price = FV / ((1 + (Maturity / 360) x Money Market Yield))
Matching, Mismatching, and Laddering Strategies
Matching - the most conservative, uses a lot of same commonalities of passive strategies Mismatching - riskier than matching and requires accurate forecasting Laddering - schedules securities to mature in phases throughout the year
Investment Decision Criteria
NPV - shows the difference in present values between the future cash flows and net investment amount Profitability Index - looks at the PV of future cash flows relative to the initial investment (indicates highest return per dollar invested) IRR - discount rate where NPV is zero, so the two methods are directly linked Accounting Rate of Return (ARR) - average net income relative to average book value; doesn't reflect economic reality well Payback Period - how long it takes to get back start-up investment costs Discounted Payback Period - how long it takes to get back start-up investment costs except cash is discounted here CFA Investment Decision Criteria: NPV, IRR, Payback Period, Discounted Payback Period, ARR, PI *NPV and IRR are preferred since they consider all cash flows and time value of money; for replacement projects, for mutually exclusive projects
Net Present Value
NPV = Sum (CF / (1 + r)) - Outlay - the most appropriate investment decision criteria because it considers all cash flows and time value of money - decision rule for NPV says to accept projects with positive NPV and reject projects with negative NPV *when rankings based on IRR/NPV conflict, NPV dominates...since discount rate used for NPV is the cost of capital, which is reasonable/practical
Nomination, Risk, and Investment Committees
Nomination Committee - recommends independent, potential board members for nomination to keep a desired balance Risk Committee - decides the risk tolerance of the firm and participates in risk monitoring Investment Committee - focuses on any acquisitions and divestitures of the firm which may be brought before the board
Profitability Index
PV = (PV of CFs / Initial Outlay) - accept projects when PI is greater than 1, reject projects when PI is less than 1
Calculating the Cost of Preferred Equity
Price = P Div / Rate of Return - taxes do NOT enter into this cost
Managing Accounts Receivable
Primary functions - granting credit and managing transactions - monitoring credit balances - measuring the performance of the credit function - while sometimes done in house, this function can also be done within a capital financing subsidiary or can be outsourced
Investment Policy / Guidelines
Purpose - reason a portfolio exists Authorities - executives that oversee a portfolio Limitations/Restrictions - boundaries of instruments Quality - types of securities Other
Capital Budgeting Projects - Categories
Replacement Projects - require less analysis, can be assessed quickly and given the go-ahead by even less senior managers Expansion Projects - more uncertainty around it, more time/energy/costs need to be considered Other Projects - do not require a lot in-depth analysis - replacement projects, expansion projects, new products and services, regulatory projects, other projects
Capital Budgeting - Basic Principles and Assumptions
Separation of Cash Flows - capital outlay, expenses, working capital *cash flows are analyzed on an after-tax basis - capital budgeting decisions are based on relevant cash flow and not on accounting income or other profitability measures - relevant cash flows are cash flows that occur (or vanish) as a direct consequence of doing a project - cash flow is used in capital budgeting decisions since it represents what is actually available to spend or to reinvest, and it can be calculated from income
Cash Forecasting Systems
Short-Term - uses daily and weekly receipts and disbursements, is most accurate, and typically used for daily cash management Medium-Term - utilizes monthly receipts and disbursements for planning financial transactions Long-Term - uses annual financial statements and statistical models
Remuneration and Company Performance
There are several things to look for when analyzing a company's remuneration policies, including: - alignment of incentives with shareholders, milestones and contingencies, variation in payout results over the years, high payouts relative to other companies, and consideration of the company's life cycle
Asset-Based Loans
Trust Receipt Arrangement - when inventory is set aside Warehouse Receipt Arrangement - when a third party is put in charge of set aside inventory - when receivables or inventory are used as collateral for a secured loan - in these cases, the lender may also receive a blanket lien giving the lender claim on other assets, to further back up the loan - a company can also get cash from its receivables by factoring or selling them - inventory can be used as collateral through a variety of arrangements
Introduction - Capital Budgeting
capital budgeting - a process used by companies to evaluate which large projects to invest in - capital projects are balance sheet long-term assets, and mistakes are costly to a company
Inventory Costs
carrying costs - costs of storing inventory ordering costs - costs of placing each order stock-out costs - costs of running out of inventory policy costs - opportunity cost of doing research into inventory strategies
Active and Passive Investment Strategies
passive - highly liquid, very safe active - need more monitoring than passive, not as liquid, not as safe
