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BEC - Notes Chapter 3

Financial Modeling and Analysis


Relevant Data
When making financial decisions that will affect future periods, revenues and costs related to those decisions are only
deemed to be relevant if
They change as a result of selecting different alternatives
What kind of costs are relevant costs (describe them)
1. Can either be fixed or variable, but are not always relevant
2. Direct costs - costs that can be identified with or traced to a given cost object
3. Prime costs - DM & DL
4. Discretionary costs - costs arising from a periodic or annual budgeting decision
5. Opportunity costs - the cost of foregoing the next best alternative when making a financial decision
How would you determine the opportunity cost Ex) Carter paid $1,000,000 for land 3years ago. He estimates he can
sell the land for $1,200,000, net of selling costs. If the land is not sold, hell plans to develop the land at a cost of
$1,500,000. Carter estimates net cash flow from the development in the first year of operations would be $500,000. What
is Carter's opportunity cost of the development
$1,200,000 = the revenue that will not occur if Carter develops the land instead of selling it.
Relevant costs and revenues are also referred to as (synonyms of relevant costs)
1. Incremental (aka differential) costs - additional costs incurred to produce an additional unit over current output
2. Avoidable - costs or revenues resulting from choosing one course of action instead of another
What kind of costs are NOT relevant costs (describe them)
1. Unavoidable - costs or revenues that will be the same regardless of the chosen course of action
2. Sunk costs - represent costs incurred in the past and cannot be recovered as a result of the decision
o Ex = cost of old machinery (gains/losses on old machinery are not sunk cost, but theyre not relevant)
Forecasting and Trends Cash Flows Related to Capital Budgeting
Overview What are capital budgeting decisions used for
Long term investments or financing large expenditures
Overview What is a limitation/disadvantage of the models used in capital budgeting (calculating discounted cash flow,
internal rate of return, and net present value)
They all rely on forecasting of future data
Based on predictions of an uncertain future
What is an important input item when doing capital budgeting
Equipment requests
The most important factor when deciding which project to invest in is the cash flows. What is the difference between a
direct effect V an indirect effect on cash flows
Direct effect = a company pays out or receives cash
Indirect effect = transactions either indirectly associated with a capital project (sale of old assets) or
that represent non-cash activity (depreciation) that produce cash benefit (reduces taxable income)
When would you accept a project
When the sum of the PVFCF (present value of future cash flows) > todays cost
Cash flows exist through the life cycle of a capital investment project. What are the general stages in which cash flows
(direct and indirect) are categorized
1. Inception of the project
2. Operations
3. Disposal of the Project
What is the first stages formula for determining the net initial outflows for the new project
Invoice price + cost of shipping + cost of installation + training
+ Increase in working capital (i.e. increase in payroll, supplies expenses or inventory requirements)
-- Decrease in working capital (i.e. decrease in amount of inventory required to be on hand)
-- Cash proceeds on sale of old asset (net of tax) [proceeds on sale -- taxes paid on gain OR + taxes saved on loss (g/l tax)]
= net cash outflow for new PPE
Working capital = current assets current liabilities

BEC - Notes Chapter 3

What is the second stages formula for determining the future annual cash inflows from operations
Pre-tax cash inflow (1-tax rate)
+ (Depreciation marginal tax rate)
(depreciation tax shield)
= After tax annual cash flows
What is the third stages formula for determining the one time terminal year inflow
Proceeds when asset is sold [proceeds on sale -- taxes paid on gain OR + taxes saved on loss (g/l tax rate)]
-- Expenses incurred for the disposal/removal [include the amount after taxes are subtracted out]
+ If asset is scrapped or donated [include the amount after taxes are subtracted out]
+ Decrease in working capital
= terminal year net inflow
Which types of cash flows are relevant to capital budgeting, pre-tax or after-taxwhat are the formulas for both
After tax = RELEVANT
Pre-tax cash inflow (1-tax rate)
Pre tax
Income before taxes + Amortization + Depreciation
Generally, what would result in the highest present value for cash flows
A decrease in taxes
Which method is the best one to use for capital budgeting
Net present value
Financial Analysis Discounted Cash Flows (DCF)
The DCF valuation method, which includes the net present value (NPV) and internal rate of return (IRR), are methods
that use what
The time value of money to measure the PV of the cash flows expected from a project
When should you use discounted cash flows
When the risks of the individual components of a project's cash flows are different
The desired rate of return for the project is also known as whatWhat are some characteristics about it
The hurdle rate
o It compensates for all risk assumed

