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Flashcards in Module 44: Financial Management Deck (220):
1

financial management includes the following five functions

1. financing function
2. capital budgeting function
3. financial management function
4. corporate governance function
5. risk management function

2

financing function

raising capital to support the firms operations and investment programs

3

capital budgeting function

selecting the best projects in which to invest firm resources, based on a consideration of risks and return (module 43b)

4

financial management function

managing the firms internal cash flows and its capital structure (mix of debt and equity financing) to minimize the financing costs and ensure that the firm can pay its obligations when due

5

corporate governance function

developing an ownership and corporate governance system for the firm that will ensure that managers act ethically and inthe best interest of stakeholders (m 40)

6

risk managment function

managing the firms exposure to all types of risk (m 40 ERM)

7

working capital management

involves managing and financing the current assets and current liabilities of the firm

the primary focus of working capital management is managing inventories and receivables

8

managing the firms cash conversion cycle

the cash conversion cycle of a firm is the length of time between when the firm makes payments and when it receives cash inflows (graph on page 242)

9

the cash conversion cycle may be analyzed using the following three periods

1. inventory conversion period
2. receivables collection period
3. payables deferral period

10

inventory conversion period

the average time required to convert materials into finished goods and sell those goods

= avg inventory / COGS per day*

*in some references this ratio is calculated using sales per day instead of COGS per day

11

receivables collection period (days sales outstanding)

the average time reuired to collect accounts receivable

= average receivables / credit sales per day (or total sales if avg is not given)

12

payables deferral period

the average length of time between the purchase of materials and labor and the payment of cash for them

= avg payables / purchases per day (COGS/365)

13

cash conversion cycle

= inventory conversion period + receivables conversion period - payables deferral period

14

effective working capital management involves

shortening the cash conversion cycle as much as possible without harming operations

15

cash management

the firm should attempt to minimize the amount of cash on hand while maintaining a suffieient amount to:
1. take advantage of purchase discounts
2. maintain its credit rating
3. meet unexpected needs

16

firms hold cash for two basic reasons:

1. transactions- cash must be held to conduct business operations
2. compensation to financial institution- financial institutions require minimum balances (1) for certain levels of service or (2) as a requirement of loan agreements

compensating balances- are these minimums required

17

firms prepare cash budgets to make sure that they have adequate cash balances to:

1. take advantage of cash discoutns
2. assure that the firm maintains its credit rating
3. take advanage of favorable business opportunities (like acquisitions) these are sometimes called speculative balances
4. meet emergencies, such as funds for strikes, natural disasters, and cyclical downturns - these are sometimes called precautionary balances

18

speculative balances

funds kept to take advanage of favorable business opportunities (like acquisitions)

19

precautionary balances

funds kept to meet emergencies, such as funds for strikes, natural disasters, and cyclical downturns

20

a key technique for cash management is managing a

float, which is the time that elapses relating to mailing, processing, and clearing checks

a float exists for both the firms payments to suppliers and the firms receipts from customers

effective cash management involves extending the float for disbursements and shortening the float for cash receipts (collect as early you can and pay as late as you can)

21

zero-balance accounts

this cash management technique involves maintaining a regional bank account to which just enough funds are transferred daily to pay the checks presented

regional banks typically receive the checks drawn on their customers accounts in the morning from the federal reserve

the customer can the be notified as to the amount of cash needed to cover the checks and arrange to have that amount of cash transferred to the account

22

zero-balance account advantages

(maintaining a regional bank account to which just enough funds are transferred daily to pay the checks presented)

1. check take longer to clear at a regional bank, providing more float for cash disbursements

2. extra cash does not have to be deposited in the account for contingencies

a zero balance account is cost-effective if the amount the firm saves on interest costs from the longer float is adequate to cover any additional fees for account maintenance and cash transfers

23

lock-box system

customer payments are sent to a post office box that is maintained by a bank

bank personnel retrieve the payments and deposit them into the firms bank account

24

lock-box advantages

1. increases the internal control over cash because firm personnel dont have access to deposits

2. provides for more timely deposit of receipts which reduces the need for cash for contengencies (banks charge fees)

25

compensating balance

increases effective interest rate of loan

it requires a min bal for certain levels of services or as a requirement of a loan agreement

26

concentration banking

a way to speed up collection of payments on accounts

customers in an area make payments to a local branch office rather than firm headquarters. the local branch makes deposits in an account at a local bank. then, surplus funds are periodically transferred to the firm's primary bank. since these offices and banks are closer to customers, the firm gets the use of the funds more quickly. the float related to cash receipts is shortened

note: wire transfers can be expensive but official bank check transfers are not

used together with a lock box system (for western or eastern us- the checks get to the PO box faster and then the bank deposits them into the local account)

27

official bank transfers

a slower but less expensive way of transferring funds from one account to another

28

electronic funds transfer

electronic funds transfer is a system in which funds are moved electronically between accounts without the use of a check

