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CMA Part 2 Financial Decision Making Cram Session Ronald Schmidt, CMA, CFM Patti Burnett, CMA

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CMA Part 2

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  • CMA Part 2 Financial Decision Making

    Cram Session

    Ronald Schmidt, CMA, CFM

    Patti Burnett, CMA

  • CMA Exam & Gleim

    CMA overview pages 3 6

    Pass both parts within 3 years

    Satisfy the experience requirements (see next page)

    CPEs

    Gleim website

    You can create a mock exam on website, and there are ones already created for you

  • Experience Requirements

  • Exam format

    3 hrs - 100 multiple choice questions = approx. 1.5 minutes per question (on average). Find ways to bank time Look for short-cuts You will find that you most question do not seem easy, dont get

    discouraged You earn points for each question answered correctly Some questions are test questions that carry no point value. You will not

    know which ones they are Extra time can be carried forward to the Essay portion

    1 hr - 2 Essay questions with up to 8 sub-parts You cant go back to multiple-choice part once you enter this portion of the

    exam Whatever you have typed on the screen will be saved as your answer,

    irrespective if the timer runs out on you

  • Exam format

    Topics Financial Statement Analysis 25%

    Corporate Finance 25%

    Decision Analysis and Risk Management 25%

    Investment Decisions 20%

    Ethics 5%

    If you find you have weaknesses in any topic ref. Appendix A for ref. the appropriate sub units

  • Last minute prep for the exam

    Focus on what you dont know Realize that you will be more proficient in some topics

    more than others Practice the Essay questions use the Gleim Essay Wizard Create short mock multiple choice exams (say no more

    than 50 questions) to condition for the longer 100 question exam, or take the Gleim online CMA Practice Exam that came with your Gleim study material. It is a 4 hour exam.

    You can also read the question and only the correct answer of questions at the end of each SU. It is a fast way of covering a lot of ground.

    Make sure your financial calculator has a fresh battery, and that it is not the first time you used it.

  • Day of the Exam

    Do not study up to the exam day/time Give yourself plenty of time to get to the testing center. Make sure you have identified exact

    location prior Make sure you are well rested (probably not a good idea to take exam after a long day of work, for

    example It is a four hour exam, make sure you are prepared for the duration (eat, etc.) Dress in layers. You can always shed layers when you are there, they have lockers Dont wear a watch into the testing center You can bring your own foam earplugs, so long that they are in a plastic bag Take a copy of the type of calculators that are permitted with you. Ref. the ones listed on the IMA

    Website You realistically should not plan on any breaks outside of bathroom breaks. Note the timer keeps

    running if you do take a break. Be optimistic. At this point there is nothing else you can do, and being stressed or discouraged will

    not help your test results.

    Relax - NO ONE HAS DIED FROM FAILING THE CMA EXAM, there is life beyond and we will help you pass it!!!!

  • Exam

    Budget your time, know your time hacks See how many Essay sub-questions you will be given.

    There are two parts with different amounts of sub-parts

    Answer the questions in consecutive order, and limit the number you want to come back to no more than say 10, but make sure you answer it before going on to the next.

    Never leave a question unanswered, score is based on number of correct answers.

    Do not allow the answer choices to affect your reading of the question

  • Most common reasons for missing questions

    1. Misreading the requirement (stem) Read the question first2. Not understanding what is required3. Making a math error Try to not do calculations of paper first, with the

    idea of transferring to the exam later. If you know how to use your memory button(s) well on your calculator, use it (i.e. save sub-calculations in your calculator).

    4. Applying the wrong rule or concept5. Being distracted by one or more of the answers the most common

    wrong answers are the incorrect alternatives6. Incorrectly eliminating answers from considerations read all answers

    first, some are more correct or complete then others7. Not having any knowledge of the topic tested dont agonize over it. If

    possible try to make an educated guess by eliminating obvious wrong answers. If you guess, use the same letter each time.

    8. Employing bad intuition when guessing

  • The essays

    Remember, 2 essay questions with up to 8 parts each!

    Ref. Scenario for Essay Questions 9 -11

    The CMA exam uses essays to reflect a more "real-world" environment in which candidates must apply the knowledge they have acquired. Essays are graded on both writing skills and subject matter. Partial credit IS available for essays that have some correct and some incorrect points. Finally, it is important to remember that essays are not intended to test typing ability, so the time you allocated for essay response is adequate to complete the questions even if you do not have the best typing skills.

    Answering multiple-choice questions is an effective method to study the material for both the multiple-choice and essay sections of the exam. They are an excellent diagnostic tool that will allow you to quickly identify your weak areas. Also, think about what your answer would be if the question were not multiple-choice. When reviewing the correct and incorrect answer explanations, your "essay answers" should be somewhat equivalent to the detailed answer explanations.

  • Ethics

    Ethics is tested from: Individual Perspective Part 1 Organizational Perspective Part 2

    Questions could be either Multiple Choice or Essay Make sure you study the IMA Framework on Ethics, ref. the

    IMA website, or following URL: http://www.imanet.org/PDFs/Public/Press_Releases/STATEMENT%20OF%20ETHICAL%20PROFESSIONAL%20PRACTICE_2.2.12.pdf

    http://www.imanet.org/resources_and_publications/ethics_center_helpline.aspx

    Have it conceptually memorized. Similar to the AICPA version You will then be able to answer any question from there Stay within an objective view, and dont get side-tracked in

    emotional distractors

  • SU 1 - Sarbanes-Oxley Act of 2002

    Enron, Arthur Andersen

    Extensive responsibilities on issuers / auditors of publicly traded securities.

    Sec 406(a) Senior financial officers Code of Ethics

    Reasonably necessary to promote Honest and ethical conduct

    Full, fair, accurate, timely, and understandable disclosure

    Compliance with governmental rules and regulations

    SOX does not define ethics.

  • SU 1- Corporate Responsibility for Ethical Behavior

    Values and Ethics: From Inception to Practice

    Responsible to : Foster a sense of ethics Written code of Conduct and ethical behavior

    Pervasive sense of ethical values has benefits. White space vs. Gray area.

    Tone at the top

    Human capital - Doing the right thing.

    Corporate culture

    Ethics training

  • SU 1- Basic Financial Statements, their users and limitations

    Statement of Financial position Balance sheet Single point in time, a few day changes a lot

    Assets versus Liabilities and Equity Contingent liabilities

    Purpose of the Balance Sheet It helps users assess the entitys liquidity, financial flexibility, profitability, and risk. Proprietary theory owners equity Under the proprietary theory, revenues increase capital,

    while expenses reduce it. Net income belongs to the owner, representing an increase in the proprietor's capital.

    Usefulness and Limitations Historical cost vs. market value Book value (def.?) does not reflect market value. Estimates Non-measurement of employees, reputations, etc.

  • SU 1- Basic Financial Statements, their users and limitations

    Companies financing structure Liabilities

    Current versus non-current assets (def., examples?)

    Equity = Residual balance Types of stock Additional paid in capital Reasons for equity to restricted Treasury stock (def., affect on equity)

    Notes in the financial statement Purpose Types

    Def. Real Accounts & Permanent Accounts

  • SU 1 - Statement of Cashflows

    Understand: Purpose Indirect method vs. Direct method Categories

    Operating Activities direct and indirect Investing Activities Financing Activities

    Two methods to report cash flows Direct method (FASB req.) Indirect method

    See questions 31 page 53 33 page 54 34 page 55

  • SU 1 Statement of Income and Statement of Retained Earnings

    Understand the different elements of the Income Statement Revenues versus gains Expenses versus losses

    Transactions that matter and that dont Transactions with owners Prior-period adjustments Items from other comprehensive income Transfers to and from appropriated retained earnings Adjustment made in a quasi-reorganization

  • SU 1 Statement of Income and Statement of Retained Earnings

    Cost of Goods COGS

    BI + COGM (Purchases for Retailer ) = GAFS EI = COGS

    COGM (Purchases for Retailer) BWIP + TTL Mfg cost for period EWIP = COGM Similar to COGS + EFG - BFG

    Statement of Retained Earnings Beg RE + NI Dividends = End RE Dividends Paid or declared?

  • SSU 1 Statement of Income and Statement of

    Retained Earnings Other Expenses

    S, G & A G & A incurred for the benefit of the organization as a

    whole Interest Expenses based on passage of time; effective

    interest rate method

    Irregular Items Discontinued Operations = Income from operations, and gain/loss

    from disposal of operations

    Extraordinary Items = both usual in nature and infrequent in occurrence in the environment in which the organization operates

    Continued

  • SU 1 Statement of Income and Statement of Retained Earnings

    Comprehensive Income

    Exclude from NI but included in OCI

    Fair value changes of available-for-sale securities

    Currency translations

    Service cost, gains and losses not prev. recognized in pension exp.

    Must be displayed with other financial statements

  • SU 1 Common-Size Financial Statements

    Percentages and Comparability Restate financial statement line items in terms of

    percentages of a given amount (baseline figure)

    Percentage of net sales or Total Asses or Liabilities and Equities

    Easier to see differences between companies

    Vertical and Horizontal Analysis Vertical - Explained above

    Horizontal Several periods also known as trend analysis/percentages, and usually for the same company

  • SU 2 - Ratio Analysis

    You need to understand what effects typical business transactions have on a firms liquidity, rather than on the mechanics of calculating the ratios.

