FINC 3620 Exam 4 Smith (Ch. 8, 10, TVM)
1. Define and explain the concept of working capital management.
Working capital management is controlling current assets and current liabilities in a way that the firm can sustain successful business, meaning cash levels, inventory levels. It maximizes the return on its assets and minimizes payments needed to pay off liabilities
Risk and return
You're unlikely to get extra return without taking on extra risk. Investing in a small startup is a bigger risk than investing in a well-established company, but the investment in the startup has the potential for a bigger payoff after a number of years. It's essential that you are comfortable with and aware of the amount of risk in your investing strategy. If you can stomach the lows and highs that come with extra risk, it could make sense to strive for the extra return and in turn, lower your monthly payment value.
What is a scalable business?
a business designed to perform well under continually increasing operational demands
What would cause a business's return on cash to consistently lag behind its sales?
a business may be investing in inventory
Payback method
a capital budgeting method that calculates the number of years it will take a business to get back the money it invests in a proposed project or asset purchase
Bank line of credit:
a company obtains a credit limit, but the company isn't obligated to make payments unless it actually borrows money a line of credit is normally obtained from a company's primary bank and must usually be repaid in full at least once a year
Quantity discount
a discount based on the # of units ordered by a customer
Cash discount
a discount offered to a credit customer to entice the customer to pay their bill early, rather than waiting until the last permitted day to pay aka a sales discount
Cumulative discount (cumulative purchase rebate)
a discount/rebate (above and beyond any applicable trade, cash, or quantity discount) available after a designated purchase threshold has been met by a customer
Capital budgeting
a process used to justify the acquisition of capital assets or the investment in projects that support the expansion of business operations
Aging of accounts receivable
a schedule that categorizes unpaid customers invoices based on the # of days they have been outstanding
Annuity
a series of equal payments
5. When determining NPV or LTC, sometimes calculating one percent value of an ordinary annuity (PVOA) can be utilized as a shortcut to calculating multiple present value of a lump sum. When is this possible, and how is the PVOA factor calculated?
a. A shortcut to calculating NPV does exist, but it can't be utilized in every instance. If there are multiple consecutive years with the same EAATB, one present value of an ordinary annuity (PVOA) calculation can replace multiple present value of a lump sum calculations.
2. Why is cash flow considered a more appropriate tool for decision making than net income?
a. Many business owners and stakeholders use cash flow rather than net income as the gauge of an entity's relative success and as a tool to make decisions. This is because cash flow is a measure of whether a company has enough capital to sustain itself. A business can be profitable and still go out of business because it runs out of cash
4. NPV calculations are made using a discount rate that matches our perceived cost of capital. Define perceived cost of capital and provide some examples of perceived cost of capital included in the chapter.
a. Our perceived cost of capital is just that, the cost of capital we perceive based on the opportunities at hand and the specific circumstances surrounding our own company.
3. What three methods of analysis are typically used to make sound capital budgeting decisions? How do we use the results of these three methods of analysis to choose between investment options?
a. Payback method that calculates the number of years it will take for the business to get back the money that it invests. b. The net present value (NPV) method is a capital budgeting method that considers the time value of money by discounting the future cash flows associated with a proposed project or asset purchase back to the present. c. Lowest total cost (LTC) method is a capital budgeting method similar to the net present value method commonly used by business owners who must replace fixed assets on a regular basis
1. List and define the costs and benefits relevant to capital budgeting analysis
a. Start-up costs—the costs that will be incurred before a new asset or project can begin to provide its intended benefit b. Operational costs—the costs that will be incurred on an ongoing basis to support a new asset or project c. Working capital costs—the costs associated with the increased demands on a business's working capital necessitated by a new asset or project d. Tax costs—the additional taxes that may need to be paid as a result of an investment decision e. Some benefits may be, the amount of any increase in net income, the amount of any decrease in income taxes to be paid due to tax benefits, which are the income-tax-reducing effects of items like the depreciation of fixed assets (which decreases net income and therefore decreases the amount of income taxes that must be paid) and investment tax credits (which directly reduce the amount of income taxes that must be paid. The amount of any increase in cash flow.