Higher hurdle rate means there is a higher risk involved


o You want to jump over the hurdle before you start making a profit
o When you discount the cash flows the factor is based on the hurdle rate
When is the hurdle rate amount determined
Its predetermined in advance for computations of NPV, but NOT for IRR
Discounted cash flow (DCF) methods are considered the best methods to use for long-run decision because it accounts
for time value of money. However, what is its limitation
It only uses a single growth rate, which is unrealistic as interest rates change over time.
o There is more risk associated with receiving a cash inflow of a project 10 years from now compared to a cash
inflow in the 1st year of a project
o NPV method will fix this problem
How do you determine the factor/table to use when discounting
Use Present value of $1 when the cash inflows are different (happens when different depreciation rates)
Use Present value of an Ordinary Annuity of $1 when the cash inflows are same across all years (straight line dep)
Net Present Value Method (NPV)
What is the objective of NPV
Focus decision makers on the initial investment amount that is required to purchase/invest in a project that will yield
returns in excess of the hurdle rate (required/desired rate of return)
o Requires managers to evaluate the dollar amount of return
What is an advantage of the NPV method.What is a limitation of NPV
Adv = It allows for different rates to be used for different time periods (more flexible) [IRR cant do this]
o Can increase discount rates to account for risk
o Can increase discount rates to account for inflation
Disadv = It does not provide the true rate of return on the investment

BEC - Notes Chapter 3


It just indicates whether an investment will have a positive NPV meaning to accept it (it was over the hurdle)

What is the formula to determine the net present value (NPV)


After-tax cash flow on operations [Pre-tax cash inflow (1-tax rate)]
+ (Depreciation marginal tax rate)
(depreciation tax shield) (depreciation DOESNT include WC)
+ Salvage value (in final year only)
= Total after tax cash flow on operations
Present value of $1/annuity
= Present value
Add up the sum of PV for all years
-- Initial cash outflow [includes additional cost +/-- WC]
= Net Present Value (NPV)
When do you know when to accept or reject certain projects
Accept if Positive NPV: sum of PVFCF > initial outflow(also means rate of return > hurdle/discount rate/desired
ROR)
Reject if Negative NPV: sum of PVFCF < initial outflow(also means rate of return < hurdle/discount rate/desired
ROR)
What factors would increase V decrease the NPV
Increase = Extend the project life or increase salvage value
Decrease the estimated effective income tax rate.
Decrease = Increase the discount rate.
When a company has limited capital, how do they know which project to invest in when there are multiple projects that
have a positive NPV (profitable)
The projects are ranked by their profitability ratios. The projects resources are then spent on the projects with the
highest profitability ratio and go in descending order
o If funds are unlimited, then invest in all projects that are above 0 for the NPV
What is the profitability index ratioWhat do the results mean
PV of net future cash inflows
PV of net initial investment
= profitability index ratio
If the answer is greater than 1.0 then the PV of the inflows > the PV of the outflows = profitable
The greater the number, the better the investment is
What happens to the value of the depreciation tax shield if MACRS is used as opposed to straight line
It will increase (bigger tax savings) because MACRS is an accelerated depreciation method
Internal Rate of Return (IRR)
What is the objective of IRR
Focus decision makers on the discount rate at which the PV of cash inflows = the PV of the cash outflows
o (IRR) = the discount rate that produces a NPV of zero.
o Focuses on percentages
What is the formula to determine IRR
Net incremental investment (investment required)
Net annual cash flows
= Factor of the IRR
When do you know when to accept or reject certain projects
Accept = IRR > hurdle/discount rate/desired ROR
Reject IRR < hurdle/discount rate/desired ROR
What are some limitations with IRR
IRR assumes cash flows from reinvestment are reinvested at the IRR %
Less reliable when there are differing cash flows (compared to NPV)
Does not consider the amount of profit
Overview-- How are cash flows reinvested under the NPV method V the IRR method
NPV = The discounted rate

