BEC - Financial Management Flashcards
(190 cards)
1
Q
Cost Defined
A
The amount paid in cash or other resources for a good or service
2
Q
Expense Defined
A
The portion of Cost that relates to the portion of a good or service that has been used up.
3
Q
Sunk Costs Defined
A
Costs of resources that have been incurred in the past and cannot be changed by current or future decisions
•not relevant in making current decisions.
Ex: cost of a piece of machinery that needs to be replaced.
4
Q
Opportunity Cost Defined
A
Discounted dollar value of benefits lost from an opportunity not taken as a result of choosing another opportunity.
•relevant in current decisions.
Ex: revenue lost from an alternative not selected.
5
Q
Differential/Incremental Cost Defined
A
Costs that are different between two or more alternatives.
•Cost elements that are the same are not relevant in making economic comparisons.
6
Q
Cost of Capital Defined
A
Cost of long-term funds - (debt/equity) - used to finance an operation.
•long-term debt, preferred stock and common stock
7
Q
Cost of Debt Defined
A
Rate of return that must be paid to attract (investors) and retain lenders’ (funds)
•rate of return required is determined by many factors. (Level if interested Rate in generally market, perceived default risk of the firm, etc.)
8
Q
Generally _____ is considered less risky than equity
A
DEBT.
Required rate of return of debt (cost of debt) is less than on preferred or common stock.
9
Q
Cost of Preferred Stock Defined
A
Rate of return that must be paid to attract and retain preferred shareholders’ investment.
•had characteristics of debt and equity.
- dividends expected and paid before common dividends & possible claim to additional dividends and priority claim to assets upon liquidation.
- more risky than debt, but less risky than common stock. (RRoR goes the same way)
10
Q
Cost of Common Stock Defined
A
Rate of return that must be paid to attract and retain common shareholders’ investment.
- determined by (a) perceived risk of stock, (b) expected dividends (c) expected price appreciation.
- most risky (RRoR is greater than on debt or preferred stock)
11
Q
Underlying concept of Cost of Capital
A
Rate of return required by each source is determined by the OPPORTUNITY COST each source has in the market for comparable risk.
12
Q
Weighted Average Cost of Capital (WACC) Defined
A
Rate of return of each source of Capital weighted by its share of the total capital.
- percent of total capital is determined for each source is calculated
- percent of each is multiplied by the cost of Capital for that source of Capital
- resulting weighted costs of Capital are summed to get the weighted average cost of Capital.
13
Q
Product Cost (Inventoriable cost) Defined
A
The Cost assigned to goods that were either purchased or manufactured for resale.
14
Q
Present Value of a Single Amount
A
Determined the value now - at the present - of a single amount to be received in the future.
15
Q
Future Value of a Single Amount
A
Determined the value at some future date of a Single Amount invested now
•Assumes annual “compounding” (I.e. Interest is earned on unpaid interest)
16
Q
Interest Defined
A
Cost of the use of money.
17
Q
Fixed interest rate
A
Percentage rate of interest does. It change over the life of the instrument.
18
Q
Variable interest rate
A
Percentage rate of interest can change over the life of the instrument.
•changes relate to Fed rate or prime rate
19
Q
Changing based of interest
A
Rate type may change over the life of the instrument.
20
Q
Stated interest rate
A
Annual rate of interest specified (stated) in a contract
- rate per loan agreement, bond coupon rate
- does not take into account compounding effects of frequency of payments
21
Q
Simple interest
A
Interest computed on original principal only
•no compounding in interest calculation
•no interest paid on interest
22
Q
Compound interest
A
Interest computed on principal plus accumulated unpaid interest
•interest is paid on interest.
23
Q
Effective interest rate
A
Annual interest rate implicit in the relationship between the re proceeds of a borrowing and the dollar cost of that borrowing.
- calculation = net cost of borrowing (amount of interest) / net proceeds (amount borrowed less interest)
- net proceeds received may be less than amount borrowed due to:
- Discounting-interest deducted in advance
- Compensating balance requirement
24
Q
Annual Percentage Rate (APR)
A
Annualized effective interest rate without compounding on a borrowing that is for a fraction of a year.
