Working Capital Liquidity

Question 1

Cash conversion cycle & NWC to sales

Answer 1

are positively related

Question 2

NWC

Answer 2

Excludes cash, mktable securities from CA & short term debt from CL. So it includes only drs, crs, inventory, accrued & prepaid exp

Question 3

Drag & pull on liquidity

Answer 3

Drag reduce cash inflow (uncollected receivable, obsolete inventory, borrowing constraint) & pull increase cash outflow (reduced credit limit, limit on short term lining of credit, low liquidity position)

Question 3

Current ratio

Answer 3

Cash + Mktable sec + Receivables + Prepaid exp / Accr exp + short term debt

Question 4

EAR of Supplier financing

Answer 4

{(1+Disc%/100 - Disc%)^365/payt period - Disc period} - 1. Compare this rate with bank rate. If bank rate is low don’t opt for supplier financing

Question 4

Quick Ratio

Answer 4

Ignore Prepaid exp & Inventory

Question 5

Primary vs Secondary liquidity source

Answer 5

Cash & marketable sec on hand, Borrowing from bank bondholders, supplier’s trade credit & CF vs Delaying or reducing Capex, dividend, issue equity, renegotiating contract (Short term debt to long term), selling asset, bankruptcy filing

Question 5

Cash Ratio

Answer 5

Ignore Acc receivable as well Pg 119

Question 6

Long term vs short term financing

Answer 6

High vs low financing cost, Early stage co vs matured co

Question 7

Capital Investments

Answer 7

GC project, regulatory or compliance project, expansion project & other

Question 8

ROIC

Answer 8

After tax operating profit (EBIT x (1-T))/ Avg Invested capital (Long term debt & equity). Independent analyst use it becoz of non availability of project by project info. Accounting (non-cash) based measure unlike IRR & NPV. ROIC can be increased by increasing profit margin or asset turnover. A high-profit margin company can earn a low ROIC if asset turnover is low, and a low-profit margin company can earn a high ROIC if asset turnover is high.

Question 8

When co needs money

Answer 8

evaluate liquidation cost. Liquidation cost for accounts payable is total payable x disc rate given by creditor. Pg 129, 130

Question 9

IRR

Answer 9

represents only geometric rate of return of investment. One of the problem is that multiple IRR exist if cash flow signs change more than once. NPV is always better than IRR

Question 10

Expansion of existing business

Answer 10

Established firm with existing track record of successful expansion can use debt for it cause debtholders know it is not that risky

Question 11

Capital allocation process

Answer 11

Mgt use this process to make capital investment based on internal, non-public & public info. Process is substantially similar to those used by investors in constructing investment portfolios but occurs at more granular level of detail. Mgt seek to deliver risk adjusted return greater than what investors could earn on similar risky investments elsewhere. Idea generation, investment analysis (IRR & NPV), Planning & Prioritization, Monitoring & Post investment review

Question 12

Capital allocation pitfalls

Answer 12

Cognitive error (Calculation & other mistakes, ignoring internal financing cost, Inconsistent treatment of inflation) Behavioral bias (error in judgement & blind spot, inertia, decision based on a/cing measure, pet project bias)

Question 13

Real options

Answer 13

grant a firm the right, but not the obligation, to take an action in the future. A company should only pursue (or exercise) a real option if it is value enhancing. can alter value of capital investment. Real options are similar to financial options, except that they deal with real, instead of financial, assets.

Question 14

Timing option

Answer 14

Choose to delay investing decision

Question 15

Sizing option

Answer 15

abandonment option - abandon the investment after it is undertaken if the financial results are disappointing

Question 16

Flexibility option

Answer 16

For example, suppose a firm finds that demand for a product or service exceeds capacity. Management may be able to exercise a price-setting option. By increasing prices, the company could benefit from the excess demand, which it cannot do by increasing production. Alternatively, a firm may consider production flexibility options to alter production when demand differs from its forecast. For example, a firm may add overtime or extra shifts to increase production for a given capacity.

Question 17

Fundamental option

Answer 17

entire value of an investment may depend on factors outside the firm’s control, such as the price of a commodity. For example, the value of an oil well or refinery investment is contingent on the price of oil. The value of a gold mine is contingent on the price of gold. If oil prices were low, a company likely would not choose to drill a well. If oil prices were high, it would go ahead and drill.

Question 18

Project NPV

Answer 18

NPV (without options) – Option cost + Option value

Question 19

What primarily drives a firm’s value

Answer 19

PV of Future CF rather than capital structure

Question 20

Mgt target capital structure

Answer 20

stated using BV or through financial leverage ratio such as max ratio of debt or net debt to EBITDA or min credit rating

Question 21

Weights in WACC (type of financing)

Answer 21

depends on issuer's business model (Capital intensive or capital light) & on co's life cycle stage

Question 22

Shareholder value is increased by

Answer 22

higher return on investment and a capital structure that results in a lower WACC.