BEC - Notes Chapter 3

IRR = rate of return on the project

OverviewWhat is the difference between NPV and IRR.


NPV calculates $ amounts
IRR calculates percentages
The NPV formula solves for the present value of a stream of cash flows, given a discount rate.
The IRR solves for a rate of return when setting the NPV equal to zero
Payback Period Method
What is the payback period
The time required for the net after-tax cash inflows to recover the initial investment in a project
o Focuses decision makers on both liquidity and risk
What are some advantages of the payback methodwhat are limitations when using the payback method
Adv = Easy to understand
Disadv= It ignores the time value of money (undiscounted)
It ignores reinvestment of cash flows
It ignores cash flows that happen after the initial investment is recovered
It ignores profitability
How do you compute the payback period
Net initial investment (includes additional costs +/-- WC)
Increase in expected annual cash flow (after tax) [expected CF savings depreciation = NI before tax tax rt = tax exp]
Then [ expected CF savings tax exp = Inc in expected annual CF]
= payback period
If you are given after tax CF for each yr, keep adding up the years till it reaches initial investment

For partial years do: amt needed to recover remaining initial investment CF for that entire yr =
amt of partial yr that needs to be added to full yrs
The initial inv inc. exp. CF is best used when only given 1 yr of info
If you have multiple years given, then do the [exp CF savings dep = NIBT tax rt = tax exp] steps for
each year and keep adding up the years till it reaches initial investment
o Note: depreciation does not include WC in calculation

Discounted Payback Period


What is the discounted payback period
It computes payback period using expected cash flows that are discounted by the projects cost of capital
o It is an improvement over the regular payback period because it considers the time value of money
o Focuses decision makers on the number of years needed to recover the investment from discounted net CF
How do you compute the discounted payback period
Do the same as the payback period except apply the discount factor to the after tax annual cash flows (based on
the discount rate and years of the project) before adding up all the CFs to the initial investment

Capital Management Including Working Capital


Operational and Financial Leverage
Operational-- What is operating leverage
The degree to which a firm uses fixed costs (as opposed to variable costs) for leverage
o Fixed (i.e. Executive salaries) = total cost is independent of sales
o Variable (i.e. commissions) = total cost is dependent on sales
Operational-- What does a high V low operating leverage meanHow does each one effect the risk &potential return
High = a firm has high fixed operating costs and low variable operating costs
o Increases risk and potential return
Low = a firm has low fixed operating costs and high variable operating costs
o Decreases risk and potential return
Operational-- How is the degree of operating leverage (DOL) calculated
% change in EBIT
% change in sales
= Degree of Operating Leverage

