CPA Business Notes - Chapter 5

Chapter 3 Factors Affecting Financial Modeling and Decision Making Financial Manager is required to evaluate the business wisdom of different alternatives - Use of financial models allows manager to predict outcomes for various alternatives using different assumptions for the variables included in the model. Steps needed to reach a decision: 1. Determine the strategic issues
Enhance shareholder/firm value 2. Specify criteria and identify alternative courses of action a. Short-term quantifiable criteria b. Non-quantifiable criteria 3. Perform analysis of relevant costs and strategic costs a. Obtain information b. Make predictions about future costs c. Consider strategic issues 4. Choose an alternative 5. Evaluate performance to provide feedback Relevant data: future revenues and costs are relevant if they change as a result of selecting different alternatives. • Variable or fixed, but usually variable because they change with production volume and output • Direct costs: costs that can be identified with or traced to a given cost object. Variable costs are usually direct costs. • Prime costs: direct material and direct labor. • Discretionary costs: costs arising from periodic budgeting decisions • Incremental/differential costs: additional costs incurred to produce an additional amount of the unit over the present output • Avoidable costs
NOT RELEVANT COSTS
They are sunk/historical costs o Result from choosing one course of action instead of another. o Cost or revenue that will be the same regardless of the decision o Absorption costs
fixed manufacturing overhead (i.e. insurance costs). NOT relevant • Value chain: defines each major activity that adds value to the product or service produced by an organization o Decisions regarding the value chain represent evaluation of the relevant costs at the highest level Qualitative: not numerical. (employee morale and customer satisfaction. Quantitative: may be reduced to numerical measurements - Financial: denominated in currency - Non-financial: time/units produced Probability: chance an event will occur. Between 0 and 1. - Objective probability: based on past outcome
returns on stock market - Subjective probability: based on an individual’s belief
outcome of a lawsuit

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Expected value: used to determine best course of action when there is uncertainty - the weighted average of the probable outcomes - difference between the expected payoff under certainty and the expected monetary value of the best alternative under uncertainty Expected value = (probability of each outcome) x (its payoff) and summing the results Financial Modeling for Capital Decisions Capital budgeting
which project to invest in Cash flows: - Direct effect- a company pays out or receives cash - Indirect effect: transactions either indirectly associated (sale of old) or that represent non-cash activity (depreciation) that produces cash benefits or obligation (tax benefit) - Net effect: Goal
PV cash inflow > cash outflows Stages of cash flows: - Inception of the project: o Time period = 0 o Net cost of new property, plant, and equipment (PPE) `Invoice + Shipping + Installation +/- ∇ working capital** - cash proceeds on sale of old (net of tax) Net cash outflow for new PPE **Additional working capital = increase in payroll, supplies expenses, or inventory requirements **Reduced working capital = just-in-time inventory system is a decrease in current assets Cash-in flows: - Cash flows from operations of asset = annuity - Depreciation tax shields create ongoing indirect cash flow - Disposal of the investment at end of project = direct or indirect cash flow effects Pre-tax cash flows: - Investment value = PV of cash flows that investors receive in future - Cash outflows > cash inflows = UNPROFITABLE After-tax cash flows: - Income taxes are deducted in estimating annual cash flows

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Tax depreciation on new equipment x Marginal tax rate Tax Deduction/cash flow savings + After tax CF on operations Total after-tax CF on operations Excellent example on page B3-13! Accounting rate of return = an evaluation method that uses GAAP income rather than cash flows Discounted cash flow (DCF): capital budgeting technique that uses time value of money. - Best method to use for long-run decisions - Steps: o Initial investment (cash outflow) o Future cash inflows and outflows o Rate of return desired for the project
Hurdle rate Rate of return: ◊ hurdle rate ◊ Weighted-average cost of capital (WACC) method ◊ Discount rate be related to the risk specific to the proposed project DCF Limitation: ◊ It only uses a single growth rate, which is unrealistic as interest rates change over time

Calculate after tax cash flows = Annual net cash flow x (1 – tax rate) + Add depreciation benefit = Depreciation x tax rate x Multiply result by appropriate present value of an annuity Subtract initial cash outflow Net present value

Payback period: time period that is required for the net after-tax cash inflows to recover the initial investment. - Liquidity: measures the time it will take to recover the initial investment - Risk: sooner I recover my investment, the better - Net cash inflows are assumed to be constant for each period during the life of the project - Depreciation tax shield
add to after-tax CFO