EFT actually takes the float out of both the receipts and disbursements process

29

international cash management

multinational firms can use various systems, including electronic systems, to manage the cash accounts they hold in various countries

example: management may be able to transfer funds to a country in which interest rates are higher, allowing increased returns on investments

30

marketable securities

in most cases, firms hold marketable securities for the same reasons they hold cash

they can generally be converted to cash very quickly, and marketable securities have an advantage over cash in that they provide an investment return

31

factors that should be considered in choosing marketable securities

1. minimum investment required
2. safety (risk)
3. marketability (liquidity)
4. maturity
5. yield

32

major types of short term investments (marketable securities)

1. treasury bills
2. treasury notes
3. treasury inflation protected securities (TIPS)
4. federal agency securities
5. certificates of deposits (CDs)
6. commercial paper
7. banker's acceptance
8. eurodollar certificate of deposit
9. money market funds
10. money market accounts
11. equity and debt securities

33

treasury bills

short term obligations of the federal government;

offered from 91- 182 days; active market ensures liquidity

34

treasury notes

government obligations with maturities from one year to ten years

35

treasury inflation protected securities (TIPS)

government obligations that pay interest that equates to a real rate of return specified by the US treasury, plus principal at maturity that is adjusted for inflation

36

federal agency securities

offerings of government agencies, such as the federal home loan bank;

secure, liquid, and pay slightly higher yields than treasury issues

37

certificates of deposits (CDs)

savings deposits at financial institutions; two tier market;

small CDs ($500-$1000) with lower interest rates and large ($100,000 or more) with higher interest rates;

there is a seconfary market providing some liquidity

normally ensured up to $250,000 by the federal government

38

commercial paper

large unsecured short term promissory notes issued to the public by large credit worthy corporations

has 2 to 9 month maturity period and is usually held to maturity by the investor because there is no active secondary market

39

bankers acceptance

a draft drawn on a bank for payment when presented to the bank

generally arise from payments for goods by corporations in foreign countries

a secondary market has developed for sale at a discount because the corporation receiving the bankers acceptance usually has to wait 30-90 days to present the acceptance for payment

involve slightly more risk than government securities but slightly higher yields

40

eurodollar certificate of deposit

are US dollars held on deposit by foreign banks and in turn lent by banks to anyone selling dollars

to obtain dollars, foreign banks offer eurodollar certificates of deposit

pay higher yields than treasury bills or CDs at large US banks

41

money market funds

shares in a fund that purchases higher yielding bank CDs, commercial paper and other large denomination, higher yielding securities

MM funds allow smaller investors to participate in these markets

42

money market accounts

similar to savings accounts, individual or business investors deposit idle funds in the accounts and the funds are used to invest in higher yielding bank CDs, commercial paper, etc.

43

equity and debt securities

are publically traded stocks and bonds of other corporations

have greater risk than other short term investments, but they also offer higher average long term returns

if management invests in such securities it should purchase a balanced portfolio to diversify away the unsystematic risk (default risk) of the individual investments

44

Inventory management

effective inventory management starts with effective forecasting of sales and coordination of purchasing and production

two goals of inventory management are:
1. ensure adequate inventories to sustain operations
2. minimize inventory costs, including carrying costs, ordering and receiving costs, and cost of running out of stock (stockout costs)

45

protection pattern

if the firm has seasonal demand for its products, management must decide whether to plan for level or seasonal production

46

level production (protection pattern)

involves working at a consistent level of effort to manufacture the annual forecasted amount of inventory

results in the most efficient use of labor and facilities throughout the year

however, it also results in inventory buildups during slow sales (=inventory holding costs)

47

seasonal production (protection pattern)

involves increasing production during periods of peak demand and reducing production during slow periods

often has additional operating costs (overtime and maintenance)

48

inventory and inflation

a firms inventory policy also might be affected by inflation (delfation)

example: if silver as a raw material is needed, the co may experience gains or losses due to fluctuation in price

49

supply chain

describes a goods production and distribution

it illustrates the flow of goods and 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

50

supply chain management

used to manage inventories and their relationships with their suppliers

key aspect is sharing of information from the point of sale to the final consumer back to the manufacturer, to the manufacturers suppliers, and to the suppliers' suppliers

specialized software facilitates the process of information sharing along the supply chain network

51

economic order quantity
how much to order?

the amount to be ordered is known as the economic order quantity (EOQ)

it 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 size)

EOQ = Sq root of (2 a D / K)
a= cost of placing one order
D= annual demand in units
K= cost of carrying one unit of inventory for one year

52

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 maintainted

safety stocks may be used to guard against stock outs; they are maintained by increasing the lead time (the time that elapses from order placement until the order arrival)

safety stocks decrease stockout costs but increase carrying costs

53

carrying cost examples

1. storage
2. interest
3. spoilage
4. insurance
5. property taxes

54

stockout costs

1. profit on lost sales
2. customer ill will
3. idle equipment
4. work stoppages

55

inventory management and MRP

materials requirements planning (MRP) is a computerized system that manufactures finished goods based on demand forecasts