- calculation APR = effective rate for fraction of year x number of fractions in year. (Semi annually =2)
- APR is the legally required basis for interest rate disclosure in US
25
Effective Annual Percentage Rate (EAPR) aka "Annual percentage yield"
Annual percentage rate WITH COMPOUNDING on borrowings for fraction of a year
26
Negative Interest Rate
Interest rate terms under which the owner of funds pays a recipient interest to hold (and possibly use) the funds.
•the owner pays another party interest for holding and using the owners funds.
27
Theory behind negative interest rate
Encourages businesses and individuals to spend, lend or invest funds, rather than pay to have those funds held by a financial institution.
•used by EU central bank and Japan's national bank
28
Valuation Defined
Process of assigning worth or value to something.
29
Financial Valuation Defined
Process of estimating the FV of an asset, liability, or an entire business.
30
Accounting FV Defined
Price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (per FASB).
31
Value is at a point in time called the .....
Measurement date.
32
Level 1 Inputs
Unadjusted quoted prices obtained at the measurement date in active markets for assets and liabilities identical to those being valued.
*most reliable.
33
Level 2 Inputs
Observable for the item being valued, either directly or indirectly but are other than quoted prices described in Level 1
* quoted prices for similar, but not identical, item in active market
* quoted prices for identical or similar item in market that is not active
* Inputs other than quoted prices that are observable for the item being valued
* Inputs derived principally from or corroborated by market data or other.
34
Level 3 Inputs
Unobservable for item being valued.
* based on assumptions and internal data
* should only be used when level 1 & 2 are not available.
Ex: expected cash flows, expected life of an asset, likelihood of events occurring.
35
3 US GAAP approaches to developing FV
* Market approach
* Income approach
* Cost approach
36
Market Approach (aka Sales Comparison Approach)
Uses prices other than relevant info generated by market transactions for items identical or comparable to item being valued
•common in establishing value of pre-existing house or building
37
Income Approach
Uses valuation techniques to convert future amounts of economic benefits or sacrifices of economic benefits to determine what the future amounts are worth at valuation date.
```
Techniques include:
•discounted CFs
•option pricing models
•earnings capitalization models
•etc.
```
38
Cost Approach (aka Replacement cost Approach or reproduction cost Approach)
Uses valuation techniques to determine the amount required to acquire or construct a substitute item.
* more limited than market or income approaches
* especially useful for specialized item (no comparables in the market)
39
Active markets include ....
Stock markets, bond markets, commodities markets, currency markets, over-the-counter markets
•active market price for identical item = FV
40
A market is not active when ....
* few relevant transactions are available
* prices are not current or vary substantially
* little publicly available information
41
Level 2 Inputs would be used when...
Examples:
•stock restricted from trading, but similar to traded shares
•securities traded in brokered markets, rather than public markets
•residential and commercial property with comparable sales
•private debt securities for which there is publicly traded debt with comparable risks and terms
42
Capital Asset Pricing Model (CAPM) Defined
An economic model that determines a measure of relationship between risk and expected return.
* used in valuing various assets
* incorporates risk-free rate of return and a risk measurement called "beta"
43
Beta Defined
Measure of systematic risk as reflected by the volatility of an investment or other asset.
•measure of volatility of an asset when compared to a benchmark for the whole class of the asset
44
Beta = 1
Asset being valued moves in line with benchmark
•asset being valued has the same level of systematic risk as that class of asset.
45
Beta > 1
Asset being valued moves greater than benchmark.
•asset being valued is more volatile (more systematic risk) than that class of asset.
46
Beta < 1
Asset being valued moves less than benchmark
•asset being valued is less volatile (less systematic risk) than that class of asset.
47
CAPM assumptions and limitations
* there is an asset class and benchmark for the asset being valued.
* all investors have equal access to all investments of the class being valued and all use a one-period time horizon.
* asset risk is measured solely by variance if the asset being valued from asset class benchmark
* no external costs involved - no commissions, taxes, etc.
* no restrictions on borrowing or lends at the risk-fees rate; all parties can do so
* uses historical data, which may not be appropriate for computing future returns.
48
Option Defined
Contract that entities owner to buy or sell an asset at a stated price within a specified period
* American style - option permits exercise any time before expiration
* European style - option permits exercise only at maturity date.
49
Black Scholes Model was Developed to value options under specific circumstances, including...
* for European call options.
* stock pays no dividends.
* stock prices increase in small increments.
