Operational leverage

- the degree to which a firm uses fixed operating costs, as opposed to variable operating costs.
- A firm that has HIGH operating leverage has HIGH fixed operating costs and relatively LOW variable operating costs.
- A firm that has LOW operating leverage has LOW fixed operating costs and HIGH variable operating costs

High operating leverage

must produce sufficient sales revenue to cover its high fixed costs, but when they are covered, additional revenue goes straight to operating income

Low operating leverage

new sales dollars can only be achieved with additional variable costs

Operational Leverage computation

Degree of operating leverage = % change in Earnings Before Interest & Tax / % change in Sales

Financial leverage

- The degree to which a firm’s use of debt to finance the firm magnifies the effects of a given % change in earnings before interest and taxes (EBIT) on the percentage change in its earnings per share (EPS)
- When making financing decisions, a firm can choose to issue debt or equity.

- When debt is issued, the firm must pay fixed interest costs.

- When equity is issued, it does not result in increase in fixed cost, because dividend payments are not required.

Debt issuance

a company that issues debt must produce sufficient operating income (EBIT) to cover its fixed interest costs. When they are covered, additional EBIT goes to to net income

Financial leverage computation

Degree of financial leverage = % change in Earnings per share / % change in EBIT

Applying financial leverage to risk/return decision

- Firms with HIGHER % of fixed financial costs will have a HIGHER degree of financial leverage.
- Small change in earnings before interest and taxes will have a greater effect on profits and shareholders value.
- Higher = more profitability and risk

Combined leverage

results from the use of fixed operating costs and fixed financing costs to magnify returns to the firm’s owners

Combined leverage computation

degree of combined leverage = % change in EPS / % change in sales= DOL x DFL

Combined leverage - implications

HIGH DCL = a greater portion of sales goes to the bottom line

Applying combined leverage to Risk/Return decisions

Firms with a higher % of fixed operating leverage in addition to fixed financing costs will have a higher degree of combined leverage.

The weighted average cost of capital and optimal capital structure

seves as a major link between the long term investment decisions associated with a corporation’s capital structure and the wealth of a corporation’s owners.

Capital structure and firm value

the value of a firm can be computed as the present value of the cash flow it produces, discounted by the costs of capital used to finance it. The lower the overall cost of capital, the higher value of the firm.

Computing the weighted average cost of capital

the average cost of debt and equity financing associated wit ha firm’s existing assets and operations.

WACC = (Cost of equity x % equity in capital structure) / (Weighted average cost of debt x % debt in capital structure)

Weighted average cost of debt

debt costs are stated as the interest rate of the various debt instruments.

Weighted average interest rate = (Effective annual interest payments/Debt cash available)

Individual capital components

- Long term elements - long term debt, preferred stock, common stock, retained earnings
- Short term elements - short term interest bearing debt, current liabilities
- After tax cash flows - the most relevant

Optimal capital structure

the lowest WACC

The optimal cost of capital

the ratio of debt to equity that produces the lowest WAAC

Application of capital budgeting

the historic WACC may be not appropriate for all projects unless it has the same risks

Cost of capital components

- cost of borrowing - interest rates on debt

2. cost of equity - return required by investors in exchange for assumed risk

Cost of long term debt kdx

after tax cost of raising long term funds by borrowing

Pre tax cost of debt kdt

cost of debt before considering the tax shielding effects of the debt

after tax cost of debt kdx

interest on debt is deductible

avoided taxes reduce the cost of debt

Pre tax cost of debt x (1-Tax rate)

or kdt x (1-Tax rate)

Cost of preferred stock kps

after tax considerations are irrelevant with equity securities because dividends are not tax deductible. Preferred stock cash dividends represent payments to preferred stockholders.

Net proceeds of preferred stocks nps

the net proceeds from a preferred stock issuance can be calculated as the gross proceeds net of flotation costs

Preferred stock cash dividends dps

the finance charge to the company for raising capital with preferred stock.

Preferred stock dividends can be stated as a dollar amount or a percentage.