56

demand forecasts

used to develop bills of materials that outline the materials, components, and subassemblies that go into the final products

57

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

58

a key weakness of MRP (materials requirement planning)

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 slow downs or unreliable demand forecasts

59

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

60

just in time purchasing (JIT)

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

the most important aspect of a JIT system is selection of, and relationships with, suppliers

if suppliers to not make timely deliver of defect free materials, stockouts and customer returns will occur and they will be more pronounced

also, if sales forecasts are not reliable, goods ordered will vary from what is expected, causing inventories to build up along the supply chain somewhere

61

JIT production

a "demand-pull" system in which each component of a finished good is produced when needed by the next produciton stage (driven by demand)

it begins with an order by the customer triffering the need for a finished good and works its way back through each stage of production to the beginning of the process

62

JIT purchasing and production advantages over traditional systems:

1. lower investments in inventories and in space to store inventories
2. lower inventory carrying and handling costs
3. reduced risk of defective and obsolete inventory
4. reduced manufacturing costs
5. the luxury of dealing with a reduced number of reliable quality oriented suppliers

63

backflush costing

JIT allows this simplified costing system

all costs are simply run through cost of goods sold instead of cost flow (LIFO FIFO)

64

JIT disadvantages

can break down with disastrous results if:
1. suppliers do not provide timely delivery of quality materials
2. employees are not well trained or supervised
3. technology and equipment are not reliable

65

enterprise resource planning (ERP) systems

are enterprise-wide computerized information systems that connect all functional areas within an organization

by sharing info from a common database, marketing, purchasing, production, distribution, and customer relations management can be effectively coordinated

66

receivables management

effective receivables maangement involves systems for deciding whether or not to grant credit and for monitoring the receivables

67

a credit policy should consist of the following:

1. credit period- the length of time buyers are given to pay for their purchases

2. discounts- percentage provided and period allowed for discount for early payment

3. credit criteria- required financial strength of acceptable credit customers. firms often use a statistical technique called credit scoring to evaluate a potential customer

4. collection policy- diligence used to collect slow paying accounts

68

in making an individual credit decision,

management must determine the level of credit risk of the customer based on prior records of paument, financial stability, current financial position and other factors

69

Dun & Bradstreet Information Services

a source that credit information is available to make credit decisions

70

Days sales outstanding

used by management to provide overall monitoring of receivables

= receivables / sales per day

71

aging schedule of accounts receivable

breaks down receivables by age (days outstanding)

72

management of accounts receivable also involves

determining the appropriate credit terms and criteria to maximize profit from sales after considering the cost of holding accounts receivable and losses from uncollectible accounts

73

financing current assets

because many firms have seasonal fluctuations in the demand for their products or services, current assets tend to vary in amount from month to month

conventional wisdom says current assets should be financed with current liabilities (AP, commercial bank loans, commercial paper, etc)

however, a certain amount of current assets are needed for operational purposes

74

permanent current assets

the amount of current assets that are required to operate the business in even the slowest periods of the year

are more appropriately financed with long-term financing (stock or bonds) instead of current liabilities (AP, commercial bank loans, commercial paper, etc)

additional current assets are accumulated during periods of higher production and sales

75

temporary current assets

additional current assets that are accumulated during periods of higher production and sales

may be financed with short term financing

76

financing current assets

various strategies are used

since short term debt is less expensive than long term debt firms generally attempt to finance current assets with short term debt

however, use of extensive amouns of short term debt is aggressive in that firms must pay off the debt or replace it as it comes due

77

more conservative strategies for financing current assets

involve financing some current assets with long term debt which involves a more stable interest rate (remember long term debt is more expensive)

long term debt aslo has provisions or covenants that generally constrain the firms future actions

prepayment penalties may make early repayment of long term debt an expensive proposition

78

maturity matching or self-liquidating approach to financing assets inovles

also referred to as the hedging approach

matching asset and liability maturities

this strategy minimizes the risk that the firm will be unable to pay its maturing obligations

79

generalizations about the cost, riskiness, and flexibility of short term versus long term debt depend on

the type of short term debt being used

80

sources of short term funds

1. accounts payable (trade credit)
2. short term bank loans
3. accounts receivable financing
4. commercial paper
5. inventory financing
6. hedging to reduce interest rate

81

accounts payable (trade credit)

a source of short term funds- most common

firms generally purchase goods and services from other firms on credit

trade credit, especially for small firms, is a very significant source of short term funds

a major advantage is that it arises in the normal course of business and bears no interest cost providing it is paid on time

2/10 net 30 means the vendor will offer a 2% discount if the payable is paid within 10 days but it is due in 30 days with no discount

82

nominal rate or the approximate cost of not taking the payment term discount "2/10 net 30"

= (discount % / 1- discount %) * (days in year / (payment peirod - discount period ))

83

short term bank loans

note payable to commercial banks represents the second most important source of short term funds

key features:
1. maturity- business loans typically mature in 90 days
2. promissory note- specifies the terms of the agreement; enforceable in court
3. interest- fluctuates with short term interest rates as measured by indexes (prime rate, london interbank offered rate)
4. compensating balances
5. informal line of credit
6. revolving credit agreements
7. letter of credit

