Transcript Study Unit 2 - CMAPrepCourse

CMA Part 2
Financial Decision Making
Cram Session
Ronald Schmidt, CMA, CFM
Jim Clemons, CMA
CMA Exam & Gleim
• CMA overview pages 3 – 6
– Pass both parts within 3 years
– Satisfy the experience requirements (see next page)
– CPEs
• Gleim website
– You can create a mock exam on website, and there
are ones already created for you
Experience Requirements
Exam format
• 3 hrs - 100 multiple choice questions = approx. 1.5 minutes per question
(on average).
– Find ways to “bank” time
– Look for short-cuts
– You will find that you most question do not seem “easy”, don’t get
discouraged
– You “earn” points for each question answered correctly
– Some questions are “test” questions that carry no point value. You will not
know which ones they are
– Extra time can be carried forward to the Essay portion
• 1 hr - 2 Essay questions with up to 8 sub-parts
– You can’t go back to multiple-choice part once you enter this portion of the
exam
– Whatever you have typed on the screen will be saved as your answer,
irrespective if the timer runs out on you
Exam format
• Topics
– Financial Statement Analysis
– Corporate Finance
– Decision Analysis and Risk Management
– Investment Decisions
– Ethics
25%
25%
25%
20%
5%
– If you find you have weaknesses in any topic ref.
Appendix A for ref. the appropriate sub –units
Last minute prep for the exam
• Focus on what you don’t know
• Realize that you will be more proficient in some topics
more than others
• Practice the Essay questions – use the Gleim Essay Wizard
• Create short mock multiple choice exams (say no more
than 50 questions) to condition for the longer 100 question
exam, or take the Gleim online CMA Practice Exam that
came with your Gleim study material. It is a 4 hour exam.
• You can also read the question and only the correct answer
of questions at the end of each SU. It is a fast way of
covering a lot of ground.
• Make sure your financial calculator has a fresh battery, and
that it is not the first time you used it.
Day of the Exam
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Do not study up to the exam day/time
Give yourself plenty of time to get to the testing center. Make sure you have identified exact
location prior
Make sure you are well rested (probably not a good idea to take exam after a long day of work, for
example
It is a four hour exam, make sure you are prepared for the duration (eat, etc.)
Dress in layers. You can always shed layers when you are there, they have lockers
Don’t wear a watch into the testing center
You can bring your own foam earplugs, so long that they are in a plastic bag
Take a copy of the type of calculators that are permitted with you. Ref. the ones listed on the IMA
Website
You realistically should not plan on any breaks outside of bathroom breaks. Note the timer keeps
running if you do take a break.
Be optimistic. At this point there is nothing else you can do, and being stressed or discouraged will
not help your test results.
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Relax - “NO ONE HAS DIED FROM FAILING THE CMA EXAM”, there is life beyond and we will help
you pass it!!!!
Exam
• Budget your time, know your “time hacks”
• See how many Essay sub-questions you will be given.
There are two parts with different amounts of subparts
• Answer the questions in consecutive order, and limit
the number you want to come back to no more than
say 10, but make sure you answer it before going on to
the next.
• Never leave a question unanswered, score is based on
number of correct answers.
• Do not allow the answer choices to affect your reading
of the question
Most common reasons for missing
questions
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Misreading the requirement (stem) – Read the question first
Not understanding what is required
Making a math error – Try to not do calculations of paper first, with the
idea of “transferring” to the exam later. If you know how to use your
memory button(s) well on your calculator, use it (i.e. save subcalculations in your calculator).
Applying the wrong rule or concept
Being distracted by one or more of the answers – the most common
wrong answers are the incorrect alternatives
Incorrectly eliminating answers from considerations – read all answers
first, some are more correct or complete then others
Not having any knowledge of the topic tested – don’t agonize over it. If
possible try to make an educated guess by eliminating obvious wrong
answers. If you guess, use the same letter each time.
Employing bad intuition when guessing
The essays
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Remember, 2 essay questions with up to 8 parts each!
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Ref. Scenario for Essay Questions 9 -11
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The CMA exam uses essays to reflect a more "real-world" environment in which
candidates must apply the knowledge they have acquired. Essays are graded on
both writing skills and subject matter. Partial credit IS available for essays that have
some correct and some incorrect points. Finally, it is important to remember that
essays are not intended to test typing ability, so the time you allocated for essay
response is adequate to complete the questions even if you do not have the best
typing skills.
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Answering multiple-choice questions is an effective method to study the material
for both the multiple-choice and essay sections of the exam. They are an excellent
diagnostic tool that will allow you to quickly identify your weak areas. Also, think
about what your answer would be if the question were not multiple-choice. When
reviewing the correct and incorrect answer explanations, your "essay answers"
should be somewhat equivalent to the detailed answer explanations.
Ethics
• Ethics is tested from:
– Individual Perspective – Part 1
– Organizational Perspective – Part 2
• Questions could be either Multiple Choice or Essay
• Make sure you study the IMA Framework on Ethics, ref. the
IMA website, or following URL:
http://www.imanet.org/docs/default-source/press_releases/statement-of-ethical-professional-practice_2-212.pdf?sfvrsn=2
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Have it “conceptually” memorized.
Similar to the AICPA version
You will then be able to answer any question from there
Stay “within” an objective view, and don’t get side-tracked in
emotional distractors
SU 1 - Sarbanes-Oxley Act of 2002
• Enron, Arthur Andersen…
• Extensive responsibilities on issuers / auditors
of publicly traded securities.
– Sec 406(a) Senior financial officers Code of Ethics
• Reasonably necessary to promote
– Honest and ethical conduct
– Full, fair, accurate, timely, and understandable disclosure
– Compliance with governmental rules and regulations
• SOX does not define ethics.
SU 1- Corporate Responsibility for Ethical
Behavior
• “Values and Ethics: From Inception to Practice”
• Responsible to : Foster a sense of ethics
– Written code of Conduct and ethical behavior
• Pervasive sense of ethical values has benefits.
– White space vs. Gray area.
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Tone at the top
Human capital - Doing the right thing.
Corporate culture
Ethics training
SU 2 – Some basic understanding
Financial Statements, their users and limitations
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Statement of Financial position – Balance sheet
– Single point in time, a few day changes a lot
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Assets versus Liabilities and Equity
– Contingent liabilities
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Purpose of the Balance Sheet
– It helps users assess “the entity’s liquidity, financial flexibility, profitability, and risk.”
– Proprietary theory – owners equity – “Under the proprietary theory, revenues increase capital,
while expenses reduce it. Net income belongs to the owner, representing an increase in the
proprietor's capital.”
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Usefulness and Limitations
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Historical cost vs. market value
Book value (def.?) does not reflect market value.
Estimates
Non-measurement of employees, reputations, etc.
SU 2 – Some basic understanding
Financial Statements, their users and limitations
• Companies financing structure
– Liabilities
• Current versus non-current assets (def., examples?)
– Equity = Residual balance
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Types of stock
Additional paid in capital
Reasons for equity to restricted
Treasury stock (def., affect on equity)
• Notes in the financial statement
• Purpose
• Types
• Def. – Real Accounts & Permanent Accounts
SU 2 - SU 2 – Some basic understanding
Statement of Cashflows
• Understand:
– Purpose
– Indirect method vs. Direct method
– Categories
• Operating Activities – direct and indirect
• Investing Activities
• Financing Activities
• Two methods to report cash flows
– Direct method (FASB req.)
– Indirect method
• See questions –
• 31 – page 53
• 33 – page 54
• 34 – page 55
SU 2 – Some basic understanding
Statement of Income and Statement of Retained
Earnings
• Understand the different elements of the Income
Statement
– Revenues versus gains
– Expenses versus losses
• Transactions “that matter” and that don’t
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Transactions with owners
Prior-period adjustments
Items from other comprehensive income
Transfers to and from appropriated retained earnings
Adjustment made in a quasi-reorganization
SU 2 – Some basic understanding
Statement of Income and Statement of Retained
Earnings
• Cost of Goods
– COGS
• BI + COGM (Purchases for Retailer ) = GAFS – EI = COGS
– COGM (Purchases for Retailer)
• BWIP + TTL Mfg cost for period – EWIP = COGM
• Similar to COGS + EFG - BFG
• Statement of Retained Earnings
• Beg RE + NI – Dividends = End RE
• Dividends – Paid or declared?
SU 2 – Some basic understanding
Statement of Income and Statement of Retained
Earnings
• Other Expenses
– S, G & A
– G & A – “incurred for the benefit of the organization as a
whole”
– Interest Expenses – based on passage of time; effective
interest rate method
– Irregular Items
• Discontinued Operations = Income from operations, and gain/loss
from disposal of operations
• Extraordinary Items = “both” usual in nature and infrequent in
occurrence in the environment in which the organization operates
Continued
SU 2 – Some basic understanding
Statement of Income and Statement of Retained
Earnings
• Comprehensive Income
– Exclude from NI but included in OCI
• Fair value changes of available-for-sale securities
• Currency translations
• Service cost, gains and losses not prev. recognized in
pension exp.
– Must be displayed with other financial statements
SU 2 – Some basic understanding
Common-Size Financial Statements
• Percentages and Comparability
– Restate financial statement line items in terms of
percentages of a given amount (baseline figure)
– Percentage of net sales or Total Asses or Liabilities and
Equities
– Easier to see differences between companies
• Vertical and Horizontal Analysis
– Vertical - Explained above
– Horizontal – Several periods also known as trend
analysis/percentages, and usually for the same company
SU 2 - Ratio Analysis
• You need to understand what effects typical
business transactions have on a firm’s
liquidity, rather than on the mechanics of
calculating the ratios.
• What is the importance of Ratio Analysis?
Remember
Common-size statement s recast all items in a particular financial
statement as a percentage of a selected (usually the largest and most
important) item on the statement.
These statements can be used to:
• Compare elements in a single year’s financial statements.
• Analyze trends across a number of years for one business.
• Compare businesses of differing sizes within an industry (such as WalMart to Target).
• Compare the company’s performance and position with an industry
average.
Common-size statements are useful when comparing businesses of
different sizes because the financial statements of a variety of companies
can be recast into the uniform common-size format regardless of the size
of individual elements.