What area tends to be where entrepreneurs get themselves into the most trouble and why?
accrued liabilities why? because many accrued liabilities involve a relationship between an entrepreneur's business and a government entity
Tax costs
additional taxes includes: - income taxes on increased net income - real estate taxes on new/improved facilities - personal property taxes on inventories/equipment
Trade discount
an amount deducted from the list price of an item when specific services are performed by a trade customer --> a recurring customer approved to purchase product on trade credit
Annuity due
an annuity where the payments are made/received at the beginning of each time period
Ordinary annuity
an annuity where the payments are made/received at the end of each time period
Ordering costs usually...
are the cost associated with the utilization of an employee's time
Credit terms
are the rules a business establishes regarding the required payments associated with the use of the credit by a customer
Security cameras should...
be in areas where cash is transferred from customer to the business, but the cameras become ineffective if people other than the owner(s) know where they are/know how to delete footage
All checks issued by the business should...
be signed by an owner
Why do many business owners and stakeholders use cash flow rather than net income as the gauge of an entity's relative success and as a tool to make decisions?
because a business can be profitable and still go out of business because it runs out of cash
Why should you pay bills when they're due and not before they're due?
because it's a proper working capital management practice that many debt-phobic entrepreneurs may have to adjust entrepreneurs can sometimes inadvertently create completely avoidable cash flow problems for their businesses as a result of their poor working capital management practices
Individuals must invest in people, financial assets, or capital assets—assets that have an expected useful life in excess of one year—in order to
become financially secure and lead happy, successful lives
How does an entrepreneur avoid the problem of not having the funds needed to pay the applicable tax amounts when they are due?
by funneling the funds needed to pay accrued liabilities into a bank account separate from the business's regular checking account
In order to speed up collections of accounts receivable:
cash discounts are often offered to business customers the offer of a cash discount is often inherent in the terms stated for credit repayment
Lowest total cost (LTC) method
commonly used by business owners who must replace fixed assets on a regular basis emphasizes minimizing total cost bc the benefit stream doesn't change with the fixed asset chosen no chance of a positive NPV using LTC
Net present value (NPV) method
considers the time value of money by discounting the future cash flows associated with a proposed project or asset purchase back to the present
Working capital cost
cost that is associated with increased demands costs includes: - costs associated w the need to invest in increased levels of inventory & accounts receivable in order to accommodate an increased level of sales
Start-up costs
cost that is incurred before includes the cost of: - equipment - installation - any needed changes to the company's facilities to accommodate the equipment - any needed employee recruitment/training
Operational costs
cost that is incurred on an ongoing basis includes the ongoing increased expenditures: - maintenance - utilities - insurance also includes: - additional payroll - payroll taxes - other employee-related expenses
What is a good first step in the effort to speed up the collection of accounts receivable?
created an aging of accounts receivable
IRR = 10% Discount rate = ? Negative NPV
discount rate is higher
What should you do if the NPV is negative?
don't make the investment
Compound interest
earning or charging interest on both a stated principal amount and the interest that has been previously earned or charged It's interesting to note that the simple interest formula can actually be used to calculate compound interest
A growing business can be profitable but still...
experience negative cash flows because it's often investing in its future by spending cash on improved technology and other fixed assets
Why should an owner perform surprise physical inventory counts?
in order to identify the nature and amount of any lost, damaged, or stolen inventory
Step 2: Work-in-progress inventory
in the process of being assembled, modified, or otherwise translated into finished goods
Expected annual after-tax benefit (EAATB)
increase in cash flow
For many businesses, what represents the company's largest current asset?
inventory
Step 3: Finished goods inventory
inventory items that have been translated into a final product ready to be sold by the business (from the raw materials)
Not depositing cash on the same day it's received is an...
invitation for theft
Bootstrapping
involves borrowing non-cash assets, bartering for non-cash assets and services, and utilizing strategic negotiation tactics in order to avoid, delay, or minimize the outlay of cash
Making a decision regarding how much cash needs to be kept on hand vs invested...