84

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, bc the firm does not get use of the full amount of the loan principal

85

informal line of credit

an informal specification of the macimum amount that the bank will lend to the borrower (at one time)

86

revolving credit agreements

a line of credit in which the bank is formally committed to lend the firm a specified max amount

87

letter of credit

an instrument that facilitates international trade

a letter of credit, issued by the importers bank. promises that the bank will pay for the impoted merchandise when it is delivered

it is designed to reduce the risk of nonpayment by the importer

88

commercial paper

a form of insecured promissory note issued by large, credit worthy firms

sold primarily to other firms, insurance ocmpanies, pension funds, banks, and mutual funds

typically has a maturity date that vary from one day to nine months

rate is usually 2%-3% less than the prime rate and there are no compensating balance rewuirements

market is less predictable than bank financing

89

pledging of receivable (AR financing)

involves committing the receivables as collateral for a loan from a financial institution

90

factoring (AR financing)

when receivables are factored, they are sold outright to a finance company

91

asset-backed public offerings (AR financing)

large firms recently have begun floating public offerings of debt (e.g. bonds) collateralized by the firm's accounts receivable

bc they are collateralized, such securities generally carry a high credit rating, even though the issuing firm may have a lower credit rating

92

inventory financing

a firm may also borrow funds using its inventory as collateral

methods used by lenders to control the pledged inventories include:
1. blanket inventory lien
2. trust receipt
3. warehousing

93

hedging to reduce interest rate risk

firms that must borrow significant amounts of short term variable rate funds are exposed to high levels of interest rate risk

to mitigate this interest rate risk, management may decide to hedge the risk with derivatives purchased or sold in the financial futures market

94

blanket inventory lien

this is simply a legal document that establishes the inventory as collateral for the loan

no physical control over inventory is involved

95

trust receipt

an instrument that acknowledges that the borrower holds the inventory and that proceeds from sale will be put in the trust for the lender

when the inventory is sold, the funds are transferred to the lender and the trust receipt is cancelled

this form of financing is also referred to as floor planning and is widely used for automobile and industrial equipment dealers

96

warehousing

this is the mose secure form of inventory financing

the inventory is stored in a public warehouse or under the control of public warehouse personnel

the goods can only be removed with the lenders permission

97

capital structure

involves the combination of debt and equity

how you finance your assets

A= L + SE

98

long term debt

the characteristics of the various forms of financing available to the firm help determine the funding sources that are most appropriate

99

private debt

has two principal types:

1. loans from financial institutions (either an individual institution or a syndicated loan from multiple institutions); almost universally have a floating interest rate tied to a base rate, usually LIBOR (london international offered rate) or the US bank prime rate

2. private placement of unregistered bonds sold directly to accredited investors (often pension funds or insurance companies); typically less expensive to issue than public debt

100

public long term debt

offerings involve selling SEC registered bonds directly to investors

the bond agreement specifies that par value, the coupon rate, and the maturity date of the debt

par value- face amount of bond, usually $1,000 for corporate bonds

coupon rate- interest rate paid on the face amount of the bond; since bonds have a fixed rate of interest, the market value of the bond fluctuates with changes in the market interest rate

maturity date- the final date on which repayment of the bond principal is due

101

eurobonds

the market for eurobonds is a market with increasing importance

it is a bond payable in the borrower's currency but sold outside the borrowers country

the registration and disclosure requirements for eurobonds are less stringent than those of the SEC for US issued bonds (therefore cost of issuance is less)

102

debt covenants

both private and public debt agreements contain restrictions (debt covenants)

they allow investors (lendors) to monitor and control the activities of the firm

103

negative debt covenants

specify the actions the borrow cannot take, such as:

1. the sale of certain assets
2. the incurrence of additional debt
3. the payment of dividends
4. the compensation of top management

104

positive debt covenants

specify what the borrower must do and include such requirements as:

1. provide audited financial statements each year
2. maintain certain minimum financial ratios
3. maintain life insurance on key employees

105

typical provisions of debt agreements

1. security provisions
2. methods of payments

106

security provisions on debt

debt may be secured or unsecured

secured debt is one which specific assets of the firm are pledged to the bondholders in the event of default

based on their security provisions debt may be classified as:
1. mortgage bond
2. collateral trust bond
3. debenture
4. subordinated debenture
5. income bond

107

mortgage bond

a bond secured with the pldege of specific property (usually property or plant assets)

108

collateral trust bond

a bond secured by financil assets of the firm

109

debenture

a bond that is not secured by the pledge of specific property; its a general obligation of the firm

bc of the default risk, such bonds can only be issued by firms with the highest credit rating

they typically have a higher yield than mortgage bonds and other secured debt

110

subordinated debenture

a bond with claims subordinated to other general creditors in the event of bankruptcy of the firm

that is the bondholders receive distributions only after general creditors and senior debt holders have been paid