Categories of Financial Ratios
• Activity: how efficiently a company performs dayto-day tasks such as collection of receivables and
management of inventory
• Liquidity: company’s ability to meet its shortterm obligations
• Solvency: ability to meet long-term obligations
• Profitability: company’s ability to generate
profitable sales from its resources (assets)
• Valuation: quantity of an asset or flow (earnings)
associated with ownership of a specified claim
(Share)
SU 2 - Liquidity Ratios
• Liquidity is the firm’s ability to pay its current
obligations as they come due. - Short run
– How easy is it to convert assets to cash.
• Liquidity ratios relates liquid assets to current
liabilities.
– Current assets – converted to cash within 1 year or
operating cycle.
• Current asset ratios – Firm’s ability to operate in short
term.
• Current assets/liabilities are shown in descending order of
liquidity.
SU 2 - Liquidity Ratios – Working
Capital
• Working capital is a measure of a company’s
ability in the short run to pay its obligations.
Working capital is calculated as shown:
Current assets – Current Liabilities
– How much capital is left after paying current
obligations?
• Net Working Capital “ratio” = Cur. Assets – Cur.
Liab./Total Assets
– Most conservative of working capital ratios.
Remember!
Current assets are defined as cash or other
liquid investments, such as inventory and
accounts receivable (A/R), that can be converted
to cash within a year.
Current liabilities are obligations that will be
paid within a year, such as accounts payable and
notes and interest payable.
Liquidity Ratios - Current Ratio
• The current ratio measures the degree to which
current assets cover current liabilities.
– A higher ratio indicates greater ability to pay current
liabilities with current assets, thus greater liquidity.
• Current ratio = Current Assets / Current Liabilities
• Most common liquidity measurement
– Low ratio = Possible liquidity problems
– High ratio = Management not investing assets
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Should be proportional to the operating cycle.
Shorter operating cycles may justify lower ratio.
Converting to cash quicker.
LIFO lowers ratio.
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Liquidity Ratios – Quick Ratio and
other
Quick ratio – (Acid test) = Cash + Mkt Securities + Net receivables / Current
liabilities
– Avoids inventory valuation issues.
– Conservative approach.
– The quick ratio , or acid-test ratio, examines liquidity from a more immediate
aspect than does the current ratio by eliminating inventory from current assets.
The quick ratio removes inventory because it turns over at a slower rate than
receivables or cash and assumes that the company will be able to sell the items
to a customer and collect cash.
Cash ratio = Cash + Mkt Securities/Current Liab.
– The cash ratio analyzes liquidity in a more conservative manner than the quick
ratio, by looking at a company’s immediate liquidity.
Cash Flow ratio = C/F from Operations/Cur. Liab.
– Measures a companies ability to meet its debt obligations with cash generated
in the normal course of business.
SU 2.1 Practice Question
Given an acid test ratio of 2.0, current assets of $5,000, and
inventory of $2,000, the value of current liabilities is
A
$1,500
B
$2,500
C
$3,500
D
$6,000
SU 2.1 Practice Question Answer
Correct Answer: A
The acid test, or quick, ratio equals the quick assets (cash,
marketable securities, and accounts receivable) divided
by current liabilities. Current assets equal the quick assets
plus inventory and prepaid expenses. (This question
assumes that the entity has no prepaid expenses.) Given
current assets of $5,000, inventory of $2,000, and no
prepaid expenses, the quick assets must be $3,000.
Because the acid test ratio is 2.0, the quick assets are
double the current liabilities. Current liabilities therefore
are equal to $1,500 ($3,000 quick assets ÷ 2.0).
Activity Measures
Another way to analyze liquidity is to focus on the
management of key current assets, namely inventory and A/R.
A manager successfully managing inventory and collecting A/R
in a timely manner also will be improving liquidity.
Operating activity analysis is done over a period of an
operating cycle—the time elapsed between when goods are
acquired and when cash is received from the sale of the
goods.
– Measures how quickly noncash assets are converted to cash.
– Over a period of time. Includes I/S data.
– The Balance Sheet data should always be an average
Activity Measures - Receivables
• A/R Turnover = Net credit sales / Ave. A/R
– Efficiency of A/R collections.
– High ratio : Customers pay promptly.
– Highly seasonal should use monthly A/R average.
– One of the assumption of this ratio is that sales occur evenly throughout the
year, therefore average A/R can be estimated using the average of beginning
and ending A/R balances.
– When sales are seasonal or uneven, the beginning and ending balances may
not be indicative of the average A/R balance. This is one of the reasons that
most retailers have a fiscal year ending on January 31 and not December 31,
because the sales in that industry are seasonal.
Activity Measures
A/R turnover also can be analyzed in days instead
of times
• Days’ Sales Outstanding (DSO)
• DSO = Days in year / AR turnover
– Average collection period in days.
– May use 365, 360 or 300 days
– Compared to credit terms to determine if customers
pay within terms.
Activity Measures
• Inventory turnover = COGS / Ave. Inventory
– Measures efficiency of inventory management.
– High ratio : Quicker inventory turns
• Inventory not obsolete, not carrying excess.
– Highly seasonal should use monthly Inv. average.
– LIFO valuation not comparable to other methods.
– Inventory turnover is industry specific.
• Grocery vs. Concrete
• Days’ Sales in Inventory = Days in year/Inv.
Turnover
– How many days sales are tied up in inventory.
Activity Measures - Payables
• Accounts Payable Turnover = Purchases /
Ave. AP
– Highly seasonal should use monthly Payables
average.
• Days’ Purchases in Accounts Payable (DPO)
• DPO =Days in year / AP Turnover
– Compared to credit terms to determine if the
firm is paying within terms.
Continued
Activity Measures
• Operating Cycle = DSI + DSO
– The amount of time to convert inventory to cash.
– Figure 2-2 Page 67
• Cash Cycle = Operating Cycle – DPO
– Is the days that cash is tied up as another asset.
Activity Measures
• Fixed Assets Turnover Ratio = Net Sales / Ave. Net PP&E
– How efficiently the company deploys its investment in plant
assets to generate revenues.
– Higher turnover is preferable.
– Affected by the capital intensiveness of the company and its
industry, by the age of the assets, and by depreciation
method used.
• Total Assets Turnover Ratio = Net Sales / Ave. Total Assets
– Higher turnover is preferable.
– Exclude assets that do not relate to sales. Ex: investments
SU 2.3 Practice Question
Selected data from Sheridan Corporation’s year-end financial statements are presented
below. The difference between average and ending inventory is immaterial.
Current ratio
2.0
Quick ratio
1.5
Current liabilities
$120,000
Inventory turnover
(based on cost of goods sold)
Gross profit margin
Sheridan’s net sales for the year were
A
B
C
D
8 times
40%
$800,000
$480,000
$1,200,000
$240,000
SU 2.3 Practice Question Answer
Correct Answer: A
Net sales can be calculated indirectly from the inventory turnover ratio
and the other ratios given. If the current ratio is 2.0, and current
liabilities are $120,000, current assets must be $240,000 (2.0 ×
$120,000). Similarly, if the quick ratio is 1.5, the total quick assets must
be $180,000 (1.5 × $120,000). The only major difference between
quick assets and current assets is that inventory is not included in the
definition of quick assets. Consequently, ending inventory must be
$60,000 ($240,000 – $180,000). The inventory turnover ratio (COGS ÷
average inventory) is 8. Thus, cost of goods sold must be 8 times
average inventory, or $480,000, given no material difference between
average and ending inventory. If the gross profit margin is 40%, the
cost of goods sold percentage is 60%, cost of goods sold equals 60% of
sales, and net sales must be $800,000 ($480,000 ÷ 60%).
2.4 – Solvency
• Solvency is a firm’s ability to pay its noncurrent obligations
as they come due…
• Long-run as opposed to liquidity which focuses on short-term (current
items)
• Firms capital structure incl.
• Liabilities (external) – Long-term and short-term debt
• Equity – (internal) – Residual
• Capital decisions have consequences
• > debt = > risk = > cost of capital
• > equity = < ret. on equity
• Which det. deg. of leverage
2.4 – Solvency
• Debt = creditors interest
– = contractual obligations
– Ret > cost of debt = > equity
• Equity = permanent capital
– Ret. uncertainty even with Pre. Stock
2.4 – Solvency
• Capital Structure Ratios
– Total Debt to Total Capital Ratio
• TTL Debt/TTL Capital (Debt & Equity) = total leverage
– Debt to Equity Ratio
• TTL Debt/Equity = total amount (X) that debt exceeds equity
– Long-term Debt to Equity Ratio
• Long-term debt/Equity
– ??? – which is better, increase or decrease of Long-term Debt to Equity
Ratio, year over year?
Continued
2.4 – Solvency
– Debt to Total Asset Ratio
• TTL Liabilities/ TTL Assets
– ??? – how is the same as the debt to total capital
ratio?
2.4 – Solvency
• Earnings Coverage
– Times interest earned ratio
• EBIT/Interest Expense
• ??? – What does this tell a creditor
• Most common mistake – not to add back that years interest payment
to NI before taxes
– Earnings to Fixed Charges Ratio
• EBIT + Interest portion of operating leases/Int. exp. + Int. portion of
operating leases + Div. on Pre. Stock
• More conservative; shows all fixed charges
2.4 – Solvency
– Cash Flow to Fixed Charges Ratio
• Pre-tax operating cash flow/Int. exp. + Int. portion of
operating leases + Div. on Pre. Stock
– Eliminates issues associated with accrual accounting
2.5 – Leverage
Types of Leverage
A company uses leverage in two ways: financial and operating.
• Financial leverage is raising capital through debt rather than equity. While
debt holders are entitled to interest, the owners share the earnings of the
company. Hence, when a company can earn a higher rate of return on its
invested capital through its operations than the interest rate on its debt, it
could increase the return for its investors by financing the growth of
company operations through borrowed capital.
• Operating leverage is the existence of fixed operating costs. Because
these costs are fixed, the higher the percentage of operating leverage, the
greater the effect changes in sales revenues have on operating income.
The focus on leverage in this section is on financial leverage. The cost of
financial leverage is interest costs, which must be paid regardless of sales.
2.5 – Leverage
– Leverage = relative of fixed cost
• ??? – which fixed cost?
• ??? – what financial statement do we find on?
– Deg. of leverage = Pre-fixed-cost income
amount/Post-fixed-cost income amount
2.5 – Leverage
• Distinguish between variable costing and full-costing
• Why do we have to have variable costing for measuring
the DOL
– Degree of Op. Lev. – Single-Period Version
• DOL = Contribution Margin/Operating Income or EBIT
• Contribution Margin = ???