involves determining the amount of cash needed both at the business's physical location and in the business's checking account
Internal rate of return (IRR)
is the actual rate of return of an investment. Its calculation considers the time value of money. The IRR is the interest rate that matches the present value of the cost of our investment directly to the present value of the future benefits to be received. The IRR, then, is the interest rate that, when used as the discount rate to determine the NPV of a proposed investment, results in an NPV of zero
What does it mean to sell inventory on trade credit?
it means accounts receivable, not cash, is generated from the sale the company is more profitable because it has sold more product, but its cash flow is actually worse than before the company's expansion because the company has paid out cash for an increased level of raw materials inventory but has not yet received any cash from the sales made possible by the investment in that inventory
What should you do if the NPV is positive?
make the investment
Step 4: Sell finished goods inventory
most likely to a retailer/wholesaler on trade credit
Accrued liabilities
obligations of a firm that accumulate over time during the normal course of operations these liabilities typically include: payroll, payroll taxes, certain employee-related benefits, property taxes, and sales taxes
Decisions regarding whether or not to invest in certain people, financial assets, or capital assets are referred to as
personal wealth management decisions
Turning the corner to positive cash flow...in terms of order of occurrence...
profitability usually occurs before a business becomes cash flow positive
What is one inventory item you absolutely would not want to run out of? Why?
raw materials because these are parts that are crucial to the production process and without it, we can't produce anything
Economic order quantity (EOQ)
refers to the optimal quantity a business should purchase every time it places an order for an inventory item EOQ attempts to balance ordering costs against storage costs
Stockout
running out of a particular item of inventory the original retail outlet sought out by the customer has now lost a sale there's a possibility that someone could permanently switch to a different retailer
So what exactly does bootstrapping involve?
seeking out what you can get for free, get for a reduced prices, or purchase used
If a manufacturer wants to expands its operations, they must use its cash to purchase:
step 1: raw materials step 2: work in progress step 3: finished goods step 4: sell finished goods
What usually works together to determine the value of opportunities available to us?
taxes, interest, and time
Safety stock
the # of units of an item of inventory a company expects will be remaining in inventory when a new order for that item arrives the purpose of safety stock is to cover daily variations in production or customer demand, and the number can be rather subjective
Simple interest
the amount of interest earned or charged on a stated principal amount when there's no compounding of interest
If calculations are made using a discount rate that matches our perceived cost of capital related to a proposed investment, what might out perceived cost of capital related to that investment be?
the answer depends on the circumstances surrounding both the opportunities at hand and the specific company in question
Working capital management
the art of controlling current assets and current liabilities in such a way that a firm will maintain adequate cash and inventory levels, maximize the return on its assets, and minimize the size of the payments needed to settle its liabilities
Storage costs are usually...
the costs associated with: 1. maintaining warehouse or other facility storage space 2. the utilization of an employee's time 3. special assets and equipments (shelving, forklifts)
Working capital management typically focuses on...
the effective and efficient management of cash, marketable securities, accounts receivable, inventory, accounts payable, accrued liabilities, and short-term debt
Step 1: Raw materials inventory
the fundamental materials/components a company uses to produce its final product (ex: wood, steel, nails, glue)
Vendors often offer several types of discounts:
the most common are: - trade - cash - quantity - cumulative purchase
Reorder point (ROP)
the optimal quantity of an item that should be remaining in inventory when a business places an order for more of that item
Who should open all the business's postal mail?
the owner him/herself
Maturity amount
the total amount due related to a loan or investment; equal to the principal borrowed or invested, plus interest
Future value (FV)
the value at some future point in time of an amount loaned, borrowed, saved, or invested today
Why do businesses offer customers the ability to pay later (the reason businesses carry accounts receivable on their balance sheets)?
to increase sales people/businesses tend to buy more products and services when they don't have to immediately pay for those products and services
Proper working capital management and bootstrapping can help an entrepreneur overcome what?
to overcome: - cash flow issues - issues associated with a business being underfunded
What is the usual goal of accounts payable management?
