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 eriodic or annual budgeting decision !i"e" landscaing#
Incremental/differential costs - additional costs incurred to roduce an additional unit over current outut
Avoidable - costs or revenues resulting from choosing one course of action instead of another
$ot Relevant data
Unavoidable - costs or revenues that will be the same regardless of the chosen course of action
Absorption costs - reresent the allocated ortion of fixed mfg %&, and therefore are not relevant
Objective probability - based on ast outcomes !li'e returns on the stoc' mar'et
Subjective probability - based on an individuals belief about the li'elihood of an event occurring !a lawsuit#
Expected value - is the weighted avg of the robable outcomes
(xected value ) !robability of each outcome * its ayoff# then sum the results
Financial modelling for capital decisions
Cash flow direct effect - a comany ays out or receives cash
Cash flow indirect effect - transactions either indirectly associated !sale of old assets# with a caital roject or
that reresent non-cash activity !dereciation# that roduce cash benefit !reduces taxable income#
+nvoice rice , cost of shiing , cost of installation
,-- .or'ing caital /such as increase in ayroll, sulies exenses or inventory re0uirements1
- Cash roceeds on sale of old asset net of tax
= net cash outflow for new 22(
3ax dereciation on new 22(
* Marginal tax rate
) Dereciation tax shield
4fter-tax cash flow on oerations
, Dereciation tax shield
) 3otal after tax cash flow on oerations
* resent value of annuity
- initial cash outflow
) $et 2resent 5alue !$25#
Discounted cash flow !DC6# methods are considered the best methods to use for long-run decision because it
accounts for time value of money" &owever, it only uses a single growth rate, which is unrealistic as interest
rates change over time"
Paybac period - is simle to understand and focuses on the time eriod for return of investment !li0uidity#"
&owever, it ignores the time value of money" +t shows the return of investment not the return on investment
!ignores cash flows occurring after initial investment is recovered#
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BEC - Notes Chapter 3
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$et initial investment /cash outflow , change in .C - sale roceeds on old 22(1
7 increase in annual net after-tax cash flow /4fter-tax cash flow on oerations , Dereciation tax shield1
) aybac' eriod
3he larger the denominator the shorter the aybac' eriod
Discounted paybac met!od - comutes aybac' eriod using exected cash flows that are discounted by the
rojects cost of caital
$25 uses a hurdle rate to discount cash flows
$25 ) or 8 than 9, ma'e the investment because the rate of return is ) or 8 than the hurdle rate-discount
rate-re0uired rate of return
$25 is suerior to +RR because it can still calculate when there are uneven cash flows or inconsistent rates of
return"
:se Present value of "# when the cash inflows are different
:se Present value of an Ordinary Annuity of "# when the cash inflows are same across all years
$25 is considered the best single techni0ue for caital budgeting, however, $25 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 $I%%& is the exected rate of return of a roject
$25 calculates amounts, while the +RR calculates ercentages
Reject +RR if it is less than or e0ual to the hurdle rate
&ow to calculate the +RR
Determine the life of the roject
:se the aybac' eriod !net increment investment 7 net annual cash flows# as the resent value factor
:se the table to calculate +RR
'()*+ example of !o, to calculate t!e I%%
Limitations
+RR assumes cash flows from reinvestment are reinvested at the +RR ;
Less reliable when there are differing cash flows
Does not consider the amount of rofit
.ant rofitability index over <"9 which means that the 25 of inflows is greater than the 25 of outflows
25 of net future cash inflows
7 25 of net initial investment
) 2rofitability index
-!e profitability index measures the cash-flow return er dollar invested= the higher the better
Strategies for short-term and long-term financing
%is indifferent be!aviour - increase in ris' does not increase management>s re0uired rate of return
Certainty e0uivalent ) exected value
%is averse be!aviour - increase in ris', increases management>s re0uired rate of return
Certainty e0uivalent ? exected value
%is)seein. be!aviour - increase in ris', decreases managements re0uired rate of return
Certainty e0uivalent 8 exected value
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BEC - Notes Chapter 3
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Diversifiable ris/ unsystematic ris/ non)maret ris - ris' that is firm secific and can be diversified
away
0ondiversifiable ris/ systematic ris/ maret ris - ris's that can not be diversified away
4s any ris' factor increases !interest rate ris', mar'et ris', credit ris', default ris'# the re0uired rate of return
increases, which causes the 25 or an asset to decrease
2rojected cash flow 7 re0uired rate of return ) 25 of asset
Stated interest rate $nominal interest rate& - is the interest rate charged before any adjustments for mar'et
factors /rate shown in the debt agreement1
Effective interest rate ) the actual interest rate charged with a borrowing after reducing loan roceeds for
charges and fees related to a loan origination"
(ffective interest rate ) couon 7 roceeds
Annual percenta.e rate ) effective eriodic interest rate * number of eriods in a year
3he annual ; rate is the rate re0uired for disclosure by federal regulators
Simple interest ) original rincial * interest * number of eriods
1ompound interest ) original rincial * !< , interest rate#
number of eriods
Operatin. 2evera.e - the degree to which a firm uses fixed costs !as oosed to variable costs# for leverage
6ixed !i"e" (xecutive salaries# - ris' and otential return increases
5ariable !i"e" commissions# - ris' and otential return decreases