• Example page 72
2.5 – Leverage
– Degree of Operating Leverage – Perc.-Change Version
• %Chng. in Op. Inc. or EBIT/%Chng. in Sales
• Example page 72
– Degree of Financial Leverage – Single-Period Version
– EBIT/EBT
• A variation is the Percentage-change Version
SU 2.5 Practice Question
A degree of operating leverage of 3 at 5,000 units means that a
A
3% change in earnings before interest and taxes will cause a 3% change in sales.
B
3% change in sales will cause a 3% change in earnings before interest and taxes.
C
1% change in sales will cause a 3% change in earnings before interest and taxes.
D
1% change in earnings before interest and taxes will cause a 3% change in sales.
SU 2.5 Practice Question Answer
Correct Answer: C
The degree of operating leverage (DOL) is the
multiple of contribution margin over operating
income (also called earnings before interest and
taxes, or EBIT). A high multiple indicates heavy
use of fixed costs in the firm’s operations. This
firm’s contribution margin is 3 times EBIT. Thus,
a given percentage change in sales will result in
a change 3 times as great in EBIT.
SU 2.5 Practice Question
Firms with high degrees of financial leverage would be best characterized as having
A
High debt-to-equity ratios.
B
Zero coupon bonds in their capital structures.
C
Low current ratios.
D
High fixed-charge coverage.
SU 2.5 Practice Question Answer
Correct Answer: A
The degree of financial leverage (DFL) is the
multiple of operating income (or earnings before
interest and taxes, called EBIT) over earnings
before taxes (EBT). A high multiple indicates
heavy use of fixed costs in the firm’s capital
structure, revealed by high interest payments on
debt.
Capital Structure – Other considerations
Consider that increases in debt create higher fixed costs for interest
and principal payments. It also results in a higher debt to equity ratio
and, therefore, a less favorable position for long-term debt-paying
ability.
Decreases in equity, as a result of redemption of stock or losses from
operations, also would result in a higher debt to equity ratio and
higher risk for the company’s ability to pay long-term debt.
Increases in equity, such as those from profits, without corresponding
increases in debt would lower the debt to equity ratio, increasing the
company’s position for long-term debt-paying ability.
Capital Structure – Other considerations
What is Off -Balance Sheet Financing, and how does it affect
financial rations?
• Off -balance sheet financing is a form of financing in which
large capital expenditures are kept off an organization’s
balance sheet through various classification methods.
• Organizations oft en use off -balance sheet financing to
keep their debt to equity and leverage ratios low, especially
if the inclusion of a large expenditures would violate debt
covenants.
• Four of the common techniques employed to achieve off balance sheet financing are: factoring of A/Rs, specialpurpose entities, leases, and joint ventures.
Capital Structure – Other considerations
Special-Purpose Entities
Many firms create special-purpose entities (SPEs) for a
“special,” sometimes undisclosed, business purpose. For
example:
• SPEs may be created to facilitate leasing activities, loan
securitizations, R&D activities, or trading in financial
derivatives (i.e. Enron).
• Because these were created as “separate” entities from the
parent corporation, the financials and business transactions
of these SPEs were not consolidated with that of the
parent.
• By excluding such ventures from consolidation, the
company is “hiding” significant business risk from investors
Capital Structure – Other considerations
Leases
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Firms usually use leases to get use of an asset without having to show it on the balance sheet
as an asset and the corresponding liability. If the firm were to purchase the asset, it might
have to use cash, thus converting short-term assets into long-term assets and worsening
short-term liquidity ratio. Purchasing the asset on credit would increase the firm’s accounts
payable, again worsening its short-term liquidity ratios. If the firm were to use long-term
financing to purchase, it would worsen the debt to equity or other solvency ratios.
A way to avoid any of these adverse consequences on the balance sheet, firms sometimes
lease the asset. Generally accepted accounting principles require that a determination be
made on whether the lease is an operating lease or a capital lease. When the lease meets
one of the four conditions established for capital leases, the lease payments are accounted
for as a long-term liability.
However, sometimes firms are able to structure a lease so as not to meet any of the four
conditions. It can then classify the lease as an operating lease. With an operating lease, the
firm is able to obtain the use of the asset without having to record its obligation to pay, thus
obtaining off-balance sheet financing.
Capital Structure – Other considerations
Joint Ventures
A joint venture is a business entity that is owned, operated, and jointly controlled
by a small group of investors with a specific business purpose.
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•
Sometimes a corporation is a partner in a venture, which allows it to be active in
management and involved in decision making but not report the venture on the
financial statement of the corporation.
An investment in a corporate joint venture that exceeds 50% of the venture’s
outstanding shares must be treated as a subsidiary investment, leading to
consolidation in the financial statement. However, firms sometimes are careful to
hold less than 50% (say 48.5%) of outstanding shares to avoid such consolidation—
providing off -balance sheet financing.
SU 2 - Liquidity Ratios – Effects of
Transactions
• You need to understand what effects typical
business transactions have on a firm’s
liquidity, rather than on the mechanics of
calculating the ratios.
• See problems 10 – 13, p. 56 - 57
Profitability Analysis
Profitability is a firm’s ability to generate earnings over a period of time with a given
set of resources. It is analyzed by examining the elements of revenues, the cost of
sales, and operating and other expenses.
There are a number of ways an investor can look at return on his or her investment.
Some returns involve the price of the stock as it trades in the securities markets.
Although there are actions a company can take to make its stock more attractive to
investors, return on market price depends on when each investor purchases and sells
the stock. Thus, the analyst of a company’s financial and operating
performance cannot make this calculation for the individual investor. An analyst, can,
however, examine how the investor’s contribution to the company performed on a
per-share basis. This can be done by measuring earnings per share and the dividend
yield.
Profitability Analysis
The numerator of the return ratio is some measure of earnings or profits. The measure selected
for the numerator should match the investment base in the denominator. For example, if total
assets are used in the denominator, the income to all providers of the capital ought to be
included in the numerator, which includes interest. Thus, interest usually is added back to the net
income when computing the ROA. This leads to a popular measure known as earnings before
interest, taxes, depreciation, and amortization (EBITDA).
When return on common equity capital is computed, net income after deductions for interest
and preferred dividends is used. The final ROI always must reflect all applicable costs and
expenses, including income taxes, particularly when the return on shareholders’ equity is
computed. Profit, or “the profit motive,” is realized when an organization is generating more
resources than it consumes during the course of a year. That is, profit is the amount by which
revenue from sales exceeds the costs required to achieve those sales. And the profit margin is the
percentage of revenues represented by that excess of revenues over costs. Revenues and costs,
however, are measured by diverse criteria.
Profitability Analysis
Profit margins commonly are calculated using one of
three different profit measures:
1. Gross profit , which equals net sales revenue minus the
cost of goods sold (COGS).
2. Operating income , which equals gross profit minus
various administrative expenses, not including interest or
taxes (because they are not part of operations). Operating
income is sometimes called earnings before interest and
taxes (EBIT).
3. Net income , which reduces revenues by all expenses—
cost of goods, operating expenses, and interest and taxes.
Profitability Analysis
Gross profit margin is what percentage of gross revenues remains with the firm after
paying for merchandise.
Revenue – COGS = GP
As with all financial ratios, the gross margin derives its meaning by comparison to
performance of the company in past years as well as by comparison to industry
averages. One of the things an analyst looks for is the trend of the gross profit margin:
Is it increasing, decreasing, or remaining steady?
Key – That the percentage of GP remains or increases with sales.
GP – SG&A = Operating Profit
Profitability Analysis
• Gross Profit Margin = Gross Profit / Net Sales
= Net Sales – COGS / Net Sales
• Profit Margin = Net Income / Net Sales
= Net Sales – COGS – G&A – Fixed costs – Tax –
Interest
What is left to be reinvested or distributed?
• Net Profit Margin and Profit Margin are the same
• Difference between Operating Income and EBIT 
OTHER
• Other Income
• Other Loss
Profitability considerations
Financial analyst must also look for reasons that explain
changes. Here are some reasons that gross profit margin
may change:
• Sales prices have not increased at the same rate as the
change in inventory costs.
• Sales prices have declined due to competition.
• The mix of products sold has changed to more
products with lower profit margins.
• Inventory is being stolen. (If this is the case, the cost of
goods will be higher against the same sales.)
Profitability Analysis
• EBITDA  performance measure that approximates accrual-basis
profits from ongoing operations
• EBITDA / Net Sales  adding back 2 major noncash expenses to
EBIT
• ROI: what is Return and what is Investment?
– ROA: how well Management is deploying the firm’s assets in the
pursuit of a profit
• NET INCOME / AVG TOTAL Assets
• That ratio will be very low in High Assets industry (Manufacturing)
– ROE: measures the return per owner dollar invested
• NET INCOME / AVG TOTAL Equity
– The difference between the two are Liabilities, which is why ROE is
always larger than ROA
Key Take-Away
• CMA are expected to be able to determine the
profitability of a business by calculating ROA /
ROE using the DuPont Model and explain how it
helps analysis
• Demonstrate:
– That you know the formulas
– That you are able to properly apply and analyze and
evaluate
– Discussion on inconsistent definitions and what
factors contribute to inconsistency
DUPONT Analysis
• Developed in 1919 as a way to better
understand return ratios and why they change
over time.
• The bases for this approach are the linkages
made through financial ratios between the
Balance Sheet and the I/S
• Breaking returns into their components
DuPont Model
Dupont Model: Deep Dive
• ROE = Profit Margin X Asset Turnover X Equity Multiplier
Profitability
Operating
Efficiency
Financial
Leverage
• High Turnover Industries = retail, groceries  volume
• High Margin Industries = fashion, luxury  rare,
customized
• High Leverage Industries = financial sector, real estate
Return on Assets: ROA
• ROA = Net Income / Sales X Sales / Total
Assets
• How effectively assets are used?
