FI 400 EXAM 4 ALABAMA SPRING 2017

Investment bankers

are financial intermediaries who, in addition to their role in selling new security issues, can be hired by acquirers in mergers to find suitable target companies and assist in negotiations. - The investment banker is typically compensated with a fixed fee, a commission tied to the transaction price, or a combination of fees and commissions

Spontaneous Liabilities

are financing that arises from the normal course of business; the two major short-term sources of such liabilities are accounts payable and accruals

Takeover defenses

are strategies for fighting hostile takeovers. - A white knight is a takeover defense in which the target firm finds an acquirer more to its liking than the initial hostile acquirer and prompts the two to compete to take over the firm. - A poison pill is a takeover defense in which a firm issues securities that give their holders certain rights that become effective when a takeover is attempted; these rights make the target firm less desirable to a hostile acquirer. - Greenmail is a takeover defense under which a target firm repurchases, through private negotiation, a large block of stock at a premium from one or more shareholders to end a hostile takeover attempt by those shareholders. Other takeover defenses include: - A leveraged recapitalization is a takeover defense in which the target firm pays a large debt-financed cash dividend, increasing the firm ʼs financial leverage and thereby deterring the takeover attempt. - Golden parachutes are provisions in the employment contracts of key executives that provide them with sizable compensation if the firm is taken over; deters hostile takeovers to the extent that the cash outflows required are large enough to make the takeover unattractive. - Shark repellents are antitakeover amendments to a corporate charter that constrain the firm ʼs ability to transfer managerial control of the firm as a result of a merger.

Subsidiaries

are the companies controlled by a holding company

Credit terms

are the terms of sale for customers who have been extended credit by the firm.

Effects of Leasing on Future Financing

A capitalized lease is a financial (capital) lease that has the present value of all its payments included as an asset and corresponding liability on the firm ʼs balance sheet, as required by the Financial Accounting Standards Board (FASB) in FASB Statement No. 13. An operating lease, on the other hand, need not be capitalized, but its basic features must be disclosed in a footnote to the financial statements. FASB Statement No. 13, of course, establishes detailed guidelines to be used in capitalizing leases.

Convertible Securities

A conversion feature is an option that is included as part of a bond or a preferred stock issue and allows its holder to change the security into a stated number of shares of common stock. - The conversion feature typically enhances the marketability of an issue. A convertible bond is a bond that can be changed into a specified number of shares of common stock. A straight bond is a bond that is nonconvertible, having no conversion feature. Because the conversion feature provides the purchaser with the possibility of becoming a stockholder on favorable terms, convertible bonds are generally a less expensive form of financing than similar-risk nonconvertible or straight bonds. Convertible preferred stock is preferred stock that can be changed into a specified number of shares of common stock. Straight preferred stock is preferred stock that is nonconvertible, having no conversion feature.

Leasing: Leasing Arrangements

A direct lease is a lease under which a lessor owns or acquires the assets that are leased to a given lessee. A sale-leaseback arrangement is a lease under which the lessee sells an asset to a prospective lessor and then leases back the same asset, making fixed periodic payments for its use. A leveraged lease is a lease under which the lessor acts as an equity participant, supplying only about 20 percent of the cost of the asset, while a lender supplies the balance Maintenance clauses are provisions normally included in an operating lease that require the lessor to maintain the assets and to make insurance and tax payments. Renewal options are provisions especially common in operating leases that grant the lessee the right to re-lease assets at the expiration of the lease. Purchase options are provisions frequently included in both operating and financial leases that allow the lessee to purchase the leased asset at maturity, typically for a prespecified price.

cash discount

is a percentage deduction from the purchase price; available to the credit customer who pays its account within a specified time. - For example, terms of 2/10 net 30 mean the customer can take a 2 percent discount from the invoice amount if the payment is made within 10 days of the beginning of the credit period or can pay the full amount of the invoice within 30 days

A derivative security

is a security that is neither debt nor equity but derives its value from an underlying asset that is often another security; called "derivatives," for short.

A single-payment note

is a short-term, one-time loan made to a borrower who needs funds for a specific purpose for a short period. - This type of loan is usually a one-time loan made to a borrower who needs funds for a specific purpose for a short period. - The resulting instrument is a note, signed by the borrower, that states the terms of the loan, including the length of the loan and the interest rate. - This type of short-term note generally has a maturity of 30 days to 9 months or more. - The interest charged is usually tied in some way to the prime rate of interest.

A leveraged buyout (LBO)

is an acquisitiontechnique involving the use of a large amount of debt to purchase a firm; an example of a financial merger. An attractive candidate for acquisition via a leveraged buyout should possess three key attributes: 1. It must have a good position in its industry, with a solid profit history and reasonable expectations of growth. 2. The firm should have a relatively low level of debt and a high level of "bankable" assets that can be used as loan collateral. 3. It must have stable and predictable cash flows that are adequate to meet interest and principal payments on the debt and provide adequate working capital.

A wire transfer

is an electronic communication that, via bookkeeping entries, removes funds from the payerʼs bank and deposits them in the payeeʼs bank.

A materials requirement planning (MRP) system

is an inventory management technique that applies EOQ concepts and a computer to compare production needs to available inventory balances and determine when orders should be placed for various items on a productʼs bill of materials. Manufacturing resource planning II (MRP II) is a sophisticated computerized system that integrates data from numerous areas such as finance, accounting, marketing, engineering, and manufacturing and generates production plans as well as numerous financial and management reports.

A short-term, self-liquidating loan

is an unsecured short-term loan in which the use to which the borrowed money is put provides the mechanism through which the loan is repaid. - These loans are intended merely to carry the firm through seasonal peaks in financing needs that are due primarily to buildups of inventory and accounts receivable. - As the firm converts inventories and receivables into cash, the funds needed to retire these loans are generated. - Banks lend unsecured, short-term funds in three basic ways: through single-payment notes, lines of credit, and revolving credit agreements

A depository transfer check (DTC)

is an unsigned check drawn on one of a firmʼs bank accounts and deposited in another.

