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BEC - Notes Chapter 3

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Factors Affecting Financial Modeling and Decision Making
Relevant data - data, such as future revenues or costs, that change as a result of selecting different alternatives
• Can either be fixed or variable, but usually variable
• Direct costs - costs that can be identified with or traced to a given cost object
• Prime costs - DM & DL
• Discretionary costs - costs arising from a periodic or annual budgeting decision (i.e. landscaping)
• Incremental/differential costs - additional costs incurred to produce an additional unit over current output
• Avoidable - costs or revenues resulting from choosing one course of action instead of another

Not Relevant data


• Unavoidable - costs or revenues that will be the same regardless of the chosen course of action
• Absorption costs - represent the allocated portion of fixed mfg OH, and therefore are not relevant

Objective probability - based on past outcomes (like returns on the stock market
Subjective probability - based on an individuals belief about the likelihood of an event occurring (a lawsuit)

Expected value - is the weighted avg of the probable outcomes


Expected value = (probability of each outcome * its payoff) then sum the results

Financial modelling for capital decisions


Cash flow direct effect - a company pays out or receives cash
Cash flow indirect effect - transactions either indirectly associated (sale of old assets) with a capital project or
that represent non-cash activity (depreciation) that produce cash benefit (reduces taxable income)

Invoice price + cost of shipping + cost of installation


+/- Working capital [such as increase in payroll, supplies expenses or inventory requirements]
- Cash proceeds on sale of old asset net of tax
= net cash outflow for new PPE

Tax depreciation on new PPE


* Marginal tax rate
= Depreciation tax shield

After-tax cash flow on operations


+ Depreciation tax shield
= Total after tax cash flow on operations
* present value of annuity
- initial cash outflow
= Net Present Value (NPV)

Discounted cash flow (DCF) methods are considered the best methods to use for long-run decision because it
accounts for time value of money. However, it only uses a single growth rate, which is unrealistic as interest
rates change over time.

Payback period - is simple to understand and focuses on the time period for return of investment (liquidity).
However, it ignores the time value of money. It shows the return of investment not the return on investment
(ignores cash flows occurring after initial investment is recovered)

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BEC - Notes Chapter 3
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Net initial investment [cash outflow + change in WC - sale proceeds on old PPE]
÷ increase in annual net after-tax cash flow [After-tax cash flow on operations + Depreciation tax shield]
= payback period

The larger the denominator the shorter the payback period

Discounted payback method - computes payback period using expected cash flows that are discounted by the
projects cost of capital

NPV uses a hurdle rate to discount cash flows


NPV = or > than 0, make the investment because the rate of return is = or > than the hurdle rate/discount
rate/required rate of return

NPV is superior to IRR because it can still calculate when there are uneven cash flows or inconsistent rates of
return.

Use Present value of $1 when the cash inflows are different


Use Present value of an Ordinary Annuity of $1 when the cash inflows are same across all years

NPV is considered the best single technique for capital budgeting, however, NPV does not indicate the true rate
of return on investment, just merely if it is less than or greater than our hurdle rate.

Internal rate of return (IRR) is the expected rate of return of a project


NPV calculates amounts, while the IRR calculates percentages

Reject IRR if it is less than or equal to the hurdle rate

How to calculate the IRR


Determine the life of the project
Use the payback period (net increment investment ÷ net annual cash flows) as the present value factor
Use the table to calculate IRR
B3-27 example of how to calculate the IRR

Limitations
IRR assumes cash flows from reinvestment are reinvested at the IRR %
Less reliable when there are differing cash flows
Does not consider the amount of profit

Want profitability index over 1.0 which means that the PV of inflows is greater than the PV of outflows
PV of net future cash inflows
÷ PV of net initial investment
= Profitability index

The profitability index measures the cash-flow return per dollar invested; the higher the better

Strategies for short-term and long-term financing


• Risk indifferent behaviour - increase in risk does not increase management's required rate of return
Certainty equivalent = expected value
• Risk averse behaviour - increase in risk, increases management's required rate of return
Certainty equivalent < expected value
• Risk-seeking behaviour - increase in risk, decreases managements required rate of return
Certainty equivalent > expected value
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BEC - Notes Chapter 3
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• Diversifiable risk, unsystematic risk, non-market risk - risk that is firm specific and can be diversified
away
• Nondiversifiable risk, systematic risk, market risk - risks that can not be diversified away

As any risk factor increases (interest rate risk, market risk, credit risk, default risk) the required rate of return
increases, which causes the PV or an asset to decrease
Projected cash flow ÷ required rate of return = PV of asset

Stated interest rate (nominal interest rate) - is the interest rate charged before any adjustments for market
factors [rate shown in the debt agreement]

Effective interest rate = the actual interest rate charged with a borrowing after reducing loan proceeds for
charges and fees related to a loan origination.
Effective interest rate = coupon ÷ proceeds

Annual percentage rate = effective periodic interest rate * number of periods in a year
The annual % rate is the rate required for disclosure by federal regulators

Simple interest = original principal * interest * number of periods


Compound interest = original principal * (1 + interest rate) number of periods

Operating Leverage - the degree to which a firm uses fixed costs (as opposed to variable costs) for leverage
Fixed (i.e. Executive salaries) - risk and potential return increases
Variable (i.e. commissions) - risk and potential return decreases

% change in EBIT
÷ % change in sales
= Degree of Operating Leverage
If the numerator changes by a bigger amount than the denominator, that firm is employing leverage
So if a firms EBIT increases by 21% as sales increase by 7% then the DOL is 3. Meaning for every 1% increase
in sales, profit increases by 3%

Higher DOL implies that a small increase in sales will have a greater affect on profits and shareholder value.
But more risk.