111

income bond

a bond with interest payments that are contingent on the firms earnings

higher degree of risk and carry even higher yields

112

methods of payment- bonds may be paid as a single sum at maturity or through:

1. serial payments
2. sinking fund provisions
3. conversion
4. redeemable
5. a call feature

113

serial payments

serial bonds are paid off in installments over the life of the issue

serial bonds may be desirable to bondholders bc they can choose their maturity date

114

sinking fund provisions

the firm makes payments into a sinking fund which is used to retire bonds by purchase

115

conversion

the bonds may be convertible into common stock and this may provide the method of payment

116

redeemable

a bondholder may have the right to redeem the bonds for cash under certain circumstances (e.g. the firm is acquired by another firm)

117

a call feature

the bonds may have a call provision allowing the firm to force the bondholders to redeem the bonds before maturity

call for payment is typically 5% to 10% premium over par

investors generally do not like call features bc they may be used to force them to liquidate their investment

118

bond yield

there are three different yields that are relevant to bonds:
1. coupon rate
2. current yield
3. yield to maturity (prevailing rate of interest in market of similar bonds)

119

the price of a bond is dependent on

the current risk free interest rate and the credit risk of the particular bond

bond rating agencies have rating systems for bonds to capture credit risk

120

credit default insurance

companies that invest in a significant amount of bonds may decide to share the credit risk by purchasing credit default insurance

121

other types of bonds

1. zero coupon rate bonds
2. floating rate bonds
3. registered bonds
4. junk bonds
5. foreign bonds
6. eurobonds

122

zero-coupon rate bonds

do not pay interest

instead they sell at a deep discount from face or maturity value

the return to the investor is the difference between the cost and the bonds maturity value

advantage: there are no interest payment requirements until the bonds mature

123

floating rate bonds

the rate of interest paid on this type of bond floats with changes in the market rate

124

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

125

registered bonds

these bonds are registered in the name of the bondholder

interest payments are sent directly to the registered owners

126

junk bonds

these bonds carry very high risk premiums

often have resulted from leveraged buyouts or are issued by large firms that are in troubled circumstances

purchased by investors that feel they can diversify the risk by purchasing a portflio of the bonds in different industries

127

foreign bonds

these bonds are international bonds that are denominated in the currency of the nation in which they are sold

128

eurobonds

international bonds that are denominated in US dollars

129

advantages of debt financing

1. interest is tax deductible
2. the obligation is generally fixed in terms of interest and principal payments
3. in periods of inflation, debt is paid back with dollars that are worth less than the ones borrowed (you got more than what you had to pay back)
4. the owners (common stockholders) do not give up control of the firm
5. debtors do not participate in excess earnings of the firm
6. debt is less costly than equity

130

disadvantages of debt financing

1. interest and principal oblifations must be paid regadless of the economic position of the firm
2. interest payments are fixed in amount regardless of how poorly the firm performs
3. debt agreements contain covenenants that place restrictions on the flexibility of the firm
4. excessive debt increases the risk of equity holders and therefore depresses share prices

131

leasing as a form of financing

is a potential source of immediate or long term financing

two types:
1. capital leases
2. operating leases

132

capital leases

those that meet any one of the following four conditions as set forth in SFAS 13:
1. transfers ownership by the end of the lease

2. lease contains a bargain purchase price option at the end of the lease (exercising of the option must be reasonably possible)

3. lease term is equal to 75% or more of the estimated life of the leased property

4. the PV of the minimum payment equals 90% or more of the FV of the leased property at the inveption of the lease

if one of these criteria is met, the firm must record the leased asset and related liability on its balance sheet, and account for the asset much like it would a purchased asset

asset is recorded at the PV of the future lease payments and amortized (depreciated)

liability is recorded at the same amount and each lease payment involves payment of interest and principal on the obligation

133

operating lease

one that does not meet the capital lease requirements

are treated as rental agreements or off balance sheet financing

134

lease advantages over purchasing

1. a firm may be able to lease an asset when it does not have the funds or credit capacity to purchase
2. provisions of a lease agreement may be less stringent than a bond indenture
3. there may be no down pmt required
4. creditor claims on certain types of leases, such as real estate are restricted in bankruptcy
5. the cost of a lease to the lessee may be reduced (could be structured that the lessor receives the tax benefits)
6. operating leases do not require recognition of a liability on the f/s of the lessee

135

leasing disadvantages

the dollar cost of leasing an asset is often higher than the cost of purchasing the asset

136

common stock

the ultimate owners of the firm are the common shareholders

they generally have control of the business and are entitiled to a residual claim to income of the firm after the creditors and preferred shareholders are paid

common stock ownership involves a high degree of risk

137

classes of common stock

most firms issue only one class of common stock

however a second class that differes with respect to the shareholders right to vote or receive dividends

138

stock warrants

are sometimes issued with bonds to increase their marketibility

a stock warrant is an option to buy common stock at a fixed price for some period of time

once the bond is sold, the stock warrants often may be sold separately and traded on the market

