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BEC - Notes Chapter 3 http://www.cpa-cfa.org

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) 1

BEC - Notes Chapter 3 http://www.cpa-cfa.org

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 2

BEC - Notes Chapter 3 http://www.cpa-cfa.org

• 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 3

BEC - Notes Chapter 3 http://www.cpa-cfa.org

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 4

BEC - Notes Chapter 3 http://www.cpa-cfa.org

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] 5

BEC - Notes Chapter 3 http://www.cpa-cfa.org

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)

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