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Net initial investment  Increase in annual net after-tax cash flow

= Payback period 

Depreciation tax shield = (Depreciation expense) x (Marginal tax rate) Advantages of payback: - Easy to use and understand - Emphasis on liquidity Limitations of payback: - Time vale of money is ignored - Project cash flows occurring after the initial investment is recovered are not considered - Reinvestment of cash flows is not considered - Total project profitability is neglected Review example page B3-19. Discounted Payback Method: - Computes payback period using expected cash flows that are discounted by the project’s cost of capital - To evaluate how quickly new ideas are converted into profitable ideas - Focus on liquidity and profit - Advantages and disadvantages are the same as payback method except that discounted payback method takes into effect the time value of money Net present value method (NPV) Calculate after tax cash flows = Annual net cash flow x (1 – tax rate) + Add depreciation benefit = Depreciation x tax rate x Multiply result by appropriate present value of an annuity Subtract initial cash outflow Net present value . -

Purchase (or invest) in a capital asset that will yield returns in an amount in excess of a management designated hurdle rate Estimate the cash flows: o Ignore depreciation except to the extent it reduces tax payments o Ignore method of funding: NPV uses a hurdle rate to discount cash flows Discount all cash flows (in and out) using appropriate discount factor (hurdle rate) NPV method assumes that the cash flows are reinvested at the same rate used in the analysis Hurdle rate: desired rate of return set by management Result ≥ zero
Make investment o If result > zero
rate of return is greater than hurdle rate o If result = zero
rate of return is equal to hurdle rate Result < zero
do not make investment o Rate of return for the project is less than the hurdle rate

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NPV incorporates many types of hurdle rates (i.e. cost of capital, discount rate of opportunity cost, etc.) o Discount rates may be increased to further factor differences in risk o Inflation (affects cash inflows)
increases expected rate o Different rates may be used for different time periods Advantage of NPV: flexible and can be used when there is no constant rate of return Limitation of NPV: even though NPV is considered the best single technique, it is limited by not providing the true rate of return on the investment Example on page B3-24, B3-25

Internal Rate of Return (IRR): - Expected rate of return of a project and is sometimes called time-adjusted rate of return - Determines the present value factor that yields an NPV equal to zero - How to compute? o Determine the life of the project or asset o Calculate the payback period (present value factor) Net incremental investment = Payback period (present value factor) Net annual cash flows

-

o Find proper present value table to use o Locate present value interest factor o Find approximate IRR IRR > Hurdle rate
Accept IRR ≤Hurdle rate
Reject Limitations: o Unreasonable reinvestment
assumes that cash is to be reinvested at the same rate  (NPV assumes reinvestment at the hurdle rate = more conservative) o Inflexible cash flow assumption
IRR less reliable than NVP when there are several alternating periods of net cash inflows and net cash outflows

Capital rationing: - Ultimately the decision to invest or not is limited by the amount of capital available to fund the investment - If unlimited capital = all investments with a positive NPV should be accepted - If limited capital
choose from two best choices o Managers will allocate capital to the combination of projects with the maximum NPV  Rank project and accept Profitability Index: - The higher the better. Present value of net future cash inflows = Profitability index Present value of net initial investment

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Strategies for short-term and long-term financing How should we raise the capital? Selection of long-term and short-term capitalization for a company’s permanent financing is decided within a context that considers the nature of a specific business, its industry, and the market. Trade-offs between risk and return
Borrowing money vs. adding partners Risk = uncertainty Risk-indifferent behavior: increase in risk does NOT increase the higher rate of return
NOT typical - Certainty equivalent = expected value Risk-averse behavior: increase in risk, increase in required return
Typical - Certainty equivalent < expected value Risk-seeking behavior: increase in risk, decreases managements required rate of return
NOT typical - Certainty equivalent > expected value Diversification Diversifiable risk: non-market, unsystematic or firm-specific risk - Strikes, lawsuits, regulatory actions, or the loss of a key account Non-diversifiable risk: market or systematic risk - War, inflation, international incidents, and political events The only relevant risk is
Non-diversifiable D – Diversifiable risk U – Unsystematic risk (non-market, firm specific) N – Non-diversifiable risk S – Systematic risk (market) Risks that impact investor’s required return: 1) Interest rate risk: exposure of the owner of the instrument to fluctuations in the value of the instrument in response to changes in interest rates 2) Market risk: exposure of a security or firm to fluctuations in value as a result of operating within an economy is referred to as market risk 3) Credit risk: exposure to credit risk includes a company’s inability to secure financing or secure unfavorable credit terms as a result of poor credit ratings 4) Default risk: organization is exposed to default risk to the extent that it is possible that its debtors may not repay the principal or interest due on their indebtedness As any risk factor goes , so does required return thus:  Present value asset = CF r