• It measures the combine effects of profit
margins and asset turnover
Return on Equity: ROE
•
ROE = Net Profit / Equity
=
Net Profit / Pre-tax Profit
Tax Burden
X
Pre-tax Profit / EBIT
Interest Burden
• ROE = Tax burden X Interest burden X Margin X Turnover
X Leverage
• ROE = Tax burden X ROA X Compound Leverage factor
ROCE
• Return on Common Equity = Net Income – Preferred
Dividends / AVG Common Equity
• ROCE = IACS / Net Sales X Net Sales / AVG Ttl Assets X
Leverage
– The equity multiplier measures a company’s financial
leverage
– High financial leverage means that the company relies more
on debt to finance its assets
– Raising capital with debt, the company can increase its
equity multiplier and improve its ROE
– However, on the other hand, taking on additional debt may
worsen the company’s solvency and increase the risk of
going bankrupt
Other measures
• Sustainable Equity Growth rate = ROCE x (1 –
Dividend Payout)
Plowback rate
• Plowback rate = Net Income not distributed =
reinvested in RE
• Net Profit Margin on Sales = Net Income / Sales
BEPS and DEPS
• Basic Earnings per Share = IACS / WACSO
– Income available to common shareholders can be income from
continuing operations or net income
• Diluted Earnings per Share: IACS is increased by the amounts that
would not have had to be paid if dilutive potential CS had been
converted:
– Dividends on Convertible PS
– After-tax interest on Convertible Debt
WACSO is adjusted (increased) by the weighted average number of
additional shares of CS that would have been outstanding if dilutive
potential CS had been converted
 Page 97 # 17 and 18
Weighted average number of shares outstanding
example revisited
If there were 800,000 shares outstanding from January
through June and 1,200,000 shares outstanding between July
and August, the weighted average would be calculated as
shown next:
800,000 Shares (Jan. 2 June) 3 6 Months / 12 Months =
400,000 Shares
1,200,000 Shares (July 2Dec.) 3 6 / 12 = 600,000 Shares
Weighted Average Shares Outstanding (Jan. 2 Dec.) = 400,000
Shares 1 600,000 Shares = 1,000,000 Shares
Dividend Payout Ratio
The dividend payout ratio is a near complement
to the percentage of shareholders’ equity.
However, it considers EPS on a fully diluted
basis, which is a more conservative measure
than comparing earnings against currently
outstanding shares of common stock only.
Other Market-based Measures
• Objective of Companies = increasing shareholder wealth
• Earning Yield = Earning per Share / Market Price per Share
• Dividend Payout Ratio = Dividends to CS / IACS
– Is it better a high or low ratio?
– Growing Companies, mature market, start-up?
• Dividend Yield = Dividend per Share / Market Price per
Share
Effect of Accounting Changes
For example, two commonly used methods of inventory
valuation are first-in, first-out (FIFO) and last-in, first-out
(LIFO). For the same underlying economic event, use of LIFO,
under certain assumptions of increasing inventory units and
prices, yields lower income than the FIFO inventory valuation
method. Thus, a firm using LIFO would report lower income
and lower inventory value than a similar firm using FIFO
inventory valuation method. Lower income and lower assets
both affect the computation of the return of asset ratio. An
analyst is required to consider such effects of accounting
policy choices on various financial ratios. The CMA exam tests
the ability to evaluate and deduce the effects of various
accounting choices on common ratios.
SU 3 - Effects of Off-Balance-Sheet
Financing
• Purpose – Reduce a companies debt load and
thereby improving the ratios
• Examples include:
– Unconsolidated subsidiaries
– Special Purpose Entities
– Operating Leases
– Factoring Receivables with Recourse
SU 3 – Market Valuations Measures
• Book value per share
• Market/Book Ratio
• Price/Earning Ratio
• Price/EBITDA
SU 3 – Earnings per Share and Dividend
Payout
• EPS
• Diluted Earnings per share
SU 3 – Factors affecting Reported
Profitability
• “Among the many factors involved in measuring
profitability are the definition of income; the stability,
sources, and trends of revenues; revenue relationships;
and expenses, including cost of sales.”
• Income quality
• Factors affecting include:
–
–
–
–
Income
Revenues
Receivables and Inventories
Recognition Principles
SU 4.1 – Risk and Return
• Systematic
• Unsystematic
• Relationship between Risk and Return
• Expected Rate of return calc. – p. 146
• Security Risk vs. Portfolio Risk
• Specific Risk vs. Market Risk
SU 4.1 - CAPM
• In order to measure how a particular security
contributes to the risk and return of a diversified
portfolio, investors can use CAPM.
• CAPM quantifies the required return on a security by
relating the security’s level of risk to the average return
available in the market (portfolio)
• Investors must be compensated for their investment in
2 ways:
– Time value of money
– Risk
Know the CAPM formula!
SU 4.1 – Two types of Risk
• Business Risk
• Financial Risk
• Indifference Curve
SU 4.1 - Standard Deviation
• It measures the tightness of the distribution and
the riskiness of the investment
• A large deviation reflects a broadly dispersed
probability distribution meaning the range of
possible returns is wide
• The smaller the deviation, the tighter the
probability distribution and the lower the risk
• The greater the deviation the riskier the
investment
SU 4.1 - Coefficients
• It measures the degree to which any 2 variables
are related
• Perfect positive correlation = +1 means that 2
variables always move together
• Given perfect negative correlation, risk would in
theory be eliminated
• In practice, the existence of market risk makes
the perfect correlation nearly impossible
• The normal range for the correlation of 2
randomly selected stocks is 0.5 to 0.7. the result
is a reduction in risk, not elimination.
SU 4.1 - Covariance
• Correlation coefficient of 2 securities can be
combined with their standard deviations to
arrive at their covariance
• Covariance = measure of mutual volatility
SU 4.1 - Diversification and Beta
• Portfolio Theory = balancing risk with return
– Asset Allocation is a key concept: stocks, bonds, real estate,
cash, etc…
– The purpose of diversification is to reduce risk while maximizing
returns and therefore reducing market correlation
• Expected rate of return of a Portfolio is the weighted
average of the expected rate of return of each individual
assets in the same portfolio
–
–
–
–
Specific risk = diversifiable risk = unsystematic risk
This risk can be potentially eliminated with diversification
Can risk be 100% eliminated?
Benefits of diversification become extremely low when > 20/30
stocks are held
SU 4.2 - Portfolio Management
• 4 important decisions are involved (not only 2)
– Amount of money to invest
– Securities in which to invest (expected net cash
flows)
– Time scale (Liquidity) = maturity matching
– Objectives: what for? = will dictate appetite for
risk
– Others: transaction costs
SU 5.1 - Bonds
• Term structure of interest rates
• There are three main types of yield curve shapes:
– Normal
– Inverted
– and flat (or humped). A normal yield curve (upward sloping) is
one in which longer maturity bonds have a higher yield
compared to shorter-term bonds due to the risks associated
with time.
– The slope of the yield curve is also seen as important: the
greater the slope, the greater the gap between short- and
long-term rates.
SU 5.1 - Bonds
– When plotting yield curves we hold the following
constant:
•
•
•
•
Default risk
Taxability
Callability
Sinking fund
SU 5.1 - Bonds
• Features of Bonds
• Par Value = Maturity amount = Face Amount
• State rate = Coupon rate
• Indenture = Terms
• Issuing bonds takes time and money
• > Risk = > Return (yield)
• How can you mitigate some of the market
required return?
SU 5.1 - Bonds
• Following are means to reduce the required
rate of return for bonds:
– Sinking Fund – payments to a segregated fund
which will equal the maturity value
– Insured
– Secured
SU 5.1 - Bonds
• Advantages of Bonds
– Interest is tax deductible
– Retain corporate control
• Disadvantages of Bonds
–
–
–
–
Interest is considered legal obligation
Raises risk level
Raises risk profiles
Contractual requirements (e.g. required debt to
equity)
– Debt financing limits
SU 5.1 - Bonds
• Types of Bonds
– Maturity
• Term bond – single maturity
• Serial bond
– Valuation
• Variable rate
• Zero-coupon or deep-discount bonds
• Commodity-backed bonds
– Redemption Provisions
• Callable bonds – by the issuer
• Convertible bonds – into equities
– Securitization
• Mortgage bonds – specific
• Debentures – borrower’s general credit but not specific collateral
SU 5.1 - Bonds
• Bond valuation and sales price
– Several components to determining the fair price of a bond:
•
•
•
•
•
•
Risk
Duration
Face amount
Interest payment
Other features such as callable, convertibility
Stated versus Market rate
– Mkt rate is = state rate
– Mkt rate is < state rate
– Mkt rate is > state rate
• 5.3 – Corporate/Stock Valuation Methods P. 181
SU 5.1 – Equity
• Common Stock
– Advantages to the issuer
• No fixed dividend (Common Stock only)
• No maturity date
• Increases creditworthiness
– Disadvantages to the issuer
•
•
•
•
•
No tax deductible distribution
Diluted controlling rights
Diluted earnings
Higher underwriting costs
Increase average cost of capital
What is a preemptive rights?
SU 5.1 – Equity
• Preferred Stock = hybrid of debt and equity
– Advantages to the issuer
• Form of equity
• Does not dilute control
• Superior earning still go to CS
– Disadvantages to the issuer
• No tax deductible distribution and therefore greater
cost to bonds
• Dividends in arrears can cause issues
SU 5.1 – Equity
• Characteristics of Preferred Stock
–
–
–
–
–
–
–
–
–
Priority in assets and earnings
Potential accumulation of dividends
Convertibility
Participation
Par value
Redeemability
Voting rights
Callability
Maturity – Sinking fund
• Stock Valuations
– Preferred is similar to Bonds in valuation
– Discount rate will probably be higher then bonds due to riskiness
– Common stock valued also the same way except based on earnings (per share)
SU 5 – Corporate/Stock Valuation
Methods
• Dividend Discount Model
– Based on PV of “expected” dividends per share
– Can only be used when dividends are expected to
grow at constant rate
Dividend per share
Cost of Capital – dividend growth rate
SU 5 – Corporate/Stock Valuation
Methods
• Preferred Stock Valuation
Dividend per share
Cost of Capital
SU 5 – Corporate/Stock Valuation
Methods
• Common Stock with Variable Dividend Growth
– 3 Step process
• Step 1 – Calculate and sum the PV of Dividends in the
period of high growth
• Step 2 – Calculate the PV of the stock based on the
period of steady growth discounted back to year 1
using the dividend discount method.
• Step 3 – Sum the totals from Step 1 and 2
SU 5 – Cost of Capital - Current
• Investor Required Rate of Return
• Components of Capital
– Debt – after-tax interest rate on the debt
– Preferred Stock – dividend yield ratio
– Common Stock – dividend yield ratio
– Retained Earnings cost = Common Stock – Why?
SU – 5.6 Cost of Capital - Current
• Weighted Average Cost of Capital – WACC
• Target Capital Structure
“Firms WACC is a single, composite rate of return on its
combined components of capital”.