Formula kps

kps = dps / nps

Cost of retained earnings - kre

the cost of equity capital obtained through retained earnings, kre, is equal to the rate of return required by the firm’s common stockholders.

Common methods of computing kre (cost of retained earnings)

- Capital asset pricing model (CAPM)
- Discounted cash flow (DCF)
- Bond yield plus risk premium (BYRP)

The capital asset pricing model (CAPM)

Assumptions

- cost of retained earnings = risk free rate + risk premium
- risk premium = risks associated with the entire market risk
- risk premium is the product of systematic risk
- arbitrage pricing theory assumes multiple risks should be considered as part of capital asset pricing, not simply one risk

The capital asset pricing model (CAPM)

Key factors and their formula notations

- The cost of retained earnings kre
- The risk free rate krf
- The risk premium = the stock’s beta coefficient x market risk premium
- The market risk premium = the market rate - risk free rate

Cost of retained earnings formula

- kre = risk free rate + risk premium
- kre = krf + (bi x PMR)
- kre = krf + (bi x (km - krf))

kre = krf + (bi x (km- krf))

cost of retained earnings = risk free rate + (stock’s beta coefficient x (market rate - risk free rate)

Discounted cash flow DCF

Assumptions

- Stocks price = risk and return “Fair price”
- the estimated expected rate of return will yield an estimated required rate of return
- the expected growth rate may be based on projections of past growth rates, a retention growth model, or analysts’ forecasts

Discounted cash flow formula

kre = (D1 / P0) + g

Cost of retained earnings = Dividends in the future / Current Market Price + constant rate of growth in dividends

The bond yield plus risk premium (BYRP)

Assumptions

- Equity and debt security values are comparable before taxes
- Risks are associated with both the individual firm and the state of the economy. Risk premiums depend on nondiversifiable risk
- Risk estimation can be derived by using a market analysts’ survey approach or by subtracting the yield on an average corporate long term bond form an estimate of the market rate

The bond yield plus risk premium formula

kre = kdt + PMR

cost of retained earnings = pre tax cost of long term debt + market risk premium

Return on Investment ROI formula

provides the assessment of a company’s percentage return relative to its capital investment risk.

ROI = Income / Investment capital

ROI = Profit margin x Investment turnover

ROI = Profit margin (Income/Sales) X Investment turnover (Sales / Invested capital)

Return on Assets ROA

Net income / Average total assets

Asset effectiveness and/ or efficiency - residual income and EVA

the residual income method measures the excess of actual income earned by an investment over the required return rate required by the company.

Residual income

Net income - Required return

Required return = Net book value x Hurdle rate

We want it positive number

Benefits of residual income performance measures

- Realistic target rates

2. Focus on target return and amount

Weakness of residual income performance measures

- Reduced comparability

2. Target rates require judgment

Economic Value Added EVA

method of performance evaluation is similar to the residual income method. While the residual income method computes required return based on a hurdle rate determined by management, EVA measures the excess of income after taxes earned by an investment over the return rate defined by the company’s cost of capital. Economic value added ensures that performance is measured in comparison to changes associated with all capital, debt, and equity. EVA is expressed as an amount and is considered a form of economic profit.

Economic Value Added formula

- Calculate return and income after taxes

Investment x Cost of capital = Required return

- Compare income to the required return

Income after taxes - Required return = Economic value added

Interpretation of EVA

a positive - good

a negative - bad

Economic Value Added Component issues

- Investment valuation issues

a. Capitalization of research and development

b. Current valuation of the balance sheet - Income determination

Debt to total capital ratio

Debt to total capital ratio = Total debt / (Total capital = debt+equity)

Measure of financial leverage (risk)

The lower the ratio, the better

Only interest bearing liabilities

Debt to asset ratio

Debt to asset ratio = total debt / total assets

the lower the ratio, the better

Debt to equity ratio

Debt to equity ratio = Total debt / total shareholders’ equity

The lower, the better

Working capital management

managing cash so that a company can meet its short term obligations and includes all aspects of the administration of current assets and current liabilities.