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CF = future cash flow r = required rate of return

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Stated interest rate: rate charged before any adjustment for compounding or market factors - Rate shown on the agreement Effective interest rate: the actual finance charge associated with a borrowing after reducing loan proceeds for charges and fees - Discounted notes
interest collected in advance - Effective interest rate = Amount of interest paid Net proceeds received Annual percentage rate: the rate required for disclosure by federal regulations - Computed as the effective periodic interest rate times the number of periods in a year - Annual percentage rate = effective periodic interest x number of periods in a year Simple interest (amount): interest paid only on the original amount of principal - SI = P0(i)(n) Compounded interest (amount): interest earnings or expense that is based upon the original principal plus any unpaid interest - FVn = P0 (1+i)n Operational and Financial Leverage Leverage: amplifies risk and potential return Aggressive
borrow, not add partners
want to use leverage Conservative
add partners
do NOT want to use leverage 1. Fixed – salaries – risk and potential return  2. Variable – commissions – risk and potential return  Degree to which a firm uses fixed operating costs

Operating leverage: -

Degree of operating leverage (DOL) = -

A higher degree of operating leverage implies that a relatively small change in sales (increase or decrease) will have greater effect on profits and shareholder value – EPS The higher a firm’s degree of operating leverage, the greater is profitability (but also the greater its risk)

Financial leverage: -

Percentage change in EBIT Percentage change in sales

1. Fixed – borrow money – risk and return  2. Variable – add partners/stockholders – risk and return 

Degree to which a firm uses fixed financial costs Degree of financial leverage (DFL) =

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Percentage change in EPS Percentage change in EBIT Page 7 of 18

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A higher degree of financial leverage implies that a relatively small change in earnings before interest and taxes will have greater effect on profits and shareholder value The higher a firm’s degree of financial leverage, the greater its profitability (but also the greater its risk)

Combined (total) leverage: use of fixed cost resources and fixed cost financing to magnify returns to the firm’s owners. Degree of combined leverage (DCL) =

Percentage change in EPS Percentage change in sales

DOL x DFL = DCL DOL % change in EBIT % change in sales

DFL % change in EPS % change in EBIT

DCL % change in EPS % change in sales

Weighted average cost of capital and optimal capital structure Firm value = CF1 . WACC  The lower the WACC, the higher the firm value or net worth. Long-term elements: long-term debt, preferred stock, common stock, and retained earnings Short-term elements: short-term interest-bearing debt After-tax cash flows: cost of capital must be developed on an after-tax basis for debt Management must invest capital in projects that will get a return greater than WACC (hurdle rate).

WACC =

Cost of equity multiplied by the percentage equity in capital structure

+

Weighted average cost of debt (aftertax) multiplied by the percentage debt in capital structure

When the percentage of the debt increases, the WACC decreases. Optimal capital structure = Lowest WACC Marginal cost of capital: WACC changes mathematically as the components of capital structure change. Appropriate application of WACC as a hurdle rate for capital projects involves use of the weighted average cost of each additional new dollar of capital raised at the margin as that capital need arises.