BEC - Notes Chapter 3

If you know total fixed and variable costs: fixed cost variable cost = DOL

Operational-- What does the DOL formula and answer tell you
If the numerator changes by a bigger amount than the denominator, that firm is employing leverage
So if a firms EBIT increases by 21% as sales increase by 7% then the DOL is 3.
o Meaning for every 1% increase in sales, profit increases by 3%
A higher DOL implies that a small increase/decrease in sales will have a greater effect on profits and shareholder value
(more sensitive). But also more risk.
Financial-- What is financial leverage
The degree to which a firms use of debt to finance the firm magnifies the effects of a given percentage change in
earnings before interest and tax (EBIT) and earnings per share (EPS)
Financial When making financing decisions, a firm can choose to issue debt or equity. Is debt and equity fixed or
variable costs
Debt = fixed because interest expense is independent of the potential profit
Equity = variable because dividend distribution is dependent on profit and are not required to happen
Financial -- How is the degree of financial leverage (DFL) calculated
% change in EPS [or net income]
% change in EBIT
= Degree of financial leverage
Financial -- What can the DFL formula and answer tell you
Firms with a higher percentage of fixed financing costs will have a higher degree of financial leverage
A higher DFL implies that a small change in EBIT will have a greater effect on profits and shareholder value (more
sensitive). But also more risk.
Total Combined-- What is the total combined leverage
The use of fixed operating costs and fixed financing costs to magnify returns to firm owners
Total Combined-- How is the total combined leverage (DCL) calculated
% change in EPS
% change in sales
= Degree of total combined leverage
OR
Degree of total combined leverage = DOL DFL
Total Combined-- What does the DCL tell you
A high leverage implies that a greater portion of sales goes to the bottom line
The Weighted-Average Cost of Capital
What is the purpose of the weighted-average cost of capital (WACC)
It serves as a major link between the LT investment decisions associated with a firm's target or optimal capital structure
and to maximize the net worth/wealth of the firm
o Its the average cost of debt and equity financing associated with a firms existing assets and operations
o Its frequently used as the hurdle rate within capital budgeting techniques. Investments that provide a return
that exceeds the weighted-average cost of capital should continuously add to the value of the firm.
How is WACC computed
(Cost of equity % equity in capital structure)
+ (weighted-average cost of debt % debt in capital structure)
= WACC

Example =
The optimal capital structure is the mix of debt and equity financing that produces the __(highest or lowest)__ WACC
which maximizes the firm value
Lowest

BEC - Notes Chapter 3

Cost of Capital Components


What is the cost of capital
The rate of return on assets that covers the costs associated with the funds employed.
o It considers the cost of all funds, whether they are short-term, long-term, new or old.
How do you compute the after tax cost of long term debt
After tax cost of debt = pre-tax cost of debt (1 - tax rate)
How do you compute the cost of preferred stock
Cost of preferred stock= P.S. Dividends Net Proceeds of P.S.
o P.S. dividends = a firm is comprised of 10%, $100 par value p.s. = $10
o Net proceeds = gross proceeds flotation costs i.e. stock issuance
What are examples of LT debt V equity financing option
Debt = Bonds and Debt
Equity = Preferred Stock and Common Stock
Which type of financing carries the lowest cost of capital and is tax deductible (debt or equity)
Debt
o Equity (dividends) are not tax deductible and they have more risk
The higher the tax rate, the more incentive exists to use _____ financing
Debt
The cost of retained earnings is equal to
The rate of return required by the firms common stockholders
o C.S. dividends C.S. sell price per share
What are the 3 most common methods of computing cost of RE
1. Capital Asset Pricing Model (CAPM)
2. Discounted Cash Flow (DCF)
3. Bond Yield plus Risk Premium (BYRP)
What does eta represent in CAPM
The measure of a particular stock's percentage change compared to the percentage change in the market over the
same period.
What does it mean when eta = 1, is greater than 1, or is less than 1
=1 as risky as market
> 1 more risky than market
< 1 less risky than market
When will the value of the firm increase in regard to eta
When a capital investment whose rate of return > the rate of return associated with the firm's beta factor
What is the cost of RE using CAPM
CAPM = Risk Free Rate + [eta (Expected Return on Market -- Risk Free Rate)]
o Write the percents as whole numbers
What is the cost of RE using DCF
(Current Dividend/ Share Current Market Value of Price) + Growth Rate of Dividends
Subtract any underpricing and flotation costs from the current market value of price if given
A company uses its company-wide cost of capital to evaluate new capital investments. What is the implication of this
policy when the company has multiple operating divisions, each having unique risk attributes and capital costs
High-risk divisions will over-invest in new projects and low risk divisions will under-invest in new projects.
o higher risk divisions will automatically beat the threshold for investments and invest in higher risk
projects that beat the company wide average
Asset Effectiveness and Efficiency ROI
What does return on investment (ROI) and return on assets (ROA) measure (describe some characteristics)
ROI= It is the most common profitability ratio and measures the performance of a business based on the
efficiency of an investment

