Flashcards in Financial Management - Wiley Q&A 86 Questions Deck (46):
Capital Asset Pricing Model explain what is it for and the equation to arrive at this
Formula is: Cost of Equity = RF + (RF-km) x bi
Where RF is risk free rate of return and km is market rate and bi is beta.
CAPM ultimate goal is to calculate the cost of equity.
Formula example above, first you must solve the right side of equation after the + sign and then allow this result to be added to RF preceding the + sign to get your answer.
Formula for Determining EFFECTIVE RATE OF LOAN INTEREST - Compute THE FOLLOWING: Company borrows a One Year Bank Loan of $500,000 at a stated rate of 8% with a requirement to maintain a 20% balance in its checking account. The company would otherwise maintain a zero balance checking without this requirement.
1st: Consider how much the company would maintain in the account if the compensating balance did not exist. If there is a zero-balance maintenance concept, we do not need to figure any required minimum balances into our equation. FIGURE THE EFFECTIVE RATE OF INTEREST:
Available Principal: = $500,000 - (20% * $500,000) =
Interest PAID for 360 days: = $500,000 * 8% * (360 days/360 days) = $40,000 note if it were a shorter loan period the numerator would be the loan days, the denominator is the number of days in financial year.
Effective Interest Rate Calc:
INTEREST PAID $40,000
____________________ = 10%
Compensating balances—Loan agreements may require the borrower to maintain an average demand deposit balance equal to some percentage of the face amount of the loan. Such requirements increase the effective interest rate of the loan, because the firm does not get use of the full amount of the loan principal. As an example, if a firm gets a $100,000, 90-day loan at 6% with a 10% compensating balance arrangement, the effective interest rate on the loan would be calculated as follows:
Principal available = $100,000 – (10% × $100,000)
Interest for 90 days=$100,000 × 6% × (90 days/360 days)=$1,500
Effective interest rate=Interest paid/Principal available × (360 days/90 days)=
$1,500/$90,000 × (360 days/90 days)
Order of operations, work the first part of equation $1,500/$90,000 and then multiply this by 4 to get 6.67% otherwise the answer will differ.
How does the Arbitrage Pricing Model compare to the Capital Asset Pricing Model?
The arbitrage pricing model uses a series of systematic risk factors.Investors face two different types of risk for an investment.
Arbitrage pricing model. Investors face two different types of risk for an investment.
•Systematic risk—Market risk that cannot be diversified away.
•Unsystematic risk—The risk of the specific investment that can be eliminated through diversification.
CAPM uses only one variable to capture systematic risk, the market rate of return or km. The arbitrage pricing model uses a series of systematic risk factors to develop a value that reflects the multiple dimensions of systematic risk. For example, systematic risk may be affected by future oil prices, exchange rates, interest rates, economic growth, etc. The formulation of the arbitrage pricing model is as follows:
rp = b1(k1–kRF) + b2 (k2–kRF) + b3 (k3–kRF)
rp = The risk premium on the particular investment. This is the amount that should be added to the risk-free rate to get an estimate of the cost of capital.
krf = The risk-free interest rate.
b 1,2,3… = The betas for the individual risk factors (e.g., exchange rate risk, oil price risk, interest rate risk, etc.)
k 1,2,3… = The market interest rate associated with each of the risk factors.
As you can see, the amounts in the parentheses are equal to the risk premium associated with each of the factors, (i.e., the market rate for each factor minus the risk-free rate).
What is the major advantage of a zero-balance account system?
It maximizes the float involved in cash disbursements.
E.g. by using regional banks and not transferring funds until the checks are presented, the float on disbursements is maximized.
A company has an outstanding one-year bank loan of $500,000 at a stated interest rate of 8%. The company is required to maintain a 20% compensating balance in its checking account. The company would maintain a zero balance in this account if the requirement did not exist. What is the effective interest rate of the loan?
