3.Corporate Finance

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CMA/CFM REVIEW

PART 3 - CHAPTER 3

CORPORATE FINANCE

Magic Memory OutlineTM

I.MANAGING CURRENT ASSETS 3-3-IA. Working Capital ..........................................................................................................

B. Cash Management ...............................................................................................

1. Purposes ..................................................................................................

a. Transaction Motive ...............................

b. Precautionary Motive ...........................................................................................................................

c. Speculative Purposes ...........................................................................................................................

d. Other Legal Requirements ...................................................................................................................

2. Cash Cycle ...................................................................................................................................................

a. Cash Operations/Conversion Cycle .....................................................................................................

b. Cash Flow Cycle ..................................................................................................................................

3. Cash Budget .................................................................................................................................................

4. Cash Inflows ................................................................................................................................................

a. Acceleration Techniques ......................................................................................................................

b. Lock Box ..............................................................................................................................................

c. Other Methods ......................................................................................................................................

d. Effects of Inflow Changes ...................................................................................................................

5. Cash Outflows ..............................................................................................................................................

a. Delay Techniques .................................................................................................................................

b. Drafts v Checks ....................................................................................................................................

c. Effects of Outflow Changes .................................................................................................................

6. Zero Balancing .............................................................................................................................................

7. Timing Deposit Savings ..............................................................................................................................

C. Electronic Commerce ..........................................................................................................................................

D. Investing Excess Cash .........................................................................................................................................

E. Marketable Securities ..........................................................................................................................................1. Investment Selection ....................................................................................................................................

a. Safety ....................................................................................................................................................

b. Marketability/Liquidity ........................................................................................................................

c. Yield .....................................................................................................................................................

d. Maturity ................................................................................................................................................

e. Taxability .............................................................................................................................................

2. Common Types of Marketable Securities ......................................................................................................

a. Treasury Bills, Notes, and Bonds ........................................................................................................

b. Repurchase Agreements ......................................................................................................................

c. Certificates of Deposit .........................................................................................................................

d. Negotiable Certificates of Deposit .......................................................................................................

e. Federal Agency Securities ...................................................................................................................f. Eurodollars ...........................................................................................................................................

g. Banker's Acceptances ...........................................................................................................................

h. Commercial Paper ................................................................................................................................

i. Other Marketable Securities ................................................................................................................

F. Accounts Receivable ...........................................................................................................................................

1. Decision to Carry Receivables ....................................................................................................................

2. Level of Receivables ....................................................................................................................................

3. Average Collection Period (or Days Sales Outstanding) ............................................................................

4. Estimated Cash Discounts Taken ................................................................................................................

5. Effect of Change in Credit Policy ...............................................................................................................

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6. Opportunity Cost of Accounts Receivable ..................................................................................................

G. Inventory .............................................................................................................................................................

1. Reasons to Carry Inventory .........................................................................................................................

2. Level of Inventory .......................................................................................................................................

3. Economic Order Quantity ............................................................................................................................

a. Formula ................................................................................................................................................

b. Lead Time ............................................................................................................................................

c. Safety Stock .........................................................................................................................................

d. Reorder Point .......................................................................................................................................

e. Average Inventory Level .....................................................................................................................

4. Just-in-Time Inventory System ...................................................................................................................a. JIT Savings ...........................................................................................................................................

b. JIT Costs ...............................................................................................................................................

c. Calculation of Net JIT Savings ............................................................................................................

5. Kanban .........................................................................................................................................................

II. FINANCING CURRENT ASSETS 3-3-7

A. Trade Credit .........................................................................................................................................................

1. Usual Situation .............................................................................................................................................

2. Cost of Foregone Discounts ........................................................................................................................

B. Short-Term Bank Loan, Line of Credit, Revolving Credit ................................................................................

1. Compensating Balances and Effective Interest ...........................................................................................

2. Commitment Fee .........................................................................................................................................

3. Protective Covenants and Restrictions ........................................................................................................

C. Commercial Paper ...............................................................................................................................................

D. Banker's Acceptance ...........................................................................................................................................

E. Factoring of Receivables .....................................................................................................................................

1. Factoring v Pledging ....................................................................................................................................

a. Features of Factoring ...........................................................................................................................

b. Features of Pledging ............................................................................................................................

2. Advantages of Factoring ..............................................................................................................................

3. Disadvantages of Factoring .........................................................................................................................