BEC - Notes Chapter 3


ROA= A profitability measure that can be used to evaluate the efficiency of asset usage
o They are both expressed as a percentage
o They both are designed to motivate managers on achieving targets

How do you calculate ROI


1. ROI = Profit Margin Investment Turnover
o Profit margin = Net Income Sales
o Investment turnover = Sales Invested capital
OR
2. ROI = Net Income Invested capital
[Invested Capital = Avg PPE + Avg WC]
How do you calculate (ROA)
ROA = Net Income Average Total Assets
The ____(higher/lower)___ the percentage of ROI the better.
Higher
What are some advantages and limitations of ROIThese items may make _____ superior
Adv = Can be compared to other companies who are different in size
Disadv= It has a short-term focus (ignores long term)
o May lead to rejecting projects that yield a positive cash flow
Residual Income
What is a way to meet or achieve your ROI target
Delay investment in new PP&E because this will reduce ROI
How do you calculate Return on Equity (ROE)

Asset Effectiveness and Efficiency RI & EVA


What dose residual income (RI) measure (describe some characteristics)
The excess of actual income earned by an investment over the hurdle rate (required rate of return, imputed int,
WACC).
o Another type of performance measure like ROI
o Expressed as an amount
How do you calculate RI
RI = Net Income -- Required return in dollars
o Net Income can be determined by subtracting expenses/COGS from revenue/sales
NI can also be found by: NI = sales return on sales %
o Required Return = Net Book Value of Assets Hurdle Rate (aka required rate of return/imputed int, WACC)
NBV of assets can be found by: capital turnover = sales average invested capital
What does a positive V negative RI mean
Positive = Performance is meeting standards
Negative = Performance is NOT meeting standards
What are some advantages and limitations of using RI
Adv = The ease of measurement of actual dollars earned by an investment above the required amount
Has realistic target rates and goals
Disadv = Since it is measured in amount it reduces being able to compare it to larger units/divisions or companies
Overview-- How are ROI V RI answers/results expressed as
ROI = Percentage
RI = Amount
What does economic value added (EVA) measure (describe some characteristics)
It is similar to RI (computes required return based upon a hurdle rate determined by management) but it measures the
excess of income after taxes earned by an investment over the return rate defined by the cost of capital
o Expressed as an amount

BEC - Notes Chapter 3


Ensures that performance is measured in comparison to changes associated with capital, debt, and equity

How do you calculate EVA


Investment
Cost of Capital
= Required Return
Then: Income after taxes Required return in dollars = EVA
What does a positive V negative EVA mean
Positive = Performance is meeting standards
Negative = Performance is NOT meeting standards