Actual Interest paid during the loan period
divided by Available Principal/ (360/# of days of loan)
Short formula example if using interest rates only:
In this example we can use .08/1-.20 or .08/.80 = 10%
or substitute with numbers $40,000/$400,000.
Short examples work great if the loan is a full year. If a partial year loan less then 360 days, use the long formula with $ amounts to be safe in your answer.
Compute best checking account or loan.
Kemple is a newly established janitorial firm, and the owner is deciding what type of checking account to open. Kemple is planning to keep a $500 minimum balance in the account for emergencies and plans to write roughly 80 checks per month. The bank charges $10 per month plus a $0.10 per check charge for a standard business checking account with no minimum balance. Kemple also has the option of a premium business checking account that requires a $2,500 minimum balance but has no monthly fees or per check charges. If Kemple’s cost of funds is 10%, which account should Kemple choose?
Standard Business Checking will cost - As Annualized:
$120 annual bank charges
$ 96 per check chg at 80 checks x .10 per ck. per mo.
$ 50 for $500 planned balance at 10% cost of funds
$266 Total cost of checking account.
Premium Checking will cost:
$250 for $2,500 minimum balance x cost of funds 10%
Result: Standard Business Checking will cost $16 more per year. Kemple should choose the Premium Checking.
DQZ Telecom is considering a project costing $50,000,000. DQZ plans to use the following combination of debt and equity to finance the investment:
• Issue $15,000,000 of 20-year bonds at a price of 101, with a coupon rate of 8%, and flotation costs of 1.5% of par. The after-flotation cost yield is 8.08%.
•Use $35,000,000 of funds generated from earnings.
•The equity market is expected to earn 12%. US Treasury bonds currently yield is 5%. Beta coefficient for DQZ is est to be .60. DQZ effective corporate income tax rate of 40%.
The before-tax cost of DQZ’s planned debt financing, net of flotation costs, in the first year is?
Debt financing option figured:
First Item relates to debt whereas the second two relate to equity, although the last item of three contains the "effective corporate tax rate" that is necessary for calc.
Question ask "before tax" net of flotation and first year cost
IN this example the answer is given for 8.08% or the after-flotation cost yield.
Normal calculation for cost of debt is:
Interest multiplied by 1-marginal tax rate is the cost of debt before flotation costs. Flotation costs are involved when issuing "new" debt. SEE ANOTHER NOT CARD FOR COMPUTING COST OF DEBT.
ALSO NPV SHOULD BE CALCULATED BUT WILL REQUIRE A TABLE BUT CAN BE ESTIMATED. ESTIMATE WOULD LOOK LIKE
Capital and operating leases differ in that the lessor
Capital leases characteristics:
- lessor is treated as owner even it the asset might revert back to the lessee.
- is a Financing transaction on the books by setting up the asset and corresponding note payable.
- typically payments will include P/I, repair/maint and insurance, or misc.
NOT CAPITALIZED EXPENSED INSTEAD
NOT a source of financing
Explain the average collection period, how does the firm measure the number of days?
The collection period is the average time it takes from sale to collection (receipt of payment from customer).
Note receipt does not consider bank clearing time, it only considers the time in which the firm receives its payment.
Marginal Cost of Capital compute given the following:
Currently the company has to following structure:
Debt: $650,000 of 10% debt outstanding
Equity Financing: $500,000
RRR of equity holders is 15%
Retained earnings has no money available for investment purposes currently.
Raising New Equity will cost the firm 16%
New Debt would have before-tax-cost of 9%
Corporate Tax Rate is 50%
When calculating MCC the company should assign a cost of LIST A to Equity Capital and LIST B after tax debt financing:
List A List B
Cost of Marginal Equity is already provided 16%
Cost of Debt: 9% x .50 = 4.5%
The trickier problems will involve using existing retained earnings to finance versus new debt or paying off old debt and replacing with equity if feasible.
A firm must select from among several methods of financing arrangements when meeting its capital requirements. To acquire additional growth capital while attempting to maximize earnings per share, a firm should normally
Select debt over equity initially, even though increased debt is accompanied by interest costs and a degree of risk.