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Target capital structure: how much debt vs. equity? PV of an annuity , the discount rate  PV , WACC Cost of Capital Components Cost of long-term debt: kdx - The relevant cost of long-term debt, kdx, is the after-tax cost of raising long-term funds through borrowing. - Pre-tax cost of debt, kdt = market rate/YTM - The pre-tax cost of the bonds is exactly equal to the coupon rate of interest on the bonds only if the net proceeds from the sale of bonds equal the par value. - After-tax cost of debt: kdx. o Interest on debt is tax deductible Kdx = kdt x (1-tax rate) -

The lower the cost of capital, the higher the return Debt carries the lowest cost of capital and is tax deductible The higher the tax rate, the more incentive exists to use debt financing

Cost of preferred stock: kps - Net proceeds are preferred stocks (Nps): represent gross proceeds yielded from the market, net of flotation costs - Preferred stock cash dividends (Dps): the finance charge to the company for raising capital with preferred stock. Kps = Dps/Nps

Cost of retained earnings: kre - A firm should earn at least as much on any earnings retained and reinvested in the business as stockholders could have earned on alternative investments of equivalent risk - 3 common methods of computing kre: o Capital Asset Pricing Model (CAPM) o Discounted cash flow (DCF) o Bond Yield plus Risk Premium (BYRP) - Residual earnings to common stockholders: either paid in dividends or reinvested - CAPM: o Cost of retained earnings is equal to the risk-free rate plus a risk premium o Risk-free rate, krf o The risk premium: the stock’s beta coefficient (bi) times the market risk premium (PMR) o Market risk premium (PMR): the market rate (km) minus the risk-free rate (krf) B = 1 = as risky as market B > 1 = more risky B < 1 = less risky

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Kre = krf + [bi x (km – krf)] Short-term Financing: o Current and will mature within one year o Anticipate higher levels of temporary working capital that require greater agility and flexibility o Advantages: • Increased liquidity
short-term financing presumes higher turnover • Increased profitability • Decreased financing cost
Rates tend to be lower than long-term rates o Disadvantages: • Increased interest rate risk
you did not lock in a rate long-term • Increased credit risk Long-term Financing: o Non-current and will mater after one year o Anticipate higher levels of permanent working capital o Advantages: • Decreased interest rate risk
locked in interest rate for long period • Decreased credit risk o Disadvantages: • Decreased profitability • Decreased liquidity • Increased financing costs
rates then to be higher than long-term rates Debentures
unsecured
general creditor Income bonds – used in reorganizations Junk bonds – used to raise capital or acquisitions and leveraged buyouts Return on investment/return on total assets formula - Cash flow ignored ROI = Income ÷ Investment capital* OR ROI = Profit margin (or return on sale) x Investment turnover OR ROI = Total sales x Net income Investment Total sales *Investment capital = average assets = average PPE + average working capital  ROA = Net income Assets 

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Net book value = GAAP = affected by age & method of depreciation - Historical cost less accumulated depreciation Gross book value = ignores method of depreciation, but is still effected by age Replacement cost = ignores both age and method of depreciation Liquidation value = the selling price of productive assets Other asset valuation issues: 1. Capitalization policy 2. Treatment of unproductive assets 3. Treatment of intangible assets Limitations on ROI: - Short-term focus: focus managers purely on maximizing short-term returns - Disincentive to invest: profitable units are reluctant to invest in additional productive resources because their short-term result will be to reduce ROI - Thus residual income should be used instead The residual income method: - Measures the excess of actual income earned by an investment over the required (target or hurdle) return rate - ROI provides percentage measurement. Residual income provides an amount. Net book value
Equity x Hurdle rate
x CAPM Required Return Net income (from income statement) – Required return = Residual income Advantages of Residual income method: - Realistic target rates - Focus on target return and mount: performance measures encourage managers to invest in projects that generate income in excess of the hurdle rate, thereby improving company profits and promoting the congruence of individual and corporate goals. Disadvantages of residual income method: - Reduced comparability - Target rates require judgment
hurdle rate may be subjective Return on total assets: - Debt to total capital ratio o Lower the ratio, the greater the level of solvency and the greater the presumed ability to pay debts o Less risk/leverage but lower expected return

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 Debt-to-total capital ratio = Total debt  Total capital (=debt + equity) Debt to asset ratio  Debt (to asset) ratio = Total debt  Total assets The lower the ratio, the better protection afforded to creditors

o

Debt to equity ratio: - The lower the ratio, the lower the risk involved  Debt to equity ratio = Total debt  Total shareholders’ equity