    What is the importance of Ratio Analysis?

  • RememberCommon-size statement s recast all items in a particular financial statement as a percentage of a selected (usually the largest and most important) item on the statement.

    These statements can be used to: Compare elements in a single years financial statements. Analyze trends across a number of years for one business. Compare businesses of differing sizes within an industry (such as Wal-

    Mart to Target). Compare the companys performance and position with an industry

    average.

    Common-size statements are useful when comparing businesses of different sizes because the financial statements of a variety of companies can be recast into the uniform common-size format regardless of the size of individual elements.

  • Categories of Financial Ratios

    Activity: how efficiently a company performs day-to-day tasks such as collection of receivables and management of inventory

    Liquidity: companys ability to meet its short-term obligations

    Solvency: ability to meet long-term obligations Profitability: companys ability to generate

    profitable sales from its resources (assets) Valuation: quantity of an asset or flow (earnings)

    associated with ownership of a specified claim (Share)

  • SU 2 - Liquidity Ratios

    Liquidity is the firms ability to pay its current obligations as they come due. - Short run How easy is it to convert assets to cash.

    Liquidity ratios relates liquid assets to current liabilities. Current assets converted to cash within 1 year or

    operating cycle. Current asset ratios Firms ability to operate in short

    term.

    Current assets/liabilities are shown in descending order of liquidity.

  • SU 2 - Liquidity Ratios Working Capital

    Working capital is a measure of a companys ability in the short run to pay its obligations. Working capital is calculated as shown:

    Current assets Current Liabilities How much capital is left after paying current

    obligations?

    Net Working Capital ratio = Cur. Assets Cur. Liab./Total Assets Most conservative of working capital ratios.

  • Remember!

    Current assets are defined as cash or other liquid investments, such as inventory and accounts receivable (A/R), that can be converted to cash within a year.

    Current liabilities are obligations that will be paid within a year, such as accounts payable and notes and interest payable.

  • Liquidity Ratios - Current Ratio

    The current ratio measures the degree to which current assets cover current liabilities. A higher ratio indicates greater ability to pay current

    liabilities with current assets, thus greater liquidity.

    Current ratio = Current Assets / Current Liabilities Most common liquidity measurement

    Low ratio = Possible liquidity problems High ratio = Management not investing assets

    Should be proportional to the operating cycle. Shorter operating cycles may justify lower ratio. Converting to cash quicker. LIFO lowers ratio.

  • Liquidity Ratios Quick Ratio and other

    Quick ratio (Acid test) = Cash + Mkt Securities + Net receivables / Current liabilities

    Avoids inventory valuation issues.

    Conservative approach.

    The quick ratio , or acid-test ratio, examines liquidity from a more immediate aspect than does the current ratio by eliminating inventory from current assets. The quick ratio removes inventory because it turns over at a slower rate than receivables or cash and assumes that the company will be able to sell the items to a customer and collect cash.

    Cash ratio = Cash + Mkt Securities/Current Liab.

    The cash ratio analyzes liquidity in a more conservative manner than the quick ratio, by looking at a companys immediate liquidity.

    Cash Flow ratio = C/F from Operations/Cur. Liab.

    Measures a companies ability to meet its debt obligations with cash generated in the normal course of business.

  • Activity Measures

    Another way to analyze liquidity is to focus on the management of key current assets, namely inventory and A/R. A manager successfully managing inventory and collecting A/R in a timely manner also will be improving liquidity.

    Operating activity analysis is done over a period of an operating cyclethe time elapsed between when goods are acquired and when cash is received from the sale of the goods.

    Measures how quickly noncash assets are converted to cash. Over a period of time. Includes I/S data. The Balance Sheet data should always be an average

  • Activity Measures - Receivables A/R Turnover = Net credit sales / Ave. A/R

    Efficiency of A/R collections.

    High ratio : Customers pay promptly.

    Highly seasonal should use monthly A/R average.

    One of the assumption of this ratio is that sales occur evenly throughout the year, therefore average A/R can be estimated using the average of beginning and ending A/R balances.

    When sales are seasonal or uneven, the beginning and ending balances may not be indicative of the average A/R balance. This is one of the reasons that most retailers have a fiscal year ending on January 31 and not December 31, because the sales in that industry are seasonal.

  • Activity MeasuresA/R turnover also can be analyzed in days instead

    of times

    Days Sales Outstanding (DSO)

    DSO = Days in year / AR turnover Average collection period in days.

    May use 365, 360 or 300 days

    Compared to credit terms to determine if customers pay within terms.

  • Activity Measures Inventory turnover = COGS / Ave. Inventory

    Measures efficiency of inventory management. High ratio : Quicker inventory turns

    Inventory not obsolete, not carrying excess.

    Highly seasonal should use monthly Inv. average. LIFO valuation not comparable to other methods. Inventory turnover is industry specific.

    Grocery vs. Concrete

    Days Sales in Inventory = Days in year/Inv. Turnover How many days sales are tied up in inventory.

  • Activity Measures - Payables

    Accounts Payable Turnover = Purchases / Ave. AP

    Highly seasonal should use monthly Payables average.

    Days Purchases in Accounts Payable (DPO)

    DPO =Days in year / AP Turnover

    Compared to credit terms to determine if the firm is paying within terms.

    Continued

  • Activity Measures

    Operating Cycle = DSI + DSO

    The amount of time to convert inventory to cash.

    Figure 2-2 Page 67

    Cash Cycle = Operating Cycle DPO

    Is the days that cash is tied up as another asset.

  • Activity Measures Fixed Assets Turnover Ratio = Net Sales / Ave. Net PP&E

    How efficiently the company deploys its investment in plant assets to generate revenues.

    Higher turnover is preferable.

    Affected by the capital intensiveness of the company and its industry, by the age of the assets, and by depreciation method used.

    Total Assets Turnover Ratio = Net Sales / Ave. Total Assets Higher turnover is preferable.

    Exclude assets that do not relate to sales. Ex: investments

  • 2.4 Solvency

    Solvency is a firms ability to pay its noncurrent obligations as they come due

    Long-run as opposed to liquidity which focuses on short-term (current items)

    Firms capital structure incl.

    Liabilities (external) Long-term and short-term debt Equity (internal) Residual

    Capital decisions have consequences > debt = > risk = > cost of capital > equity = < ret. on equity Which det. deg. of leverage

  • 2.4 Solvency

    Debt = creditors interest

    = contractual obligations

    Ret > cost of debt = > equity

    Equity = permanent capital

    Ret. uncertainty even with Pre. Stock

  • 2.4 Solvency

    Capital Structure Ratios Total Debt to Total Capital Ratio

    TTL Debt/TTL Capital (Debt & Equity) = total leverage

    Debt to Equity Ratio

    TTL Debt/Equity = total amount (X) that debt exceeds equity

    Long-term Debt to Equity Ratio

    Long-term debt/Equity

    ??? which is better, increase or decrease of Long-term Debt to Equity Ratio, year over year?

    Debt to Total Asset Ratio TTL Liabilities/ TTL Assets

    ??? how is the same as the debt to total capital ratio?

  • 2.4 Solvency

    Earnings Coverage Times interest earned ratio

    EBIT/Interest Expense

    ??? What does this tell a creditor

    Most common mistake not to add back that years interest payment to NI before taxes

    Earnings to Fixed Charges Ratio EBIT + Interest portion of operating leases/Int. exp. + Int. portion of

    operating leases + Div. on Pre. Stock

    More conservative; shows all fixed charges

  • 2.4 Solvency

    Cash Flow to Fixed Charges Ratio

    Pre-tax operating cash flow/Int. exp. + Int. portion of operating leases + Div. on Pre. Stock

    Eliminates issues associated with accrual accounting

  • 2.5 LeverageTypes of Leverage

    A company uses leverage in two ways: financial and operating. Financial leverage is raising capital through debt rather than equity. While

    debt holders are entitled to interest, the owners share the earnings of the company. Hence, when a company can earn a higher rate of return on its invested capital through its operations than the interest rate on its debt, it could increase the return for its investors by financing the growth of company operations through borrowed capital.

    Operating leverage is the existence of fixed operating costs. Because these costs are fixed, the higher the percentage of operating leverage, the greater the effect changes in sales revenues have on operating income.

    The focus on leverage in this section is on financial leverage. The cost of financial leverage is interest costs, which must be paid regardless of sales.

  • 2.5 Leverage

    Leverage = relative of fixed cost

    ??? which fixed cost?

    ??? what financial statement do we find on?

    Deg. of leverage = Pre-fixed-cost income amount/Post-fixed-cost income amount

  • 2.5 Leverage

    Distinguish between variable costing and full-costing

    Why do we have to have variable costing for measuring the DOL

    Degree of Op. Lev. Single-Period Version

    DOL = Contribution Margin/Operating Income or EBIT

    Contribution Margin = ???