Secured short-term financing

is short-term financing (loan) that has specific assets pledged as collateral. - The collateral commonly takes the form of an asset, such as accounts receivable or inventory. - Holding collateral can reduce losses if the borrower defaults, but the presence of collateral has no impact on the risk of default. A security agreement is the agreement between the borrower and the lender that specifies the collateral held against a secured loan. - In addition, the terms of the loan against which the security is held form part of the security agreement. - A copy of the security agreement is filed in a public office within the state—typically, a county or state court

Unsecured short-term financing

is short-term financing obtained without pledging specific assets as collateral. - The firm should take advantage of these "interest-free " sources of unsecured short-term financing whenever possible

Corporate restructuring

is the activities involving expansion or contraction of a firmʼs operations or changes in its asset or financial (ownership) structure.

Consolidation

is the combination of two or more firms to form a completely new corporation.

A merger

is the combination of two or more firms, in which the resulting firm maintains the identity of one of the firms, usually the larger.

The acquiring company

is the firm in a merger transaction that attempts to acquire another firm.

The target company

is the firm in a merger transaction that the acquiring company is pursuing.

cost of giving up a cash discount

is the implied rate of interest paid to delay payment of an account payable for an additional number of days. • To calculate the cost of giving up the cash discount, the true purchase price must be viewed as the discounted cost of the merchandise, which is $980 for Lawrence Industries. • Another way to say this is that Lawrence Industriesʼ supplier charges $980 for the goods as long as the bill is paid in 10 days. • If Lawrence takes 20 additional days to pay (by paying on day 30 rather than on day 10), they have to pay the supplier an additional $20 in "interest." • Therefore, the interest rate on this transaction is 2.04% ($20 ÷ $980). Keep in mind that the 2.04% interest rate applies to a 20-day loan. To calculate an annualized interest rate, we multiply the interest rate on this transaction times the number of 20-day periods during a year. The following equation provides the general expression for calculating the annual percentage cost of giving up a cash discount: where CD= stated cash discount in percentage terms N= number of days that payment can be delayed by giving up the cash A simple way to approximate the cost of giving up a cash discount is to use the stated cash discount percentage, CD, in place of the first term of the previous equation: Substituting the values for CD (2%) and N (20 days) into these equations results in an annualized cost of giving up the cash discount of 37.24% [(2% ÷ 98%) × (365 ÷ 20)] and an approximation of 36.5% [2% × (365 ÷ 20)].

A revolving credit agreement

t is a line of credit guaranteed to a borrower by a commercial bank regardless of the scarcity of money. - It is guaranteed in the sense that the commercial bank assures the borrower that a specified amount of funds will be made available regardless of the scarcity of money. A commitment fee is the fee that is normally charged on a revolving credit agreement; it often applies to the average unused portion of the borrowerʼs credit line. - This fee often applies to the average unused balance of the borrowerʼs credit line. - It is normally about 0.5 percent of the average unused portion of the line.

Cash Conversion Cycle: Calculating the Cash Conversion Cycle

• A firmʼs operating cycle (OC) is the time from the beginning of the production process to collection of cash from the sale of the finished product. • It is measured in elapsed time by summing the average age of inventory (AAI) and the average collection period (ACP). OC = AAI + ACP

Accounts Payable Management

• Accounts payable are the major source of unsecured short-term financing for business firms. • They result from transactions in which merchandise is purchased but no formal note is signed to show the purchaser ʼs liability to the seller. • The average payment period has two parts: (1) the time from the purchase of raw materials until the firm mails the payment and (2) payment float time (the time it takes after the firm mails its payment until the supplier has withdrawn spendable funds from the firm ʼs account). Accounts payable management is management by the firm of the time that elapses between its purchase of raw materials and its mailing payment to the supplier. - When the seller of goods charges no interest and offers no discount to the buyer for early payment, the buyer ʼs goal is to pay as slowly as possible without damaging its credit rating. - This allows for the maximum use of an interest-free loan from the supplier and will not damage the firm ʼs credit rating (because the account is paid within the stated credit terms).

Cash Conversion Cycle: Calculating the Cash Conversion Cycle

• However, the process of producing and selling a product also includes the purchase of production inputs (raw materials) on account, which results in accounts payable. • The time it takes to pay the accounts payable, measured in days, is the average payment period (APP). The operating cycle less the average payment period yields the cash conversion cycle. The formula for the cash conversion cycle is: CCC = OC - APP

Net Working Capital Fundamentals: Trade-off between Profitability and Risk

• Profitability is the relationship between revenues and costs generated by using the firmʼs assets— both current and fixed—in productive activities. - A firm can increase its profits by (1) increasing revenues or (2) decreasing costs. • Risk (of insolvency) is the probability that a firm will be unable to pay its bills as they come due. • A firm that is insolvent is unable to pay its bills as they come due.

The prime rate of interest (prime rate)

) is the lowest rate of interest charged by leading banks on business loans to their most important business borrowers. - The prime rate fluctuates with changing supplyand-demand relationships for short-term funds. - Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrower ʼs "riskiness. " - The premium may amount to 4 percent or more, although most unsecured short-term loans carry premiums of less than 2 percent

Increasing speed lowers working capital

- A firm can lower its working capital if it can speed up its operating cycle. - For example, if a firm accepts bank credit (like a Visa card), it will receive cash sooner after the sale is transacted than if it has to wait until the customer pays its accounts receivable.

Types of Business Failure

A firm may fail because its returns are negative or low. - A firm that consistently reports operating losses will probably experience a decline in market value. A second type of failure, insolvency, occurs when a firm is unable to pay its liabilities as they come due. - When a firm is insolvent, its assets are still greater than its liabilities, but it is confronted with a liquidity crisis. Bankruptcy occurs when the stated value of a firm ʼs liabilities exceeds the fair market value of its assets. - A bankrupt firm has a negative stockholdersʼ equity. The primary cause of business failure is mismanagement. - Overexpansion, poor financial actions, an ineffective sales force, and high production costs can all singly or in combination cause failure. Economic activity can contribute to the failure of a firm. - If the economy goes into a recession, sales may decrease abruptly, leaving the firm with high fixed costs and insufficient revenues to cover them. - Rapid rises in interest rates just prior to a recession can further contribute to cash flow problems and make it more difficult for the firm to obtain and maintain needed financing. A final cause of business failure is corporate maturity .