4. Cost Calculation ...........................................................................................................................................

III. RISK AND RETURN 3-3-11

A. Types of Financial Risk .......................................................................................................................................

1. Systematic/Market/Non-Diversifiable Risk ................................................................................................

2. Unsystematic/Asset-Specific/Diversifiable Risk .........................................................................................

3. Other Risk Terms .........................................................................................................................................

a. Business Risk ........................................................................................................................................

b. Default Risk ..........................................................................................................................................

c. Interest Rate Risk .................................................................................................................................

d. Liquidity Risk .......................................................................................................................................

e. Purchasing Power Risk ........................................................................................................................

B. Individual Security Risk ......................................................................................................................................

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1.

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........................................................................................................

2. Standard Deviation ......................................................................................................................................

3. Coefficient of Variation ...............................................................................................................................

C. Portfolio Risk .......................................................................................................................................................

1. Diversification ..............................................................................................................................................

2. Portfolio Risk v Individual Security Risk ..................................................................................................

D. Capital Asset Pricing Model (CAPM) ................................................................................................................

1. Expected Risk-Adjusted Return ..................................................................................................................

2. Risk-Free Rate .............................................................................................................................................

3. Risk Premium ..............................................................................................................................................4. Beta Coefficient ...........................................................................................................................................

5. Market Return ..............................................................................................................................................

E. Risk Tolerance .....................................................................................................................................................

1. Risk Averse ..................................................................................................................................................

2. Risk Neutral .................................................................................................................................................

IV. FINANCIAL INSTRUMENTS 3-3-13

A. Bonds ..............................................................................................................................................................

1. Types of Bonds ..........................................................................................................................................

a. Mortgage Bonds ...................................................................................................................................

b. Debentures ............................................................................................................................................

2. Special Provisions ........................................................................................................................................

a. Call Provision .......................................................................................................................................

b. Sinking Fund Provision ................................................................................................................

c. Protective Covenants ...................................................................................................................

B. Convertible Securities .........................................................................................................................................

1. Creditor Advantages ....................................................................................................................................

2. Debtor Advantages ......................................................................................................................................

C. Warrants ..............................................................................................................................................................

1. Advantages ...................................................................................................................................................

2. Disadvantages ..............................................................................................................................................

D. Leases ..................................................................................................................................................................

1. Financing Differences ..................................................................................................................................

2. Advantages and Disadvantages ...................................................................................................................

3. Lease vs. Term Borrowing Decision ...........................................................................................................

E. Preferred Stock ....................................................................................................................................................

1. Preferential Quality Specified ......................................................................................................................

2. Cumulative Preferred ...................................................................................................................................

3. Participating Preferred .................................................................................................................................

4. Convertible Preferred ...................................................................................................................................

5. Not a Legal Obligation ................................................................................................................................

6. No Voting Rights .........................................................................................................................................

F. Common Stock ....................................................................................................................................................

1. Different Classes of Common Stock ...........................................................................................................

2. Stated Capital ...............................................................................................................................................

3. Paid-In Capital .............................................................................................................................................

4. Authorized Shares ........................................................................................................................................

5. Outstanding Shares ......................................................................................................................................

6. Stock Options ...............................................................................................................................................

G. Treasury Shares ...................................................................................................................................................

1. Reasons for Reacquiring Stock ...................................................................................................................

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b. Employee Stock Ownership Plans (ESOPs) ........................................................................................

c. Automatic Dividend Reinvestment Plans (ADRIPs) ...........................................................................

d. Stock Repurchase Programs .................................................................................................................

2. Advantages and Disadvantages of Holding Treasury Stock .......................................................................

H. Retained Earnings ...............................................................................................................................................

1. Advantages ...................................................................................................................................................

2. Disadvantages ..............................................................................................................................................

I. Dividends .............................................................................................................................................................

1. Relevant Dates .............................................................................................................................................a. Declaration Date ...................................................................................................................................

b. Ex-Dividend Date .................................................................................................................................

c. Holder-of-Record Date .........................................................................................................................

d. Payment Date ...... .................................................................................................................................

2. Factors Restricting Dividends ......................................................................................................................

3. Non-Cash Dividend .....................................................................................................................................

a. Usefulness .............................................................................................................................................

b. Stock Dividend .....................................................................................................................................

c. Stock Split ............................................................................................................................................

d. Reverse Stock Split ..............................................................................................................................