    Example page 72

  • 2.5 Leverage

    Degree of Operating Leverage Perc.-Change Version

    %Chng. in Op. Inc. or EBIT/%Chng. in Sales

    Example page 72

    Degree of Financial Leverage Single-Period Version

    EBIT/EBT

    A variation is the Percentage-change Version

    Quiz

  • Capital Structure Other considerations

    Consider that increases in debt create higher fixed costs for interest and principal payments. It also results in a higher debt to equity ratio and, therefore, a less favorable position for long-term debt-paying ability. Decreases in equity, as a result of redemption of stock or losses from operations, also would result in a higher debt to equity ratio and higher risk for the companys ability to pay long-term debt.

    Increases in equity, such as those from profits, without correspondingincreases in debt would lower the debt to equity ratio, increasing thecompanys position for long-term debt-paying ability.

  • Capital Structure Other considerations

    What is Off -Balance Sheet Financing, and how does it affect financial rations?

    Off -balance sheet financing is a form of financing in which large capital expenditures are kept off an organizations balance sheet through various classification methods.

    Organizations oft en use off -balance sheet financing to keep their debt to equity and leverage ratios low, especially if the inclusion of a large expenditures would violate debt covenants.

    Four of the common techniques employed to achieve off -balance sheet financing are: factoring of A/Rs, special-purpose entities, leases, and joint ventures.

  • Capital Structure Other considerationsSpecial-Purpose Entities

    Many firms create special-purpose entities (SPEs) for a special, sometimes undisclosed, business purpose. For example:

    SPEs may be created to facilitate leasing activities, loan securitizations, R&D activities, or trading in financial derivatives (i.e. Enron).

    Because these were created as separate entities from the parent corporation, the financials and business transactions of these SPEs were not consolidated with that of the parent.

    By excluding such ventures from consolidation, the company is hiding significant business risk from investors

  • Capital Structure Other considerationsLeases

    Firms usually use leases to get use of an asset without having to show it on the balance sheet as an asset and the corresponding liability. If the firm were to purchase the asset, it might have to use cash, thus converting short-term assets into long-term assets and worsening short-term liquidity ratio. Purchasing the asset on credit would increase the firms accounts payable, again worsening its short-term liquidity ratios. If the firm were to use long-term financing to purchase, it would worsen the debt to equity or other solvency ratios.

    A way to avoid any of these adverse consequences on the balance sheet, firms sometimes lease the asset. Generally accepted accounting principles require that a determination be made on whether the lease is an operating lease or a capital lease. When the lease meets one of the four conditions established for capital leases, the lease payments are accounted for as a long-term liability.

    However, sometimes firms are able to structure a lease so as not to meet any of the four conditions. It can then classify the lease as an operating lease. With an operating lease, the firm is able to obtain the use of the asset without having to record its obligation to pay, thus obtaining off-balance sheet financing.

  • Capital Structure Other considerationsJoin Ventures

    A joint venture is a business entity that is owned, operated, and jointly controlled

    by a small group of investors with a specific business purpose.

    Sometimes a corporation is a partner in a venture, which allows it to be active in management and involved in decision making but not report the venture on the financial statement of the corporation.

    An investment in a corporate joint venture that exceeds 50% of the ventures outstanding shares must be treated as a subsidiary investment, leading to consolidation in the financial statement. However, firms sometimes are careful to hold less than 50% (say 48.5%) of outstanding shares to avoid such consolidationproviding off -balance sheet financing.

  • SU 2 - Liquidity Ratios Effects of Transactions

    You need to understand what effects typical business transactions have on a firms liquidity, rather than on the mechanics of calculating the ratios.

    See problems 10 13, p. 79

  • Profitability Analysis

    Profitability is a firms ability to generate earnings over a period of time with a given set of resources. It is analyzed by examining the elements of revenues, the cost of sales, and operating and other expenses.

    There are a number of ways an investor can look at return on his or her investment.

    Some returns involve the price of the stock as it trades in the securities markets. Although there are actions a company can take to make its stock more attractive to investors, return on market price depends on when each investor purchases and sells the stock. Thus, the analyst of a companys financial and operating

    performance cannot make this calculation for the individual investor. An analyst, can, however, examine how the investors contribution to the company performed on a per-share basis. This can be done by measuring earnings per share and the dividend yield.

  • Profitability AnalysisThe numerator of the return ratio is some measure of earnings or profits. The measure selected for the numerator should match the investment base in the denominator. For example, if total assets are used in the denominator, the income to all providers of the capital ought to be included in the numerator, which includes interest. Thus, interest usually is added back to the net income when computing the ROA. This leads to a popular measure known as earnings before interest, taxes, depreciation, and amortization (EBITDA).

    When return on common equity capital is computed, net income after deductions for interest and preferred dividends is used. The final ROI always must reflect all applicable costs and expenses, including income taxes, particularly when the return on shareholders equity is computed. Profit, or the profit motive, is realized when an organization is generating more resources than it consumes during the course of a year. That is, profit is the amount by which revenue from sales exceeds the costs required to achieve those sales. And the profit margin is the percentage of revenues represented by that excess of revenues over costs. Revenues and costs, however, are measured by diverse criteria.

  • Profitability Analysis

    Profit margins commonly are calculated using one of three different profit measures:

    1. Gross profit , which equals net sales revenue minus the cost of goods sold (COGS).

    2. Operating income , which equals gross profit minus various administrative expenses, not including interest or taxes (because they are not part of operations). Operating income is sometimes called earnings before interest and taxes (EBIT).

    3. Net income , which reduces revenues by all expensescost of goods, operating expenses, and interest and taxes.

  • Profitability Analysis

    Gross profit margin is what percentage of gross revenues remains with the firm after paying for merchandise.

    Revenue COGS = GP

    As with all financial ratios, the gross margin derives its meaning by comparison to performance of the company in past years as well as by comparison to industry

    averages. One of the things an analyst looks for is the trend of the gross profit margin:

    Is it increasing, decreasing, or remaining steady?

    Key That the percentage of GP remains or increases with sales.

    GP SG&A = Operating Profit

  • Profitability Analysis

    Gross Profit Margin = Gross Profit / Net Sales= Net Sales COGS / Net Sales

    Profit Margin = Net Income / Net Sales= Net Sales COGS G&A Fixed costs Tax

    InterestWhat is left to be reinvested or distributed?

    Net Profit Margin and Profit Margin are the same Difference between Operating Income and EBIT

    OTHER Other Income Other Loss

  • Profitability considerations

    Financial analyst must also look for reasons that explain changes. Here are some reasons that gross profit margin may change:

    Sales prices have not increased at the same rate as the change in inventory costs.

    Sales prices have declined due to competition. The mix of products sold has changed to more

    products with lower profit margins. Inventory is being stolen. (If this is the case, the cost of

    goods will be higher against the same sales.)

  • Profitability Analysis

    EBITDA performance measure that approximates accrual-basis profits from ongoing operations

    EBITDA / Net Sales adding back 2 major noncash expenses to EBIT

    ROI: what is Return and what is Investment? ROA: how well Management is deploying the firms assets in the

    pursuit of a profit NET INCOME / AVG TOTAL Assets That ratio will be very low in High Assets industry (Manufacturing)

    ROE: measures the return per owner dollar invested NET INCOME / AVG TOTAL Equity

    The difference between the two are Liabilities, which is why ROE is always larger than ROA

  • Key Take-Away

    CMA are expected to be able to determine the profitability of a business by calculating ROA / ROE using the DuPont Model and explain how it helps analysis

    Demonstrate: That you know the formulas

    That you are able to properly apply and analyze and evaluate

    Discussion on inconsistent definitions and what factors contribute to inconsistency

  • DUPONT Analysis

    Developed in 1919 as a way to better understand return ratios and why they change over time.

    The bases for this approach are the linkages made through financial ratios between the Balance Sheet and the I/S

    Breaking returns into their components

  • DuPont Model

  • Dupont Model: Deep Dive

    ROE = Profit Margin X Asset Turnover X Equity Multiplier

    High Turnover Industries = retail, groceries volume High Margin Industries = fashion, luxury rare,

    customized High Leverage Industries = financial sector, real estate

    Profitability Operating Efficiency

    Financial Leverage

  • Return on Assets: ROA

    ROA = Net Income / Sales X Sales / Total Assets

    How effectively assets are used?