Min. WACC = Shareholder Wealth Maximizing
Impact of taxes on Capital Structure and Capital Decisions
SU 6.1 – Working Capital
Working capital and types of capital policies?
Working capital (or current capital) generally refers to the funds
a company holds in current (short-term) asset accounts, and
includes cash, marketable securities, receivables, and
inventories.
Net working capital provides a measure of immediate liquidity
and indicates how much cash a firm has available to sustain and
build its business, and refers specifically (from an accounting
perspective ) to the difference between a firm’s current assets
and its current liabilities. Depending on a firm’s level of current
liabilities, the number may be positive or negative.
SU 6.1 – Working Capital
Working Capital policies include:
– Conservative = minimize risk = Higher current ratio & acid test ratio focuses on low-risk, low return working capital investment and
financing greater proportion of capital in liquid assets but at the
sacrifice of some profitability; uses higher-cost capital but
postpones the principal repayment of debt or avoids it entirely by
using equity; current assets will be much greater than current
liabilities.
– Moderate = average risk - uses risk and return and financing
strategies that match the maturity of the assets with the maturity of
the financing; seeks a balance between current assets and current
liabilities.
– Aggressive = more (max) risk = Lower current ratio & acid test ratio focuses on high profitability potential, despite the cost of high risk
and low liquidity. Capital being minimized in current assets versus
long-term investments ; higher levels of lower-cost short-term debt
and less long-term capital investments. With an aggressive policy,
current assets will be less than current liabilities.
SU 6.1 – Working Capital
• What is the optimal level of working capital?
– Varies with industry!
– Contrast a grocery chain which has to rotate its inventory
and probably has no receivables versus a manufacturer
– Consequently ratios are only meaningful in terms of norms
and trends and relative its competitors or the industry it
which it operates
• Permanent and Temporary Working Capital
– Def. – The minimum level of current assets maintained by
a firm (which could fluctuate with seasonality).
– It should increase as the company grows
– Permanent financed with long-term debt
SU 6.2 – Cash Management
• Managing the cash levels
– What are the motives for holding cash?
• Transactional
• Precautionary
• Speculative
– What is the firms optimal cash?
• Economic Order Quantity (EOQ) – As applied to cash (as
opposed to inventory)
• Questions you will have to answer
– How much cash
– Transaction cost
– Return on marketable securities
SU 6.2 – Cash Management
• Cash Management EOQ Model P. 161
• Review examples – forecasting future cash
flows (see examples on page 161, very typical
test questions!)
• Lockbox benefit analysis = Net Benefit from
Lockbox = Reduction in Float Opportunity Cost
+ Reduction in Internal Processing Costs Lockbox Processing Costs
SU 6 – Marketable Securities
Management
Remember!
Companies invest in marketable securities for three main
reasons:
1.
2.
3.
Reserve liquidity. To provide a source of near cash (or instant
cash) and cover any working capital imbalances resulting from
insufficient cash inflows or unforeseen cash needs
Controllable outflows. To earn interest on funds that are being
held for predictable downstream cash outflows (such as
interest payments, taxes, dividends, or insurance policies)
Income generation. To earn interest on surplus cash for which
the company has no immediate use
SU 6.4 – Receivable Management
• Overview
– A firm must balance default risk and sales
maximization
• Basic Receivable Formulas
– Average collection period
– Accounts Rec. – days vs. dollars
• Assessing impact of a credit term change (see
example page 166 - 167)
SU 6.5 – Inventory Management
• Inventory management refers to the process of
determining and maintaining the required level of
inventory that will ensure that customer orders
are properly filled on time.
1.
2.
3.
What to order (or make)?
When to order (or make)?
How much to order (or make)?
• Reasons for carrying inventory include:
– Hedging against supply uncertainty
– Hedging against demand uncertainty
– Ensuring that operations are not interrupted (ref. JIT)
SU 6.5 – Inventory Management
• Inventory costs
– Purchase cost – actual invoice amounts
– Carrying cost incl. – Storage, Insurance, Security,
Inventory taxes, Depreciation or rent, Interest,
Obsolescence and/or spoilage and Opportunity
cost.
• Inventory costs incl. - Ordering costs and Stockout
costs (see example page 226).
SU 6 – Inventory Management
• Inventory Replenishment Models
– With Certainty = Average daily demand X Lead time in days
– Without Certainty = Average daily demand X Lead time in days) + Safety Stock
•
Cost of Safety Stock = Expected stockout cost + Carrying
Cost
See example on page 170
Economic order quantity (EOQ) – Represents the optimum
order size—the quantity of a regularly ordered item to be
purchased at a point in time that results in minimum total cost
(i.e., the sum of ordering costs and carrying costs).
SU 6.6 - Short-term Financing
• Sources
– Spontaneous Forms of Financing
• Trade credit
• Accrued expenses
– Commercial banks, and
– Market-based instruments
Cost of not taking a discount (see example page 230)
• Short-term bank loans
–
–
–
–
–
In addition to trade credit sources
Increased risk
May not renew
Contractual restrictions
Prime interest rate – best customers only
Continued
SU 6.6 - Short-term Financing
• Simple interest loans – Interest paid at the end
of the term; stated is same as nominal
• Effective Interest Rate on a Loan
Net interest expense
Usable funds
SU 6 - Short-term Financing
• Discounted Loans
Amount needed
(1.0 – Stated rate)
• Loans with compensating balances – increases
effective interest rate
• Lines of Credit with Commitment Fees
SU 7 - Financial Markets and Security Offerings
• Benefits of Financial Markets
– Facilitate the transfer of funds from those that
need to invest to those that need to borrow.
• Direct or indirect
• Intermediate entities & financial markets – special
expertise.
• Aggregate view of Financial Markets –
Demand/Supply of Securities
– Some of the securities included are Stocks, Corporate
bonds, Mortgages, Consumer loans, Leases, Commercial
paper, CD’s, Governmental securities, Derivatives
SU 7.1 - Financial Markets and Security Offerings
• Money Markets vs. Capital Markets
– Short term vs. Long term
• Money Markets
– Dealer driven – Dealer buy and sell at their own
risk.
– Dealer is principal in transaction vs. stockbroker
is an agent
– Short term and marketable
– Low default risk
Continued
SU 7.1 - Financial Markets and Security Offerings
– Exist in New York, London, & Tokyo
• Government T-bills, T-notes and bonds, Federal agency
and S-T tax exempt securities, Commercial paper, CD’s –
US and Eurodollar, Repurchase agreements, Banker’s
acceptances
• Capital Markets – LT debt & equities – NY
Stock Exchange
SU 7.1 - Financial Markets and Security Offerings
• Primary Markets, Secondary Markets and
Financial Intermediaries
– Primary market – IPO / Issuer receives the
proceeds
– Secondary market – Trading among investors
• Pros
– Company prestige
– Increased liquidity of firms’ securities
• Cons
– Reporting requirement
– Hostile takeovers
• Provide market makers
SU 7.1 - Financial Markets and Security Offerings
• Secondary market continued…..
– Over-the-counter markets – Broker & Dealer market
•
•
•
•
Bonds – US companies, federal, state, & local governments
Open-end investment company shares of mutual funds
New securities issues
Secondary stock distributions – whether of not listed on the
exchange
– NASD – National Association of Securities Dealers
• NASDAQ – NASD Automated Quotation system
– Transaction happen in virtual space
– Price quotes and volume
– Auction markets – NY Stock Exchange
– Transaction happen at NYSE by floor traders
• Financial Intermediaries – Use funds from savers
– Banks, CU’s, Insurance co., Pension funds, etc.
SU 7.1 - Financial Markets and Security Offerings
• Efficient Markets Hypothesis
– Current stock prices immediately and fully reflect all
relevant information. Impossible to obtain consistently
abnormal returns with fundamental or technical analysis.
– Three forms of efficient markets hypothesis
• 1) Strong form
– All public and private information is instantaneously reflected in
securities’ price.
– Insider trading would not result in abnormal returns.
• 2) Semi-strong form
– All publicly available data are reflected in security price, but private or
insider data are not immediately reflected.
– Insider trading can result in abnormal returns.
• 3) Weak form
– Prices reflect all recent past price movement data.
– Technical analysis will not provide a basis for abnormal returns.
– Data does not support the strong form.
SU 7.1 - Financial Markets and Security Offerings
• Investment Banking
– Intermediary between businesses and capital providers.
• Sell new securities | Business combinations | Brokers & Traders
– With new securities - Help determine method of
issuance, pricing, distributing, advice, and certification.
• Signal sourced, Negotiates deal – sets price and fees
• Sold by best efforts sales – No guarantee
• Underwritten deal – IB purchases securities from issuer and
resells them
• IB makes the process easier, because of resources and
reputation.
– Buyers look to IB reputation for fair deals.
– Structuring of the floatation.
• Terms of arrangement, capital type and amount
– Flotation costs – Higher for common, then preferred,
lower for bonds.
SU 7.1 - Financial Markets and Security Offerings
• IPOs
– Advantages of going public
• Raise additional funds, establish value in market, stock
liquidity
– Disadvantages
• Costs, data public, shareholder information public,
insider limitations, earning growth pressure, stock price
doesn’t reflect firm net worth, loss of control, growth
brings move management control, shareholder costs
– Steps involved in going public
• Prefiling period – Negotiate and agreements with
underwriters. Buying or selling securities is prohibited.
• Apply to a stock exchange, pay fee, fulfill membership
requirements,
Continued
SU 7.1 - Financial Markets and Security Offerings
• Waiting period - File registration statement
and prospectus with SEC. May make oral
offers to buy and sell securities. Tombstone
ads
– In large red ink “Preliminary prospectus”, date, and legend
must be marked. SEC 20 day review period. Debug letter – Fix
or withdraw.
– A Preliminary prospectus is called a Red-Herring
• Post effective period – Registration statement
is effective. Securities may be sold.
SU 7.2 – Dividend Policy and Share Repurchase
• Dividend Policy
– “To distribute or not to distribute”?
Higher dividend – lower growth rate, finding the balance
Stable dividends are desirable
– Factors influencing Company Dividend Policy
•
•
•
•
•
•
•
Legal Restrictions- Dividend amount must be in RE.
Stability of Earnings
Rate of Growth
Cash Position
Restrictions in Debt Agreements
Tax Position of Shareholders
Residual Theory of Dividends – Minimize Cost of Capital
SU 7.2 – Dividend Policy and Share Repurchase
• Dividend “dates”
• Date of declaration – formal vote to declare a dividend. Dividend
becomes a liability to the company.
