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Chapter 3

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Factors affecting Financial Modelling & Decision Making

1. A financial manager is often required 2 evaluate the business wisdom of different alternatives.


Steps needed to reach a Decision:-

Determine Strategic issue identify problems to enhance shareholder/firm value Identify alternate courses of action o short-term quantifiable criteria o non-quantifiable criteria Perform analysis of relevant costs and strategic costs o Obtain information o Make predictors about future costs o Consider strategic issues Select the best alternative (best course of action) Evaluate the effectiveness of the decision to meet the strategic objectives


Defining Relevant Revenues & Costs

Future revenues & costs are only considered relevant if they change as a result of selecting different alternatives Only costs & revenues that change as a result of a decision are relevant to the decision making i. Specific traceability to cost object ii. Cost relevance affects decision making they can either be fixed or variable but more often variable becoz they change with production Other types of relevant costs :o Direct Costs - can be identified or traced to given cost object (generally VC) o Prime Cost - DM & DL o Discrectionary costs costs rising from periodic(usually annual) budgeting decisions to spend in areas not directly related to manufacturing o Incremental (different) Costs additional costs incurred to produce additional units over present output o Avoidable Costs - results from choosing one alternative over the other o Has no effect on decision making are the same regardless of the decision o 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 o Absorption costs fixed MOH (insurance etc) Not relevant - sunk, historical, unavoidable costs. They have NO EFFECT on the decision Value Chain - defines each major activity that adds value to the product or service produced by a firm..

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Chapter 3

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Quantitative vs. Qualitative Relevant information

Quantitative Financial numerical measurements denominated in currency Non-financial numerical measured in other e.g time Qualitative Non-numerical - employee morale & customer satisfaction



- the chance that an event will occur, assigned values between

zero & one 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
the weighted average of the probable outcomes Expected value = (probability of each outcome * its payoff) then sum the results

Financial modelling for capital decisions


Capital Budgeting
- Deciding which project to invest in. a. The goal :- Present Value of cash inflows > cash outflows b. Cash Flow Effects:a. Direct effect - a company pays out or receives cash b. 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) c. 3 Stages of cash flow a. Inception of Project - Direct cash flow effects of acquisition - Tme period = 0 - Indirect cash flow effects of working capital (WC), anticipated salvage value of replaced asset - Net cost of new PPE 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

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Chapter 3

Page 3 of 11 b. Operations - Annuity cash flow effects of acquisition - Depreciation tax shield creates ongoing indirect cash flow - Disposal of the investment at end of project = direct /indirect cash flow effects Tax depreciation on new PPE * Marginal tax rate = Depreciation tax shield

c. Calcualtion of pre-tax & after-tax cash flows i. Pre-tax cash flows - investment value = PV of cash flows that investors receive in future - cash outflows > cash inflows = UNPROFITABLE i. After-tax cash flows income taxes are deducted in estimating annual cash flows depreciation tax shield = depr expense x marginal tax rate 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 See example on page B3-13!!!!


Methods of Capital Budgeting

Accounting Rate of Return i. An evaluation method that uses GAAP income rather than cash flows ii. Average rate of return iii. Used for investments with short useful lives iv. If SL depreciation used & no residual value the average investment is equal to of Original cost Annual Net income (est. annual income) Avg (initial) investment [Cost depr]

Discounted Cash Flow (DCF) i. Capital Budgeting techniques that use time value of money concepts to measure cash inflows and outflows of a project as they occur at a single point in time ii. Best method to use for Long-term decisions iii. Steps :1. Initial investment (cash outflow) 2. Future cash inflows & outflows 3. Rate of return desired for the project hurdle rate Sikhu Mtetwa

Chapter 3

Page 4 of 11 iv. Rate for the project Hurdle rate 1. WACC use if project is similar in risk 2 ongoing projects 2. Discount rate risk specific to the proposed project v. Limitations 1. DCF only uses a single growth rate, which is unrealistic as interest rates change over time. Discounted Payback i. computes payback period using expected cash flows that are discounted by the projects cost of capital ii. evaluates how quickly new ideas are converted into profitable ideas iii. focuses on liquidity & profit iv. advantages & limitations are the same with payback except that this method takes into account the time value of money.. Payback Period i. Time period that is required 4 the net after tax cash inflows to recover the initial investment ii. Liquidity measures the time it will take to recover the initial investment iii. Risk the SOONER I recover the better!!!! iv. Net cash inflows assumed constant 4 each period v. Depreciation tax shield adds to after tax CFO vi. The larger the denominator the shorter the payback period

Advantage Disadvatnage

- is simple to understand and focuses on the time period for return - ignores the time value of money. - shows the return of investment not the return on investment - ignores cash flows occurring after initial investment is recovered

Net initial investment [cash outflow + change in WC - sale proceeds on old PPE] increase in annual net after-tax cash flow = payback period

Internal Rate of Return i. IRR is the expected rate of return of a project - NPV calculates amounts, while the IRR calculates percentages ii. Sometimes to referred to as the time-adjusted rate of return iii. Rate earned by an investment iv. Determines the present value factor that yields a NPV of zero Reject IRR if it is less than or equal to the hurdle rate NPV positive - IRR > required rate of return / hurdle rate = accept NPV negative - IRR < hurdle rate = reject IRR low = low tax credits high investment high PV factor . IRR high = low WC low investment low PV factor . = low payback period low PV factor Sikhu Mtetwa