    It measures the combine effects of profit margins and asset turnover

  • Return on Equity: ROE

    ROE = Net Profit / Equity= Net Profit / Pre-tax Profit X Pre-tax Profit / EBIT

    ROE = Tax burden X Interest burden X Margin X Turnover X Leverage

    ROE = Tax burden X ROA X Compound Leverage factor

    Tax Burden Interest Burden

  • ROCE

    Return on Common Equity = Net Income Preferred Dividends / AVG Common Equity

    ROCE = IACS / Net Sales X Net Sales / AVG Ttl Assets X Leverage

    The equity multiplier measures a companys financial leverage

    High financial leverage means that the company relies more on debt to finance its assets

    Raising capital with debt, the company can increase its equity multiplier and improve its ROE

    However, on the other hand, taking on additional debt may worsen the companys solvency and increase the risk of going bankrupt

  • Other measures

    Sustainable Equity Growth rate = ROCE x (1 Dividend Payout)

    Plowback rate = Net Income not distributed = reinvested in RE

    Net Profit Margin on Sales = Net Income / Sales Question 7 page 126

    Plowback rate

  • BEPS and DEPS

    Basic Earnings per Share = IACS / WACSO Income available to common shareholders can be income from

    continuing operations or net income

    Diluted Earnings per Share: IACS is increased by the amounts that would not have had to be paid if dilutive potential CS had been converted: Dividends on Convertible PS After-tax interest on Convertible Debt

    WACSO is adjusted (increased) by the weighted average number of additional shares of CS that would have been outstanding if dilutive potential CS had been converted

    Page 132 # 19 and 20

  • Weighted average number of shares outstanding example revisited

    If there were 800,000 shares outstanding from January through June and 1,200,000 shares outstanding between July and August, the weighted average would be calculated as shown next:

    800,000 Shares (Jan. 2 June) 3 6 Months / 12 Months = 400,000 Shares

    1,200,000 Shares (July 2Dec.) 3 6 / 12 = 600,000 Shares

    Weighted Average Shares Outstanding (Jan. 2 Dec.) = 400,000 Shares 1 600,000 Shares = 1,000,000 Shares

  • Dividend Payout Ratio

    The dividend payout ratio is a near complement to the percentage of shareholders equity. However, it considers EPS on a fully diluted basis, which is a more conservative measure than comparing earnings against currently outstanding shares of common stock only.

  • Other Market-based Measures

    Objective of Companies = increasing shareholder wealth

    Earning Yield = Earning per Share / Market Price per Share

    Dividend Payout Ratio = Dividends to CS / IACS Is it better a high or low ratio? Growing Companies, mature market, start-up?

    Dividend Yield = Dividend per Share / Market Price per Share

  • Effect of Accounting Changes

    For example, two commonly used methods of inventory valuation are first-in, first-out (FIFO) and last-in, first-out (LIFO). For the same underlying economic event, use of LIFO, under certain assumptions of increasing inventory units and prices, yields lower income than the FIFO inventory valuation method. Thus, a firm using LIFO would report lower income and lower inventory value than a similar firm using FIFO inventory valuation method. Lower income and lower assets both affect the computation of the return of asset ratio. An analyst is required to consider such effects of accounting policy choices on various financial ratios. The CMA exam tests the ability to evaluate and deduce the effects of various accounting choices on common ratios.

  • SU 3 - Effects of Off-Balance-Sheet Financing

    Purpose Reduce a companies debt load and thereby improving the ratios

    Examples include:

    Unconsolidated subsidiaries

    Special Purpose Entities

    Operating Leases

    Factoring Receivables with Recourse

  • SU 3 Market Valuations Measures

    Book value per share

    Market/Book Ratio

    Price/Earning Ratio

    Price/EBITDA

  • SU 3 Earnings per Share and Dividend Payout

    EPS

    Diluted Earnings per share

  • SU 3 Factors affecting Reported Profitability

    Among the many factors involved in measuring profitability are the definition of income; the stability, sources, and trends of revenues; revenue relationships; and expenses, including cost of sales.

    Income quality

    Factors affecting include: Income Revenues Receivables and Inventories Recognition Principles

  • SU 4 Risk and Return

    Systematic

    Unsystematic

    Relationship between Risk and Return

    Expected Rate of return calc. p. 146

    Security Risk vs. Portfolio Risk

    Specific Risk vs. Market Risk

  • SU 4 - CAPM

    In order to measure how a particular security contributes to the risk and return of a diversified portfolio, investors can use CAPM.

    CAPM quantifies the required return on a security by relating the securitys level of risk to the average return available in the market (portfolio)

    Investors must be compensated for their investment in 2 ways: Time value of money Risk

    Know the CAPM formula!

  • SU 4 Two types of Risk

    Business Risk

    Financial Risk

    Indifference Curve

  • SU 4 - Standard Deviation

    It measures the tightness of the distribution and the riskiness of the investment

    A large deviation reflects a broadly dispersed probability distribution meaning the range of possible returns is wide

    The smaller the deviation, the tighter the probability distribution and the lower the risk

    The greater the deviation the riskier the investment

  • SU 4 - Coefficients

    It measures the degree to which any 2 variables are related

    Perfect positive correlation = +1 means that 2 variables always move together

    Given perfect negative correlation, risk would in theory be eliminated

    In practice, the existence of market risk makes the perfect correlation nearly impossible

    The normal range for the correlation of 2 randomly selected stocks is 0.5 to 0.7. the result is a reduction in risk, not elimination.

  • SU 4 - Covariance

    Correlation coefficient of 2 securities can be combined with their standard deviations to arrive at their covariance

    Covariance = measure of mutual volatility

  • SU 4 - Diversification and Beta

    Portfolio Theory = balancing risk with return Asset Allocation is a key concept: stocks, bonds, real estate,

    cash, etc The purpose of diversification is to reduce risk while maximizing

    returns and therefore reducing market correlation

    Expected rate of return of a Portfolio is the weighted average of the expected rate of return of each individual assets in the same portfolio Specific risk = diversifiable risk = unsystematic risk This risk can be potentially eliminated with diversification Can risk be 100% eliminated? Benefits of diversification become extremely low when > 20/30

    stocks are held

  • SU 4 - Portfolio Management

    4 important decisions are involved (not only 2)

    Amount of money to invest

    Securities in which to invest (expected net cash flows)

    Time scale (Liquidity) = maturity matching

    Objectives: what for? = will dictate appetite for risk

    Others: transaction costs

  • SU 5 - Bonds

    Term structure of interest rates There are three main types of yield curve shapes:

    Normal

    Inverted

    and flat (or humped). A normal yield curve (upward sloping) is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time.

    The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.

  • SU 5 - Bonds

    When plotting yield curves we hold the following constant:

    Default risk

    Taxability

    Callability

    Sinking fund

  • SU 5 - Bonds

    Features of Bonds Par Value = Maturity amount = Face Amount

    State rate = Coupon rate

    Indenture = Terms

    Issuing bonds takes time and money

    > Risk = > Return (yield)

    How can you mitigate some of the market required return?

  • SU 5 - Bonds

    Following are means to reduce the required rate of return for bonds:

    Sinking Fund payments to a segregated fund which will equal the maturity value

    Insured

    Secured

  • SU 5 - Bonds

    Advantages of Bonds Interest is tax deductible Retain corporate control

    Disadvantages of Bonds Interest is considered legal obligation Raises risk level Raises risk profiles Contractual requirements (e.g. required debt to

    equity) Debt financing limits

  • SU 5 - Bonds

    Types of Bonds Maturity

    Term bond single maturity Serial bond

    Valuation Variable rate Zero-coupon or deep-discount bonds Commodity-backed bonds

    Redemption Provisions Callable bonds by the issuer Convertible bonds into equities

    Securitization Mortgage bonds specific Debentures borrowers general credit but not specific collateral

  • SU 5 - Bonds

    Bond valuation and sales price Several components to determining the fair price of a bond:

    Risk Duration Face amount Interest payment Other features such as callable, convertibility

    Stated versus Market rate Mkt rate is = state rate Mkt rate is < state rate Mkt rate is > state rate

    5.3 Corporate/Stock Valuation Methods P. 181

  • SU 5 Equity

    Common Stock Advantages to the issuer

    No fixed dividend (Common Stock only) No maturity date Increases creditworthiness

    Disadvantages to the issuer No tax deductible distribution Diluted controlling rights Diluted earnings Higher underwriting costs Increase average cost of capital

    What is a preemptive rights?

  • SU 5 Equity

    Preferred Stock = hybrid of debt and equity Advantages to the issuer

    Form of equity

    Does not dilute control

    Superior earning still go to CS

    Disadvantages to the issuer No tax deductible distribution and therefore greater

    cost to bonds

    Dividends in arrears can cause issues

  • SU 5 Equity

    Characteristics of Preferred Stock Priority in assets and earnings Potential accumulation of dividends Convertibility Participation Par value Redeemability Voting rights Callability Maturity Sinking fund

    Stock Valuations Preferred is similar to Bonds in valuation Discount rate will probably be higher then bonds due to riskiness Common stock valued also the same way except based on earnings (per share)

  • SU 5 Corporate/Stock Valuation Methods

    Dividend Discount Model Based on PV of expected dividends per share

    Can only be used when dividends are expected to grow at constant rate

    Dividend per share

    Cost of Capital dividend growth rate

    See example on p 182

  • SU 5 Corporate/Stock Valuation Methods

    Preferred Stock Valuation

    Dividend per share

    Cost of Capital

  • SU 5 Corporate/Stock Valuation Methods

    Common Stock with Variable Dividend Growth

    3 Step process Step 1 Calculate and sum the PV of Dividends in the period

    of high growth

    Step 2 Calculate the PV of the stock based on the period of steady growth discounted back to year 1 using the dividend discount method.

    Step 3 Sum the totals from Step 1 and 2

    Per-share Ratios on page 183

  • SU 5 Cost of Capital - Current

    Investor Required Rate of Return

    Components of Capital

    Debt after-tax interest rate on the debt

    Preferred Stock dividend yield ratio

    Common Stock dividend yield ratio

    Retained Earnings cost = Common Stock Why?