Generally Debt financing is the least costly and using it would tend to maximize earnings per share.
Explain ADVANTAGES and DISADVANTAGES of issuing debt (or DEBT FINANCING).
Advantages and Disadvantages of Debt Financing
In deciding whether debt should be used as a form of financing, management must keep in mind the following advantages and disadvantages.
Advantages of debt financing include
• Interest is tax-deductible.
• The obligation is generally fixed in terms of interest and principal payments.
• In periods of inflation, debt is paid back with dollars that are worth less than the ones borrowed.
• The owners (common stockholders) do not give up control of the firm.
• Debtors do not participate in excess earnings of firm.
• Debt is less costly than equity. Therefore, the use of debt, up to some limit, will lower the firm’s cost of capital.
Disadvantages of debt financing include:
•Interest and principal obligations must be paid regardless of the economic position of the firm.
• Interest payments are fixed in amount regardless of how poorly the firm performs.
• Debt agreements contain covenants that place restrictions of the flexibility of the firm.
• Excessive debt increases the risk of equity holders and therefore depresses share prices.
Which of the following inventory management techniques focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as work-in-process and raw materials?
Materials requirements planning
which is a computerized system that plans manufacturing based on demand estimates.
Inventory Management - What is Cycle Counting?
cycle costing deals with costing of facilities or products
Safety Stock Reorder Point
Is a technique used to balance inventory holding costs against the costs of stockouts.
Economic Order Quantity
Is a technique used to determine the optimum amounts to order
What are the goals of inventory management?
First - effective Forecasting of Sales and coordination with purchasing and production. Two goals are:
•To ensure adequate inventories to sustain operations
•To minimize inventory costs, including carrying costs, ordering and receiving costs, and cost of running out of stock
How and When do you compute "Production Pattern" in inventory management and what items do you compare?
f the firm has seasonal demand for its products, management must decide whether to plan for level or seasonal production.
Level production involves working at a consistent level of effort to manufacture the annual forecasted amount of inventory. Level production results in the most efficient use of labor and facilities throughout the year. However, it also results in inventory buildups during slow sales periods. This results in additional inventory holding costs.
Seasonal production involves increasing production during periods of peak demand and reducing production during slow sales periods. Seasonal production often has additional operating costs for such things as overtime wages and maintenance.
EXAMPLE: A firm has projected the following data for the two alternatives of level production and seasonal production. The firm’s short-term interest cost is 7%.
Level production Seasonal production
Average inventory $200,000 $150,000
Production costs $1,000,000 $1,010,000
Which alternative is preferable?
Under the level production alternative, the firm would incur an additional $3,500 (($200,000 – $150,000) × 7%) in inventory holding costs, but it would also save $10,000 ($1,010,000 – $1,000,000) in production costs. Therefore, level production would be the best production alternative. It would save the firm $6,500 ($10,000 – $3,500).
Explain Inflation (deflation) as it relates to Inventory.
Inventory and Inflation. A firm's inventory policy also might be affected by inflation (deflation). As an example, if a firm uses silver as a raw material, the firm could experience significant gains or losses simply because of price fluctuations that occur in the silver market. Price instability occurs in a number of markets, such as copper, wheat, sugar, etc. The problem may be partially controlled by holding low levels of inventory. Another way would be to hedge the price movement with a futures contract to sell silver at a specified price in the future. In this manner, if the price of the silver falls, reducing the value of the inventory, the value of the future contract would rise to completely or partially offset the inventory loss.
SUPPLY CHAIN - EXPLAIN.
Describes a good's production and distribution.