Holding Companies

A holding company is a corporation that has voting control of one or more other corporations. - The holding company may need to own only a small percentage of the outstanding shares to have this voting control. - A holding company that wants to obtain voting control of a firm may use direct market purchases or tender offers to acquire needed shares. - The primary advantage of holding companies is the leverage effect that permits the firm to control a large amount of assets with a relatively small dollar investment. - Disadvantages of holding companies include the increased risk resulting from the leverage effect, double taxation, and the high cost of administration Advantages of holding companies: • The primary advantage is the leverage effect that permits the firm to control a large amount of assets with a relatively small dollar investment. • The high leverage obtained through a holding company arrangement greatly magnifies earnings and losses for a holding company. • There is risk protection - failure of one of the companies does not result in the failure of the entire holding company. • Certain state tax benefits may be realized by each subsidiary in the state of incorporation. • Lawsuits or legal actions against a subsidiary do not threaten the remaining companies. • It is generally easier to gain control of a firm because stockholder or management approval is not generally necessary. Disadvantages of holding companies: • A major disadvantage of holding companies is the increased risk resulting from the leverage effect. • There is double taxation - before paying dividends, a subsidiary must first pay federal and state taxes on its earnings. • Holding companies are difficult to analyze because of their complexity. • There is a high cost of administration that results from maintaining each subsidiary as a separate entity.

Just In Time system

A just-in-time (JIT) system is an inventory management technique that minimizes inventory investment by having materials arrive at exactly the time they are needed for production. - Because its objective is to minimize inventory investment, a JIT system uses no (or very little) safety stock. - Extensive coordination among the firm ʼs employees, its suppliers, and shipping companies must exist to ensure that material inputs arrive on time. - Failure of materials to arrive on time results in a shutdown of the production line until the materials arrive. - Likewise, a JIT system requires high-quality parts from suppliers.

Cash Conversion Cycle: Funding Requirements of the Cash Conversion Cycle

A permanent funding requirement is a constant investment in operating assets resulting from constant sales over time. A seasonal funding requirement is an investment in operating assets that varies over time as a result of cyclic sales.

Stock Purchase Warrants: Key Characteristics

A stock purchase warrant is an instrument that gives its holder the right to purchase a certain number of shares of common stock at a specified price over a certain period of time. - Warrants are often attached to debt issues as "sweeteners." - Often, when a new firm is raising its initial capital, suppliers of debt will require warrants to permit them to share in whatever success the firm achieves. - In addition, established companies sometimes offer warrants with debt to compensate for risk and thereby lower the interest rate and/or provide for fewer restrictive covenants The exercise (or option) price is the price at which holders of warrants can purchase a specified number of shares of common stock. - This price is usually set at 10 to 20 percent above the market price of the firmʼs stock at the time of issuance. - Until the market price of the stock exceeds the exercise price, holders of warrants will not exercise them, because they can purchase the stock more inexpensively in the marketplace. Comparison of Warrants to Rights and Convertibles - Both result in new equity capital, although the warrant provides for deferred equity financing. - The life of a right is typically not more than a few months; a warrant is generally exercisable for a period of years. - Rights are issued at a subscription price below the prevailing market price of the stock; warrants are generally issued at an exercise price 10 to 20 percent above the prevailing market price. Comparison of Warrants to Rights and Convertibles (cont.) - The exercise of a warrant shifts the firmʼs capital structure to a less highly levered position because new common stock is issued without any change in debt. If a convertible bond were converted, the reduction in leverage would be even more pronounced, because common stock would be issued in exchange for a reduction in debt. - In addition, the exercise of a warrant provides an influx of new capital; with convertibles, the new capital is raised when the securities are originally issued rather than when they are converted. The influx of new equity capital resulting from the exercise of a warrant does not occur until the firm has achieved a certain degree of success that is reflected in an increased price for its stock. In this case, the firm conveniently obtains needed funds.

Stock Swap Transactions

A stock swap transaction is an acquisition method in which the acquiring firm exchanges its shares for shares of the target company according to a predetermined ratio. The ratio of exchange is the ratio of the amount paid per share of the target company to the market price per share of the acquiring firm. Although cash flows and value are the primary focus, it is useful to consider the effects of a proposed merger on earnings per share—the accounting returns that are related to cash flows and value. - When the ratio of exchange is equal to 1 and both the acquiring firm and the target firm have the same premerger earnings per share, the merged firmʼs earnings per share will initially remain constant. - In this rare instance, both the acquiring firm and the target firm would also have equal price/earnings (P/E) ratios. - In actuality, the earnings per share of the merged firm are generally above the premerger earnings per share of one firm and below the premerger earnings per share of the other, after the necessary adjustment has been made for the ratio of exchange. The long-run effect of a merger on the earnings per share of the merged company depends largely on whether the earnings of the merged firm grow. - Often, although an initial decrease in the per-share earnings of the stock held by the original owners of the acquiring firm is expected, the long-run effects of the merger on earnings per share are quite favorable. - Because firms generally expect growth in earnings, the key factor enabling the acquiring company to experience higher future EPS than it would have without the merger is that the earnings attributable to the target companyʼs assets grow more rapidly than those resulting from the acquiring companyʼs premerger assets.

Voluntary Settlements

A voluntary settlement is an arrangement between an insolvent or bankrupt firm and its creditors enabling it to bypass many of the costs involved in legal bankruptcy proceedings. - An extension is an arrangement whereby the firm ʼs creditors receive payment in full, although not immediately. - A composition is a pro rata cash settlement of creditor claims by the debtor firm; a uniform percentage of each dollar owed is paid. - Creditor control is an arrangement in which the creditor committee replaces the firm ʼs operating management and operates the firm until all claims have been settled. Liquidation can be carried out in two ways—privately or through the legal procedures provided by bankruptcy law. - The objective of the voluntary liquidation process is to recover as much per dollar owed as possible. - Assignment is a voluntary liquidation procedure by which a firm ʼs creditors pass the power to liquidate the firm ʼs assets to an adjustment bureau, a trade association, or a third party, which is designated the assignee

Spontaneous Liabilities: Accruals

Accruals are liabilities for services received for which payment has yet to be made. - The most common items accrued by a firm are wages and taxes. - Because taxes are payments to the government, their accrual cannot be manipulated by the firm. - However, the accrual of wages can be manipulated to some extent. - This is accomplished by delaying payment of wages, thereby receiving an interest-free loan from employees who are paid sometime after they have performed the work.