* risk-free rate of return is assumed constant.
TWO NEW UNIQUE FEATURES
•uses probabilities: probability that the price of the stock (security) will pay off by expiration date & probability that the option will be exercised.
•discounting of the exercise price.
50
What to know for the Black Scholes Model
1. It is a technique for valuing options on securities.
| 2. It's different because it uses probabilities and discounting.
51
Binomial Model (BOMP)
Uses 'tree' diagram to estimate values at a number of time points between the valuation date and the expiration date.
52
Business Valuation Defined
The estimation of the economic value of a business entity or portion thereof.
53
Market Approach (aka Guideline Public Company Method)
Determined Value of a business by comparing it with highly similar entities for which there is a readily determinable market.
•adjustments can be made. (Premiums and discounts)
54
Income Approach
Determined Value by calculating net present value of the benefit stream generated by the entity being valued
* net present value = entity value
* net present value is calculated using discount rate
* discount rate should be based on rate of return needed to attract investor funding given the level of risk.
55
Alternative income Approach methods:
* Discounted cash flows--uses discounted CFs to get present value.
* Capitalization of earnings--applies capitalization or interest rate to earnings to get value.
* Earnings multiple--applies a multiple factor to earnings to get value.
* Free cash flow--applies discount rate to free cash flows to get present value. (Variation of discounted CF method)
56
Asset Approach
Determines value. Y adding values of individual assets that comprise the entity being valued.
* FV of each individual asset (and liability) is determined.
* sum of NET assets is value of entity.
57
Valuation of individual assets requires the use of specific valuation technique:
* income Approach
* market approach
* cost Approach
58
The asset Approach is less appropriate for ...
* valuing going concern
| * valuing non-controlling interest
59
The asset Approach is more appropriate for ...
* valuing entity in liquidation
| * for entity with little or no cash flows or earnings.
60
The P/E ratio (price/earnings) for a share of common stock is computed as
Market price / EPS
•both values are on a per share basis.
61
Hedging Defined
A management strategy for mitigating (reducing) the risk of loss associated with certain transactions and positions.
•the purpose of hedging is not to make a profit, but to reduce risk.
62
Hedged Item Defined
The recognized asset, recognized liability, firm commitment, planned transaction or other item that is at risk of loss.
63
Hedging Instrument Defined
The contract (or other arrangement) entered into to mitigate (or eliminate) the risk of loss associated with the hedged item.
•primary instrument used in finance is the derivative.
64
Derivatives are contracts with all 3 of the following elements...
1. One or more "underlyings" and one of more "notional amounts".
2. Requires no initial net investment or one that is smaller than would be required for other types of similar contracts.
3. Terms requires or permit a net cash settlement. (Doesn't need to fulfill the contract if cash can be paid - most derivatives are settled with cash for the net difference between the contract price and the market price).
65
Derivatives: underlying Defined
A specified price, rate or other variable (ex: stock price, a commodity price, and interest rate, a foreign exchange rate, etc.)
66
Derivatives: notional amount Defined
A specified unit or measure (ex: shares of stock, pounds or bushels of a commodity, number of currency units, etc.)
67
Derivative value (or settlement amount) of a derivative instrument Is determined as...
Units of notional Amount X underlying
Ex: number of shares of stock X price per share
68
Major derivative instruments include (4)...
* Futures contracts
* Forward contracts
* Option contracts
* Swap contracts
69
Futures contracts
Contract to deliver or receive a commodity, foreign currency, security instrument, or other asset in the future at a price set now.
* executed through a clearinghouse (futures exchange)
* standardized contract terms - item, quantity, quality, delivery
* Have margin requirements, marked-to-market and settled daily.
70
Forward Contracts
* executed directly between contracting parties
* can be customized to any item, quantity, delivery date, etc.
* settled only at end of contract (expiration)
* gain on forward contract would be recognized as payment from counterparts to settle contract (ex: cash settlement in lieu of delivery of inventory)
71
Option Contracts
Contract between a buyer and seller that give the buyer of the option the right to buy (call option) or sell (put option) a particular asset in the future at a price set now (strike price).
* buyer had the right to buy or sell, but it not required to do so.
* buyer will exercise option only if economically favorable to do so.
* Contracts are traded either on an exchange or over-the-counter as contracts negotiated between parties.