Financial Statement and Business Implications of Liquid Asset Management Working Capital = Current assets – Current liabilities High WC, less risk (because plenty of cash)
Lower return Current Ratio = Current assets / Current liabilities High current ratio = more assets than liabilities = less risk, conservative Low current ratio = more liabilities than assets = more risk, aggressive Aggressive working capital management: Increase the ratio of current liabilities to non-current liabilities (more current assets financed with current liabilities) Conservative working capital management: Increase the ratio of current assets to non-current assets (more current assets financed by noncurrent liabilities) Quick (Acid Test) Ratio = (Cash + Marketable securities + Receivables) / Current liabilities **Inventory and prepaids are NOT included
more rigorous test of liquidity than current ratio The higher quick ratio, the better. Working capital

= Risk

= Expected Return

Reasons for holding cash: 1. Transaction motive
having enough cash to meet payments arising from the ordinary course of business. 2. Speculative motive
having enough cash to take advantage of temporary opportunities. 3. Precautionary motive
having enough cash to maintain a safety cushion so that unexpected needs may be met. Treasurer’s concern. Liquidity = safety = lower risk

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Disadvantages of holding cash: 1. Lower returns. 2. “negative arbitrage” = interest obligations > interest income 3. Increased attractiveness as a takeover target 4. Investors dissatisfied with asset allocations Primary methods of increasing cash levels (reducing the operating cycle): - Speeding up cash inflows or slowing down cash outflows! - Methods to speed up collection: o Customer screening and credit policy o Prompt billing o Payment discounts
Formula:  360 x Discount Pay Period – Discount Period 100-Discount % Cash inflows => Expedited deposit methods: EFT, Lockbox, Concentration banking, Factoring A/R Lockbox = worth it if additional interest income earned from deposit > bank fee Concentration banking = designation of a single bank Factoring A/R = selling A/R to third party
Benefits > Costs? Cash outflows => Delay disbursements: Defer payments, Drafts, line of credit, zero balance accounts Drafts = pay with check, not cash ZBA = linked to a parent account to fund any negative balances. Slows the banking payout Other cash management techniques: - Elements of float = more cash in bank earning interest longer o Positive float = wrote the check out and it’s not cashed yet o Negative float = received the check, recorded it in books, but bank has not received cash Cash conversion cycle: The shorter, the better! - Called “net operating cycle” = length of time between the date of cash expenditure for production and date of cash collection from customers (cash to cash)

Cash Conversion Cycle

Cash Conversion Cycle

(LOW) Inventory Conversion Period

=

=

Average inventory Average COGS per day

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(LOW) Receivables Collection Period

Average receivables Average sales per day

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(HIGH-DELAY) Payables Deferral Period

Average payables Average purchases per day

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Trade credit: a. Open accounts (A/P) b. Accrued expenses (short term financing) c. Notes payable d. Trade acceptances Commercial paper: - Short-term, unsecured financing - Medium-sized companies sell through dealers - Large companies sell directly to investors Common marketable securities: - United States Treasury bills (“T-Bills”)
Risk free rate (CAPM) - Certificates of Deposits (CDs) - Banker’s acceptances
short-term IOUs - Commercial paper
short-term lending of idle cash between corporations - Equity securities of public companies
High risk, high return - Eurodollars - Hedge transactions Influencing factor for the level of marketable security = Liquidity and Credit Hedge Strategies for holding marketable securities - Low rates and time required to liquidate securities = cash is preferred - High rates and minimum time required to liquidate securities = security is preferred Types of Financial Risk: - Maturity Risk Premium (MRP)
compensation for bearing risk - Purchasing power risk or Inflation premium (IP)
compensation to bear the risk that price levels/values will change - Liquidity risk premium (LP)
compensation by lenders for the risk that an asset will be sold on short notice at deep discount - Default risk premium
compensation by lenders for bearing the risk that issuer of security will fail to pay interest or principle Calculation of required rate of return: Real rate of return + Inflation premium (IP) = Risk-free rate + Risk premiums: Interest rate risk (MRP) Liquidity risk (LP) Default risk (DRP) = Required rate of return Factoring = Selling A/R to a factor is a mechanism for speeding up cash collections. SEE EXAMPLE ON PAGE B3-70