  • SU 5.6 Cost of Capital - Current

    Weighted Average Cost of Capital WACC

    Target Capital Structure

    Firms WACC is a single, composite rate of return on its combined components of capital.

    Min. WACC = Shareholder Wealth Maximizing

    Impact of taxes on Capital Structure and Capital Decisions

  • SU 6 Working Capital

    Working capital and types of capital policies?Working capital (or current capital) generally refers to the funds a company holds in current (short-term) asset accounts, and includes cash, marketable securities, receivables, and inventories.

    Net working capital provides a measure of immediate liquidity and indicates how much cash a firm has available to sustain and build its business, and refers specifically (from an accounting perspective ) to the difference between a firms current assets and its current liabilities. Depending on a firms level of current liabilities, the number may be positive or negative.

  • SU 6 Working Capital

    Working Capital policies include: Conservative = minimize risk = Higher current ratio & acid test ratio -

    focuses on low-risk, low return working capital investment and financing greater proportion of capital in liquid assets but at the sacrifice of some profitability; uses higher-cost capital but postpones the principal repayment of debt or avoids it entirely by using equity; current assets will be much greater than current liabilities.

    Moderate = average risk - uses risk and return and financing strategies that match the maturity of the assets with the maturity of the financing; seeks a balance between current assets and current liabilities.

    Aggressive = more (max) risk = Lower current ratio & acid test ratio -focuses on high profitability potential, despite the cost of high risk and low liquidity. Capital being minimized in current assets versus long-term investments ; higher levels of lower-cost short-term debt and less long-term capital investments. With an aggressive policy, current assets will be less than current liabilities.

  • SU 6 Working Capital

    What is the optimal level of working capital? Varies with industry! Contrast a grocery chain which has to rotate its inventory

    and probably has no receivables versus a manufacturer Consequently ratios are only meaningful in terms of norms

    and trends and relative its competitors or the industry it which it operates

    Permanent and Temporary Working Capital Def. The minimum level of current assets maintained by

    a firm (which could fluctuate with seasonality). It should increase as the company grows Permanent financed with long-term debt

  • SU 6 Cash Management

    Managing the cash levels What are the motives for holding cash?

    Transactional

    Precautionary

    Speculative

    What is the firms optimal cash? Economic Order Quantity (EOQ) As applied to cash (as

    opposed to inventory)

    Questions you will have to answer How much cash

    Transaction cost

    Return on marketable securities

  • SU 6 Cash Management

    Cash Management EOQ Model P. 218

    Review examples forecasting future cash flows (see examples on page 219, very typical test questions!)

    Lockbox benefit analysis = Net Benefit from Lockbox = Reduction in Float Opportunity Cost + Reduction in Internal Processing Costs -Lockbox Processing Costs

  • SU 6 Marketable Securities Management

    Remember!

    Companies invest in marketable securities for three main reasons:

    1. Reserve liquidity. To provide a source of near cash (or instant cash) and cover any working capital imbalances resulting from insufficient cash inflows or unforeseen cash needs

    2. Controllable outflows. To earn interest on funds that are being held for predictable downstream cash outflows (such as interest payments, taxes, dividends, or insurance policies)

    3. Income generation. To earn interest on surplus cash for which the company has no immediate use

  • SU 6 Receivable Management

    Overview A firm must balance default risk and sales

    maximization

    Basic Receivable Formulas Average collection period (see example on page 224)

    Accounts Rec. days vs. dollars (see page 224)

    Assessing impact of a credit term change (see example page 225)

  • SU 6 Inventory Management

    Inventory management refers to the process of determining and maintaining the required level of inventory that will ensure that customer orders are properly filled on time.

    1. What to order (or make)? 2. When to order (or make)?3. How much to order (or make)?

    Reasons for carrying inventory include: Hedging against supply uncertainty Hedging against demand uncertainty Ensuring that operations are not interrupted (ref. JIT)

  • SU 6 Inventory Management

    Inventory costs

    Purchase cost actual invoice amounts

    Carrying cost incl. Storage, Insurance, Security, Inventory taxes, Depreciation or rent, Interest, Obsolescence and/or spoilage and Opportunity cost.

    Inventory costs incl. - Ordering costs and Stockoutcosts (see example page 226).

  • SU 6 Inventory Management

    Inventory Replenishment Models With Certainty = Average daily demand X Lead time in days Without Certainty = Average daily demand X Lead time in days) + Safety Stock

    Cost of Safety Stock = Expected stockout cost + Carrying Cost

    See example on page 228

    Economic order quantity (EOQ) Represents the optimum order sizethe quantity of a regularly ordered item to be purchased at a point in time that results in minimum total cost (i.e., the sum of ordering costs and carrying costs).

  • SU 6 - Short-term Financing

    Sources Spontaneous Forms of Financing

    Trade credit Accrued expenses

    Commercial banks, and Market-based instruments

    Cost of not taking a discount (see example page 230)

    Short-term bank loans In addition to trade credit sources Increased risk May not renew Contractual restrictions Prime interest rate best customers only

    Simple interest loans Interest paid at the end of the term; statet is same as nominal

    Effective Interest Rate on a LoanNet interest expense

    Usable funds

  • SU 6 - Short-term Financing

    Discounted LoansAmount needed

    (1.0 Stated rate)

    Loans with compensating balances increases effective interest rate

    Lines of Credit with Commitment Fees

  • SU 7 - Financial Markets and Security Offerings

    Benefits of Financial Markets

    Facilitate the transfer of funds from those that need to invest to those that need to borrow.

    Direct or indirect

    Intermediate entities & financial markets special expertise.

    Aggregate view of Financial Markets Demand/Supply of Securities Some of the securities included are Stocks, Corporate

    bonds, Mortgages, Consumer loans, Leases, Commercial paper, CDs, Governmental securities, Derivatives

  • Money Markets vs. Capital Markets Short term vs. Long term

    Money Markets Dealer driven Dealer buy and sell at their own risk.

    Dealer is principal in transaction vs. stockbroker is an agent

    Short term and marketable

    Low default risk

    Exist in New York, London, & Tokyo Government T-bills, T-notes and bonds, Federal agency and S-T

    tax exempt securities, Commercial paper, CDs US and Eurodollar, Repurchase agreements, Bankers acceptances

    Capital Markets LT debt & equities NY Stock Exchange

    SU 7 - Financial Markets and Security Offerings

  • Primary Markets, Secondary Markets and Financial Intermediaries

    Primary market IPO / Issuer receives the proceeds

    Secondary market Trading among investors

    Pros Company prestige

    Increased liquidity of firms securities

    Cons Reporting requirement

    Hostile takeovers

    Provide market makers

    SU 7 - Financial Markets and Security Offerings

  • Secondary market continued.. Over-the-counter markets Broker & Dealer market

    Bonds US companies, federal, state, & local governments Open-end investment company shares of mutual funds New securities issues Secondary stock distributions whether of not listed on the

    exchange

    NASD National Association of Securities Dealers NASDAQ NASD Automated Quotation system

    Transaction happen in virtual space Price quotes and volume

    Auction markets NY Stock Exchange Transaction happen at NYSE by floor traders

    Financial Intermediaries Use funds from savers Banks, CUs, Insurance co., Pension funds, etc.

    SU 7 - Financial Markets and Security Offerings

  • Efficient Markets Hypothesis Current stock prices immediately and fully reflect all

    relevant information. Impossible to obtain consistently abnormal returns with fundamental or technical analysis.

    Three forms of efficient markets hypothesis 1) Strong form

    All public and private information is instantaneously reflected in securities price.

    Insider trading would not result in abnormal returns.

    2) Semi-strong form All publicly available data are reflected in security price, but private or

    insider data are not immediately reflected. Insider trading can result in abnormal returns.

    3) Weak form Prices reflect all recent past price movement data. Technical analysis will not provide a basis for abnormal returns.

    Data does not support the strong form.

    SU 7 - Financial Markets and Security Offerings

  • Investment Banking Intermediary between businesses and capital providers.

    Sell new securities | Business combinations | Brokers & Traders

    With new securities - Help determine method of issuance, pricing, distributing, advice, and certification. Signal sourced, Negotiates deal sets price and fees Sold by best efforts sales No guarantee Underwritten deal IB purchases securities from issuer and

    resells them IB makes the process easier, because of resources and

    reputation. Buyers look to IB reputation for fair deals.

    Structuring of the floatation. Terms of arrangement, capital type and amount

    Flotation costs Higher for common, then preferred, lower for bonds.

    SU 7 - Financial Markets and Security Offerings

  • IPOs Advantages of going public

    Raise additional funds, establish value in market, stock liquidity

    Disadvantages Costs, data public, shareholder information public, insider limitations,

    earning growth pressure, stock price doesnt reflect firm net worth, loss of control, growth brings move management control, shareholder costs

    Steps involved in going public Prefiling period Negotiate and agreements with underwriters. Buying or

    selling securities is prohibited. Apply to a stock exchange, pay fee, fulfill membership requirements, Waiting period - File registration statement and prospectus with SEC. May

    make oral offers to buy and sell securities. Tombstone ads In large red ink Preliminary prospectus, date, and legend must be marked. SEC 20

    day review period. Debug letter Fix or withdraw. A Preliminary prospectus is called a Red-Herring

    Post effective period Registration statement is effective. Securities may be sold.