to pay out as little cash as possible in order to properly settle these obligations
Note payable
typically a short-term loan to the company from a stakeholder -- often a founder or an angel investor
*Note that while a company may use one method of depreciation for general accounting and financial statement preparation purposes...
typically, a company uses an alternative method (dictated by IRS rules) to determine depreciation expense for tax purposes
Are accrued liabilities usually current liabilities?
yes
What's the point of investing money if it won't grow faster than inflation?
you'd be better off spending it now when it has a higher value. That's where the compound annual interest rate comes to the rescue basically interest on interest
What is the time value of money?
your $1 today is worth more than your $1 tomorrow because of inflation & compound interest inflation increase prices over time and decreases your $1's spending power
Section 179 deductions:
"U.S. tax code allows businesses to immediately expense up to 100% of the cost of a fixed-asset purchase for tax purposes when that fixed-asset purchase meets certain criteria. Since not all fixed-asset purchases meet the criteria to be expensed under Section 179, and since for a variety of reasons not all businesses elect to utilize the Section 179 deduction, we will assume for purposes of the examples and problems included in this chapter—and throughout the rest of this textbook—that the businesses in question are not taking advantage of the Section 179 deduction "
Cost of capital scenarios:
- QRS can invest its idle cash in a mutual fund and receive a return on that investment of 4% per year - QRS can borrow money at 8%. 8% could then be the discount rate QRS decides to use to assess the project - The owners of QRS have previously determined that they want the business to earn a minimum rate of return of 15% on every new project in which the firm invests. 15% could then be the discount rate QRS decides to use to assess the project
Effective bootstrapping practices:
- commence business operations via a kiosk, mobile cart, or vehicle instead of a permanent physical location - commence business operations from your home - commence business operations in a free/low-cost business incubator - asking a landlord for reduced rent - utilizing independent contractors instead of employees - borrowing or buying used office furniture, vehicles, or equipment instead of buying new - trading services with other entrepreneurial ventures
When making a decision using NPV, keep the following in mind:
- if the NPV is positive, make the investment - if the NPV is negative, don't make the investment
Benefits that must be determined when making a capital budgeting decision:
- increase in net income - decrease in income taxes to be paid due to tax benefits, which are the income-tax-reducing effects of items like the depreciation of fixed assets and tax credits - increase in cash flow - increase in productivity - salvage value associated w any fixed-asset purchase
The steps an entrepreneur needs to take to protect her business's assets depend very much upon...
- the nature of her business - the types of assets it holds - how many and which individuals have access to these assets
Capital Budgeting (discussion post)
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Chapter 10 homework review questions:
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Chapter 8 homework review questions:
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Chapter 8 notes from textbook:
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TVM (discussion post)
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TVM (powerpoint)
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TVM: A Simple Guide to Understand it Fast (article)
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The 4 Essential Elements Inventory (discussion post)
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2. Describe the 3 methods of capital budgeting listed in the article.
1. Internal rate of return (IRR) 2. Discounted cash flow (DCF) 3. Payback period
The NPV method vs the payback method has 2 primary advantages:
1. The future cash flows that will be paid and received are discounted back to the present so a decision can be made on the investment—or a choice can be made between investments—based on objective criteria (i.e., the value of the investment(s) in today's dollars). 2. The interest rates (discount rates) used are determined by, and based on, the expectations of—and the circumstances surrounding—the specific company making the decision.
Options associated with offering credit to customers:
1. a business issues its own credit card (ex: Macy's offers its customers a Macy's credit card) 2. a business offers its customers trade credit 3. a business offers credit to its customers via its own credit card or via trade credit and then more or less immediately factors (sells) these accounts receivables to another firm at a discount in order to turn the accounts receivable into cash quickly
Situations that might require capital budgeting analysis include
1. changes in government regulations 2. the need or desire to pursue a change in business strategy 3. to introduce new products or services
Everyday operations with good cash management, generally involve performing the following best practices:
1. depositing cash and checks as soon as possible 2. invoicing and collecting from customers on a timely basis 3. paying bills when they're due, but not before they're due 4. making strategic decisions regarding how much cash needs to be kept on hand versus how much cash is not currently needed and is therefore available to be invested in order to achieve a return
What are 2 effective ways to analyze and monitor accounts receivable?