72
Swap contracts
Contract between a buyer and seller by which they agree t exchange cash flows (typically related to interest), currencies, commodities, or risk.
* executed directly between contracting parties.
* can be customized for any item, amount or length of time.
* for CF swaps, commonly only interest CFs are swapped, not principal amounts.
73
Capital Budgeting Defined
The process of measuring, evaluating and selecting long-term investment opportunities for a firm.
74
Project Risks: Risk Defined
The possibility of loss or other unfavorable results that derives from uncertainty implicit in future outcomes.
75
Risk-Reward Relationship: Reward Defined
The benefit expected or required from investment of resources in capital projects and other undertakings.
76
Evaluation and selection of captain projects: payback period Approach
Determines the number of years needed to recover the initial cash investment in a project and compares that time with a pre-established maximum payback period.
* if payback period is less than or equal to maximum period = accept project
* if payback period is greater than maximum period = reject project
•useful in evaluating project liquidity.
77
Payback is calculated as
Investment cost / annual cash savings
78
Evaluation and selection of captain projects: discounted payback period Approach
Determines the number of years needed to recover the initial cash investment in a project using discounted cash flows and compares that time with a pre established maximum payback period.
* if payback period is less than or equal to maximum period = accept project
* if payback period is greater than maximum period = reject project
79
Evaluation and selection of captain projects: accounting rate of return Approach
Determines the expected annual incremental accounting net income from a project as a percentage of the initial (or average) investment.
* ARR greater than or equal to pre-established rate = accept project
* ARR less than pre-established rate = reject project
80
Net present value Approach (NPV) Defined
Determines the present value of expected cash inflows and compares that value with the present vale of expected outflows in the project.
•PV determined using discount rate (hurdle rate) based on cost of capital to firm (WACC)
•NPV = difference between PV of cash inflows and outflows (initial cash investment)
NPV greater than or equal to zero = accept
NPV less than zero = reject
81
Internal Rate of Return Approach (IRR) Defined
Determines the discount rate that equates the present value of expected cash inflows with the present value of expected cash outflows.
•IRR computed the discount rate that makes NPV of cash flows equal to zero.
82
Profitability Index (PI) Approach Defined
PI (aka Cost-Benefit Ratio) determines project rankings by taking into account both the new present value and the cost of each project.
83
Payback period Approach and ranking
Ranks projects based on how quickly invested capital is recovered.
* uses nominal dollars, not discounted values
* it does not rank in arms of relative total economic value; it only considers outcome up to point at which initial investment is recovered.
* useful for ranking when liquidity is a major concern.
84
Discounted payback period Approach and ranking
Ranks projects based on how quickly invested capital is recovered using discounted cash flows.
* it is better than the PPA
* it does not rank in terms of relative total economic value; it only considers outcome up to point at which the initial investment is recovered.
* useful for ranking when liquidity is a major concern.
85
Accounting rate of return and ranking
Ranks projects based on annual incremental accrual-based net income as a percentage of initial investment.
* higher percent = higher ranking
* it ignores the time value of money
* it uses accrual accounting values, not cash flows
86
Net present value Approach and ranking
Ranks projects based on their relative net present values.
* higher NPV = higher ranking
* recognizes the time value of money (rankings in terms of comparable dollars
* projects with negative NPV = not considered
* it fails to consider differences in initial project costs
**NPV Ranking of projects is a preferred method.
87
Internal Rate of return Approach and ranking
Ranks projects based on their relative internal Rate of return.
* higher IRR = higher ranking
* it recognizes the time value of money > Rankings in terms of comparable dollars
* fails to consider differences in initial project costs
88
NPV V IRR Ranking may result in different rankings due to differences in:
* project investment cost
* timing of cash flows
* project life-span
89
Profitability index Approach and ranking
Ranks projects based on the net present value of each project as a percentage of initial investment cost of each
* higher PI index = higher ranking
* recognizes time value of money > rankings in terms of comparable dollars
* takes into account the cost of each project
**PI is the preferred method for ranking.
90
Short term (working capital) financial Defined
The funding provided by obligations which become due within one year (i.e. Current liabilities)
Primary forms of ST financing: trade AP, accrued AP (wages, taxes, etc), ST NP, lines of credit, revolving credits, letters of credit, commercial paper, pledging and factoring AR, inventory secured loans
91
Payables Defined
Payables occur through the acquiring of goods or services financed by incurring an obligation to pay in the future.