Asset Effectiveness and Efficiency LT Financing


What is the debt-to-total-capital ratioWhat does it measureWhat does the result/answer from the formula mean
= Total Debt Total Capital (equity + debt)
Measures how a company is structured and financing their operations
o The lower the ratio, the greater solvency and ability to pay debt
What is the debt-to-asset ratioWhat does it measure What does the result/answer from the formula mean
= Total Debt Total Assets
Measures the proportion of a company's assets that are being financed with debt, rather than equity
o The lower the ratio, the greater protection afforded to creditors
What is the debt-to-total-equity ratioWhat does it measure What does the result/answer from the formula mean
= Total Debt Total Shareholders Equity
A measure of the funds provided by creditors versus the funds provided by owners
o The lower the ratio, the lower amount of risk is involved
Working Capital Management
A working capital policy involves managing cash so that a company can meets is short term obligations. How would a
company determine the appropriate level of working capital for their firm
It requires offsetting the benefit of current assets and current liabilities against the probability of technical insolvency.
As a company becomes more conservative or aggressive with its working capital policy, what will occur
Con = Increase the ratio of CA to nonCA (more CA are financed by nonCL)
Agg = Increase the ratio of CL to nonCL (more CA are financed with CL)
What is the working capital formula What does the result/answer from the formula mean
WC= Current Assets -- Current Liabilities
o A high WC means less risk and lower expected return
To increase it you would have to increase CA and/or decrease CL
What is the current ratio formulaWhat does it measure What does the result/answer from the formula mean
CR= Current Assets Current Liabilities
A measure of the firm's ability to pay off short-term obligations
o A high CR shows more solvency (better to have)
What is the quick ratio formulaWhat does it measure What does the result/answer from the formula mean
QR = (Cash + Marketable Securities + A/R) Current Liabilities
A measure of the firm's ability to pay off short-term obligations without relying on the sale of its inventories.
o A high CR shows more solvency (better to have)
Management of Cash & Cash Equivalents
What are different methods to speed up converting AR into cash
1.
2.
3.
4.
5.

Cash discounts - offering cash discounts to customers for paying AR quickly


Collection agencies - used to collect overdue AR.
Electronic fund transfers - a method of payment, which electronically transfers funds between banks.
Lockbox systems a bank receives payment from a companys customers and deposits into the companys account
Factoring AR - selling AR to a factor for cash.

BEC - Notes Chapter 3

When would a company offer more favorable credit terms


There is a ton of competition
The company has a shortage of cash
The cost of not taking a cash discount is generally __higher/lower__ than the cost of a bank loan.
Higher
A lockbox system at bank may speed up cash inflow, however its only worth it there is a benefit. How do you determine
the benefit/loss
The interest income > lockbox fees (collection time / 360 ) annual sales interest rate
OR

Cash receipts
Days accelerated
= Increased cash receipts
Annual interest rate
= Marginal revenue
-- Lockbox fee
= Benefit or loss

What are methods to delay disbursements


1. Drafts
2. Line of credit
3. Zero balance accounts
How would you compute the annual cost when not taking the payment discount (the APR of quick payment discount)
360 (Total pay period Discount period)
(Discount % (100% Discount %))
= Effective Percentage
o works for either buyer or seller

When you have different amounts (multiple credit terms and a bank rate) how do you determine if you 1) should
borrow/not borrow from the bank and 2) which credit term to take
Borrow/not borrow = Take the lower of the banks annual rate OR the annual cost when not taking the discount
Credit term = Chose the company with the highest APR (annual cost when not taking discount)
A float occurs when there is a difference between the bank and book balance. What is the difference between a
disbursement float V. a collection float
Disbursement = (positive) - checks have been written but not received by vendor and recorded by the bank
Collection = (negative) - deposits have been recorded on the company's books but not recorded by the bank
The cash conversion cycle is the average number of days it takes to create cash from the core business. What is the cash
conversion formulaDo you want a high or low answer/result
The shorter/lower a cash conversion cycle the better
Cash conversion cycle = inventory conversion period + A/R collection period -- Payables deferral period
want low/happen quickly
want low/happen quickly
want increase/delay
What are the inventory turnover and the inventory conversion period formulas
Inventory Turnover= COGS Average Inventory
Conversion Period = 365 Inventory Turnover
What are the AR turnover and the AR collection period (aka days sales outstanding) formulas
AR Turnover = Sales Average AR
Average Collection Period on AR= 365 AR Turnover
What are the AP turnover and the AP deferral period formulas
AP Turnover = COGS Average AP
Average Days of AP Outstanding = 365 AP Turnover
How would you determine the number of days sales in AR or the average collection period
Day discount ends % of sales for that time
+ Day payment is due % of sales for that time
= Total days
Management of A/R