139

advantages of issuing common stock

1. the firm has no firm obligation, which increases financial flexibility
2. increased equity reduces the risk to borrowers, and therefore, will reduce the firm's cost of borrowing money
3. common stock is more attractive to many investors because of the future profit potential

140

disadvantages of common stock

1. issuance costs are greater than for debt
2. ownership and control is given up with respect to the issuance of common stock
3. dividends are not tax-deductible by the corporation whereas interest is (double taxation)
4. shareholders demand a higher rate of return than lenders
5. issuance of too much CS may increase the firms cost of capital

141

preferred stock

is a hybrid security

preferred shareholders are entitled to receive a stipulated dividend and generally must receive the stipulated amount before the payment of dividends to common shareholders

preferrential stockholders have a priority over CSholders in the event of liquidation of the firm

common features of preferred stock include:
1. cumulative dividends
2. redeemability
3. conversion
4. call feature
5. participation
6. floating rate

142

cumulative dividends of preferred stock

most issues are cumulative preferred stock and have a cumulative claim to dividende (if dividends are not declared in a year, the amt becomes in arrears and the amount must be paid in addition to current dividends before common shareholders can receive a dividend)

143

redeemability of preferred stock

some is redeemable at a specific date

makes it very similar to debt

on the b/s the redeemable preferred stock is often presented between debt and equity (the so called mezzanine)

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conversion of preferred stock

may be convertible into common stock

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call feature of preferred stock

like debt, may have a call feature

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participation of preferred stock

a small % of PS are participating, which means they may share with common shareholdes in dividends above the stated amount

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floating rate preferred stock

a small % of preferred shares have a floating rather than a fixed dividend rate

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advantages of issuing preferred stock

1. the firm still has no obligation to pay dividends until they are declared, which increases financial flexibility
2. increased equity reduces the risk to borrowers and therefore will reduce the firms cost to borrow
3. common stockholders do not give up control of the firm
4. preferred shareholders do not generally participate in superior earnings of the firm

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disadvantages of preferred stock

1. issuance costs are greater than for debt
2. dividends are not tax-deductible by the corp whereas interest is
3. dividends in arrears accumulated over a number of years may create financial problems for the firm

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convertible securities

a bond or share of preferred stock that can be converted, at the option of the holder, into common stock

when the security is initially issued it has a conversion ratio that indicates the number of shares that the security may be issued into

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advantage of convertible securities

the fact that investors require a lower yield bc of the prospects that conversion may result in a significant gain

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disadvantage of convertible securities

conversion dilutes the ownership of other common stockhodlers

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spin-offs

occurs when a public diversified firm separates one of its subsidiaries, distributing the shares on a prorata basis to the existing stockholders

often part of managements strategy to turn its focus to its core businesses

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tracking stocks

a tracking stock is a specialized equity offering that is based on the operations and cash flows of a wholly owned subsidiary of a diversified firm

they are hybrid securities bc the sub is not separated from the parent, legally or operationally

the stock simply is entitled to the cash flows of the sub and therefore the trading stock trades at a valuation based on the subs expected future cash flows

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venture capital

a pool of funds that is used to make actively managed direct equity investments in rapidly growing private companies

in addition to capital, professional venture capitalists provide managerial oversight and business advice to the companies

good option for promising private companies, but management usually has to give up control

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going public

involves registering the firms shares with the SEC

from that point on, the firm must comply with the reporting and other requirements of the SEC and the exchange on which the stock trades

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advantages of going public

1. IPO provides the firm with access to a larger pool of equity capital
2. publically traded stock may be used for acquisitions of other firms; if a private company decides to acquire another company it generally must do so with cash
3. the firm can offer stock options and other stock-based compensaion to attract and retain qualified managers
4. provides owners of the private company liquidity for their investment

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disadvantages of going public

1. significant costs and management effort must be put into an IPO
2. there are significant costs of being pulblic (laws and regs and compliance)
3. being public necessarily causes managment to be focused on maximizing stock price
4. management must provide a great deal of information about the firm to investors

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employee stock ownership plans (ESOPs)

firms often reward management and key employees with stock or stock options as part of their compensation

these plans are designed to motivate management to focus on shareholder value

sometimes used as a vehicle for a leveraged buyout

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going private

some public corporations have decided (often to concentrate control) to go private

these transformations are sometimes executed through a leveraged buyout

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evaluating the best source of financing

involves considering leverage and cost of capital

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leverage

there are two types:
1. operating leverage
2. financial leverage

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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 (greater fixed costs = greater 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

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Degree of operating leverage formula

= percent change in operating income / percent change in unit volume

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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, th firm becomes more leveraged and the risk of its debt increases, cuasing the interest rate on additional debt to rise

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degree of financial leverage formula

= percent change in EPS / percent change in EBIT

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cost of capital

a firms cost of capital is an important concept in discussing financing decisions, especially those involving financing capital projects (long term projects)

if a firm can earn a return on an investment that is greater than its cost of capital, it will increase the value of the firm

the cost of capital for a firm is the weighted-average cost of its debt and equity financing components