92
Accrued Accounts Payable Defined
Result from acquiring cash and other benefits financed by an obligation to be satisfied in the future.
Ex: salaries and wages payable, taxes payable, unearned revenue (including gift and other prepaid cards)
•the time between when the benefit of cash is received and the obligation is satisfied provides short-term financing
93
Short-term notes payable defined
Result from acquiring cash through borrowing with repayment due in one year or less
* typically a promissory note is required
* interest rate charged is based on credit rating of borrower
* a compensating balance may be required
* an Amount that must be maintained in a demand deposit account with lender (increases effective cost of borrowing)
94
"Stand-by" credit arrangement Defined
An arrangement to have financing available for a specific purpose or period of time.
3 Forms of Stand-by Credit
1. line of credit (not legally binding on financial institution)
2. Revolving credit (formal agreement - is legally binding)
3. Letter of credit - a conditional commitment by a financial institution to pay a 3rd party in accordance with specified terms and conditions (often used with foreign transactions)
95
Commercial Paper Defined
Short-term, unsecured promissory notes sold by large, highly-creditworthy firms.
•most are for 180 days or less
•if more than 270 days SEC registration is required
•may be sold directly to investors or through dealers
•may be sold on discounted bases or with interest paid over the short life of the note
96
Pledging Accounts Receivable Defined
Using AR as security for short-term borrowings.
Level of borrowing available for a set of AR depends on:
•creditworthiness of the AR
•level of lender's recourse against borrower
97
Factoring Accounts Receivable
Factoring is the sale of AR
•Buyer is called "factor"
•Terms of sale may be:
Without recourse - the factor bears the risk associated with collectability, except in the case of fraud
With recourse - the factor has recourse against the seller for some or all of the risk associated with uncollectability of the receivables.
98
Inventory Secured Loans Defined
Occur when a firm pledges all or part of its inventory as collateral for a short-term loan.
99
Floating lien agreement Defined
Borrower gives a lien on all of its inventory, but retains control of its inventory which it continuously sells and replaces.
100
Chattel mortgage agreement Defined
Lender has a lien against specifically identified inventory, borrower retains control of that inventory, but cannot sell it without lender approval.
101
Field warehouse agreement Defined
Inventory remains at borrower's warehouse, but under the control of an independent third party.
102
Terminal warehouse agreement Defined
Inventory is moved to a public warehouse and placed under the control of an independent third party.
103
Long-Term (Capital) Financing Defined
Long-term, or capital, financing is providing by funding which does not become due within one year.
•it is the primary source of funding for most firms.
104
Long-term notes Defined
Result from acquiring cash through borrowing with repayment due in more than one year.
•typically a promissory note is required (often contains restrictive covenants)
•commonly from 1-10 years, but may be longer
•repayment is usually in periodic installments
•note maybe secured by a mortgage on property or real estate
105
Common restrictive covenants regarding LT notes:
* Maintaining a certain working capital condition (ex: a minimum working capital ratio)
* Restrictions on incurrence of additional debt without the original lenders approval
* Specification of required frequency and nature of financial information provided to lender, perhaps audited
* Restrictions on management changes without lender approval
106
Financial leases as a form of LT financing
Leasing is a common way of acquiring use of certain assets
| •in some cases the cost of leasing may be less than the cost of buying.
107
Net Lease Defined
Lesser assumes cost associated with ownership:
| •maintenance, taxes, insurance, -- called "executors costs" in accounting
108
Net-net Lease Defined
Lesser assumes cost associated with ownership (above) and responsibility for residual value at end of the lease
109
Bonds Defined
LT promissory notes
•in returns for proceeds (cash), the issuer of the bonds (the borrower) promises to pay bond holder (the investor) a fixed amount of interest each period and repay the face or principal at the bond maturity.
110
Bond Features
Bond indenture = Bond contract
Par/Face value = bond principal, commonly $1,000 per bond
Coupon rate of interest = Annual rate of interest stayed on face of bond ("stated rate")
Maturity = Time at which the issuer repays the bondholder principal and extinguishes debt
111
Debenture bonds Defined
Unsecured bonds
* no specific assets are designated as collateral
* they carry more risk and have higher cost than secured bonds
112
Bond Selling Price
* sells at less than par if coupon rate is less than the market rate; sells at a "discount"
* sells at more than par if coupon rate is more than the market rate; sells at a "premium"
* sells at par if coupon rate is equal to the market rate at the time of issue
113
Yield to maturity Defined
Determines the discount rate that equates the present value of future cash flows from the bonds with the current price of the bonds.