1. determining and evaluating the average accounts receivable collection period 2. creating and evaluating an aging of accounts receivable
1. Describe the 3 reasons capital budgeting is important.
1. helps clarify decisions 2. lowers risk 3. provides a financial plan
An aging accounts receivable provides a business owner with the information to do the following:
1. identify delinquent customers 2. deny additional credit to identified delinquent customers until they bring their accounts current 3. pressure delinquent customers for payment 4. turn the accounts of customers not responding to pressure for payment over to a collection agency, if needed 5. write off an account receivable when no reasonable hope of customer payment exists
Credit terms vary by industry, but U.S. credit terms commonly do the following:
1. indicated that no interest charge will apply to amounts paid in full within a stated # of days for payment (usually 30 days) 2. state the interest rate or late fee that will apply to amounts owed that remain unpaid after the stated # of days for payment 3. state a minimum portion of the total amount owed that must be repaid each month 4. indicated a maximum amount of credit the customer will be permitted
Disadvantages of the payback method
1. it doesn't consider the time value of money 2. it favors investments with a quick return over those with the largest overall return (bc it doesn't consider the value of the cash flows that occur beyond the payback period) 3. it doesn't always provide a clear answer regarding whether one should invest in a particular opportunity
The 2 primary goals of inventory management are to:
1. keep inventory at a minimum level to maximize available cash 2. keep enough inventory on hand to always satisfy production or customer demand
3 methods of analysis used to make capital budgeting decisons
1. payback 2. net present/lowest total cost 3. internal rate of return
The following are the most commonly used inventory categorizations:
1. raw materials inventory 2. work-in-progress inventory 3. finished goods inventory 4. maintenance, repair, and operation (MRO) inventory
Short-term debt may include the following:
1. short-term portion of long-term debt 2. bank lines of credit 3. short-term loans 4. notes payable, which are often incident specific (ex: when an entrepreneur makes a short-term loan to her business)
When making a capital budgeting decision, the business owner must determine 4 types of costs:
1. start-up costs 2. operational costs 3. working capital costs 4. tax costs
Three goals of cash management
1. sustain an adequate level of cash (never run out of cash) 2. achieve and maintain positive cash flow 3. obtain the highest return reasonably possible on idle cash
If an entrepreneur chooses to offer credit, a credit policy must be established, which means 3 things must be determined:
1. to whom she will grant 2. the terms of the credit granted 3. how she'll monitor credit and deal with delinquent accounts
What does 2/10 net 30 mean?
2% discount in 10 days or full amount due in 30
IRR < discount rate
= negative NPV
IRR > discount rate
= positive NPV
IRR = discount rate
= zero NPV
2. How would you use a discount rate in TVM? List 3 items that would factor in to your choice of a discount rate.
A discount rate in TVM would be used to convert future amounts into today's $ amount. The three factors in your choice of a discount rate would be the interest rate the company can borrow the money, the company's return on investment, and inflation
You have to pay a $35,000 invoice with stated terms of 1/10, net 30. What do the terms 1/10, net 30 mean?
A payment has to be made within 30 days, but a 1% discount is offered as long as they are paid within 10 days of a 30-day payment agreement.
3. How would your present value calculation change as you lower your discount rate? Why?
As you lower the discount rate, the present value calculation actually increases. Since you're discounting a less amount, the present value will actually react inversely as you are assuming it will be worth more than if you had discounted at a higher rate.