• Date of record – Shareholder on that date will receive the dividend.
– 2-6 weeks after Date of declaration
• Date of distribution – Dividend is paid. 2-4 weeks after date of record
• Ex-dividend date – Purchase before date will receive dividend
– Established by stock exchange
• Stock price will usually drop on ex-dividend date in the amount of
dividend
• Stock dividends vs. stock splits
–
–
–
–
More stock is issued, but no value increase or decrease occurs.
Stock dividend – transfers amount from RE to Paid-in capital
Stock split – no accounting entry
Lowers stock price
SU 7.2 – Dividend Policy and Share Repurchase
• Repurchase
– Treasury shares
– Mergers, Share options, Stock dividends, Tax reasons,
increase EPS, prevent hostile takeovers, eliminate a
particular ownership interest
– Dividend Reinvestment Plans - DRPs or DRIPS
• Dividends owed to shareholders are reinvested into
shares.
• Insider Trading laws
• SEC Rule 10b-5
• Leases
SU 7.2 – Dividend Policy and Share
Repurchase
• 7.2 – Dividend Policy and Share Repurchase P.
# 7 on page 229
SU 7.3 - Mergers and Acquisitions
• Merger vs. Acquisitions
– Mergers – Acquiring firm absorbs a 2nd firm.
• Types
–
–
–
–
Horizontal – Companies of same business line merge.
Vertical – Combine supplier with customer
Congeneric – Related products or services
Conglomerate – Unrelated companies merge.
• Advantages and disadvantages
– Acquisition – Acquiring firm purchases all of 2nd firms assets or
stock.
•
•
•
•
•
Requires shareholder vote.
Hostile takeover
5% ownership of any stock class requires SEC filing.
Advantages and disadvantages
Proxy – File with SEC 10 days prior, furnish shareholder with all material
subject to vote, The Proxy form, Proxies for Directors in Annual Report
• “Going private” - LBO
SU 7.3 - Mergers and Acquisitions
• Opposition to Combinations
–
–
–
–
–
–
–
–
–
–
–
–
–
–
Greenmail – Targeted Repurchase
Staggered Directors or Supermajority vote requirements
Golden Parachutes
Fair Price Provisions – Ensures all stockholder are treated equally.
Going Private and LBOs
Poison Pill – Kills the company value.
Flip-over Rights – Shareholder exchange for greater value.
Flip-in Rights – Gives existing shareholders more rights than large acquirer.
Issuing Stock Reverse Tender
ESOP
White Knight Merger
Crown Jewel Transfer
Legal Actions
• Other Restructurings
– Spin off, divestiture, asset liquidation, carve-outs, Letter stock- separate
valuation
SU 7.3 - Mergers and Acquisitions
• Motivations of mergers and subsequent
synergies
–
–
–
–
Undervaluation of firm
Managerial motivation
Break up – Parts are worth more than the whole.
Diversification
• Synergies
– Combined firms are worth more than separate.
•
•
•
•
•
Operational
Financial
Reduced competition – Antitrust
Strategic position
Tax benefits
Su7.4 Bankruptcy
• Chapter 7 vs Chapter 11
SU 7.5 – Currency Exchange Rates –
Systems and Calculations
• Foreign Currency Markets are needed due to
transactions with foreign entities
• Trade increases = demand for that countries currency
increases
• Currencies must be easily convertible at some prevailing rate
• Four systems for exchange rates:
–
–
–
–
Fixed Rate
Freely floating rates
Managed floating rates
Pegged rates
SU 7.5 – Currency Exchange Rates –
Systems and Calculations
• Fixed Exchange Rates vs. Freely Floating Rate
Systems
– “Fixed is fixed or almost fixed”
– Governments help to maintain exchange rates
– Very predictable and minimizes uncertainty re.
exchange rate loses (gains)
– Governments can manipulate (like China has been
accused of doing so)
– Freely floating helps correct disequilibrium's in the
balance of payments
SU 7.5 – Currency Exchange Rates –
Systems and Calculations
• Managed Float Exchange Rate Systems
– Government allows market forces to determine
exchange rates until they move to far, in which
case they intervene
• Pegged Exchange Rate Systems
– One country fixes the rate of exchange for its
currency with respect to another country’s
currency (or basket of several currencies)
SU 7.5 – Currency Exchange Rates –
Systems and Calculations
• Exchange Rate Basics
– Spot rate = exchange rate today
– Forward rate = some definite date in the future
• Domestic currency forward rate is greater than its spot rate, it is
trading at a forward premium
• Opposite would be a forward discount
• See Forward premium/discount calculation on page 282
Forward Rate – Spot Rate
Spot Rate
X
Days in year
Days in forward period
– Cross rate – used when two currencies are not stated in
terms of each other
SU 7.5 – Currency Exchange Rates –
Systems and Calculations
• Exchange Rates and Purchasing Power
– Understand graph on page 214
– Understand if a currency has appreciated or
depreciated
SU 7.5 – Currency Exchange Rates
• 7.5 – Currency Exchange Rates – Systems and
Calculations
– Example on page 213
– Question 20 on page 232
SU 7.5 Currency Exchange Rates – Factors
Affecting Rates and Risk Mitigation Techniques
• Exchange Rate Fluctuations over time – page
220
• Risk of Exchange Rate Fluctuations – page 221
• Hedging in Response to Exchange Rate Risk –
page 221, see examples on 222
• Tools for Mitigating Exchange Rate Risk –
Long-term - page 223, see example of page
223
SU 8 – Cost-Volume-Profit (CVP) Analysis Theory
• CVP = Break-even analysis
– Allows us to analyze the relationship between revenue and fixed and
variable expenses
– It allows us to study the effects of changes in assumptions about cost
behavior and the relevant ranges (in which those assumption are
valid) may affect the relationships among revenues, variable costs, and
fixed costs at various production levels
– Cost-volume-profit analysis is a tool to predict how changes in costs
and sales levels affect income; conventional CVP analysis requires that
all costs must be classified as either fixed or variable with respect to
production or sales volume before CVP analysis can be used.
– It considers the effects of:
•
•
•
•
Sales volume
Sales price
Product mixes
What else……?
SU 8 – Cost-Volume-Profit (CVP) Analysis Theory
• CVP analysis is done with what assumptions?
– Cost and revenue relationships are predictable
– Unit selling prices are constant
– Changes in inventory are insignificant
– Fixed costs remain constant over relevant range
(see slide 5 & 6)
– Total variable cost change proportional with
volume (see slide 7 & 8)
Continued
SU 8 – Cost-Volume-Profit (CVP) Analysis Theory
– The revenue (sales) mix is constant
– All costs are either fixed or variable (long-term all
costs are considered as variable)
– Volume is the sole revenue driver and cost driver
– The breakeven point is directly related to costs
and inversely related to the budgeted margin of
safety and the contribution margin
– Time value of money is ignored
Number of Local Calls
Total fixed costs
remain constant as
activity increases.
Monthly Basic Telephone
Bill per Local Call
Monthly Basic
Telephone Bill
SU 8 – Cost-Volume-Profit (CVP) Analysis - Theory
Number of Local Calls
Cost per call
declines as
activity increases.
Total Costs
Cost per Minute
SU 8 – Cost-Volume-Profit (CVP) Analysis - Theory
Minutes Talked
Total variable costs
increase as
activity increases.
Minutes Talked
Cost per Minute
is constant as
activity increases.
Scatter Diagrams
Draw a line through the plotted data points so that about equal
numbers of points fall above and below the line.
Total Cost in
1,000’s of Dollars
20
* ** *
**
* *
* *
10
Estimated fixed cost = 10,000
0
0
1
2
3
4
5
Activity, 1,000’s of Units Produced
6
Scatter Diagrams
Δ in cost
Δ in units
Unit Variable Cost = Slope =
Total Cost in
1,000’s of Dollars
20
* ** *
**
* *
* *
10
Horizontal distance is the
change in activity.
0
0
1
2
3
4
Activity, 1,000’s of Units Produced
5
6
Vertical
distance is
the change
in cost.
High-low method
• The following is not in this Study Unit, but it is
important to know and be able to calculate.
SU 8 – Cost-Volume-Profit (CVP) Analysis Theory
• Breakeven point def. – Level of output where
total revenues equals total expenses; the
point at which all fixed costs have been
covered and operating income is zero.
– What is the break-even point and where is it on a
graph on the next page?
CVP Graph
Break-Even Point
SU 8 – Cost-Volume-Profit (CVP) Analysis Theory
• Other terms and def.
– Margin of safety = excess of “budgeted” sales over BE Sales
– Mixed costs – (See slide 11) Costs that have both a fixed and variable
component. For example, the cost of operating an automobile includes some
fixed costs that do not change with the number of miles driven (e.g., operating
license, insurance, parking, some of the depreciation, etc.) Other costs vary
with the number of miles driven (e.g., gasoline, oil changes, tire wear, etc.).
– Revenue or sales mix is the composition of total revenues in terms of various
products
– Sensitivity analysis – (See slide 12) Examines the effect on the outcome of not
achieving the original forecast or of changing an assumption. Since many
decisions must be made due to uncertainty, probabilities can be assigned to
different outcomes (“what-if”).
SU 8 – Cost-Volume-Profit (CVP) Analysis Theory
•
Unit Contribution Margin (UCM) is an important term used with break-even point
or break-even analysis is contribution margin. In equation format it is defined as
follows:
Contribution Margin = Revenues – Variable Expenses
•
The contribution margin for one unit of product or one unit of service is defined
as:
Contribution Margin per Unit = Revenues per Unit (Sales price) – Variable
Expenses per Unit
Expressed in either percentage of the selling price (contribution margin ratio) or
dollar amount
Slope of total cost curve plotted so that volume is on the x-axis and dollar value is
on the y-axis
SU 8 – Cost-Volume-Profit (CVP) Analysis Theory
• Break-even point in units
Fixed costs
UCM
• Break-even point in dollars
Fixed costs
CMR
Remember
Computing the Break-Even Point
We have just seen one of the basic CVP relationships
– the break-even computation.
Fixed costs
Break-even point in units =
Contribution margin per unit
Unit sales price less unit variable cost
($30 in previous example)
REMEMBER
COMPUTING THE BREAK-EVEN POINT
The break-even formula may also be
expressed in sales dollars.