114
Market price of bonds changes _______ with changes in the market rate of interest.
INVERSELY.
Market rate of interest goes up = market price of bonds goes down
115
Market interest rate risk
The risk that the market value will go down due to interest rates going up.
•longer maturity = greater risk = higher the face/stated interest will be.
116
Preferred Stock Defined
P Stock is ownership interest with preference claims (over Common Stock)
•usually does not have voting rights and dividends are expected like interest (like bonds)
117
Common Stock Defined
The basic ownership interest in a corporation.
•regulatory requires limit most companies to one class of CS (some jurisdictions permit more than one class)
118
Preemptive right Defined
The right of first refusal to acquire a proportionate share of any new common stock issue.
119
Hedging principle of financing (aka Principle of self-liquidating debt)
Calls for matching CFs from assets with cash requirements needed to finance those assets
•LT assets should be financed with LT financing
•ST assets should be financed with ST financing
120
Business Risk Constraint Measurement
The variability of tue firm's expected operating Earnings Before Interest and Taxes - EBIT
121
Tax Rate Benefit
The higher the tax rate faced by a firm, greater the amount of tax saved by use of debt financing.
122
Spontaneous financing occurs when
Credit is provided in the course of day-to-day operations. Ex: accounts payable.
123
Trust receipt Defined
An instrument that acknowledges that the borrower holds the inventory and the proceeds from sale will be put in trust for the lender.
124
Line of credit Defined
An informal agreement whereby a lender agrees to extend a maximum amount of credit at any one time.
125
Revolving credit agreement
A for a legal commitment, usually by a bank, to extend credit up to some maximum amount to a borrower over a stated period.
126
Letter of credit Defined
A conditional commitment to pay a third party in accordance with specified terms and would be used to assure a foreign supplier of payment.
127
Commercial paper Defined
A ST promissory note.
128
Working Capital Defined
Working capital = current assets - current liabilities
* CA= cash & other assets expected to be converted to cash, sold or consumed within one year.
* CL= obligations due to be settled within one year.
129
Cash includes
Currency, demand instruments and demand deposits
130
Accelerating cash inflows
Involves reducing the time between when a firm has a claim to cash and when that cash is available for use.
131
"Float" Defined
Float is the time between when payment is initiated to a firm and when that payment is received and available for use.
*firms seek to reduce incoming float
132
Lock-Box system
Used to reduce float
Firm leases post office boxes in areas where it has high volume of cash inflow by mail.
*customers remit payments to local post office box and they're collected and processed by the firm's bank. Bank notifies the firm of payments.
133
Pre-Authorized Checks
Used to reduced incoming float.
Customers authorize checks in advance for payments of their obligations. (Ex. Mortgage payment - same every month)
134
Concentration banking
Used to reduce incoming float.
Accelerates the flow of funds from multiple local banks to a firm's primary bank by regular, usually automatic, transfer of funds
135
Depository Transfer Checks aka Official Bank Checks
Transfers funds between a firm's accounts
* check is unsigned, non-negotiable and payable only to an account of the firm.
* can be used in conjunction with lock-box arrangements and/or with concentration banking.
136
Wire Transfers
An electronic means of transferring funds. Relatively expensive method. Provides speed of transfer and security of funds.
137
Deferring Cash Outflows
Involves increasing the time between when a firm receives a resource or benefit and when cash is reduced to pay the related obligation.
*firms seek to increase outgoing float.
138
Remote Banking
Increases float on Checks used to pay obligations by establishing checking accounts in remote locations and making payments by checks written on those accounts.
*electronic processing and banking requirements have mostly eliminated the usefulness of remote banking as a means of delaying payment.
139
Zero-Balance Account
1. By Agreement: with its bank, a firm will have an account with a zero balance. (Bank transfers funds from another account to again "zero out" the account periodically).
2. By Deposit: firm deposits into an account an amount equal to checks written on the account so once paid the account remains zero.