4. Define bootstrapping, list five examples of effective bootstrapping practices including in the chapter, and devise a bootstrapping practice of your own, explaining how the practice could help a business avoid, delay, or minimize the outlay of cash
Bootstrapping are the entrepreneurial tactics you take to get through the start-up phase of a business for example borrowing non-cash assets. Examples include trying to commence business from your home, trying to commence business from a low cost incubator, asking a landlord for reduced rent, asking for free-rent during a start-up period, and start up business from a kiosk. A bootstrapping process of my own might include using assets that I already own
5. What does it mean to bootstrap working capital? What positive effects can bootstrapping working capital bring about?
Bootstrapping working capital effectively managing accounts like cash, accounts receivable, inventory, and accounts payable with entrepreneurial tactics. Bootstrapping working capital can bring about many positive effects including ultimately helping an entrepreneur start a business he may have never thought to start before
Determinations of business value
Decisions regarding whether or not to buy a business
Capital budgeting decisions
Decisions regarding whether or not to invest in people, technology, and fixed assets
Present value (PV):
Enter how much money you have today. If you have a $20 in your wallet, enter 20
3. Explain the potential consequences of an inventory stockout for both the retailer and the producer of a good.
For the retailer, a stockout can mean they have lost the sale and that one sale could lead to that customer preferring a different retailer entirely so then the retailer would lose an entire customer. For the producer of a good, the customer could chose another product and the producer would lose a sale and be in risk of permanently losing that customer to another product.
6. What steps can a business owner take to safeguard her business's cash and other assets?
If it is a high-cash business, the owner should always be on site during the hours of operation. You can always keep a check on the amount of cash in the register. You should also always deposit cash as quickly as you can so that it is not just laying around. You can also open all the mail yourself because you could receive checks or other assets that way. There are many different steps to take and they all involve just being smart with your assets and responsible.
You have to pay a $35,000 invoice with stated terms of 1/10, net 30. What options are available associated with paying this invoice on a timely basis?
If the payment is paid in 10 days, you will receive a 1% discount, but if you pay after 10 days but before the 30th day then you'll miss out on the discount.
Future value of money (FVM):
If you're trying to calculate what your money will be worth in the future once you've made payments and had to compound, you'll see your answer here.
IRR = ? Discount rate = 8% Positive NPV
Is the % of IRR higher or lower than the discount rate? higher
Payment (PMT):
It's the amount that you're adding to the PV per period. Think of it as a monthly contribution to an IRA (assuming you're doing monthly compounding).
The time value of money varies and involves an opportunity cost
That means that if you're putting $1000 in a savings account to save for a house, you may be giving up an opportunity to grow that money in an investment account
2. Define and explain the concept of cash management.
The concept of cash management is to make sure you have enough cash and that you are putting your cash in the right places. There are three goals typically associated with cash management and those are sustaining an adequate level of cash, keeping a positive cash flow, and obtaining a high return on idle cash.
So, you have decided to buy a car that costs $18,000. The car dealer gives you two choices: 1. Purchase the car for cash and receive a $2,000 instant cash rebate. This will make your out of pocket expense $16,000 today. 2. Or purchase the car for $18,000 with a zero percent interest 36-month loan. In this scenario, you would make monthly payments with a market interest rate of 4%. Which is the cheaper option and how much will you save?
The correct answer is option 1: it will save you $935.38. A mistake people make is comparing $16,000 to $18,000. If you choose Option A, you are paying out $16,000 now. If you choose Option B, you are paying monthly installments of $500 for 36-months totaling $18,0000.
If a customer can't find a product at an alternative retailer...
The customer may purchase a substitute product. In this case, the retailer doesn't lose a sale, the producer of the out-of-stock product loses a sale. This may not be the end of the negative effect of the stockout. When a customer buys a substitute product, they may choose to permanently buy that over the original = the producer for the original good (stockout) doesn't just lose 1 sale, that producer loses the customer entirely
Periods:
The number of times you're compounding your money. It's essential to keep in mind how extended a period is - are you compounding weekly, monthly, or annually?
1. What are 2 reasons $1 now is worth more than $1 in the future?
The two reasons why the $1 now is worth more than $1 in the future are because: a 2% annual return can be earned on that $1 if you invest it now and because of inflation, meaning that the $1 today will have more buying power
Rate:
This is the rate of growth. If you're calculating how much inflation will be, you can use a number like 3%. If you're trying to see what your money will grow if you're getting a 7% real (after inflation) rate of return, use 7%. You put in the whole number (7) instead of the actual decimal number (0.07).