Break-even point in dollars =
Fixed costs
Contribution margin ratio
Unit contribution margin
Unit sales price
SU 8 - CVP Analysis – Basic Calculations
• CVP Applications
– Target Operating Income
– Multiple products
– Choice of products
• Degree of Operating Leverage (DOL)
SU 8 - CVP Analysis – Target Income Calculations
• Target Operating Income
Fixed costs + Target operating income
UCM
• Target Net Income
Fixed costs + Target net income / (1.0 – tax rate)
UCM
• Problem 15, 16 and 18 on page 333
Computing a Multiproduct
Break-Even Point
The CVP formulas can be modified for use
when a company sells more than one product.
– The unit contribution margin is replaced with the
contribution margin for a composite unit.
– A composite unit is composed of specific numbers
of each product in proportion to the product sales
mix.
– Sales mix is the ratio of the volumes of the various
products.
SU 8 - CVP Analysis – Multiproduct Calculations
• Multiple Products (or Services)
S = FC + VC = Calculated Weighted Average Contribution Margin
See example page 318
SU 8 -CVP Analysis – Choice of Product
Calculations
• Choice of Product decisions – When resources are
limited companies have to choose which products to
produce
• A breakeven analysis of the point where the same
operating income or loss will result
See example page 318
SU 8 -CVP Analysis – Special Order
Calculations
• Special Orders (usually lower price than std.)
– The assumption are that idle capacity is sufficient
to manufacture extra units of a special order.
SU 8 - Marginal Analysis
•
Accounting Costs vs. Economic Costs
– Accounting Costs = The total amount of money or goods expended in an endeavor. It is money
paid out at some time in the past and recorded in journal entries and ledgers.
•
Economic Costs = The economic cost of a decision depends on both the cost of the
alternative chosen and the benefit that the best alternative would have provided if
chosen. Economic cost differs from accounting cost because it includes
opportunity cost.
As an example, consider the economic cost of attending college. The accounting cost of attending college
includes tuition, room and board, books, food, and other incidental expenditures while there. The
opportunity cost of college also includes the salary or wage that otherwise could be earning during the
period. So for the two to four years an individual spends in school, the opportunity cost includes the money
that one could have been making at the best possible job. The economic cost of college is the accounting
cost plus the opportunity cost.
Thus, if attending college has a direct cost of $20,000 dollars a year for four years, and the lost wages from
not working during that period equals $25,000 dollars a year, then the total economic cost of going to
college would be $180,000 dollars ($20,000 x 4 years + the interest of $20,000 for 4 years + $25,000 x 4
years).
SU 8 - Marginal Analysis
• Explicit vs. Implicit Costs
– Implicit Costs = implicit cost, also called an
imputed cost, implied cost, or notional cost, is
the opportunity cost equal to what a firm must
give up in order to use factors which it neither
purchases nor hires.
– Explicit Costs = An explicit cost is a direct payment
made to others in the course of running a
business, such as wage, rent and materials.
SU 8 - Marginal Analysis
• Accounting vs. Economic Profit
– See Utorial at http://www.khanacademy.org/economics-finance-domain/microeconomics/firmeconomic-profit/economic-profit-tutorial/v/economic-profit-vs-accounting-profit
• Accounting Profit = book income exceeds book
expenses
• Economic Profit = includes Accounting Profit +
Implicit costs
SU 8 - Marginal Analysis
• Marginal Revenue and Marginal Cost
– Marginal Revenue is the additional or incremental revenue
of one additional unit of output. See page 321
• See that Marginal Revenue is $540 between generating 4 vs. 5
units of output.
– Marginal Cost is the additional or incremental cost
incurred of one additional unit of output.
• Note that while cost decrease over some range they will at some
point begin to increase due to the process becoming lest efficient.
• Profit Maximization is where MR = MC (see page 322)
SU 8 - Marginal Analysis
• Short-Run Cost Relationship – See graph on page 323
• Other considerations/applications of CVP
– Make-or-Buy
– Capacity Constraints and Product Mix
– Disinvestments
– Sell-or-Process further
SU 8 - Short-run Profit Maximization
• Pure Competition - A market structure in which a very large
number of firms sell a standardized product into which entry
is very easy in which the individual seller has no control over
the product price and in which there is no nonprice
competition; a market characterized by a very large number
of buyers and sellers. Examples: Agricultural products
• Monopoly - A market structure in which one firm sells a
unique product into which entry is blocked in which the single
firm has considerable control over product price and in which
non-price competition may or may not be found. Examples:
Public utilities
SU 8 - Short-run Profit Maximization
• Monopolistic Competition - A market structure in which many
firms sell a differentiated product into which entry is relatively
easy in which the firm has some control over its product price
and in which there is considerable non-price competition.
Examples are grocery stores and gas stations
• Oligopoly - A market structure in which a few firms sell either
a standardized or differentiated product into which entry is
difficult in which the firm has limited control over product
price because of mutual interdependence (except when there
is collusion among firms) and in which there is typically nonprice competition.
SU 8 - Short-run Profit Maximization
•
•
•
Law of Demand - Law of demand states that ' all other things remaining unchanged,
people demand (buy) more of any good / service if the price of that good / service falls
and demand (buy) less if the price increases.
Elasticity of demand measures how responsive a products demand is to changes in its
price level.
– When we have inelastic demand, a consumer will pay almost any price for the
good.
– Generally goods which have elastic demand tend to have many substitutes
Price elasticity of demand is calculated as the percentage change in quantity demanded
divided by the percentage change in price.
Elasticity > 1 : elastic (% change in demand is greater than % change in price e.g. luxury
goods such as cars etc.)
Elasticity < 1 : inelastic (% change in demand is less than % change in price e.g.
essential goods such as food)
Elasticity = 1 : unitary elastic (% change in demand is equal to the % change in price)
SU 9 - Decision Making: Applying Marginal
Analysis
• Relevant = be made in the future (not SUNK costs)
• Committed costs are not part of the decision making
process
• Relevant = differ among the possible alternative courses of
action
• Relevant = avoidable costs (controllable = subject to
Management decision / strategy)
• Relevant = incremental (marginal or differential) 
Relevant Range = incremental cost of an additional unit of
output is the same. Outside range incremental cost
change.
• Be careful using UNIT revenue and cost
 Emphasis to be on TOTAL relevant revenues and costs
SU 9 - Decision Making: Applying Marginal
Analysis
• Marginal / Differential / Incremental Analysis
– Problem in CMA will be an evaluation of choices
among courses of action
– What are the relevant and irrelevant costs?
– Quantitative analysis = ways in which revenues
and costs vary with the option chosen.
– Focus on incremental rev & costs, not total rev &
cost
– Example page 266  idle capacity (incremental
impact)
– Compare Marginal revenue / Marginal Cost
(contribution Margin) – Fixed costs have already
been “absorbed”
SU 9 - Decision Making: Applying
Marginal Analysis
– Qualitative Factors to consider:
- Pricing rules
- Government Regulation
- Cannibalization between products (stealing MS from
yourself)
- Outsourcing
- Employee Morale
SU 9 - Decision Making: Applying
Marginal Analysis
• Add-or-drop-a-segment decisions
– Disinvestment / capital budgeting decisions
– Marginal cost > Marginal revenue = Firm should disinvest
• 4 Steps to be taken:
1/ Identify fixed costs that will be eliminated if disinvesting
2/ Determine the revenue needed to justify continuing operations
3/ Establish the opportunity cost of funds that will be received
4/ Determine whether the carrying amount of the asset = economic
value. If not revalue use market fair value and not carrying amount
Cost of idle capacity is relevant cost.
• Special Orders when excess capacity
– No opportunity costs
– Accept order = Variable costs (Contribution Margin)
SU 9 - Decision Making – Special
Orders
• Special Orders when excess capacity exists
– Differential (marginal or incremental) cost must be
considered.
• Page 268
• Special Orders when no excess capacity exists
– Differential (marginal or incremental) cost must be
considered.
• Page 268
SU 9 - Decision Making – Make or Buy
• Make or Buy = insourcing or outsourcing (critical mass)
– Not enough capacity – Outsource least efficient product
– Support services can be outsourced.
• Consider relevant costs to the investment decision
– Key variable is total relevant costs, not all total costs.
– Sunk cost & Costs that do not change between choices are irrelevant.
– Opportunity costs are considered when at full capacity.
• Capacity constraint – Use marginal analysis – maximize CM
– Product Mix
• Sell-or-Process Further Decisions – sell at split off point or process
– Joint cost of product is irrelevant.
– Based on relationship between incremental cost and revenue
SU 9 - Price Elasticity of Demand
• Demand increases when Price goes down (in theory)
• Price of product and Quantity demanded are inversely related
• Price Elasticity of Demand = sensitivity
% change in Q / % change in P
• Most accurate way to calculate elasticity = ARC method
% Δ Q / % Δ P = [(Q1 – Q2) / (Q1+Q2) ] / [(P1 – P2) / (P1+P2)]
Example page 297 # 19
• Demand elasticity > 1 = elastic (small change in price = large
change in quantity)
• Elasticity = 1 (unitary elastic)
• Elasticity < 1 = perfectly inelastic (large change in price = small
change in quantity)
• Infinite = perfectly elastic (horizontal line) – Firm has no
influence on market price (pure competition)
• Equal to zero = perfectly inelastic (vertical line) – Consumer
will pay
SU 9 - Pricing Theory
• Pricing Objectives: profit maximization / target
margin / forecasted volume / image (segmentation –
positioning) / stabilization
• Price-setting factors
– Supply & Demand = Economic (external factors)
•
•
•
•
Type of market
Customer perceptions
Elasticity
Competition
– Internal Factors
•
•
•
•
Marketing & Mix
Relevant cost
Strategy
Capacity
SU 9 - Pricing Theory
• External Factors
– Type of market (pure competition, monopolistic,
oligopolistic or monopoly)
– Customer perceptions of price and value
– Price / demand relationship
– Competitors’ products, costs, prices and amount
supplied.