140
Payment Through Draft
A firm uses a legal instrument- a draft- which is like a check, but drawn on an account of issuing bank or another bank, not the firm's account.
*sold to customers for a fee
Common forms of drafts include: bank draft, cashiers check, certified check, money order
141
Short-Term Investment Criteria
* Safety of principal - little risk of default by the issuer.
* Price stability - Not subject to market declines that would result in a significant loss if sold.
* Marketability/Liquidity - Have a ready market for converting to cash.
* Other possible criteria - Taxability, diversification, and cost of administration.
142
The market for short-term investment securities is called the
Money Market
143
ST Investment Opportunities: U. S. Treasury Bills
Direct obligations of the U.S. government: they--
•are virtually Risk free
•come in maturities of 91, 181, and 365 days
•are available periodically through the Federal Reserve Banks or continuously in the secondary market.
•Offer safety of principal, marketability and, if held to their short maturity, price stability.
144
ST Investment Opportunities: Federal Agency Securities
Securities issued by and obligation of the individual federal agencies
Ex: Federal National Mortgage Association (Fannie Mae), federal home loan bank, etc.)
* securities are the responsibility of issuing agency, not the US treasury and are not banked by the Fed Govt.
* slightly higher risk than Us treasury obligations and pay a slightly higher return.
145
ST Investment Opportunities: Negotiable Certificates of Deposit (CDs)
Securities issued by a bank in return for a fixed time deposit with bank.
* Negotiable means they can be bought and sold in the secondary market
* Offer high safety of principal and relative price stability.
* are somewhat less marketable than federal securities.
146
ST Investment Opportunities: Bankers' Acceptances
Is a draft (or order to pay) drawn on a bank by a firm with an account at the bank. If the ban accepts the draft, it becomes a negotiable instrument available for investment; they
•sometimes are used in financing foreign transactions
•are more risky and less marketable than federal securities
•pay a higher yield than federal securities.
147
ST Investment Opportunities: Commercial Paper
ST unsecured promissory notes issued by large, established firms with high credit ratings; they
•are available in various denominations with maturities of a few days up to 270 days
•are less marketable than some other ST investments.
•provide a greater return than some other ST investments.
148
ST Investment Opportunities: Repurchase Agreements (Repos)
Securities issued for loans with a Simultaneous commitment by the buyer to resell the loan security to the issuer at the original contract price plus an agreed interest for period outstanding; they
•are usually for large amounts, and
•can be for any agreed length of time (short as a day)
•risk of market price declines is avoided because the amount of interest is specified when the instrument is originated.
149
Accounts Receivable Management Defined
Concerned with:
•conditions leading to the recognition of receivables.
•process that results in elimination (collection) of receivables.
150
Risk-reward tradeoff in managing inventory
* Under investing in inventory to save costs, risks incurring shortages
* Over investing in inventory to provide "cushion", risks incurring excessive costs
151
Inventory Management Objective
To neither under invest nor over invest in inventory
152
Materials Requirement Planning (MRP) System
* supply push - goods are produced in anticipation of their sale
* the use of inventory buffers - inventory is maintained at every level as buffers against unexpected demand
* production based on long set-up time and long production runs; an inflexible system
* impersonal relationships with suppliers; purchased are based on lowest bid
* quality standards set at an "acceptable" level - allow for a certain number of defects
* use of traditional cost accounting: the emphasis is on job order and processing cost approaches
153
Just-in-Time (JIT) System
* originated with Toyota
* system is based on obtaining (on the supply side) and delivering (on the sell side) inventory just as and only when it is needed.
* Demand pull - goods are produced only when and as needed by the end user
* inventory reductions - production and purchasing occur only as needed, therefore inventories are reduced or eliminated
* production in work centers (or cells)
* close working relationships with a limited number of suppliers located physically close to production facilities
* quality being critical throughout the system, including inputs into the producing process
* uses simplified cost accounting with fewer accounts; more items are considered direct cost, thus reducing allocations
154
Inventory ordering cost and inventory carrying cost has a trade-off:
* Larger the quantity ordered, the lower per unit order cost.
* Larger the quantity ordered, the higher the carrying cost.
*Total inventory administrative cost =
Total order costs + total carrying costs
155
The Economic Order Quantity (EOQ) Model
Determines the order size that minimizes total inventory administrative costs.