It illustrates the flow of goods, services, and information from acquisition of basic raw materials through the manufacturing and distribution process to delivery of the product to the consumer, regardless of whether those activities occur in one or many firms. To manage inventories and their relationships with their suppliers many firms use a process known as supply chain management. A KEY ASPECT of supply chain management IS the SHARING OF KEY INFORMATION from the point of sale to the final consumer back to the manufacturer, to the manufacturer's suppliers, and to the suppliers' suppliers. As an example, if a manufacturer/distributor shares its sales forecasts with its suppliers and they in turn share their sales forecasts with their suppliers, the need for inventories for all firms is significantly decreased. The manufacturer/distributor, for example, needs far less raw materials inventory than normally would be the case because its suppliers are aware of the manufacturer's projected needs and are prepared to have the materials available when needed. Specialized software facilitates the process of information sharing along the supply chain network.
Economic Order Quantity - Explain
computes HOW MUCH to order. The amount to be ordered is known as the economic order quantity (EOQ).
The EOQ "minimizes" the sum of the ordering and carrying costs.
The total inventory cost function includes carrying costs (which increase with order size) and ordering costs (which decrease with order size)
The EOQ formula is derived by setting the annual carrying costs equal to annual ordering cost or by differentiating the cost function with respect to order size.
EOQ = Square root of 2aD/k
a is the cost of placing "one order"
D is the annual demand in units
k is cost of carrying one unit of inventory for one year
What are some of the costs of carrying safety stock (and inventory in general)?
1. Storage (related utilities and rent costs)
2. Interest to buy and/or carry
3. Spoilage of Obsolesence
4. Insurance to protect value may not be adequate to cover losses fully.
5. Property taxes part of the storage
Explain Safety Stock and Stockouts and costs of Stockouts.
When to reorder? The objective is to order at a point in time so as to avoid stockouts but not so early that an excessive safety stock is maintained. Safety stocks may be used to guard against stockouts; they are maintained by increasing the lead time (the time that elapses from order placement until order arrival).Thus, safety stocks decrease stockout costs but increase carrying costs. Examples of stockout costs include:
1. Profit on lost sales
2. Customer ill will
3. Idle equipment
4. Work stoppages
The most common approach to setting the optimum safety-stock level is to examine previous lead-time periods to determine the probabilities of running out of stock (a stockout) for different assessed levels of safety stock.
Explain Inventory Management and MRP.
Materials requirements planning (MRP) is a * computerized system that manufactures finished goods based on demand forecasts. Demand forecasts are used to develop bills of materials that outline the materials, components, and subassemblies that go into the final products. Finally, a master production schedule is developed that specifies the quantity and timing of production of goods, taking into account the lead time required to purchase materials and to manufacture the various components of finished products. A key weakness of MRP is that it is a "push through" system. Once the master schedule is developed goods are pushed through the production process whether they are needed or not. Therefore, inventories may accumulate at various stages, especially if there are production slowdowns or unreliable demand forecasts. MRP II was developed as an extension of MRP and it features an automated closed loop system. That is, production planning drives the master schedule which drives the materials plans which is input to the capacity plan. It uses technology to integrate the functional areas of a manufacturing company.
Explain JUST-IN-TIME (JIT) PURCHASING
JIT is a demand-pull inventory system which may be applied to purchasing so that raw material arrives just as it is needed for production. The primary benefit of JIT is reduction of inventories, ideally to zero. Because of its non-value-added nature, inventory is regarded as undesirable. In a JIT system, suppliers inspect their own goods and make frequent deliveries of materials, which are placed into production immediately upon receipt. This process eliminates the need for incoming inspection and the storeroom. Suppliers all along the supply chain are informed through specialized software (e.g., enterprise resource systems) about the forecasted demand for their products allowing them to plan to supply the items when needed.
Obviously, the most important aspect of a JIT purchasing system is selection of, and relationships with, suppliers. If suppliers do not make timely delivery of defect-free materials, stockouts and customer returns will occur and they will be more pronounced. In addition, if sales forecasts are not reliable, goods ordered will vary from what is expected, causing inventories to build up somewhere along the supply chain.