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cost of debt

is equal to the interest rate of the loan adjusted for the fact that interest is deductible

in considering the cost of new debt, costs of issuing the debt (flotation costs) must be considered

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cost of preferred equity

is determined by dividing the preferred dividend amount by the issue price of the stock

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cost of common equity

greater than that of debt or preferred equity because common shareholders assume more risk

thus they demand a higher return for their investment

common equity is raised in two ways:
1. by retaining earnings
2. by issuing new common stock

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cost of existing common equity

firms use a number of techniques to estimate the cost of existing common equity including the capital asset pricing model, the arbitrage pricing model, the bond yield plus approach and the dividend yield plus growth rate approach

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the capital asset pricing model (CAPM) method

one method of estimating the cost of common equity

steps:
1. estimate the risk free rate of interest, kRF (usually use US treasury bond rate or short term treasury bill rate)

2. estimate the stocks beta coefficient, bi for use as an index of the stocks risk (higher betas indicate more volatility and more risk)

3. estimate the expected rate of return on the market, kM (this is the expeted rate of return on stock investments with similar risk

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beta coefficient

measures the correlation between the price volatility of the stock market and the price volatility of an individual firms stock

if the stock price consistently rises and falls to the same extent as the overall market, the stock's beta would be equal to 1.00

higher betas indicate more volatility and more risk

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arbitrage pricing model

this method uses a series of systematic risk factors to develop a value that reflects the multiple dimensinos of systematic risk (CAPM only uses systematic risk- one variable)

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bond yield plus approach

simply involves adding a risk premium of 3 to 5% to the interest rate on the firms long term debt

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dividend yield plus growth rate approach (dividend valuation)

estimates the cost of common equity by considering the investors expected yield on their investment

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the cost of common new stock

if a firm is issuing new common stock, a slightly higher return must be earned

the higher return is necessary to cover the cost of distribution of the new securities (floatation or selling costs)

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optimal capital structure

defiines the mix of debt, preferred, and common equity that causes the firm's stock price to be maximized

the optimal or target capital structure involves a trade off between risk and return

incurring more debt generally leads to higher returns on equity but it also increases the risk borne by the stockholders of the firm

the firms optimal capital structure is the one that minimizes the weighted average cost of capital

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factors that generally affect a firms capital structure strategies

1. business risk
2. tax position
3. financial flexibility
4. management conservatism or aggressiveness

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buisness risk that affects capital structure strategies

the greater the inherent risk of the business the lower the optimal debt to equity ratio

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tax position that affects capital structure strategies

a major advantage of debt is the tax deductibility of interest payments

if the firm has a low marginal tax rate, debt becomes less advantageous as a form of financing

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financial flexibility that affects capital structure strategies

is the ability of the firm to raise capital on reasonable terms under adverse conditions

less debt should be assumed by firms with less financial flexibility

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management conservatism or aggressiveness that affects capital structure strategies

a firms target capital structure will be affected by the risk tolerance of management

more aggressive management may take on more debt

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weighted average cost of capital (WACC)

in determining the optimum capital structure, management often calculates the firm's weighted-average cost of capital

this process involves taking the cost of various types of financing (debt, preferred equity, common equity, etc) and weighting each by the actual or proposed percentage of total capital

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dividend policy

of a firm relates to managements propensity to distribute earnings to stockholders

major influence of the dividend policy is where the firm is in its life cycle (development, growth, expansion, maturity stages)

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dividend policy in the development and growth stage

firm needs to retain its profits to finance development and growth

if any dividends are issued they tend to be stock dividends

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dividend policy in the expansion stage

the firms needs for investment declines and management may decide to issue small cash dividends

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dividend policy in a successful maturity stage

the firm will tend to begin issuing regular and growing cash dividends

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other factors that affect managements dividend policy

1. legal requirements- most states forbid firms to pay dividends that would impair the initial capital contributions

2. cash position- cash must be available to pay dividends

3. access to capital market- if the firm has limited acces to capital markets, management is more likely to retain the earnings of the firm

4. desire for control- retaining earnings results in less need for management to seek other forms of financing which might come with restrictions on managements actions

5. tax position of shareholders- stockholders must pay taxs on dividednds and wealthier individuals pay higher taxes

6. clientele effect- some firms may have a strategy of attracting investors that require a dividend, such as retired individual

7. investment opportunities- retained earnings should be reinvested in the firm if the firm can earn a return that exceeds what the investor can earn on another investment with a similar risk

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other types of dividends

1. stock dividends
2. stock splits

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stock dividends

are payments to existing stockholders of a dividends in the form of the firms own stock

these dividends are designed to signal to investors that the firm is performing well, but it does not require the firm to distribute cash

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stock splits

are similar to stock dividends but they are generally designed to reduce the stocks price to a target level that will attract more investors

example: a 2-for-1 stock split doubles the number of shares outstanding and would be expected that the price of the stock would drop approximately half