156
Inventory Reorder Point Objective
To determine the inventory quantity at which goods should be reordered.
157
If current liabilities require a compensating balance, the effective cost is greater than:
The stated cost
158
Liquidity Measures (Solvency Measures)
Assess the ability of a firm to pay its obligations as they become due.
*particularly appropriate for management of working capital.
159
Working Capital (WC)
Measures extent to which current assets exceeds current liabilities.
WC = CA - CL
160
Working Capital Ratio
Measures the number of times CA cover CL
WC Ratio = CA / CL
161
Acid Test Ratio (Quick Ratio)
Measures the number of times Highly Liquid assets cover current liabilities.
162
Defensive Interval Ratio
Measures the number of times highly liquid assets cover average daily use of cash.
163
Times Interest Earned (TIE)
Measures the number of times current earnings cover interest payments for the period.
164
Times Preferred Dividends Earned
Measures the number of times current earnings cover preferred dividends for the period.
165
Accounts Receivable Turnover
Measures the number of times that AR are incurred and collected during a period.
166
Number of days' sales in average receivables
Measures the average number of days required to collect receivables.
167
Inventory turnover
Measures the number of times inventory is acquired and sold during a period.
168
Number of days' supply in inventory
Measures the number of days inventory is held before it is sold or used.
169
Operating (working capital) cycle length
Measures average length of time to acquire inventory, convert inventory to AR, and collect receivables.
170
Cash conversion cycle length
Measures average length of time from expenditure of cash for inventory to the collection of cash from accounts Receivable; cash-to-cash
171
Operating Cycle Length
Inventory conversion + AR conversion
172
Risk Defined
Possibility of loss or other unfavorable outcome that results from uncertainty inherent in future events.
173
Business Risk Defined
The broad, macro-risk a firm faces largely as a result of the relationship between the nature of the firm and the nature of its environment.
*a firm that utilizes only equity financing would face business Risk.
174
Business Risks are classified into two types
Diversifiable Risk
| Mom-diversifiable Risk
175
Diversifiable Risk (unsystematic or Firm-specific)
Elements of risk that can be eliminated through diversification of investments.
176
Non-Diversificable Risk (Systematic or Market-related risk)
Elements of risk that cannot be eliminated through diversification of investments.
•related to general economic and political factors.
177
Genera business Risk is measured by...
The expected variability in a firm's earnings before interest and taxes (EBIT)
178
EBIT measures
The results of a firm's operating activities, except debt financing.
*the greater the variability in EBIT, the greater the perceived business risk.
179
BETA Defined
A specific measure of how variability in a firm's results compare to variability in a benchmark.
180
Financial Risk
Common shareholders risk that result from the use of debt financing and preferred stock which require payment before common shareholders receive a return on investment.
181
Default Risk
Risk that the issuer of a security will not be able to make future interest and/or principal payments; the risk that the issuer may default in its obligation.
182
Interest Rate Risk
Risk that increases in market rate of interest will decrease the value of outstanding debt.
*there is an inverse relationship between changes in the general interest rate and changes in the market value of existing debt.
183
Inflationary (Purchasing Power) Risk
Risk that a rise in general price levels (inflation) will result in a reduction in the purchasing power of a fixed sum of money.
184
Liquidity (Marketability) Risk
Risk that an asset cannot be readily sold at FV for cash.
Ex: investment in thin market
185
Political Risk
Risk associated with operations in a foreign country that has different political, governmental, cultural, ethical, market structure, or other socio-political elements than a firm's domestic market.
186
Currency Exchange Risk
Risk associated with changes in exchange rates between two currencies.
187
Foreign currency transactions risk
Risk that transactions to be settled in a foreign currency will lose dollar value as a result of unfavorable changes in the exchange rate between the dollar and the foreign currency.
188
Foreign currency translations Risk
Risk that the dollar value of translated the financial statements of direct foreign investments will lose value from unfavorable changes in the exchange rate between the dollar and foreign currency of the investment.
189
Foreign currency economic risk
Risk that changes in exchange rates will make future international transactions less financially viable.
* ex: dollar value of foreign Currency revenues may be reduced to an unacceptable level
* ex: dollar cost of foreign currency expenses may be increased to unacceptable level
190
Materials requirement planning
Focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as work-in-process and raw materials.