    SU 7 - Financial Markets and Security Offerings

  • SU 7 Dividend Policy and Share Repurchase

    Dividend Policy To distribute or not to distribute?

    Higher dividend lower growth rate, finding the balanceStable dividends are desirable

    Factors influencing Company Dividend Policy Legal Restrictions- Dividend amount must be in RE. Stability of Earnings Rate of Growth Cash Position Restrictions in Debt Agreements Tax Position of Shareholders Residual Theory of Dividends Minimize Cost of Capital

  • SU 7 Dividend Policy and Share Repurchase

    Dividend dates Date of declaration formal vote to declare a dividend. Dividend

    becomes a liability to the company. Date of record Shareholder on that date will receive the dividend.

    2-6 weeks after Date of declaration

    Date of distribution Dividend is paid. 2-4 weeks after date of record Ex-dividend date Purchase before date will receive dividend

    Established by stock exchange

    Stock price will usually drop on ex-dividend date in the amount of dividend

    Stock dividends vs. stock splits More stock is issued, but no value increase or decrease occurs. Stock dividend transfers amount from RE to Paid-in capital Stock split no accounting entry Lowers stock price

  • SU 7 Dividend Policy and Share Repurchase

    Repurchase Treasury shares

    Mergers, Share options, Stock dividends, Tax reasons, increase EPS, prevent hostile takeovers, eliminate a particular ownership interest

    Dividend Reinvestment Plans - DRPs or DRIPS Dividends owed to shareholders are reinvested into

    shares.

    Insider Trading laws SEC Rule 10b-5

    Leases

  • SU 7 - Mergers and Acquisitions

    Merger vs. Acquisitions Mergers Acquiring firm absorbs a 2nd firm.

    Types Horizontal Companies of same business line merge. Vertical Combine supplier with customer Congeneric Related products or services Conglomerate Unrelated companies merge.

    Advantages and disadvantages

    Acquisition Acquiring firm purchases all of 2nd firms assets or stock. Requires shareholder vote. Hostile takeover 5% ownership of any stock class requires SEC filing. Advantages and disadvantages Proxy File with SEC 10 days prior, furnish shareholder with all material

    subject to vote, The Proxy form, Proxies for Directors in Annual Report Going private - LBO

  • SU 7 - Mergers and Acquisitions

    Opposition to Combinations Greenmail Targeted Repurchase Staggered Directors or Supermajority vote requirements Golden Parachutes Fair Price Provisions Ensures all stockholder are treated equally. Going Private and LBOs Poison Pill Kills the company value. Flip-over Rights Shareholder exchange for greater value. Flip-in Rights Gives existing shareholders more rights than large acquirer. Issuing Stock - Reverse Tender ESOP White Knight Merger Crown Jewel Transfer Legal Actions

    Other Restructurings Spin off, divestiture, asset liquidation, carve-outs, Letter stock- separate

    valuation

  • SU 7 - Mergers and Acquisitions

    Motivations of mergers and subsequent synergies Undervaluation of firm Managerial motivation Break up Parts are worth more than the whole. Diversification

    Synergies Combined firms are worth more than separate.

    Operational Financial Reduced competition Antitrust Strategic position Tax benefits

  • SU 7 Dividend Policy and Share Repurchase

    7.2 Dividend Policy and Share Repurchase P. 265

  • SU 7 Currency Exchange Rates

    7.5 Currency Exchange Rates Systems and Calculations P. 279

  • SU 8 Cost-Volume-Profit (CVP) Analysis -Theory

    CVP = Break-even analysis Allows us to analyze the relationship between revenue and fixed and

    variable expenses It allows us to study the effects of changes in assumptions about cost

    behavior and the relevant ranges (in which those assumption are valid) may affect the relationships among revenues, variable costs, and fixed costs at various production levels

    Cost-volume-profit analysis is a tool to predict how changes in costs and sales levels affect income; conventional CVP analysis requires that all costs must be classified as either fixed or variable with respect to production or sales volume before CVP analysis can be used.

    It considers the effects of: Sales volume Sales price Product mixes What else?

  • SU 8 Cost-Volume-Profit (CVP) Analysis -Theory

    CVP analysis is done with what assumptions?

    Cost and revenue relationships are predictable

    Unit selling prices are constant

    Changes in inventory are insignificant

    Fixed costs remain constant over relevant range (see slide 5 & 6)

    Total variable cost change proportional with volume (see slide 7 & 8)

    Continued

  • SU 8 Cost-Volume-Profit (CVP) Analysis -Theory

    The revenue (sales) mix is constant

    All costs are either fixed or variable (long-term all costs are considered as variable)

    Volume is the sole revenue driver and cost driver

    The breakeven point is directly related to costs and inversely related to the budgeted margin of safety and the contribution margin

    Time value of money is ignored

  • SU 8 Cost-Volume-Profit (CVP) Analysis - Theory

    Total fixed costs

    remain constant asactivity increases.

    Number of Local Calls

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    Cost per calldeclines as

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    Number of Local Calls

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    per

    Lo

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  • SU 8 Cost-Volume-Profit (CVP) Analysis - Theory

    Total variable costs

    increase as

    activity increases.

    Minutes Talked

    Tota

    l C

    osts

    Cost p

    er

    Min

    ute

    Minutes Talked

    Cost per Minuteis constant as

    activity increases.

  • 0 1 2 3 4 5 6

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    1,0

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    10

    20

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    Activity, 1,000s of Units Produced

    Estimated fixed cost = 10,000

    Draw a line through the plotted data points so that about equal numbers of points fall above and below the line.

    Scatter Diagrams

  • Vertical distance is the change

    in cost.

    Horizontal distance is the change in activity.

    Unit Variable Cost = Slope = in cost in units

    0 1 2 3 4 5 6

    *

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    in

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    00s

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    10

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    Activity, 1,000s of Units Produced

    Scatter Diagrams

  • High-low method

    The following is not in this Study Unit, but it is important to know and be able to calculate.

  • SU 8 Cost-Volume-Profit (CVP) Analysis -Theory

    Breakeven point def. Level of output where total revenues equals total expenses; the point at which all fixed costs have been covered and operating income is zero.

    What is the break-even point and where is it on a graph on the next page?

  • CVP GraphBreak-Even Point

  • SU 8 Cost-Volume-Profit (CVP) Analysis -Theory

    Other terms and def. Margin of safety = excess of budgeted sales over BE Sales

    Mixed costs (See slide 11) Costs that have both a fixed and variable component. For example, the cost of operating an automobile includes some fixed costs that do not change with the number of miles driven (e.g., operating license, insurance, parking, some of the depreciation, etc.) Other costs vary with the number of miles driven (e.g., gasoline, oil changes, tire wear, etc.).

    Revenue or sales mix is the composition of total revenues in terms of various products

    Sensitivity analysis (See slide 12) Examines the effect on the outcome of not achieving the original forecast or of changing an assumption. Since many decisions must be made due to uncertainty, probabilities can be assigned to different outcomes (what-if).

  • SU 8 Cost-Volume-Profit (CVP) Analysis -Theory

    Unit Contribution Margin (UCM) is an important term used with break-even point or break-even analysis is contribution margin. In equation format it is defined as follows:

    Contribution Margin = Revenues Variable Expenses

    The contribution margin for one unit of product or one unit of service is defined as:

    Contribution Margin per Unit = Revenues per Unit (Sales price) Variable Expenses per Unit

    Expressed in either percentage of the selling price (contribution margin ratio) or dollar amount

    Slope of total cost curve plotted so that volume is on the x-axis and dollar value is on the y-axis

  • SU 8 Cost-Volume-Profit (CVP) Analysis -Theory

    Break-even point in units

    Fixed costsUCM

    Break-even point in dollars

    Fixed costsCMR

  • Unit sales price less unit variable cost

    ($30 in previous example)

    We have just seen one of the basic CVP relationships the break-even computation.

    RememberComputing the Break-Even Point

    Break-even point in units = Fixed costs

    Contribution margin per unit

  • The break-even formula may also be

    expressed in sales dollars.

    REMEMBER

    COMPUTING THE BREAK-EVEN POINT

    Unit contribution margin

    Unit sales price

    Break-even point in dollars = Fixed costs

    Contribution margin ratio

  • SU 8 - CVP Analysis Basic Calculations

    CVP Applications

    Target Operating Income

    Multiple products

    Choice of products

    Degree of Operating Leverage (DOL)

  • SU 8 - CVP Analysis Target Income Calculations

    Target Operating Income

    Fixed costs + Target operating incomeUCM

    Target Net Income

    Fixed costs + Target net income / (1.0 tax rate)UCM

    Problem 15, 16 and 18 on page 333

  • The CVP formulas can be modified for use

    when a company sells more than one product.

    The unit contribution margin is replaced with the contribution margin for a composite unit.