Analyzing and Negotiating Mergers: Valuing the Target Company

Acquisition of assets - Occasionally, a firm is acquired not for its income-earning potential but as a collection of assets (generally fixed assets) that the acquiring company needs. - The price paid for this type of acquisition depends largely on which assets are being acquired; consideration must also be given to the value of any tax losses. - To determine whether the purchase of assets is financially justified, the acquirer must estimate both the costs and the benefits of the target assets.

Options: Role of Call and Put Options in Fund Raising

Although call and put options are extremely popular investment vehicles, they play no direct role in the fund-raising activities of the firm. - These options are issued by investors and option exchanges, not businesses. - They are not a source of financing to the firm because the firm does not receive the proceeds when investors buy options, nor do firms receive funds when investors exercise options to buy shares.

Cash Conversion Cycle: Aggressive versus Conservative Seasonal Funding Strategies

An aggressive funding strategy is a funding strategy under which the firm funds its seasonal requirements with short-term debt and its permanent requirements with long-term debt. A conservative funding strategy is a funding strategy under which the firm funds both its seasonal and its permanent requirements with long-term debt.

Options

An option is an instrument that provides its holder with an opportunity to purchase or sell a specified asset at a stated price on or before a set expiration date. Three basic forms of options are rights, warrants, and calls and puts A call option is an option to purchase a specified number of shares of a stock (typically 100) on or before a specified future date at a stated price. The strike price is the price at which the holder of a call option can buy (or the holder of a put option can sell) a specified amount of stock at any time prior to the optionʼs expiration date. - A call option is most valuable when its strike price is well below the market price of the underlying stock (hence, the option gives the holder the right to buy the stock at a bargain price). - When the strike price of a call option is less than the market price of the stock, the option is said to be in the money. A put option is an option to sell a specified number of shares of a stock (typically 100) on or before a specified future date at a stated price. - A put option is in the money when the market price of the underlying stock is below the strike price.

Bankruptcy: Bankruptcy Legislation Bankruptcy in the legal sense occurs when the firm

Bankruptcy in the legal sense occurs when the firm cannot pay its bills or when its liabilities exceed the fair market value of its assets. The Bankruptcy Reform Act of 1978 is the governing bankruptcy legislation in the United States today. - Chapter 7 is the portion of the Bankruptcy Reform Act of 1978 that details the procedures to be followed when liquidating a failed firm. - Chapter 11 is the portion of the Bankruptcy Reform Act of 1978 that outlines the procedures for reorganizing a failed (or failing) firm, whether its petition is filed voluntarily or involuntarily There are two basic types of reorganization petitions —voluntary and involuntary. - Voluntary reorganization is a petition filed by a failed firm on its own behalf for reorganizing its structure and paying its creditors. - Involuntary reorganization is a petition initiated by an outside party, usually a creditor, for the reorganization and payment of creditors of a failed firm. An involuntary petition against a firm can be filed if one of three conditions is met: 1. The firm has past-due debts of $5,000 or more. 2. Three or more creditors can prove that they have aggregate unpaid claims of $5,000 against the firm. If the firm has fewer than 12 creditors, any creditor that is owed more than $5,000 can file the petition. 3. The firm is insolvent, which means that (a) it is not paying its debts as they come due, (b) within the preceding 120 days a custodian (a third party) was appointed or took possession of the debtor ʼs property, or (c) the fair market value of the firm ʼs assets is less than the stated value of its liabilities. A reorganization petition under Chapter 11 must be filed in a federal bankruptcy court. Debtor in possession (DIP) is the term for a firm that files a reorganization petition under Chapter 11 and then develops, if feasible, a reorganization plan. - A hearing is held to determine whether the plan is fair, equitable, and feasible and whether the disclosure statement contains adequate information. - The court ʼs approval or disapproval is based on its evaluation of the plan in light of these standards. - Once approved, the plan and the disclosure statement are given to the firm ʼs creditors and shareholders for their acceptance. Because reorganization activities are largely in the hands of the debtor in possession (DIP), it is useful to understand the DIP ʼs responsibilities. - The DIP ʼs first responsibility is the valuation of the firm to determine whether reorganization is appropriate. - Recapitalization is the reorganization procedure under which a failed firm ʼs debts are generally exchanged for equity or the maturities of existing debts are extended. - Once the revised capital structure has been determined, the DIP must establish a plan for exchanging outstanding obligations for new securities. - Once the debtor in possession has determined the new capital structure and distribution of capital, it will submit the reorganization plan and disclosure statement to the court as described (Chapter 7) The liquidation of a bankrupt firm usually occurs once the bankruptcy court has determined that reorganization is not feasible. - When a firm is adjudged bankrupt, the judge may appoint a trustee to perform the many routine duties required in administering the bankruptcy. - The trustee is given the responsibility to liquidate the firm, keep records, examine creditors ʼ claims, disburse money, furnish information as required, and make final reports on the liquidation. - It is the trustee ʼs responsibility to liquidate all the firm ʼs assets and to distribute the proceeds to the holders of provable claims. - After the trustee has liquidated all the bankrupt firm ʼs assets and distributed the proceeds to satisfy all provable claims in the appropriate order of priority, he or she makes a final accounting to the bankruptcy court and creditors. Secured creditors are creditors who have specific assets pledged as collateral and, in liquidation of the failed firm, receive proceeds from the sale of those assets. Unsecured, or general, creditors are Creditors who have a general claim against all the firm ʼs assets other than those specifically pledged as collateral.

Management of Receipts and Disbursements: Cash Concentration

Cash concentration is the process used by the firm to bring lockbox and other deposits together into one bank, often called the concentration bank. Cash concentration has three main advantages. 1. First, it creates a large pool of funds for use in making shortterm cash investments. Because there is a fixed-cost component in the transaction cost associated with such investments, investing a single pool of funds reduces the firmʼs transaction costs. The larger investment pool also allows the firm to choose from a greater variety of short-term investment vehicles. 2. Second, concentrating the firmʼs cash in one account improves the tracking and internal control of the firmʼs cash. 3. Third, having one concentration bank enables the firm to implement payment strategies that reduce idle cash balances.