Financial leverage - the degree to which a firm uses fixed financial costs for leverage
% change in EPS [or net income
÷ % change in EBIT
= Degree of financial leverage

Total combined leverage - the use of fixed costs resources and fixed cost financing to magnify returns to firm
owners
% change in EPS
÷ % change in sales
= Degree of total combined leverage
Or
Degree of total combined leverage = DOL * DFL

The optimal capital structure is the mix or debt and equity that produces the lowest WACC which maximizes
firm value
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BEC - Notes Chapter 3
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WACC = (Cost of equity * % of capital structure) + (Cost of debt * % of capital structure)


Cost of debt must be after tax so, cost of debt = effective interest rate * (1 - tax rate)
As a general rule, as a firm raises more capital either equity or debt, the WACC increases

As the WACC or discount rate decreases, the PV increases


Debt carries the lowest cost of capital and is tax deductible
The higher the tax rate, the more incentive to use debt financing

After tax cost of debt = pre-tax cost of debt * (1 - tax rate)

Cost of preferred stock = dividends ÷ net proceeds

B3 44-45-47 examples of how to calculate cost of debt, preferred stock, and equity (retained earnings)

Cost of Equity (or Retained earnings)


A firm should earn at least as much on any earnings retained and reinvested in the business as stockholders
could have earned on alternative investments of equivalent risk, otherwise they should pay dividends

3 common methods of computing cost of equity


- Capital Asset Pricing Model (CAPM)
- DCF
- Bond Yield plus Risk Premium

CAPM = risk free rate + beta *(expected return on market - risk free rate)
[market risk premium]

B =1 as risky as market
B> 1 more risky than market
B< 1 less risky than market

Short-term financing is classified as current and will mature within 1 year


Short-term financing rates are lower than long term rates, which increases profitability
However, increased interest rate risk (didn’t lock in a rate), and increased credit risk

Debentures are unsecured, while bonds are often secured

ROI - ignores cash flows and uses GAAP income


ROI = income ÷ investment capital [avg assets] [which is avg PPE + avg WC]
or
ROI = profit margin * investment turnover
[NI ÷ sales] [sales ÷ investment]

ROA = NI ÷ assets

Net Book value = historical cost - accumulated depreciation


Net book value is affected by age and method of depreciation so it can be a misleading indicator

Gross book value - historical cost


Ignores depreciation

Replacement cost = cost to replace asset

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BEC - Notes Chapter 3
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Ignores both age and method of depreciation

The method used to value the investment affect the ROI. As the denominator increases the ROI decreases

ROI focuses on short term results and my cause a disincentive to invest because the short-term result of the new
investment may reduce ROI

Residual income measures the excess actual income earned by an investment over the required rate of return,
while ROI provides a % return

Required return = net book value * hurdle rate


[Equity] [CAPM]
Residual income = NI - Required return

Debt to total capital ratio or assets = debt ÷ assets


Debt to equity = debt ÷ equity

Financial Statement and business implications of liquid asset management


Working Capital (WC) = Current assets - current liabilities
High WC, less risk, lower expected return

Current ratio = current assets ÷ current liabilities


High current ratio shows more solvency

Quick ratio = (cash + marketable securities + A/R) ÷ current liabilities


[inventory and prepaids not included]

Transaction motive - cash to meet ordinary course of business


Speculative motive - enough cash to take advantage of temporary opportunities
Precautionary motive - enough cash to maintain safety cushion/ liquidity

Primary method to increase cash levels is to either speed up cash inflows or slow down cash outflows

Annual cost of payment discount = 360 ÷ (pay period - discount period) * discount % ÷ (100 - discount %)
[works from either perspective, buyer or seller]
B3-62 has an example of payment discount calculation

Lockbox at bank may speed up cash inflow, however only worth it if the additional interest income earned on
the prompt deposit exceeds the cost of the lockbox

Disbursement float (positive) - occurs when checks have been written but not received by vendor and recorded
by the bank
Collection float (negative) - occurs when deposits have been recorded on the company's books but not recorded
by the bank

The shorter a cash conversion cycle the better


Cash conversion cycle = inventory conversion period + A/R collection period - Payables deferral period
[avg inventory ÷ avg cost of sales per day] [avg payables ÷ avg purchases per
day]
[avg receivables ÷ avg sales per day]

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BEC - Notes Chapter 3
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Credit period is the length of time buyers are given to pay for their purchases

Accounts payable or trade credit, provides the largest source of short term financing for small firms. Defer, try
to pay your bills at the end of the pay period

Re-order point = safety stock + (lead time in days or weeks * units sold per days or weeks)

Inventory turnover = COGS ÷ avg inventory


Cost savings = inventory turn over * APR

Economic Order Quantity (EOQ) attempts to minimize ordering and carrying costs
EOQ = .5(( 2 * annual unit sales * cost per order) ÷ carrying cost per unit)