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Average collection period = A/R balance / Avg. Daily sales Number of days receivables outstanding = Avg. Or Ending A/R / Avg. Daily sales Credit Policy = major determinants of demand for a firm’s products or services, price, product quality... Credit period = length of time buyers are given to pay for their purchases. Management of accounts payable
“Defer” Trade credit = LARGEST course of short-term credit Discounts = incentive to pay quickly Compute the weighted annual interest rate with trade discounts: SEE EXAMPLE ON PAGE B3-72 1. Annualized increment for the discount: Days per year / Days outstanding after discount 2. Compute the effective interest rate with discount 3. Multiply the annualized increment by the rate 4. Weight according to discounts associated with other similar debt Management of inventory
Goal: high turnover Factors influencing inventory levels: 1. Inventory management = accuracy of sales forecasts. a. Lack of inventory = lost sales b. Extra inventory = carrying costs (storage, insurance, opportunity costs, obsolescence) Optimal levels of inventory: Safety stock, Inventory turnover, Economic order quantity, Materials requirements planning Safety Stock - It is a cushion! - Safety stock + Lead time in days or weeks x # units sell per day/week = Reorder point Stockout costs = loss of income from product unavailability + restore goodwill + additional expenses Inventory Turnover = COGS / Avg. Inventory balance Increased inventory turnover = less inventory Decreased inventory x APR = cost savings Economic Order Quantity (EOQ): minimize ordering and carrying costs. Carrying costs include: storage, obsolescence, materials, insurance, interest Does not consider stockout costs or safety stock. EOQ Formula: Order size = Square root of: ((2 * Annual Sales * Cost per purchase order)/(Carrying cost per unit)) Just-in-time inventory: reduce lag time between inventory arrival and inventory use.

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Kanban inventory: gives visual signals that a component required in production must be replenished Loan rates and loan covenants
types of institutional short-term credit - External factors influencing the short-term rate (i.e. prime rate) - Internal factors: current ratio, high working capital - Any asset can be used as security - Higher the risk to lender = higher interest rate on loan - Greater security = lower rates Appendix I Accounting rate of return = Increase in expected average annual net income Net initial investment OR “average” investment ARR and IRR = calculate rate of return percentage ARR = uses operating income after accruals and includes depreciation IRR = cash flows and time value of money Appendix II 3 methods of computing kre: 1. Capital asset pricing model (CAPM) 2. Discounted cash flow (DCF) 3. Bond yield plus risk premium (BYRP) CAPM Assumes: Cost of retained earnings = risk-free rate + risk premium Risk premium = risks associated with the entire market risk Risk premium
product of systematic (non-diversifiable) risk Formula: Kre= risk-free rate + risk premium Kre = krf + (bi x PMR) Kre = krf + (bi x (km – krf) DCF Assumes: - Stocks = risk and return - Estimated expected rate of return = estimated required rate of return - Expected growth rate based on past growth rates, retention growth model, forecasts Formula: Kre = (D1/P0) + g

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BYRP Assumes: - Equity and debt security values are comparable before taxes - Risks are associated with the firm and the economy. Risk premiums
non-diversifiable risk - Risk estimation derived by subtracting yield on an average corporate long-term bond from market rate Formula: Kre = kdt + PMR Appendix III Security market line (SML)
affected by inflationary expectations and risk aversion. Inflationary changes
effect the risk-free rate of return (RF)
SML parallel shift upwards Risk aversion
increases: stock market crash, uncertainty
steeper SML = higher risk, higher return Appendix IV Large amounts of $$$ + Time + Judgment = RISK
adjust interest rates for risk WACC = Company cost of capital When risk is average, company can use WACC as the hurdle rate. When risk is high/low, company can adjust the WACC to come up with the hurdle rate. Beta: -

define the relative level of risk in a project. Can change over time

Changes in the capital structure (i.e. debt and equity ratios) = affects the beta = effects the interest rates Consider effect of taxes on WACC. Use after-tax WACC for analysis. Leverage affects beta. Higher fixed costs = higher beta. Interest rate may be adjusted for timing cash flows if the beta is not expected to be constant over time. High risk = high discount rate = low net present value

Strategies (not objectives) for creating an optimal capital structure to maximize net worth include: 1. 2. 3. 4.

Maximizing earnings per share Minimizing the cost of debt Minimizing the cost of equity Maximizing cash flow

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The objective for the optimal capital structure: -

The financial structure that would theoretically maximize shareholder wealth by maximizing the net worth of the company.

Trade credit generally provides the largest source of short-term credit for small firms. Trade credit is subject to risk of buyer default. Accounts payable provide a spontaneous source of financing for a firm.

The imputed interest rate used in the residual income approach can best be described as the target return on investment set by the company's management.

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