BEC - Notes Chapter 3

The main objective in A/R is to convert A/R into cash quickly enough to meet short-term obligations without angering
customers. What variables are included in a credit policy
Credit period = length of time buyers are given to pay for their purchases
Credit standards = the required financial strength of credit customers
Collection policy = its strictness or leniency in collecting delinquent accounts
Discounts = includes the discount and time period
How would you determine the result/change in credit policy when different factors are altered
Make 2 columns, 1 with the old policy and 1 with the new policy and compare them at the end
Sales projection
Credit sales ratio OR Variable cost & Required rate of return (if any)
= Sales on credit OR Variable margin
Collection ratio
= A/R
If a company has an increase in sales, increase in discounts taken, decrease in the amount of bad debt, and decrease in
the investment in A/R, what happened to the average collection period
It decreased
What is the purpose of factoringHow would you determine the annual cost of financing as an amount & a percentage
To speed up cash collections
Companys A/R fee % (days in year days in collection period) = Subtotal
-- Amount not advanced
= Amount subject to interest annual rate
= Subtotal
Cost to company (add all subtotals)
-- Expenses saved
= Net cost
Net cost amount subject to interest = APR
Management of A/P
Trade credit or A/P provides what
Provides the largest source of short term financing for small firms
o It is also spontaneous
o Subject to risk of buyer default
How would you compute the weighted average annual interest rate for trade credit
Ex) Monthly purchases: 25,000
50,000
Credit term
2/10, net 30 5/10, net 90
Apply the following formula to each vendor, then add them up to get weighted average:
(Discount % (100% Discount %))
2/98 = 0.0204
5/95= 0.0526
360 (Total pay period Discount period)
360/20= 18
360/80 = 4.5
(purchases total purchases)
25,000/75,000 = 0.33
50,000/75,000 = 0.67
= Total weighted average rate
= .122
= .158
= 28%
Management of Inventory

Inventory represents the most significant current noncash resource of an organization. What factors influences the
amount of inventory companies will carry (describe)
Carrying cost
o The lower the carrying cost of inventory, the more a company is willing to carry

Storage costs
Insurance costs
Opportunity costs of inventory invested
Loss of inventory due to spoilage or it becoming obsolete
Cost of capital invested for inventory

Safety Stock-- Many companies maintain a safety stock to ensure that manufacturing or customer supply requirements
are met. What factors determine the safety stock
1.
2.
3.

Reliability of sales forecasts (more predictable causes SS to decrease)


Possibility of customer dissatisfaction resulting from back orders
Cost of running out of inventory (if it decreases so would SS)

10

4.
5.
6.

BEC - Notes Chapter 3


Lead time (if it decreases so would SS)
Seasonal demands of inventory (if it decreases so would SS)
Carrying cost of inventory ( if it decreases SS would increase)

Safety Stock-- How would you compute the total cost of safety stock
Safety stock unit level
Inventory investment per unit
Stock out cost/ unit
Carrying cost percentage
= Total stockout cost
= Carrying cost per unit
Probability at 100% stock out
Stockout units
Total orders per year
= Carrying costs
= Expected stockout costs
= Total annual cost of safety stock
Reorder Point-- The reorder point is the inventory level at which the company should order or manufacturer additional
inventory in order to meet demand and to avoid incurring stockout costs. What is included in stockout costs
Loss of income from the product unavailability
Cost of restoring goodwill
Additional expenses incurred to expedite shipping

Reorder Point-- How would you calculate the reorder point


Safety stock
+ (lead time in days or weeks units sold per days or weeks)
= Reorder Point
EOQ-- The economic order quantity (EOQ) inventory model attempts to minimize both ordering and carrying costs. What
is the EOQ equation