• Timing of demand
• Cartels = illegal practice except in international
markets
• Cartel = collusive oligopoly – restrict output, charge
higher $$
SU 9 - Pricing Theory
•
Cost-based pricing differs from Target pricing (page 358)
– 4 basic formulas
– Target pricing
– Life cycle costing
•
•
•
•
•
Market-based pricing – What consumer will pay
Competition-based pricing – Going rate & Sealed bids
New product pricing – Skimming & Penetration pricing
Pricing by intermediaries – Markups & downs
Price adjustments
–
–
–
–
–
–
–
Geographical pricing
Discounts & Allowances
Discriminatory pricing
Psychological pricing
Promotional pricing
Value Pricing
International pricing
SU 9 - Pricing Theory
• Product-mix pricing
–
–
–
–
–
Product line
Optional product
Captive product
By-product
Product bundle
• Illegal pricing
–
–
–
–
Pricing products below cost
Price discrimination among customers
Collusive pricing
Dumping
SU 9 - Pricing Theory
• Exercise page 300, questions 25 to 26
SU 9 - Risk Management
• 4 Types of Risk:
–
–
–
–
•
•
•
•
Hazard risks – insurable
Financial risks – interest rates
Operational risks – procedural failure
Strategic risks – global, political and regulatory
Volatility and Time
Capital adequacy = solvency (cash flows) / liquidity (reserves)
Risk = severity of consequences + likelihood of occurrence
5 strategies for Risk response:
–
–
–
–
–
Risk avoidance – End the activity that establishes the risk
Risk retention – Acceptance of risk. Self insurance
Risk reduction - Mitigation
Risk sharing – Moving risk to 3rd party – Insurance, hedging, JV
Risk exploitation – Deliberately entering to pursue high return.
SU 9 - Risk Management
• Residual risk – The risk that remains after the effects of
avoidance, sharing, or mitigation efforts.
• Inherent risk – The risk that arises for the activity itself.
• Benefits:
- Efficient use of resources
- Fewer surprises
- Reassuring investors
• 5 Key Steps in Risk Management Process
1/ Identify risks
2/ Assess risks
3/ Prioritize risks
4/ Formulate risk responses
5/ Monitor risk responses
• Risk appetite
SU 9 - Risk Management
• Hazard risk management
– Insurance
• Financial risk management
– Hedging
– Sinking funds
– Rigid policies (maturity matching)
• Qualitative risk assessment tools
– Identification
– Ranking
– Mapping
• Quantitative risk assessment tools
– Value at risk (VaR)
– Page 364
SU 9 – Price elasticity and demand
• 9.4 – Understand the difference in effect between an
– Change in Price – Page 271
– Change in Demand – Page 271
– Price Elasticity of Demand
Percentage change in Quantity Demanded
Percentage change in price
– See Price Elasticity of Demand Graph on page 272 and
understand between
• Elastic
• Inelastic
SU 10 – The Capital Budgeting Process
• Definition – Planning and controlling investment for
long-term projects.
– Capital budgeting unlike other considerations will affect
the company for many periods going forward – long-term,
multiple accounting periods, relatively inflexible once
made.
– Predicting the need for future capital assets is one of the
more challenging task, which can be affected by:
•
•
•
•
Inflation
Interest rates
Cash availability
Market demands
– Production capacity is a key driver
SU 10 – The Capital Budgeting Process
• Applications for capital budgeting
–
–
–
–
–
Buying equipment
Building facilities
Acquiring a business
Developing a product of product line
Expanding into new markets
– Important to correctly forecast future changes in demand
in order to have the correct capacity.
– Planning is crucial to anticipate changes in capital markets,
inflation, interest rates and money supply.
SU 10 – The Capital Budgeting Process
• Consider the tax consequences
– All decisions should be done on an after tax basis
• Considered costs in Capital Budgeting
– Avoidable cost – May be eliminated by ceasing or
improving an activity.
– Common cost – Shared by all options and is not clearly
allocable.
– Deferrable cost – May be shifted to the future.
– Fixed cost – Does not very within relevant range.
– Imputed cost – May not have a specific cash outlay in
accounting
– Incremental cost – Difference in cost of two options.
SU 10 – The Capital Budgeting Process
– Opportunity cost – Maximum benefit forgone based
on next alternative, including that of the stockholders
(which also establishes the firms hurdle rate).
– Relevant cost – Vary with action. Constant cost don’t
affect decision.
– Sunk – Cannot be avoided.
– Weighted-average Cost of Capital – Weighted average
of the interest cost of debt (net of tax) and the costs
(implicit or explicit) of the components of equity
capital to be invested in long-term assets. It is also
the “hurdle rate”.
SU 10 – The Capital Budgeting Process
• Stages in Capital Budgeting
– Identification and definition • Id What is the strategy?
• Definition – Define the projects – Revenue, costs, and cash flow
– Most difficult stage
– Search – Each investment to be evaluated be each function of the firms
value chain.
– Information-acquisition – Costs and benefits of the projects are
enumerated.
• Quantitative financial factors have highest priority
• Nonfinancial measures (quantitative and qualitative)
– Selection – Increase shareholder value. NPV, IRR..
– Financing – Debt or equity
– Implementation and monitoring – Feedback and reporting
SU 10 – The Capital Budgeting Process
• Investment Ranking Steps
– Determine Net Investment Costs – Gross cash requirement less cash
recovered from trade or sale of existing assets, adjusted for taxes
– Investment required includes funds to provide for increases in working
capital, i.e. additional receivables and inventories.
– Calculating estimated cash flows –
•
•
•
•
Capture increase in revenue, decrease costs
Net cashflow period by period from investment
Economic life of the investment
Depreciable life
– Comparing cash-flows to Net Investment Costs – Evaluate the benefit.
Continued
SU 10 – The Capital Budgeting Process
– Ranking investments – NPV, IRR, Payback
– Other considerations
• Book Rate of Return –
GAAP NI from Investment
Book Value of Investment
– Also called accrual accounting rate of return
– Don’t use accrual accounting numbers, instead use cash flow
– Reason – Net Income are affected by company’s choices of
accounting methods
– Also, do not compare project book rate to company’s book rate of
return for investments which could be distorted
Continued
SU 10 – The Capital Budgeting Process
• Relevant cash flows
– Net initial investment –
» New equipment cost
» Working capital requirements,
» After tax disposals proceeds
– Annual net cash flows –
» After tax cash collections for operations
» Depreciation tax savings
– Project termination cash flows –
» After tax disposal
» Working capital recovery
See example on page 309
SU 10 – The Capital Budgeting Process
• Other Considerations
– Inflation – Raises hurdle rate.
– Post-audits – Deterrent of bad projects.
» Actual to expected cashflow
» Identify sources of unrealistic estimates
» Avoid premature evaluations of projects
» Non-quantitiative benefits
SU 10 - Discounted Cash flow Analysis
• Time Value of Money
– Concepts – A dollar received in the future is worth less
than today.
– Present Value (PV) – Value today of future payment
– Future Value (FV) – Future value of an investment today.
– Annuities – equal payments at equal intervals
• Ordinary annuity (in arrears)
• Annuity due (in advance) – PV & FV is always greater than ordinary
annuity
See examples on page 311 through 312
SU 10 - Discounted Cash flow Analysis
– Hurdle rate – Goal is for companies discount rate
to be as low as possible.
• WACC or Shareholder’s opportunity cost of capital.
• The lower the firm’s discount rate, the lower the
“hurdle” the company must clear to achieve
profitability
• Net Present Value (NPV) – Project return in $$
See example on 313
SU 10 - Discounted Cash flow Analysis
• Internal Rate of Return (IRR) – Project return
in %
– IRR shortcomings •
•
•
•
Directional changes of cash flows
Mutually exclusive projects
Varying rates of return
Multiple investments
SU 10 - Discounted Cash flow Analysis
• Cash flows and discounting
NPV =
Cash flow0
(1 + r)0
Cash flow1 Cash flow2
(1 + r)1
(1 + r)2
• Comparing Cash flow Patterns – Pg 315
SU 10 - Discounted Cash flow Analysis
• NPV vs IRR comparison
– Reinvestment rate NPV assumes the cash flow can be reinvested at projects
discount rate.
– Independent projects:
• NPV and IRR give same accept/reject decision if projects are independent.
• All acceptable independent projects can be undertaken.
– Mutually exclusive projects.
•
•
•
•
•
•
•
Cost of one greater than other
Timing, amounts, and direction of cash flow are different
Different useful lives
IRR provides 1 rate, NPV can be used with multiple rates.
Multiple investments. NPV is adaptable, IRR is not.
IRR assumes cash flow is reinvested at IRR rate.
NPV assumes reinvestment in the desired rate of return.
– NPV and IRR are most sound decision making tools for wealth maximization.
– NPV profile – Page 317
• Select greatest NPV over greatest IRR
SU 10 - Payback and discounted payback
• Payback period = Number of years to pay for
itself.
– Pro - Simple
– Cons - No consideration for time value of money.
Does not consider cash flow after payback period.
• Payback and constant cash flows vs variable
cash flows
See example on page 318
SU 10 - Payback and discounted payback
• Discounted payback method is used to
overcome the payback methods disregard for
time value of money
– Pro – More conservative yet still simple
– Con – Does not consider cash flow after payback
period.
See example on page 318
SU 10 - Payback and discounted payback
• Other payback methods
– Bailout payback = Considers salvage value
– Payback reciprocal (1 divided by payback)
estimate of IRR
– Breakeven time = Time require for discounted
cash flows to = 0.
• Alternative is to consider the time required for the
present value of the cumulative cash inflows to equal
the present value of all the expected future cash flows
SU 10 - Ranking investment projects
• Why should we rank investment projects
– Capital rationing
• Reasons – include lack of financial resources, control
estimation bias, and unwillingness to issue new equity
(to raise new capital)
SU 10 - Ranking investment projects
• Methods
– Profitability index = NPV / Net Investment
See example on page 320
– Internal capital markets – Internal funding
– Linear programming – Technique for optimizing
resource allocation.
SU 10 - Risk Analysis and real options in Capital
Investments
• Risk analysis – Attempt to measure the variability of future
returns from proposed investment.
– Informal method – NPV is calculated and reviewed.
– Risk-adjusted discount rates – Adjust rate of return upwards as
project becomes more risky.
– Certainty equivalent adjustments- from Utility theory – the
point where you are indifferent to a choice between a certain
sum of money and the expected value of a risky sum.
– Simulation analysis – Computer is used to generate many
results based upon various assumptions.
• Pilot plants
– Sensitivity analysis – An iterative process of recalculated returns
based on changing assumptions.
SU 10 - Risk Analysis and real options in Capital
Investments
• Real (managerial or strategic) options
– Value of a real option – The difference between the
projects NPV with the option vs. without the option.
• Usually more valuable the later it is exercised.
– Types of real options:
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•
•
•
•
•
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Abandonment (Put option)
Follow-up investment
Wait and Learn (call option)
Flexibility option – vary an input
Capacity option – vary an output
New geographical markets
New product option – follow on products