Inventory Management

Differing viewpoints about appropriate inventory levels commonly exist among a firm ʼs finance, marketing, manufacturing, and purchasing managers. - The financial managerʼs general disposition toward inventory levels is to keep them low, to ensure that the firm ʼs money is not being unwisely invested in excess resources. - The marketing manager, on the other hand, would like to have large inventories of the firm ʼs finished products. - The manufacturing manager ʼs major responsibility is to implement the production plan so that it results in the desired amount of finished goods of acceptable quality available on time at a low cost. - The purchasing manager is concerned solely with the raw materials inventories.

Enterprise resource planning (ERP)

Enterprise resource planning (ERP) is a computerized system that electronically integrates external information about the firmʼs suppliers and customers with the firmʼs departmental data so that information on all available resources—human and material—can be instantly obtained in a fashion that eliminates production delays and controls costs.

LBOs and Divestitures

Firms divest themselves of operating units by a variety of methods. - One involves the sale of a product line to another firm. - A second method that has become popular involves the sale of the unit to existing management. This sale is often achieved through the use of a leveraged buyout (LBO). - Sometimes divestiture is achieved through a spin-off, which is a form of divestiture in which an operating unit becomes an independent company through the issuance of shares in it, on a pro rata basis, to the parent companyʼs shareholders. - The final and least popular approach to divestiture involves liquidation of the operating unitʼs individual assets. Regardless of the method used to divest a firm of an unwanted operating unit, the goal typically is to create a more lean and focused operation that will enhance the efficiency as well as the profitability of the enterprise and create maximum value for shareholders. Comparisons of postdivestiture and predivestiture market values have shown that the breakup value— the value of a firm measured as the sum of the values of its operating units if each were sold separately—of many firms is significantly greater than their combined value.

Management of Receipts and Disbursements: Slowing Down Payments

Float is also a component of the firmʼs average payment period. Controlled disbursing is the strategic use of mailing points and bank accounts to lengthen mail float and clearing float, respectively.

Management of Receipts and Disbursements: Float

Float refers to funds that have been sent by the payer but are not yet usable funds to the payee. Float has three component parts: 1. Mail float is the time delay between when payment is placed in the mail and when it is received. 2. Processing float is the time between receipt of a payment and its deposit into the firmʼs account. 3. Clearing float is the time between deposit of a payment and when spendable funds become available to the firm

Use of Inventory as Collateral

Inventory is generally second to accounts receivable in desirability as short-term loan collateral. - The most important characteristic of inventory being evaluated as loan collateral is marketability. - A warehouse of perishable items, such as fresh peaches, may be quite marketable, but if the cost of storing and selling the peaches is high, they may not be desirable collateral. - Specialized items, such as moon-roving vehicles, are not desirable collateral either, because finding a buyer for them could be difficult A floating inventory lien is a secured short-term loan against inventory under which the lenderʼs claim is on the borrowerʼs inventory in general. - This arrangement is most attractive when the firm has a stable level of inventory that consists of a diversified group of relatively inexpensive merchandise. - Because it is difficult for a lender to verify the presence of the inventory, the lender generally advances less than 50 percent of the book value of the average inventory. - The interest charge on a floating lien is 3 to 5 percent above the prime rate A trust receipt inventory loan is a secured shortterm loan against inventory under which the lender advances 80 to 100 percent of the cost of the borrowerʼs relatively expensive inventory items in exchange for the borrowerʼs promise to repay the lender, with accrued interest, immediately after the sale of each item of collateral. - The borrower is free to sell the merchandise but is trusted to remit the amount lent, along with accrued interest, to the lender immediately after the sale. A warehouse receipt loan is a secured short-term loan against inventory under which the lender receives control of the pledged inventory collateral, which is stored by a designated warehousing company on the lenderʼs behalf. - A terminal warehouse is a central warehouse that is used to store the merchandise of various customers. - Under a field warehouse arrangement, the lender hires a field-warehousing company to set up a warehouse on the borrowerʼs premises or to lease part of the borrowerʼs warehouse to store the pledged collateral.

Options: Hedging Foreign-Currency Exposures with Options

Options allow companies to hedge, which involves offsetting or protecting against the risk of adverse price movements, while simultaneously preserving the possibility of profiting from favorable price movements. - Using options to hedge risk is similar to purchasing insurance. - The firm pays a premium (the cost of the option), and in exchange it receives a cash inflow if the event that the firm is hedging against actually occurs. - If the event does not occur, then the option expires worthless and the money spent to acquire the option is lost, just as would be the case if you purchased auto insurance and never had an accident.

International Mergers

Perhaps in no other area does U.S. financial practice differ more fundamentally from practices in other countries than in the field of mergers. - Outside of the United States (and, to a lesser degree, Great Britain), hostile takeovers are virtually nonexistent, and in some countries (such as Japan), takeovers of any kind are uncommon. - Since the European Unionʼs (EUʼs) economic and monetary union (EMU) integration involving the introduction of a single European currency, the euro, on January 1, 2002, the number, size, and importance of cross-border European mergers has continued to grow rapidly. - Both European and Japanese companies have been active as acquirers of U.S. companies in recent years.

A hostile merger

is a merger transaction that the target firmʼs management does not support, forcing the acquiring company to try to gain control of the firm by buying shares in the marketplace.

An operating unit

is a part of a business, such as a plant, division, product line, or subsidiary, that contributes to the actual operations of the firm.

Management of Receipts and Disbursements: Speeding Up Collections

Speeding up collections reduces customer collection float time and thus reduces the firmʼs average collection period, which reduces the investment the firm must make in its cash conversion cycle. A popular technique for speeding up collections is a lockbox system, which is a collection procedure in which customers mail payments to a post office box that is emptied regularly by the firmʼs bank, which processes the payments and deposits them in the firmʼs account. This system speeds up collection time by reducing processing time as well as mail and clearing time.