    A composite unit is composed of specific numbers of each product in proportion to the product sales

    mix.

    Sales mix is the ratio of the volumes of the various products.

    Computing a MultiproductBreak-Even Point

  • SU 8 - CVP Analysis Multiproduct Calculations

    Multiple Products (or Services)

    S = FC + VC = Calculated Weighted Average Contribution Margin

    See example page 318

  • SU 8 -CVP Analysis Choice of Product Calculations

    Choice of Product decisions When resources are limited companies have to choose which products to produce

    A breakeven analysis of the point where the same operating income or loss will result

    See example page 318

  • SU 8 -CVP Analysis Special Order Calculations

    Special Orders (usually lower price than std.)

    The assumption are that idle capacity is sufficient to manufacture extra units of a special order.

  • SU 8 - Marginal Analysis

    Accounting Costs vs. Economic Costs Accounting Costs = The total amount of money or goods expended in an endeavor. It is money

    paid out at some time in the past and recorded in journal entries and ledgers.

    Economic Costs = The economic cost of a decision depends on both the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen. Economic cost differs from accounting cost because it includes opportunity cost.

    As an example, consider the economic cost of attending college. The accounting cost of attending college includes tuition, room and board, books, food, and other incidental expenditures while there. The opportunity cost of college also includes the salary or wage that otherwise could be earning during the period. So for the two to four years an individual spends in school, the opportunity cost includes the money that one could have been making at the best possible job. The economic cost of college is the accounting cost plus the opportunity cost.

    Thus, if attending college has a direct cost of $20,000 dollars a year for four years, and the lost wages from not working during that period equals $25,000 dollars a year, then the total economic cost of going to college would be $180,000 dollars ($20,000 x 4 years + the interest of $20,000 for 4 years + $25,000 x 4 years).

  • SU 8 - Marginal Analysis

    Explicit vs. Implicit Costs

    Implicit Costs = implicit cost, also called an imputed cost, implied cost, or notional cost, is the opportunity cost equal to what a firm must give up in order to use factors which it neither purchases nor hires.

    Explicit Costs = An explicit cost is a direct payment made to others in the course of running a business, such as wage, rent and materials.

  • SU 8 - Marginal Analysis

    Accounting vs. Economic Profit See Utorial at http://www.khanacademy.org/economics-finance-domain/microeconomics/firm-

    economic-profit/economic-profit-tutorial/v/economic-profit-vs-accounting-profit

    Accounting Profit = book income exceeds book expenses

    Economic Profit = includes Accounting Profit + Implicit costs

  • SU 8 - Marginal Analysis

    Marginal Revenue and Marginal Cost Marginal Revenue is the additional or incremental revenue

    of one additional unit of output. See page 321 See that Marginal Revenue is $540 between generating 4 vs. 5

    units of output.

    Marginal Cost is the additional or incremental cost incurred of one additional unit of output. Note that while cost decrease over some range they will at some

    point begin to increase due to the process becoming lest efficient.

    Profit Maximization is where MR = MC (see page 322)

  • SU 8 - Marginal Analysis

    Short-Run Cost Relationship See graph on page 323

    Other considerations/applications of CVP

    Make-or-Buy

    Capacity Constraints and Product Mix

    Disinvestments

    Sell-or-Process further

  • SU 8 - Short-run Profit Maximization

    Pure Competition - A market structure in which a very large number of firms sell a standardized product into which entry is very easy in which the individual seller has no control over the product price and in which there is no nonpricecompetition; a market characterized by a very large number of buyers and sellers. Examples: Agricultural products

    Monopoly - A market structure in which one firm sells a unique product into which entry is blocked in which the single firm has considerable control over product price and in which non-price competition may or may not be found. Examples: Public utilities

    Monopolistic Competition - A market structure in which many firms sell a differentiated product into which entry is relatively easy in which the firm has some control over its product price and in which there is considerable non-price competition. Examples are grocery stores and gas stations

    Oligopoly - A market structure in which a few firms sell either a standardized or differentiated product into which entry is difficult in which the firm has limited control over product price because of mutual interdependence (except when there is collusion among firms) and in which there is typically non-price competition.

  • SU 8 - Short-run Profit Maximization

    Law of Demand - Law of demand states that ' all other things remaining unchanged, people demand (buy) more of any good / service if the price of that good / service falls and demand (buy) less if the price increases.

    Elasticity of demand measures how responsive a products demand is to changes in its price level.

    When we have inelastic demand, a consumer will pay almost any price for the good.

    Generally goods which have elastic demand tend to have many substitutes

    Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.

    Elasticity > 1 : elastic (% change in demand is greater than % change in price e.g. luxury goods such as cars etc.) Elasticity < 1 : inelastic (% change in demand is less than % change in price e.g. essential goods such as food) Elasticity = 1 : unitary elastic (% change in demand is equal to the % change in price)

  • SU 9 - Decision Making: Applying Marginal Analysis

    Relevant = be made in the future (not SUNK costs) Committed costs are not part of the decision making

    process Relevant = differ among the possible alternative courses of

    action Relevant = avoidable costs (controllable = subject to

    Management decision / strategy) Relevant = incremental (marginal or differential)

    Relevant Range = incremental cost of an additional unit of output is the same. Outside range incremental cost change.

    Be careful using UNIT revenue and cost Emphasis to be on TOTAL relevant revenues and costs

  • SU 9 - Decision Making: Applying Marginal Analysis

    Marginal / Differential / Incremental Analysis Problem in CMA will be an evaluation of choices

    among courses of action What are the relevant and irrelevant costs? Quantitative analysis = ways in which revenues

    and costs vary with the option chosen. Focus on incremental rev & costs, not total rev &

    cost Example page 347 idle capacity (incremental

    impact) Compare Marginal revenue / Marginal Cost

    (contribution Margin) Fixed costs have already been absorbed

  • SU 9 - Decision Making: Applying Marginal Analysis

    Qualitative Factors to consider:

    - Pricing rules

    - Government Regulation

    - Cannibalization between products (stealing MS from yourself)

    - Outsourcing

    - Employee Morale

  • SU 9 - Decision Making: Applying Marginal Analysis

    Add-or-drop-a-segment decisions Disinvestment / capital budgeting decisions Marginal cost > Marginal revenue = Firm should disinvest

    4 Steps to be taken:1/ Identify fixed costs that will be eliminated if disinvesting2/ Determine the revenue needed to justify continuing operations3/ Establish the opportunity cost of funds that will be received4/ Determine whether the carrying amount of the asset = economic value. If not revalue use market fair value and not carrying amount

    Cost of idle capacity is relevant cost.

    Special Orders when excess capacity No opportunity costs Accept order = Variable costs (Contribution Margin)

  • SU 9 - Decision Making Special Orders

    Special Orders when excess capacity exists

    Differential (marginal or incremental) cost must be considered.

    Page 348

    Special Orders when no excess capacity exists

    Differential (marginal or incremental) cost must be considered.

    Page 349

  • SU 9 - Decision Making Make or Buy

    Make or Buy = insourcing or outsourcing (critical mass) Not enough capacity Outsource least efficient product Support services can be outsourced.

    Consider relevant costs to the investment decision Key variable is total relevant costs, not all total costs. Sunk cost & Costs that do not change between choices are irrelevant. Opportunity costs are considered when at full capacity.

    Capacity constraint Use marginal analysis maximize CM Product Mix

    Sell-or-Process Further Decisions sell at split off point or process Joint cost of product is irrelevant. Based on relationship between incremental cost and revenue

  • SU 9 - Price Elasticity of Demand

    Demand increases when Price goes down (in theory) Price of product and Quantity demanded are inversely related Price Elasticity of Demand = sensitivity

    % change in Q / % change in P

    Most accurate way to calculate elasticity = ARC method% Q / % P = [(Q1 Q2) / (Q1+Q2) ] / [(P1 P2) / (P1+P2)]Example page 380 # 19

    Demand elasticity > 1 = elastic (small change in price = large change in quantity)

    Elasticity = 1 (unitary elastic) Elasticity < 1 = perfectly inelastic (large change in price = small

    change in quantity) Infinite = perfectly elastic (horizontal line) Firm has no

    influence on market price (pure competition) Equal to zero = perfectly inelastic (vertical line) Consumer

    will pay

  • SU 9 - Pricing Theory

    Pricing Objectives: profit maximization / target margin / forecasted volume / image (segmentation positioning) / stabilization

    Price-setting factors Supply & Demand = Economic (external factors)

    Type of market Customer perceptions Elasticity Competition

    Internal Factors Marketing & Mix Relevant cost Strategy Capacity

  • SU 9 - Pricing Theory

    External Factors Type of market (pure competition, monopolistic,

    oligopolistic or monopoly) Customer perceptions of price and value Price / demand relationship Competitors products, costs, prices and amount

    supplied.