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How to calculate the IRR:1. Determine the life of the project e.g = 5yrs 2. Use the payback period (net increment investment net annual cash flows) as the present value factor e.g = 100/25 = 4.00(TVMF) 3. Locate PV factor using the tables then find approximate IRR NPV has a direct r/ship with IRR NPV NPV > 0 NPV = 0 NPV < 0 IRR IRR > discount rate IRR = discount rate IRR < discount rate

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

PV of an Annuity - the amount of cash needed 2day to yield a series of equal net cash flows at a fixed time intervals in the future e.g lease capitalization FV of an Annuity - amount available in n periods in future as a result of the deposit of an amount today e.g bond sinking fund Net Present Value (NPV) NPV focuses on the initial investment amount that is required to purchase (invest ) a capital asset that will yield a return amount in excess of hurdle/discount rate. Uses a hurdle rate to discount cash flows Calcuation steps:o Estimate Cash flows Ignore depreciation - unless adding back tax shield Ignore method of funding NPV uses a hurdle rate 2 discount cash flows o Discount the Cash Flows Discount all cash in & outflows using appropriate discount factor NPV is superior to IRR because it can still calculate when there are uneven cash flows or inconsistent rates of return. Assumes the cash flows are re-invested at the same rate Hurdle rate o NPV = or > than 0, make the investment because the rate of return is = or > than the hurdle rate/discount rate/required rate of return o Desired rate set by management ( cost of capital, minimum rate of return based on strategic plans , returns earned in industry etc) o Opportunity cost Interpreting Results :o Positive Results ( NPV > hurdle rate or = zero ) = make investment o Negative Result ( result > zero ) = dont invest

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Chapter 3 Advantages:-

Page 6 of 11 1. NPV is flexible & can be used when there is no constatnt rate of return 2. best for LR decisions 3. NPV is considered superior to IRR method b/c it is flexible to handle uneven cash flows


4. dont actually know the rate of return on project assumption

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. Can be decreased by increasing the discount rate Can be increased by decreasing the income tax rate / decrease tax shield (depr) / increase cash inflow / increase life of project - increase salvage value / reduces NPV cash outflow / increases NPV

After-tax cash flow on operations (net cash flow x (1-tax rate)) + Depreciation tax shield depreciation x tax rate = Total after tax cash flow on operations x present value of annuity - initial cash outflow = Net Present Value (NPV see example on page B3-24-25


Capital Rationing Ultimately the decision to invest or not is limited by the amount of capital
available to the fund the investment. Unlimited Capital = ALL investments with a positive NPV should be accepted Limited Capital = choose from 2 best choices o Managers should allocate capital to the combination of projects with the maximum NPV


Profitability Index
measures the cash-flow return per dollar invested the higher the better NPV index ( excess present value) 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

Sikhu Mtetwa

Chapter 3

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Strategies for short-term and long-term financing

Trade offs between risk & return borrowing money vs. adding partners How should we raise capital? Risk indifferent - increase in risk does not increase management's required rate of return Certainty equivalent = expected value Risk averse - increase in risk, increases management's required rate of return Certainty equivalent < expected value Risk-seeking - increase in risk, decreases managements required rate of return Certainty equivalent > expected value Diversification Risk is often reduced by diversification, the process of mixing investments of different (offsetting) risks, Not all risks can be managed this way though. Diversifiable risk Un-systematic risk, non-market risk - risk that is firm specific and can be diversified away Non-diversifiable 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 of an asset to decrease Projected cash flow required rate of return = PV of asset Computation of Return o Stated interest rate (nominal interest rate) is the interest rate charged before any adjustments for market factors rate shown in the debt agreement o 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 = Interest paid (coupon) net proceeds o 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 o Simple interest Interest paid only on the original amount of principal original principal * interest * number of periods o Compound interest Interest earnings or expense based on the original principal + any unpaid interest original principal * (1 + interest rate) number of periods Sikhu Mtetwa

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Operational & Financial leverage

Leverage amplifies risk & potential return Operating Leverage o the degree to which a firm uses fixed costs (as opposed to variable costs) for leverage o Aggressive borrow, not add partners want 2 use leverage o Conservative add partners dont want to use leverage Fixed (i.e. Executive salaries) - risk and potential return increases Variable (i.e. commissions) - risk and potential return decreases % change in EBIT (operation income) % change in sales Example:- 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% Logic - Higher DOL implies that a small increase in sales will have a greater effect on profits and shareholder value. But more risk. - the higher the firms DOL the greater its profitability & greater risk Financial leverage - the degree to which a firm uses fixed financial costs for leverage o Fixed - borrow money risk & return increases o Variable - add partners /stockholders risk & return decrease o Logic - Higher DFL implies that a small increase in EBIT will have a greater effect on profits and shareholder value. But more risk. o the higher the firms DFL the greater its profitability & greater risk % change in EPS % change in EBIT Total combined leverage o the use of fixed costs resources and fixed cost financing to magnify returns to firm owners o Degree of total combined leverage = DOL * DFL % change in EPS % change in sales

Weighted Average Cost of Capital (WACC)

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

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Cost of debt must be after tax so, cost of debt = effective interest rate * (1 - tax rate) ***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 (didnt 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] - invested capital = average assets = average PPE + average WACC 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 Sikhu Mtetwa

Chapter 3 Gross book value - historical cost Ignores depreciation Replacement cost = cost to replace asset Ignores both age and method of depreciation

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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 shortterm 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

Sikhu Mtetwa

Chapter 3

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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] 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) Sikhu Mtetwa