JIT methodology can also be applied to production. JIT production is a "demand pull" system in which each component of a finished good is produced when needed by the next production stage. The production process is driven by the demand. It begins with an order by the customer triggering the need for a finished good and works its way back through each stage of production to the beginning of the process. A JIT system strives to produce high-quality products that meet the customer's needs on a timely basis and at the lowest possible cost. Obviously, JIT production reduces inventories to a minimal level. To accomplish JIT production, management must
Emphasize reducing production cycle time (manufacturing lead time) and setup time. Cycle time is the time required to complete a product from the start of its production until it is finished. Setup time is the time required to get equipment and materials ready to start working on the product. The time for both is cut to a minimum in a JIT system.
Emphasize production flexibility. Plant layout is organized around manufacturing cells that produce a product or type of product with the workers being able to operate a number of the different machines. Machinery is purchased that can be used for multiple functions.
Emphasize solving production problems immediately. If it is discovered that parts are absent or defective, production is corrected on the spot. This practice contrasts with traditional systems, in which the production of defective products often continues because defective goods are sitting in inventory—awaiting sale and thus ultimate feedback from the customer. In a JIT system, each worker is responsible for the quality of his or her own work. Thus, JIT results in reductions in scrap and rework.
Focus on simplifying production activities. The goal of JIT is to identify and eliminate non-value-added activities. Less factory space is used for inventory storage and production activities, and materials handling between workstations is streamlined.
Name the main advantages and disadvantages of JIT purchasing and JIT production as compared to traditional systems.
Lower investments in inventories and in space to store inventory.
Lower inventory carrying and handling costs.
Reduced risk of defective and obsolete inventory.
Reduced manufacturing costs.
The luxury of dealing with a reduced number (when compared with traditional systems) of reliable, quality-oriented suppliers.
JIT allows a simplified costing system called backflush costing. The lack of inventories in a JIT system makes choices about cost-flow (such as LIFO and FIFO) unimportant—all manufacturing costs are simply run through cost of goods sold.
DISADVANTAGES On the other hand, JIT systems can break down with disastrous results if (1) suppliers do not provide timely delivery of quality materials, (2) employers? (maybe this should be employees) are not well trained or supervised, or (3) technology and equipment are not reliable.
Enterprise Resource Planning (ERP) Systems.
RP systems are enterprise-wide computerized information systems that connect all functional areas within an organization. By sharing information from a common database, marketing, purchasing, production, distribution, and customer relations management can be effectively coordinated. ERP systems also facilitate supply chain management by connecting the firm electronically to its suppliers and customers.
How do you best measure average age of accounts receivable?
Use Days’ sales outstanding provides a measure of the average age of accounts receivable. Computed:
DSO = Receivables/Sales per Day
EXAMPLE: Assume that a firm’s outstanding receivables balance is $2,000,000 and annual sales is $52,000,000; the days sales outstanding is calculated below.
Days sales outstanding = $2,000,000
_________ = 14 days
A/R or A/P aging breakdown example includes
Age of Account (Days) Amount Percentage
0-10 $1,355,000 67.7
11-30 505,000 25.3
31-45 90,000 4.5
46-60 43,000 2.2
Over 60 7,000 0.3
Total $2,000,000 100.0
By monitoring days sales outstanding and the aging schedule, management can detect adverse trends and evaluate the performance of the credit department.
Cash Conversion Cycle
Inventory conversion period
+ Receivables conversion period
− Payables deferral period
Zero-coupon rate bonds
These types of bonds do not pay interest. Instead they sell at a deep discount from the face or maturity value. The return to the investor is the difference between the cost and the bond’s maturity value. The advantage of these bonds is that there are no interest payment requirements until the bonds mature. In addition, the amortization of interest is tax-deductible even though the firm is not making any interest payments.
Floating rate bonds
The rate of interest paid on this type of bond floats with changes in the market rate (usually monthly or quarterly). Therefore the market price of the bond does not fluctuate as widely. Reverse floaters are floating rate bonds that pay a higher rate of interest when other interest rates fall and a lower rate when other rates rise. Reverse floaters are riskier than normal bonds.