J. Valuation of Stocks, Options, and Bonds ...........................................................................................................

1. Intrinsic Value ..............................................................................................................................................a. Without Taxes ......................................................................................................................................

b. After Tax Effect ....................................................................................................................................

2. Value of Stock Options ................................................................................................................................

3. Value of a Bond ...........................................................................................................................................

E. Derivatives ...........................................................................................................................................................

1. Background ..................................................................................................................................................

2. Definition .......................................................................................................................

3. Varieties .....................................................................................................................................................

a. Forward Contracts ................................................................................................................................

b. Futures ..................................................................................................................................................

c. Swaps ....................................................................................................................................................

d. Structured Notes ...................................................................................................................................

e. Inverse Floaters ....................................................................................................................................

f. Collateralized Mortgage Obligations ...................................................................................................

V. COST OF CAPITAL ...................................................................................................................................................... 3-3-18

A. Weighted Average Cost of Capital After Tax ....................................................................................................

1. Fixed Interest Debt Instruments ..................................................................................................................

a. Calculations With Premium/Discount .................................................................................................

1) Simple ...........................................................................................................................................

2) Complex ........................................................................................................................................

b. Adjustment for Tax ..............................................................................................................................

2. Preferred Stock ............................................................................................................................................

a. Formulas ...............................................................................................................................................

1) Market ...........................................................................................................................................

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2) New Issue ......................................................................................................................................

b. No Adjustment for Tax ........................................................................................................................

3. Common Stock ............................................................................................................................................

a. Formulas ...............................................................................................................................................

1) Dividend Growth Without Flotation ............................................................................................

2) Dividend Growth With Flotation ..................................................................................................

3) CAPM Model ................................................................................................................................


4. Retained Earnings ........................................................................................................................................

a. Formulas ...............................................................................................................................................1) Retained Earnings .........................................................................................................................

2) Dividend Growth ..........................................................................................................................

3) CAPM ...........................................................................................................................................


C. Marginal Cost of Capital .....................................................................................................................................

1. Increasing Costs ...........................................................................................................................................

2. Investment Decision ....................................................................................................................................

CMA/CFM REVIEW

PART 3 - CHAPTER 3

CORPORATE FINANCE

The material in this chapter is tested on the CMA exam at Level B, which means that the candidate is responsible for

demonstrating knowledge, comprehension, application, and analysis.

I. MANAGING CURRENT ASSETS

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A. Working Capital

Working capital is simply the difference between Current Assets and Current Liabilities. Working capital is necessary to

operate a business on a day-to-day basis, so working capital must be managed to ensure that it is maintained at a level necessary to

support the firm's operations.

B. Cash Management

The cash management function includes planning and controlling cash collections, disbursements, and cash balances. Cash is

currency and demand deposits in commercial banks.

1. Purposes: Cash is a non-interest earning liquid asset which is held for four purposes.

a. Transaction Motive: The transaction motive is necessary to meet payroll, purchases of material, dividends, and

other on-going operating expenses.

b. Precautionary Motive: The precautionary motive is based upon the solvency requirement. Cash needs relate to

the predictability of cyclical cash inflows and outflows. If predictability is low, large cash reserves may be needed to fund emergencies

that arise periodically.

c. Speculative Purposes: Speculative purposes will allow a firm to move on an opportunity quickly.

d. Other Legal Requirements: A firm may be required to hold cash for other purposes. This might include

balances in a non-interest bearing account as a condition of a bank loan. Cash not necessary for any of these four purposes should be

invested in marketable securities or other interest-earning accounts including money market funds.

2. Cash Cycle:

a. Cash Operations/Conversion Cycle: The cash operation cycle, also called the cash conversion cycle, is cash to

purchasing inventory to the cash collection from sales of the finished product.

b. Cash Flow Cycle: The length of the cash flow cycle is the average age of accounts receivable plus the average

age of inventory in process less the average age of accounts payable.

3. Cash Budget: A cash budget includes projected sales, purchases, percentages of collections, and terms of payments.

Non-cash expenses such as depreciation and amortization must be disregarded. Cash budgets are used as an aid in determining when

cash deficits and cash surpluses are expected to arise because of seasonal patterns and/or unique needs. See CMA Part 2, Chapter 1 for

examples of calculations for the timing of cash receipts and disbursements.

If interest rates are high, patterns of cash flows (and the ways to minimize the cash needs) become more important.