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share repurchases (treasury stock)

firms will often repurchase some of their shares to have them available for executive stock options or acquisitions of other firms

other reasons to repurchase stock are:
1. it sends a positive signal to investors that management believes the stock is undervalued
2. it reduces the number of shares outstanding and thereby increasing earnings per share
3. it provides a temporary floor for the stock

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financial markets

are markets in which financial assets are traded (borrowing and lending, sale of previously issued securities, and sale of newly issued securities)

markets for stocks and debt: new york stock exchange, US government bond market, NASDAQ

markets for futures and option contracts: Chicago Board of Trade, Chicago Mercantile Exchange

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primary financial markets

markets in which newly issued securities are sold

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secondary financial markets (NYSE)

markets in which previously issued securities are sold

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bull (financial) market

a rising market

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bear (financial) market

a declining or lethargic market

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major players in (financial) markets

1. brokers- commissioned agents of buyers or sellers

2. dealers- similar to brokers in that they match buyers and sellers; dealers can and do take positions in the assets and buy and sell their own inventory

3. investment banks-assist in the initial sale of newly issued securities by providing advice, underwriting, and sales assistance

4. financial intermediaries- financial institutions that borrow one form of financial asset (e.g. savings deposit) and distribute the asset in another form (e.g. commercial loan)

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asset and liability valuation

an important aspect of financial management

valuations are needed for a number of purposes invluding investment evaluation, capital budgeting, mergets and acquisitions, financial reporting, tax reporting and litigation

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major types of asset and liability valuation models

1. using active markets for identical assets

2. using markets for similar assets

3. valuation models

4. valuation under US GAAP

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using active markets for identical assets

the most straightforward method of valuing a financial instrument is using prices for identical instruments is an active market

appropriate if markets have sufficient volume to ensure the price is reliable

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using markets for similar assets

another method for valuing instruments involves deriving values from:
1. the active market prices of similar but not identical instruments
2. the market prices for identical items in inactive markets

the key to this method is accurately adjusting for the differences between the instruments

example: the price might need to be adjusted for such factors as restrictions on sales, or differences in maturity dates, exercise dates, block sizes, credit risk, etc.

financial models are often used to adjust the value of the instrument for these differences

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valuation models

a method that can be used in the absence of an active market is determining estimated fair value based on a valuation models, such as discounted cash flows

such valuations generally rely on assumptions about future events and conditions that affect income and cash flows

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valuation under US GAAP

accounting fair value is defied as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date

this assumes that the asset or liability is exchanged in an orderly transaxtion between market participants to sell the asset or transfer the liability in the principal market (or, in absence of a principal market, the most advantageous market)

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market approach (US GAAP valuation)

uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities

used for items such as publically traded commodities, stocks, bonds, derivatives

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income approach (US GAAP valuation)

uses valuation techniques to conver future benefits or sacrifices to a single present value

examples: discounted cash flows and earnings capitalization models

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cost approach (US GAAP valuation)

is based on the amount that currently would be required to replace the service capacity of an asset (current replacement cost)

this approach is particularly appropriate for specialized facilities or equipment

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business valuations

are obtained for a number of purposes including:
1. tax purposes
2. sales purposes
3. acquisition purposes, etc.

value will differ depending on whether the transactions are for an acquisition or merger versus a liquidation

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approaches used for business valuations

1. market approach- determines the value a nonpublic company based on the market value of comparable firms that are publically traded

2. income approach- determines the vaue of the firm is by estimating the present value of the future benefit stream (income cash flow) of the firm; NPV is determined by applying a discount or capitalization rate that reflects the risk level of the investment firm

3. asset approach- determines the value of the firm by valuing the individual assets of the firm (more applicable to liquidations)

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alternative income approaches (business valuations)

1. discounted cash flow
2. capitalization of earnings
3. multiple of earnings

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discounted cash flows (income approach for business valuations)

application of capital budgeting techniques to an entire firm rather than a single investment

two key items needed for this approach:
1. a set of pro forma financial statements are developed that project the incremental cash flows that are expected to result from the merget

2. a discount rate, or cost of capital, to apply to the projected cash flows

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capitalization of earnings (income approach for business valuations)

determiens the value of the firm by captializing future earnings based on the required rate of return

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multiple of earnings (income approach for business valuations)

applies a multiple to forecasted earnings

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mergers

business mergers may involve many of the considerations involved in the acquisition of any asset or group of assets

additional considerations:
1. firms often acquire other firms due to synergies (the two firms can perform more effectively together than separate)

2. management may also acquire a firm for diversification or tax considerations, or to take advantage of a bargain purchase price

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types of mergers

1. horizontal merger
2. vertical merger
3. congeneric merger
4. conglomerate merger

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horizontal merger

when a firm combines with another in the same line of business

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vertical merger

when a firm combines with another firm in the same supply chain (e.g. manufacturer combines with one of its suppliers)

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congeneric merger

when the merging firms are somewhat related but not enough to make it a vertical or horizontal merger

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conglomerate merger

when the firms are completely unrelated

these types of mergers provide the greatest degree of diversification