; change in (@+3
7 ; change in sales
) Degree of %erating Leverage
+f the numerator changes by a bigger amount than the denominator, that firm is emloying leverage
Ao if a firms (@+3 increases by B<; as sales increase by C; then the D%L is D" Meaning for every <; increase
in sales, rofit increases by D;
&igher D%L imlies that a small increase in sales will have a greater affect on rofits and shareholder value"
@ut more ris'"
3inancial levera.e - the degree to which a firm uses fixed financial costs for leverage
; change in (2A /or net income
7 ; change in (@+3
) Degree of financial leverage
-otal combined levera.e - the use of fixed costs resources and fixed cost financing to magnify returns to firm
owners
; change in (2A
7 ; change in sales
) Degree of total combined leverage
%r
Degree of total combined leverage ) D%L * D6L
3he otimal caital structure is the mix or debt and e0uity that roduces the lowest .4CC which maximiEes
firm value
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.4CC ) !Cost of e0uity * ; of caital structure# , !Cost of debt * ; of caital structure#
Cost of debt must be after tax so, cost of debt ) effective interest rate * !< - tax rate#
4s a general rule, as a firm raises more caital either e0uity or debt, the .4CC increases
4s the .4CC or discount rate decreases, the 25 increases
Debt carries the lowest cost of caital and is tax deductible
3he higher the tax rate, the more incentive to use debt financing
4fter tax cost of debt ) re-tax cost of debt * !< - tax rate#
Cost of referred stoc' ) dividends 7 net roceeds
@D FF-FG-FC examles of how to calculate cost of debt, referred stoc', and e0uity !retained earnings#
Cost of (0uity !or Retained earnings#
4 firm should earn at least as much on any earnings retained and reinvested in the business as stoc'holders
could have earned on alternative investments of e0uivalent ris', otherwise they should ay dividends
D common methods of comuting cost of e0uity
- Caital 4sset 2ricing Model !C42M#
- DC6
- @ond Hield lus Ris' 2remium
C42M ) ris' free rate , beta *!exected return on mar'et - ris' free rate#
/mar'et ris' remium1
@ )< as ris'y as mar'et
@8 < more ris'y than mar'et
@? < less ris'y than mar'et
Ahort-term financing is classified as current and will mature within < year
Ahort-term financing rates are lower than long term rates, which increases rofitability
&owever, increased interest rate ris' !didnIt loc' in a rate#, and increased credit ris'
Debentures are unsecured, while bonds are often secured
R%+ - ignores cash flows and uses J442 income
R%+ ) income 7 investment caital /avg assets1 /which is avg 22( , avg .C1
or
R%+ ) rofit margin * investment turnover
/$+ 7 sales1 /sales 7 investment1
R%4 ) $+ 7 assets

$et @oo' value ) historical cost - accumulated dereciation
$et boo' value is affected by age and method of dereciation so it can be a misleading indicator
Jross boo' value - historical cost
+gnores dereciation
Relacement cost ) cost to relace asset
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BEC - Notes Chapter 3
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+gnores both age and method of dereciation
3he method used to value the investment affect the R%+" 4s the denominator increases the R%+ decreases
R%+ focuses on short term results and my cause a disincentive to invest because the short-term result of the new
investment may reduce R%+
Residual income measures the excess actual income earned by an investment over the re0uired rate of return,
while R%+ rovides a ; return
Re0uired return ) net boo' value * hurdle rate
/(0uity1 /C42M1
Residual income ) $+ - Re0uired return
Debt to total caital ratio or assets ) debt 7 assets
Debt to e0uity ) debt 7 e0uity
Financial Statement and business implications of liquid asset management
.or'ing Caital !.C# ) Current assets - current liabilities
&igh .C, less ris', lower exected return
Current ratio ) current assets 7 current liabilities
&igh current ratio shows more solvency
Kuic' ratio ) !cash , mar'etable securities , 4-R# 7 current liabilities
/inventory and reaids not included1
-ransaction motive - cash to meet ordinary course of business
Speculative motive - enough cash to ta'e advantage of temorary oortunities
Precautionary motive - enough cash to maintain safety cushion- li0uidity
2rimary method to increase cash levels is to either seed u cash inflows or slow down cash outflows
4nnual cost of ayment discount ) DL9 7 !ay eriod - discount eriod# * discount ; 7 !<99 - discount ;#
/wor's from either ersective, buyer or seller1
'()4* !as an example of payment discount calculation
Loc'box at ban' may seed u cash inflow, however only worth it if the additional interest income earned on
the romt deosit exceeds the cost of the loc'box
Disbursement float !ositive# - occurs when chec's have been written but not received by vendor and recorded
by the ban'
1ollection float !negative# - occurs when deosits have been recorded on the comany>s boo's but not recorded
by the ban'
3he shorter a cash conversion cycle the better
Cash conversion cycle ) inventory conversion eriod , 4-R collection eriod - 2ayables deferral eriod
/avg inventory 7 avg cost of sales er day1 /avg ayables 7 avg urchases er
day1
/avg receivables 7 avg sales er day1
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BEC - Notes Chapter 3
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Credit eriod is the length of time buyers are given to ay for their urchases
4ccounts ayable or trade credit, rovides the largest source of short term financing for small firms" Defer, try
to ay your bills at the end of the ay eriod
Re-order oint ) safety stoc' , !lead time in days or wee's * units sold er days or wee's#
+nventory turnover ) C%JA 7 avg inventory
Cost savings ) inventory turn over * 42R
Economic Order 5uantity $EO5& attemts to minimiEe ordering and carrying costs
(%K ) "G!! B * annual unit sales * cost er order# 7 carrying cost er unit#
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