Definition of net working capital

current assets - current liabilities

Balancing profitability and risk

working capital is expensive to carry because it must be financed with long term or short term debt or with stockholders equity.

Current ratio

current assets / current liabilities

the higher the better

Deteriorating current ratio

reduced ability to generate cash

increase in short term debt

decrease in current assets

Quick ratio

(Cash + Marketable securities + AR) / Current liabilities

The higher the better

Management of cash and cash equivalents

Motives for holding cash

a. transaction motive

b. speculative motive

c. precautionary motive

Disadvantages of hight cash levels

- negative arbitrage effect - interest obligations exceed interest income from cash reserves
- increased attractiveness as a takeover target
- investor dissatisfaction with allocation of assets

Primary methods of increasing cash levels

Methods to speed collections

a. customer screening and credit policy

b. prompt billing

c. payment discounts

APR of quick payment discount = (360/// (pay period - discount period) x (discount/// 100 - discount %)

d. Expedite deposits

- electronic funds transfer

- lockbox system

e. Concentration banking

f. Factoring accounts receivable

Methods to delay disbursements

a. Defer payments

b. Drafts

c. Line of credit

d. Zero balance accounts

Cash management techniques

- Managing float
- Overdraft protection
- Compensating balances

Cash conversion cycle

the length of time from the date of cash expenditure for production to the date of cash collection from customers

The cash conversion cycle formula

Cash conversion cycle = Inventory conversion period + Receivables collection period - Payables deferral period

Elements of the cash conversion cycle formula

easily calculated using the related turnover ratios

Inventory conversion period

Inventory turnover = COGS / Ave inventory

Inventory conversion period = 365 / Inventory turnover

Receivable collection period

Accounts receivable turnover = Sales / Ave AR

Receivables collection period = Days sales outstanding = 365 / AR turnover

Payables deferral period

AP turnover = CPGS / Ave AP

AP deferral period = 365 / AP turnover

Management of accounts receivable

arriving at an appropriate balance between the accounts receivable balance outstanding and the amount of bad debts and converting accounts receivable into cash quickly to meet short term obligations

Management of AR

- Credit policy

a. Credit standards

b. Credit period

c. Collection policy

d. Discounts - Factoring

Management of accounts payable

- Trade credit

a. Trade credit

b. Discounts - Accruals

Management of inventory

Factors influencing inventory levels

- Storage costs
- Insurance costs
- Opportunity costs of inventory investment
- Lost inventory due to obsolescence or spoilage

Optimal levels of inventory

- Inventory turnover
- Safety stock
- Reorder point
- Economic order quantity
- Materials requirements planning

Safety stock

- Reliability of sales forecasts
- Possibility of customer dissatisfaction
- Cost of running out of inventory
- Lead time - the time that elapses from the placement to the receipt of an order
- Seasonal demands on inventory

Reorder point

inventory level at which a company should order or manufacture additional inventory in order to meet demand and avoid incurring stockout costs.

Stock out costs

Incurred when customers orders can’t be filled: loss of income from the product unavailability, the cost of restoring goodwill, cost of expedite shipping

Reorder point = Safety stock + (Lead time x Sales during lead time)

Economic order quantity model

attempts to to minimize both ordering and carrying costs. The model can be applied to the management and any exchangeable good.

Economic order quantity assumptions

it assumes that demand is known and is constant throughout the year, so EOQ does not consider stockout costs or costs of safety stock. Assumes that carrying costs and ordering costs are fixed.

Economic order equation

E = Pi (2SO/C)

Order size = Pi (2 annual sales in units x Cost per purchase order) / Carrying cost per unit

Inventory management issues

- Just in time inventory models
- Kanban inventory control - gives visual signals when something must be replaced
- Computerizes inventory control - every purchase is recognized immediately and reordered when needed (no human element)
- Materials requirements planning - computer based and control the usage of raw materials

Management of marketable securities

provide lower returns than operating assets, but higher returns than cash

Common marketable securities

- United states treasury bill
- Negotiable certificates of deposits
- banker’s acceptances
- commercial paper
- equity securities of public companies
- eurodollars
- hedge transactions

Factors influencing the level of marketable securities

- Liquidity

2. Credit hedge

Strategies for holding marketable securities

- Periods of low rates

2. Periods of high rates

Economic Order Quantity model for inventory management. A decrease in which variables would decrease the EOQ?