Focus on Ethics

Stretching Accounts Payable—Is It a Good Policy? - Stretching payables has often been considered good cash management. - There are two negative ramifications of stretching accounts payables (A/P). • First, the stretching out of payables can be pushed too far, and a business can get tagged as a slow-payer. Vendors will eventually put increasing pressure on the company to make more timely payments. • Stretching accounts payables also raises ethical issues. First, it may cause the firm to violate the agreement it entered with its supplier when it purchased the merchandise. More important to investors, the firm may stretch A/P to artificially boost reported operating cash flow during a reporting period. In other words, firms can improve reported operating cash flows due solely to a decision to slow the payment rate to vendors. Although vendor discounts for early payment are very rewarding, what are some of the difficulties that may arise to keep a firm from taking advantage of those discounts

Cash Conversion Cycle: Calculating the Cash Conversion Cycle

Substituting for OC, we can see that the cash conversion cycle has three main components, as shown in the following equation: (1) average age of the inventory, (2) average collection period, and (3) average payment period. CCC = AAI + ACP - APP

Leasing: Types of Leases

Technically, under FASB (Financial Accounting Standards Board) Statement No. 13, "Accounting for Leases, " a financial (or capital) lease is defined as one that has any of the following elements: 1. The lease transfers ownership of the property to the lessee by the end of the lease term. 2. The lease contains an option to purchase the property at a "bargain price. " Such an option must be exercisable at a "fair market value. " 3. The lease term is equal to 75 percent or more of the estimated economic life of the property (exceptions exist for property leased toward the end of its usable economic life). 4. At the beginning of the lease, the present value of the lease payments is equal to 90 percent or more of the fair market value of the leased property

Inventory Management: Common Techniques for Managing Inventory

The ABC inventory system is an inventory management technique that divides inventory into three groups—A, B, and C, in descending order of importance and level of monitoring, on the basis of the dollar investment in each. - The A group includes those items with the largest dollar investment. Typically, this group consists of 20 percent of the firm ʼs inventory items but 80 percent of its investment in inventory. - The B group consists of items that account for the next largest investment in inventory. - The C group consists of a large number of items that require a relatively small investment. The inventory group of each item determines the item ʼs level of monitoring. - The A group items receive the most intense monitoring because of the high dollar investment. Typically, A group items are tracked on a perpetual inventory system that allows daily verification of each item ʼs inventory level. - B group items are frequently controlled through periodic, perhaps weekly, checking of their levels. - C group items are monitored with unsophisticated techniques, such as the two-bin method; an unsophisticated inventory-monitoring technique that involves reordering inventory when one of two bins is empty. The large dollar investment in A and B group items suggests the need for a better method of inventory management than the ABC system. The Economic Order Quantity (EOQ) Model is an inventory management technique for determining an item ʼs optimal order size, which is the size that minimizes the total of its order costs and carrying costs. - The EOQ model is an appropriate model for the management of A and B group items. EOQ assumes that the relevant costs of inventory can be divided into order costs and carrying costs. - Order costs are the fixed clerical costs of placing and receiving an inventory order. - Carrying costs are the variable costs per unit of holding an item in inventory for a specific period of time. The EOQ model analyzes the tradeoff between order costs and carrying costs to determine the order quantity that minimizes the total inventory cost. A formula can be developed for determining the firm ʼs EOQ for a given inventory item, where S = usage in units per period O = order cost per order C = carrying cost per unit per period Q = order quantity in units The order cost can be expressed as the product of the cost per order and the number of orders. Because the number of orders equals the usage during the period divided by the order quantity ( S/ Q), the order cost can be expressed as follows: Order cost = O × S/Q The carrying cost is defined as the cost of carrying a unit of inventory per period multiplied by the firm ʼs average inventory. The average inventory is the order quantity divided by 2 ( Q/2), because inventory is assumed to be depleted at a constant rate. Thus carrying cost can be expressed as follows: Carrying cost = C × Q/2 The firm ʼs total cost of inventory is found by summing the order cost and the carrying cost. Thus the total cost function is Total cost = (O× S/Q) + (C×Q/2) Because the EOQ is defined as the order quantity that minimizes the total cost function, we must solve the total cost function for the EOQ. The resulting equation is The reorder point is the point at which to reorder inventory, expressed as days of lead time × daily usage. Because lead times and usage rates are not precise, most firms hold safety stock—extra inventory that is held to prevent stockouts of important items.

Cash Conversion Cycle

The cash conversion cycle (CCC) is the length of time required for a company to convert cash invested in its operations to cash received as a result of its operations.

General features of convertibles

The conversion ratio is the ratio at which a convertible security can be exchanged for common stock. The conversion ratio can be stated in two ways: 1. Sometimes the conversion ratio is stated in terms of a given number of shares of common stock. To find the conversion price, which is the per-share price that is effectively paid for common stock as the result of conversion of a convertible security, divide the par value of the convertible security by the conversion ratio. 2. Sometimes, instead of the conversion ratio, the conversion price is given. The conversion ratio can be obtained by dividing the par value of the convertible by the conversion price. The conversion (or stock) value is the value of a convertible security measured in terms of the market price of the common stock into which it can be converted. Contingent securities include convertibles, warrants, and stock options. Their presence affects the reporting of a firmʼs earnings per share (EPS). - Firms with contingent securities, that if converted or exercised would dilute (that is, lower) earnings per share, are required to report earnings in two ways—basic EPS and diluted EPS. - Basic EPS are earnings per share (EPS) calculated without regard to any contingent securities. - Diluted EPS are earnings per share (EPS) calculated under the assumption that all contingent securities that would have dilutive effects are converted and exercised and are therefore common stock. Convertibles can be used for a variety of reasons: - As a form of deferred common stock financing - As a "sweetener" for financing - To raise cheap funds temporarily

Stock Purchase Warrants: Implied Price of an Attached Warrant

The implied price of a warrant is the price effectively paid for each warrant attached to a bond. The warrant premium is the difference between the market value and the theoretical value of a warrant. The theoretical value of a stock purchase warrant is the amount one would expect the warrant to sell for in the marketplace. The following equation gives the theoretical value of a warrant: where TVW= theoretical value of a warrant P0= current market price of a share of common stock E= exercise price of the warrant N= number of shares of common stock obtainable with one warrant

Credit Selection and Standards Credit standards

The five Cʼs of credit are as follows: 1. Character: The applicantʼs record of meeting past obligations. 2. Capacity: The applicantʼs ability to repay the requested credit. 3. Capital: The applicantʼs debt relative to equity. 4. Collateral: The amount of assets the applicant has available for use in securing the credit. 5. Conditions: Current general and industry-specific economic conditions, and any unique conditions surrounding a specific transaction.