Question 23

Capital intensive business

Answer 23

Low asset turnover (low sales-to-total-assets ratio), high capex to sales, and high NWC to sales ratios.

Question 24

to find interest rate on new debt

Answer 24

look to what interest rate similarly situate co have recently borrowed at

Question 25

cost of debt & equity are chosen by

Answer 25

investors in financial mkt & not by mgt so it is dynamic & non-trivial endeavor

Question 26

Corporate life cycle

Answer 26

Startup (Leases & Convertible debt), Growth (Secured debt & equity remains major source of financing), Mature (Unsecured)

Question 27

Operating leverage

Answer 27

Fixed cost/Total cost. debt investors would extend credit at lower cost of debt to firm with low FC because of its profit stability

Question 28

MM Proposition I (W/o Taxes)

Answer 28

If the value of an unlevered company is not equal to that of a levered company, investors could make a riskless arbitrage profit at no cost by selling shares of the overvalued company and using the proceeds to buy shares of the undervalued company, forcing their values to become equal. The value of a firm is thus determined not by how it finances itself but, rather, by its expected future cash flows. Summary: V(L) = V(U). In absence of taxes, WACC is unaffected by capital structure

Question 29

MM Proposition II (W/o Taxes)

Answer 29

Adding any amount of lower-cost debt capital to the capital structure is always perfectly offset by an increase in the cost of equity, resulting in no change in the company’s WACC. It explains why investors require higher returns on levered equity; their required returns should match the increased risk from leverage. Specifically, MM Proposition II without taxes implies that a firm’s equity cost is a linear function of its debt-to-equity ratio (D/E): r e = r 0 + ( r 0 − r d ) D/E where re is the cost of equity, r0 is the cost of capital for a company financed only with equity, rd is the cost of debt, D is the market value of debt, and E is the market value of equity. As per this theory, higher leverage raises re but doesnt change firm value or WACC & increase in re exactly offset the benefit of using low cost of debt

Question 30

Under MM Proposition W/o Tax

Answer 30

WACC & Firm value won't change

Question 31

MM Proposition I (W Taxes)

Answer 31

In the presence of corporate taxes (but not personal taxes), the value of the levered company is greater than that of the all-equity company by an amount equal to the tax rate multiplied by the value of the debt (tD), defined as the present value of the debt tax shield: VL = VU + tD. As per this theory, a profitable co can increase its value by using debt & higher the tax rate greater the benefit of using debt in capital structure

Question 32

MM Proposition II (W Taxes)

Answer 32

If the value of the company increases as it uses more debt, the company’s WACC must decrease as it uses more debt. That is, in the earlier propositions without corporate taxes, the lower cost of debt was fully offset by an increase in the cost of equity. Now, in the presence of corporate taxes, the cost of debt is further lowered by the tax benefit such that the lower debt cost outweighs the increase in the cost of equity and results in a lower WACC. r e = r 0 + ( r 0 − r d ) (1 − t) D/E . As per this theory, re raises at slower rate as co uses more equity than in no-tax cases, as co's use of debt increases WACC decreases (value increase) & use of debt is value enhancing at the extreme 100% debt is optimal

Question 33

Cost of financial distress

Answer 33

lower for firms whose assets have ready secondary market.

Question 34

Static trade-off theory

Answer 34

The value-enhancing effect of the tax shield from leverage is offset by the value-reducing impact of the present value of expected (or probability-weighted) costs of financial distress or bankruptcy. VL = VU + tD − PV(Costs of financial distress). Determines optimal capital structure

Question 35

Firm's actual capital structure may

Answer 35

differ from its target

Question 36

Pecking order theory

Answer 36

managers give first preference to financing methods with the least potential info content (internally generated funds) and last preference to methods with the most potential information content (public equity offerings). managers prefer internal financing, and if external financing is needed, they prefer private debt to public debt and prefer equity issuance least of all. There is no optimal capital structure, and a firm’s capital structure reflects its historic need for external financing. based on asymmetric information held by investors and issuers and the idea that managers consider what their actions may signal to investors.

Question 37

Free cash flow hypothesis

Answer 37

Higher debt levels discipline managers by forcing them to manage the company efficiently and use cash wisely so the company can make its interest and principal payments. Based on agency cost

Question 38

DE ratio into weight

Answer 38

simple way of transforming a debt-to-equity ratio (D/E) into a weight—that is, D/(D + E)—is to divide D/E by 1 + D/E.

Question 39

Delaying FCF from project reduces

Answer 39

both IRR & NPV