- Decreased cost per order
- Decreased safety stock level
- Decreased quantity demanded

EOQ = Pi ((2SO)/C) EOQ - order size S - annual sales quantity in units O - cost per purchase order C - annual cost of carrying one unit in stock for one year

Optimal level of inventory is affected by

- The inventory usage rate
- The cost per unit of inventory - which will have a direct impact on inventory carrying costs
- The cost of placing on order impacts order frequency, which affects order size and optimal inventory levels

Days’ sales in accounts receivable

Days’ sales = Ending accounts receivable / Average daily sales

CAPM formula

C = R + B (M - R) C = cost of equity capital B = beta coefficient of comparable publicly traded stock M = market rate of return

Cost of capital

rate of return on assets that covers the costs associated with the funds employed

Imputed interest rate used in residual income approach

Historical weighted average cost of capital for the company.

Usually used as the target or hurdle rate

Bonds with an effective interest rate 14% and the corporate tax rate 30%. What is the firm’s net cost of debt?

14% x (1-30%) = 9.8%

The cost of issuing the stock

Preferred stock sold for $40

par value 9% and $20

Cost of issuing stock $5

Cost of issuing stock = Dividend / Net proceeds

Dividend paid $20 x 9% = $1.80 Net proceeds ($40 selling price - $5 floatation) = $35 Cost of preferred shares 1.8 / 35 = 5.1%

Elements needed to estimate the cost of equity capital for use in determining a firm’s weighted-average cost of capital are:

- Current dividends per share (D)
- Expected growth rate in dividends (g)
- Current market price per share of common stock (P)

R = D/P + g

Cash conversion cycle

Inventory conversion period + Receivables collection period - Payables Deferral period

Discounted cash flow analysis includes:

- Future operating cash savings
- Current asset disposal price
- Tax effects of future asset depreciation
- Future asset disposal price

Net present value method

recognizes the time value of money and discounts cash flows over the life of a project, using the minimum desired (hurdle) rate

When determining net present value in an inflationary environment, adjustments should be made to

- increase the estimated cash inflows and increase the discount rate.
- future cash flows should be increased to the extent of predicted inflation and the discount rate too

Accounting rate of return

capital budgeting technique, not a rate

Net present value analysis uses rates

- cost of capital
- hurdle rate
- discount rate
- required rate of return

The internal rate of return (IRR)

is the discount rate that produces a NPV of zero

The internal rate of return (IRR)

rate of interest that equates the present value of cash outflows and the present value of cash inflows

The beta coefficient (CAPM) measures the volatility of risk inherent in an investment by

computing the ratio of percentage changes in a stock’s price to percentage changes in overall market values during the same period.

% change in stock price / % change in market price

A firm’s target or optimal capital structure is consistent with

minimum weighted average cost of capital

The optimal capital structure is

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

Strategies for creating an optimal capital structure to maximize net worth include

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

Working capital management

matching the maturity life of each asset with the length of the financial instrument used to finance that asset.

Net working capital

the difference between current assets and current liabilities

Methods of converting accounts receivable into cash

- Collection agencies
- Factoring
- Cash discounts
- Electronic fund transfers

The commercial paper market:

- Avoids the expense of maintaining a compensating balance with a commercial bank.
- Provides a broad distribution for borrowing.
- Accrues a benefit to the borrower because its name becomes more widely known
- There are restrictions as to the type of corporation that can enter into the commercial paper market for short term financing

Depreciation tax shield = Depreciation expense x Margin tax rate

The greater the depreciation expense, the greater the depreciation tax shield

Average gross receivable balance

Average daily sales x average collection period

Operating leverage calculation

Fixed costs / Variable costs

Return on assets

income / ave assets

Return on assets

(Income / Sales) x (Sales x Ave assets)