International Loans

The important difference between international and domestic transactions is that payments are often made or received in a foreign currency. - Not only must a U.S. company pay the costs of doing business in the foreign exchange market, but it also is exposed to exchange rate risk. - Typical international transactions are large in size and have long maturity dates. Therefore, companies that are involved in international trade generally have to finance larger dollar amounts for longer time periods than companies that operate domestically. - Furthermore, because foreign companies are rarely well known in the United States, some financial institutions are reluctant to lend to U.S. exporters or importers, particularly smaller firms.

Lease-versus-Purchase Decision

The lease-versus-purchase (or lease-versusbuy) decision is the decision facing firms needing to acquire new fixed assets: whether to lease the assets or to purchase them, using borrowed funds or available liquid resources The lease-versus-purchase decision involves application of the capital budgeting methods presented in Chapters 10 through 12. First, we determine the relevant cash flows and then apply present value techniques. The following steps are involved in the analysis: Step 1 Find the after-tax cash outflows for each year under the lease alternative. This step generally involves a fairly simple tax adjustment of the annual lease payments. In addition, the cost of exercising a purchase option in the final year of the lease term must frequently be included. Step 2 Find the after-tax cash outflows for each year under the purchase alternative. This step involves adjusting the sum of the scheduled loan payment and maintenance cost outlay for the tax shields resulting from the tax deductions attributable to maintenance, depreciation, and interest. Step 3 Calculate the present value of the cash outflows associated with the lease (from Step 1) and purchase (from Step 2) alternatives using the after-tax cost of debt as the discount rate. The after-tax cost of debt is used to evaluate the lease-versus-purchase decision be-cause the decision itself involves the choice between two financing techniques—leasing and borrowing—that have very low risk. Step 4 Choose the alternative with the lower present value of cash outflows from Step 3. It will be the least-cost financing alternative

Options: Options Trading

The most common motive for purchasing call options is the expectation that the market price of the underlying stock will rise by more than enough to cover the cost of the option, thereby allowing the purchaser of the call to profit. Put options are purchased in the expectation that the share price of a given security will decline over the life of the option. Investors gain from put options when the price of the underlying stock declines by more than the per-share cost of the option.

Merger Fundamentals: Motives for Merging

The overriding goal for merging is maximization of the ownersʼ wealth as reflected in the acquirerʼs share price. More specific motives include: - Growth or Diversification - Synergy - Fund raising - Increased managerial skill or technology - Tax considerations - Increased ownership liquidity - Defense against takeover

Characteristics of Secured Short-Term Loans

The percentage advance is the percentage of the book value of the collateral that constitutes the principal of a secured loan. - Normally between 30 and 100 percent of the book value of the collateral. Commercial finance companies are lending institutions that make only secured loans—both shortterm and long-term—to businesses. - Unlike banks, finance companies are not permitted to hold deposits.

Accounts Receivable Management

The second component of the cash conversion cycle is the average collection period. The average collection period has two parts: 1. The time from the sale until the customer mails the payment. 2. The time from when the payment is mailed until the firm has the collected funds in its bank account. The objective for managing accounts receivable is to collect accounts receivable as quickly as possible without losing sales from high-pressure collection techniques. Accomplishing this goal encompasses three topics: (1) credit selection and standards, (2) credit terms, and (3) credit monitoring.

Determining the Value of a Convertible Bond

The straight bond value is the price at which a convertible bond would sell in the market without the conversion feature. - This value is found by determining the value of a nonconvertible bond with similar payments issued by a firm with the same risk. - The straight bond value is typically the floor, or minimum, price at which the convertible bond would be traded. - The straight bond value equals the present value of the bond ʼs interest and principal payments discounted at the interest rate the firm would have to pay on a nonconvertible bond. The market value of a convertible is likely to be greater than its straight value or its conversion value. The amount by which the market value exceeds its straight or conversion value of a convertible security is called the market premium

Options: Options Markets

There are two ways of making options transactions. - The first involves making a transaction through one of 20 or so call and put options dealers with the help of a stockbroker. - The other, more popular mechanism is the organized options exchanges. - The dominant exchange is the Chicago Board Options Exchange (CBOE), which was established in 1973. Other exchanges on which options are traded include the International Securities Exchange (ISE), the American Stock Exchange, and the Philadelphia Stock Exchange. - The options traded on these exchanges are standardized and thus are considered registered securities.

Merger Negotiation Process

To initiate negotiations, the acquiring firm must make an offer either in cash or based on a stock swap with a specified ratio of exchange. - The target company then reviews the offer and, in light of alternative offers, accepts or rejects the terms presented. - Normally, it is necessary to resolve certain nonfinancial issues related to the existing management, product line policies, financing policies, and the independence of the target firm. - The key factor, of course, is the per-share price offered in cash or reflected in the ratio of exchange. When negotiations for an acquisition break down, tender offers may be used to negotiate a "hostile merger " directly with the firm ʼs stockholders. - A tender offer is a formal offer to purchase a given number of shares of a firm ʼs stock at a specified price. The offer is made to all the stockholders at a premium above the market price. - Occasionally, the acquirer will make a two-tier offer, a tender offer in which the terms offered are more attractive to those who tender shares early

Use of Accounts Receivable as Collateral

Two commonly used means of obtaining short-term financing with accounts receivable are pledging accounts receivable and factoring accounts receivable. - A pledge of accounts receivable is the use of a firmʼs accounts receivable as security, or collateral, to obtain a short-term loan. - Factoring accounts receivable is the outright sale of accounts receivable at a discount to a factor or other financial institution. - A factor is a financial institution that specializes in purchasing accounts receivable from businesses. Pledges of accounts receivable are typically made on a nonnotification basis, which is the basis on which a borrower, having pledged an account receivable, continues to collect the account payments without notifying the account customer. The alternative, notification basis, is the basis on which an account customer whose account has been pledged (or factored) is notified to remit payment directly to the lender (or factor).

Financing with Convertibles

When the price of the firm ʼs common stock rises above the conversion price, the market price of the convertible security will normally rise to a level close to its conversion value. - When this happens, many convertible holders will not convert, because they already have the market price benefit obtainable from conversion and can still receive fixed periodic interest payments. - Because of this behavior, virtually all convertible securities have a call feature that enables the issuer to encourage or"force"conversion. - The call price of the security generally exceeds the securityʼs parvalue by an amount equal to 1 year's stated interest on the security.- An overhanging issue is a convertible security that cannot be forced into conversion by using the call feature.