EOQWhat is an assumption of EOQ


Demand is known
EOQ-- How would you determine the average inventory for a product when EOQ is given
EOQ 2 = Avg inventory w/out SS
Avg inventory w/out SS + safety stock = Average inventory
If a firm manufacturers its own inventory, the ordering costs will include primarily of
Production set up
Describe the following terms/techniques
1. Just-In-Time Management
o A pull approach that reduces the time between inventory arrival and usage
o It deduces the amount of inventory needed on hand, but requires supplier/manufacturer coordination
o It also increases the inventory turnover
2. Kanban Inventory Control
o Gives signs that a component required in production must be replenished
o Prevents oversupply or interruption of the entire manufacturing process due to a lack of a component
3. Materials Requisition Planning (MRP)
o Projects and plans inventory levels in order to control the usage of raw materials in the production
process.
o Primarily applies to work in process and raw materials.
Management of Marketable Securities
Marketable securities typically provide mush lower returns than operating assets, but yield higher returns than cash.
What are the 5 most common marketable securities (list from least risky to the most risky AND describe them)
1. U.S. Treasury Bills = Maturities back by the U.S. government
o They are default, liquidity, and maturity risk-free (therefore safest security on market)
2. Certificates of Deposits (CDs) = Has a slight risk of bank failure and default so a little more riskier than T-Bills
o Has an active secondary market on Wall Street
3. Bankers Acceptance = Short-term IOUs of large, creditworthy corps that are guaranteed by commercial banks

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BEC - Notes Chapter 3


4. Commercial Paper (notes/drafts) = Short-term lending of idle cash from one creditworthy corp to another.
5. Equity Securities of Public Companies = Risky because of a volatile stock market, but there is a far greater chance of
gains/losses
Eurodollars & hedge transactions are also types

Summary of Financial Ratios:


Return on investment Ratios/ Various
1.

2.

3.

4.

5.

Return on Investment (ROI) = Profit Margin Investment Turnover OR = Net Income Invested Capital
Profit margin = Net Income Sales
Investment turnover = Sales Invested Capital
[Invested Capital = Avg PPE + Avg WC]
o Measures the performance of a business based on the efficiency of an investment
Want a high percent
Return on Assets (ROA) = Net Income / Average Total Assets
o A measure that can be used to evaluate the efficiency of asset usage
Want a high percent
Return on Total equity (ROE) = (Net Income / Sales) (Sales / Assets) (Assets / Equity)
o Measures a corporation's profitability by revealing how much profit a company generates with the money shareholders
have invested.
Want a high percent
Residual Income (RI) = Net Income Required Return in Dollars
Required Return = Net Book Value of Assets Hurdle Rate (aka required rate of return/imputed int, WACC)
o Measure the excess of actual income earned by an investment over the hurdle rate
Want a positive amount
Economic Value Added (EVA) = Investment Cost of Capital = Required Return
Then: Income After Taxes Required Return = EVA
o Measures the excess of income after taxes earned by an investment over the return rate set by cost of capital
Want a positive amount

Financial Risk Ratios / Solvency Ratios


1.

2.

3.

Debt to Total Capital = Total Debt / Total Capital (debt + equity)


o Measures how a company is structured and financing their operations
Lower = better
Debt to Asset = Total Debt / Total Assets
o Measures the proportion of a company's assets that are being financed with debt, rather than equity
Lower = better
Debt to Equity = Total Debt / Total Shareholders Equity
o A measure of the funds provided by creditors versus the funds provided by owners
Lower = better

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BEC - Notes Chapter 3


Liquidity Ratios
1.

2.

Current Ratio = Current Asset / Current Liability


o Indicates the extent to which the claims of short-term creditors are covered by assets that are expected to be converted
to cash in a period roughly corresponding to the maturity of the liabilities.
Quick Ratio = (Cash + Marketable Securities + AR) / Current Liability
o A measure of the firm's ability to pay off short-term obligations without relying on the sale of its inventories.

Activity Ratios
1.
2.
3.

Inventory Turnover = COGS / Average Inventory


Average Days to Sell = 365 / Inventory Turnover
AR Turnover = Sales / Average AR

4.

Average Collection Period on AR= 365 / AR Turnover

5.

AP Turnover = COGS / Average AP

6.

Average Days of AP Outstanding = 365 / AP Turnover

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