    Timing of demand

    Cartels = illegal practice except in international markets

    Cartel = collusive oligopoly restrict output, charge higher $$

  • SU 9 - Pricing Theory

    Cost-based pricing differs from Target pricing (page 358) 4 basic formulas Target pricing Life cycle costing

    Market-based pricing What consumer will pay Competition-based pricing Going rate & Sealed bids New product pricing Skimming & Penetration pricing Pricing by intermediaries Markups & downs Price adjustments

    Geographical pricing Discounts & Allowances Discriminatory pricing Psychological pricing Promotional pricing Value Pricing International pricing

  • SU 9 - Pricing Theory

    Product-mix pricing Product line Optional product Captive product By-product Product bundle

    Illegal pricing Pricing products below cost Price discrimination among customers Collusive pricing Dumping

  • SU 9 - Pricing Theory

    Exercise page 376

    Questions 10 to 12

  • SU 9 - Risk Management 4 Types of Risk:

    Hazard risks insurable Financial risks interest rates Operational risks procedural failure Strategic risks global, political and regulatory

    Volatility and Time Capital adequacy = solvency (cash flows) / liquidity (reserves) Risk = severity of consequences + likelihood of occurrence 5 strategies for Risk response:

    Risk avoidance End the activity that establishes the risk Risk retention Acceptance of risk. Self insurance Risk reduction - Mitigation Risk sharing Moving risk to 3rd party Insurance, hedging, JV Risk exploitation Deliberately entering to pursue high return.

  • SU 9 - Risk Management Residual risk The risk that remains after the effects of

    avoidance, sharing, or mitigation efforts. Inherent risk The risk that arises for the activity itself. Benefits:

    - Efficient use of resources- Fewer surprises- Reassuring investors

    5 Key Steps in Risk Management Process1/ Identify risks2/ Assess risks3/ Prioritize risks4/ Formulate risk responses5/ Monitor risk responses

    Risk appetite

  • SU 9 - Risk Management Hazard risk management

    Insurance

    Financial risk management Hedging Sinking funds Rigid policies (maturity matching)

    Qualitative risk assessment tools Identification Ranking Mapping

    Quantitative risk assessment tools Value at risk (VaR) Page 364

  • SU 9 Price elasticity and demand

    9.4 Understand the difference in effect between an Change in Price Page 351 Change in Demand Page 352

    Price Elasticity of Demand

    Percentage change in Quantity DemandedPercentage change in price

    See Price Elasticity of Demand Graph on page 353 and understand between Elastic Inelastic

  • SU 10 The Capital Budgeting Process

    Definition Planning and controlling investment for long-term projects. Capital budgeting unlike other considerations will affect

    the company for many periods going forward long-term, multiple accounting periods, relatively inflexible once made.

    Predicting the need for future capital assets is one of the more challenging task, which can be affected by: Inflation Interest rates Cash availability Market demands

    Production capacity is a key driver

  • SU 10 The Capital Budgeting Process

    Applications for capital budgeting Buying equipment Building facilities Acquiring a business Developing a product of product line Expanding into new markets

    Important to correctly forecast future changes in demand in order to have the correct capacity.

    Planning is crucial to anticipate changes in capital markets, inflation, interest rates and money supply.

  • SU 10 The Capital Budgeting Process

    Consider the tax consequences All decisions should be done on an after tax basis

    Considered costs in Capital Budgeting Avoidable cost May be eliminated by ceasing or

    improving an activity. Common cost Shared by all options and is not clearly

    allocable. Deferrable cost May be shifted to the future. Fixed cost Does not very within relevant range. Imputed cost May not have a specific cash outlay in

    accounting Incremental cost Difference in cost of two options.

  • SU 10 The Capital Budgeting Process

    Opportunity cost Maximum benefit forgone based on next alternative, including that of the stockholders (which also establishes the firms hurdle rate).

    Relevant cost Vary with action. Constant cost dont affect decision.

    Sunk Cannot be avoided.

    Weighted-average Cost of Capital Weighted average of the interest cost of debt (net of tax) and the costs (implicit or explicit) of the components of equity capital to be invested in long-term assets. It is also the hurdle rate.

  • SU 10 The Capital Budgeting Process Stages in Capital Budgeting

    Identification and definition - Id What is the strategy? Definition Define the projects Revenue, costs, and cash flow

    Most difficult stage

    Search Each investment to be evaluated be each function of the firms value chain.

    Information-acquisition Costs and benefits of the projects are enumerated. Quantitative financial factors have highest priority Nonfinancial measures (quantitative and qualitative)

    Selection Increase shareholder value. NPV, IRR..

    Financing Debt or equity

    Implementation and monitoring Feedback and reporting

  • SU 10 The Capital Budgeting Process

    Investment Ranking Steps Determine Net Investment Costs Gross cash requirement less cash

    recovered from trade or sale of existing assets, adjusted for taxes Investment required includes funds to provide for increases in working

    capital, i.e. additional receivables and inventories.

    Calculating estimated cash flows Capture increase in revenue, decrease costs Net cashflow period by period from investment Economic life of the investment Depreciable life

    Comparing cash-flows to Net Investment Costs Evaluate the benefit.

    Continued

  • SU 10 The Capital Budgeting Process

    Ranking investments NPV, IRR, Payback

    Other considerations Book Rate of Return GAAP NI from Investment

    Book Value of Investment

    Also called accrual accounting rate of return

    Dont use accrual accounting numbers, instead use cash flow

    Reason Net Income are affected by companys choices of accounting methods

    Also, do not compare project book rate to companys book rate of return for investments which could be distorted

    Continued

  • SU 10 The Capital Budgeting Process

    Relevant cash flows Net initial investment

    New equipment cost

    Working capital requirements,

    After tax disposals proceeds

    Annual net cash flows

    After tax cash collections for operations

    Depreciation tax savings

    Project termination cash flows

    After tax disposal

    Working capital recovery

    See example on page 393

  • SU 10 The Capital Budgeting Process

    Other Considerations

    Inflation Raises hurdle rate.

    Post-audits Deterrent of bad projects.

    Actual to expected cashflow

    Identify sources of unrealistic estimates

    Avoid premature evaluations of projects

    Non-quantitiative benefits

  • SU 10 - Discounted Cash flow Analysis

    Time Value of Money Concepts A dollar received in the future is worth less

    than today.

    Present Value (PV) Value today of future payment Future Value (FV) Future value of an investment today. Annuities equal payments at equal intervals

    Ordinary annuity (in arrears) Annuity due (in advance) PV & FV is always greater than ordinary

    annuity

    See examples on page 394 through 396

  • SU 10 - Discounted Cash flow Analysis

    Hurdle rate Goal is for companies discount rate to be as low as possible. WACC or Shareholders opportunity cost of capital.

    The lower the firms discount rate, the lower the hurdle the company must clear to achieve profitability

    Net Present Value (NPV) Project return in $$

    See example on 397

  • SU 10 - Discounted Cash flow Analysis

    Internal Rate of Return (IRR) Project return in %

    IRR shortcomings -

    Directional changes of cash flows

    Mutually exclusive projects

    Varying rates of return

    Multiple investments

    + +

  • SU 10 - Discounted Cash flow Analysis

    Cash flows and discounting

    NPV = Cash flow0 Cash flow1 Cash flow2

    (1 + r)0 (1 + r)1 (1 + r)2

    Comparing Cash flow Patterns Pg 399

  • SU 10 - Discounted Cash flow Analysis

    NPV vs IRR comparison Reinvestment rate NPV assumes the cash flow can be reinvested at projects

    discount rate. Independent projects:

    NPV and IRR give same accept/reject decision if projects are independent. All acceptable independent projects can be undertaken.

    Mutually exclusive projects. Cost of one greater than other Timing, amounts, and direction of cash flow are different Different useful lives IRR provides 1 rate, NPV can be used with multiple rates. Multiple investments. NPV is adaptable, IRR is not. IRR assumes cash flow is reinvested at IRR rate. NPV assumes reinvestment in the desired rate of return.

    NPV and IRR are most sound decision making tools for wealth maximization. NPV profile Page 401

    Select greatest NPV over greatest IRR

  • SU 10 - Payback and discounted payback

    Payback period = Number of years to pay for itself. Pro - Simple

    Cons - No consideration for time value of money. Does not consider cash flow after payback period.

    Payback and constant cash flows vs variable cash flows

    See example on page 402

  • SU 10 - Payback and discounted payback

    Discounted payback method is used to overcome the payback methods disregard for time value of money

    Pro More conservative yet still simple

    Con Does not consider cash flow after payback period.

    See example on page 403

  • SU 10 - Payback and discounted payback

    Other payback methods

    Bailout payback = Considers salvage value

    Payback reciprocal (1 divided by payback) estimate of IRR

    Breakeven time = Time require for discounted cash flows to = 0.

    Alternative is to consider the time required for the present value of the cumulative cash inflows to equal the present value of all the expected future cash flows

  • SU 10 - Ranking investment projects

    Why should we rank investment projects

    Capital rationing

    Reasons include lack of financial resources, control estimation bias, and unwillingness to issue new equity (to raise new capital)

  • SU 10 - Ranking investment projects

    Methods

    Profitability index = NPV / Net Investment

    See example on page 404

    Internal capital markets Internal funding

    Linear programming Technique for optimizing resource allocation.

  • SU 10 - Risk Analysis and real options in Capital Investments

    Risk analysis Attempt to measure