These bonds are registered in the name of the bondholder. Interest payments are sent directly to the registered owners.
These bonds carry very high-risk premiums. Junk bonds often have resulted from leveraged buyouts or are issued by large firms that are in troubled circumstances. They may appeal to investors who feel they can diversify the risk by purchasing a portfolio of the bonds in different industries.
These bonds are international bonds that are denominated in the currency of the nation in which they are sold. Foreign bonds might serve as an effective hedge for a firm that is heavily invested in assets in the foreign country.
These bonds are international bonds that are denominated in U.S. dollars.
What do Dividends paid by a corporation typically exhibit?
In practice Dividends exhibit greater stability than earnings.
Most people argue that the relevance of dividends is in their information content. Dividends signal to investors that management believes that the firm had a good year. Increases in dividends tend to increase share prices, while reductions tend to depress share prices. As a result, management is hesitant to decrease dividends.
Economic Order Quantity numerator and denominator components
a $ Cost of placing "one" P. O. in numerator
D # of Units Demanded in a "year" in numerator
2 to helps to better average out the square root.
k = Inventory carrying cost for "one" unit in denominator
Formula EOQ = sq rt of 2aD/k
When managing cash and short-term investments, a corporate treasurer is primarily concerned with
Short-term investments must be liquid and safe to provide funds when needed. Primary concerns are liquidity and safety!
Operating Leverage explain and the Formula
Operating leverage. Operating leverage measures the degree to which a firm builds fixed costs into its operations. If fixed costs are high a significant decrease in sales can be devastating. Therefore, all other things being equal, the greater a firm’s fixed costs the greater its business risk. On the other hand, if sales increase for a firm with a high degree of operating leverage, there will be a larger increase in return on equity. The degree of operating leverage (DOL) may be computed using the following formula:
% Change in operating income
% change in volume unit
Highly leveraged firms, such as Ford Motor Company, enjoy substantial increases in income when sales volume increases. Less leveraged firms enjoy only modest increases in income as sales volume increases.
Financial Leverage explain and the Formula
Financial leverage measures the extent to which the firm uses debt financing. While the use of debt can produce high returns to stockholders, it also increases their risk. Since debt generally is a less costly form of financing, a firm will generally attempt to use as much debt for financing as possible. However, as more and more debt is issued, the firm becomes more leveraged and the risk of its debt increases, causing the interest rate on additional debt to rise. Therefore, the optimal capital structure for a firm involves a mixture of debt and equity. The degree of financial leverage (DFL) for a firm may be computed using the following formula:
% Change in EPS
% change in EBIT
As you can see from the tables, the more financially leveraged strategy results in much more earnings for common stockholders when the firm performs well. However, it results in much more loss per share when the firm performs poorly. These examples clearly illustrate the major advantages and disadvantages of financial leverage.
If the corporation purchases treasury with surplus cash what does this do to financial leverage?
Purchase of treasury stock decreases the firm’s assets and stockholders’ equity. Therefore it increases the firm’s financial leverage.
Stock Dividends do not affect par value like stock splits do, they are payments to existing stockholders of a dividend in the form of the firm’s own stock. As an example, a 10% stock dividend would involve the issuance of 10% more shares to each stockholder. Such dividends are designed to signal to investors that the firm is performing well, but it does not require the firm to distribute cash.
stock dividend involves a ratable distribution of additional shares to common stockholders
they do NOT decrease assets in corp
they do NOT increase a shareholders proportionate share of corporate ownership
Are NOT like stock splits in the regard no change in par value..in other respects they are similar.
are similar to stock dividends but they are generally designed to reduce the stock’s price to a target level that will "attract more investors". As an example, a 2-for-1 stock split doubles the number of shares outstanding and it would be expected that the price of the stock would drop approximately in half. HOWEVER WITH STOCK SPLITS PAR VALUE CHANGES AND it par does not change with stock dividends.