Net Working Capital Fundamentals: Working Capital Management

Working capital (or short-term financial) management is the management of current assets and current liabilities. - Current assets include inventory, accounts receivable, marketable securities, and cash. - Current liabilities include notes payable, accruals, and accounts payable. - Firms are able to reduce financing costs or increase the funds available for expansion by minimizing the amount of funds tied up in working capital.

Net Working Capital

Working capital refers to current assets, which represent the portion of investment that circulates from one form to another in the ordinary conduct of business. • Net working capital is the difference between the firmʼs current assets and its current liabilities; can be positive or negative

ratio of exchange in market price

indicates the market price per share of the acquiring firm paid for each dollar of market price per share of the target firm. where MPR = market price ratio of exchange MPacquiring = market price per share of the acquiring firm MPtarget = market price per share of the target firm RE = ratio of exchange

An ACH (automated clearinghouse) transfer

is a preauthorized electronic withdrawal from the payerʼs account and deposit into the payeeʼs account via a settlement among banks by the automated clearinghouse, or ACH.

An operating lease

is a cancelable contractual arrangement whereby the lessee agrees to make periodic payments to the lessor, often for 5 or fewer years, to obtain an assetʼs services; generally, the total payments over the term of the lease are less than the lessorʼs initial cost of the leased asset

A holding company

is a corporation that has voting control of one or more other corporations.

Credit scoring

is a credit selection method commonly used with high-volume/small-dollar credit requests; relies on a credit score determined by applying statistically derived weights to a credit applicantʼs scores on key financial and credit characteristics

An aging schedule

is a credit-monitoring technique that breaks down accounts receivable into groups on the basis of their time of origin; it indicates the percentages of the total accounts receivable balance that have been outstanding for specified periods of time.

A zero-balance account (ZBA)

is a disbursement account that always has an end-of-day balance of zero because the firm deposits money to cover checks drawn on the account only as they are presented for payment each day

hybrid security

is a form of debt or equity financing that possesses characteristics of both debt and equity financing. - Examples include preferred stock, financial leases, convertible securities, and stock purchase warrants.

Commercial paper

is a form of financing consisting of short-term, unsecured promissory notes issued by firms with a high credit standing. - Generally, only large firms of unquestionable financial soundness are able to issue commercial paper. - Most commercial paper issues have maturities ranging from 3 to 270 days. - Although there is no set denomination, such financing is generally issued in multiples of $100,000 or more. - A large portion of the commercial paper today is issued by finance companies; manufacturing firms account for a smaller portion of this type of financing.

letter of credit

is a letter written by a company ʼs bank to the company ʼs foreign supplier, stating that the bank guarantees payment of an invoiced amount if all the underlying agreements are met. - The letter of credit essentially substitutes the bank ʼs reputation and creditworthiness for that of its commercial customer. - A U.S. exporter is more willing to sell goods to a foreign buyer if the transaction is covered by a letter of credit issued by a well-known bank in the buyer ʼs home country.

A floating-rate loan

is a loan with a rate of interest initially set at an increment above the prime rate and allowed to "float, " or vary, above prime as the prime rate varies until maturity.

A fixed-rate loan

is a loan with a rate of interest that is determined at a set increment above the prime rate and remains unvarying until maturity.

A financial (or capital) lease

is a longer-term lease than an operating lease that is noncancelable and obligates the lessee to make payments for the use of an asset over a predefined period of time; the total payments over the term of the lease are greater than the lessorʼs initial cost of the leased asset

A congeneric merger

is a merger in which one firm acquires another firm that is in the same general industry but is neither in the same line of business nor a supplier or customer, while a conglomerate merger is a merger combining firms in unrelated businesses.

A horizontal merger

is a merger of two firms in the same line of business, while a vertical merger is a merger in which a firm acquires a supplier or a customer

A strategic merger

is a merger transaction undertaken to achieve economies of scale.

A financial merger

is a merger transaction undertaken with the goal of restructuring the acquired company to improve its cash flow and unlock its unrealized value.

A friendly merger

is a merger transaction endorsed by the target firmʼs management, approved by its stockholders, and easily consummated.

A cash discount period

is the number of days after the beginning of the credit period during which the cash discount is available. The net effect of changes in this period is difficult to analyze because of the nature of the forces involved. - For example, if a firm were to increase its cash discount period by 10 days (for example, changing its credit terms from 2/10 net 30 to 2/20 net 30), the following changes would be expected to occur: (1) Sales would increase, positively affecting profit. (2) Bad-debt expenses would decrease, positively affecting profit. (3) The profit per unit would decrease as a result of more people taking the discount, negatively affecting profit.

Credit period

is the number of days after the beginning of the credit period until full payment of the account is due. Changes in the credit period, the number of days after the beginning of the credit period until full payment of the account is due, also affect a firmʼs profitability. - For example, increasing a firmʼs credit period from net 30 days to net 45 days should increase sales, positively affecting profit. But both the investment in accounts receivable and bad-debt expenses would also increase, negatively affecting profit.

Credit Monitoring

is the ongoing review of a firmʼs accounts receivable to determine whether customers are paying according to the stated credit terms. - If they are not paying in a timely manner, credit monitoring will alert the firm to the problem. - Slow payments are costly to a firm because they lengthen the average collection period and thus increase the firmʼs investment in accounts receivable. - Two frequently used techniques for credit monitoring are average collection period and aging of accounts receivable. The average collection period has two components: (1) the time from sale until the customer places the payment in the mail and (2) the time to receive, process, and collect the payment once it has been mailed by the customer. The formula for finding the average collection period is: Assuming receipt, processing, and collection time is constant, the average collection period tells the firm, on average, when its customers pay their accounts.

Leasing

is the process by which a firm can obtain the use of certain fixed assets for which it must make a series of contractual, periodic, tax-deductible payments. The lessee is the receiver of the services of the assets under a lease contract. The lessor is the owner of assets that are being leased

A divestiture

is the selling of some of a firmʼs assets for various strategic reasons.

A tax loss carryforward

is, in a merger, the tax loss of one of the firms that can be applied against a limited amount of future income of the merged firm over 20 years or until the total tax loss has been fully recovered, whichever comes first. - A company with a tax loss could acquire a profitable company to utilize the tax loss. - A tax loss may also be useful when a profitable firm acquires a firm that has such a loss