4. Cash Inflows:

a. Acceleration Techniques: Cash inflows can be accelerated through tighter credit terms, prompt and more

frequent billings, offering a discount for prompt payment, decentralized invoicing and collections, electronic fund transfers and

factoring of receivables.

b. Lock Box: A lock box system allows cash to be collected regionally and thus speeds up deposits.

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Example

:

Answer:

Ace Manufacturing is a national distributor firm that currently uses a centralized collection system under which all

remittances are sent to headquarters in New York. It takes an average of 5 days to receive the remittances, 4 days for Ace

to process the checks and 1-1/2 days for the checks to clear the banks. A proposed lock-box system would reduce the mail

and processing time to 3 days and the bank clearing time to 1 day. Ace has an average daily collection of $100,000. By

what amount would Ace's average cash balance increase?

Ace's average cash balance would increase by $650,000. (10.5 - 4 days) x $100,000 = 6.5 x $100,000 = $650,000.

c. Other Methods: Receivables may be factored or pledged as collateral to obtain a short-term bank loan

d. Effects of Inflow Changes: Tighter credit terms may increase cash flow but may irritate (and perhaps

lose) some existing customers who are "slow payers?' Sales and average accounts receivable balances may decrease and

troubled accounts will be identified earlier.

5.Cash Outflows:

a. Delay Techniques: Cash outflows can be delayed by centralizing disbursements, utilizing vendors'

maximum payment terms, using draft and check floats, etc.

b. Drafts v Checks: Drafts have an advantage over checks in that they must be presented to the drawer for

payment; upon presentment the funds must then be deposited. Checks are payable upon demand at the drawer's bank and

thus the cash outflow occurs sooner.

c. Effects of Outflow Changes: Average accounts payable balances may increase. However, too slow

payments may irritate (or perhaps lose) some suppliers.

6. Zero Balancing: Checks are drawn on a special disbursement sweep account which is designed to have no

balance. Checks presented for payment cause a negative balance but an automatic transfer from a central control account

brings the balance up to zero. The advantage of zero balancing is that this system eliminates the risks of overdrafts and

non-interest bearing cash balances. The disadvantage is that there is a service fee charged by the bank for the zerobalancing service.

7. Timing Deposit Savings: The exam has asked questions where the candidate is required to calculate the annual

dollar savings of a proposal to match daily deposits to a disbursement float outflow schedule. The usual assumption is a

consistent outflow of funds, no compensating balance requirements, and no bank charges due to zero balancing or NSF

overdrafts. Varieties of this same type of question include the savings realized from using a lock box service to speed cash

collections.

Example: Employer Corporation pays its employees weekly on Friday. Friday morning it deposits the total payroll amount into the payroll account

at the same time the paychecks are distributed to the employees. The average interest rate offered for one-to-ten-day investments over

$5,000 is 7.3%. The treasurer has accumulated the following average cash inflow and outflow data for the check clearing account:

Business Day Deposit Clearing Pattern Balance

Friday $1,000,000 $400,000 $600,000

Monday -0- $200,000 $400,000

Tuesday -0- $200,000 $200,000

Wednesday -0- $100,000 $100,000

Thursday -0- $100,000 -0-

The treasurer is recommending that deposits be made daily in amounts equal to the expected total of clearing checks. The payroll funds not yet deposited

would be invested at a 7.3% annual rate. What would be the annual dollar savings to Employer Corporation resulting from adopting this proposal?

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Answer: The annual dollar savings are the average incremental amount made available for investments times the average interest rate offered for

those investments.

Incremental Days Dollar Days

Amount Invested per Week per Week

600,000 3 $1,800,000

400,000 1 400,000

200,000 1 200,000

100,000 1 100,000

-0- 1 -0-

7 $2.500.000

Average Incremental Amount Invested = Total Dollar Days per Week = $2.500~000 = $357,142.85

Days per Week 7

Estimated Annual Dollar Savings = Average Incremental Amount Invested x Interest Rate = $357,142.85 x .073 (market rate of interest)

= $26.071.43

C. Electronic Commerce

Electronic commerce is the practice of conducting business through computers, typically over the Internet. It includes the

buying and selling of goods or services through digital communications, electronic data interchange (EDI) systems to exchange

inventory requirements with vendors and customers, electronic funds transfer (EFT), Internet storefronts, and value-added networks

(VANs). (For more details, see CMA Part 2, Chapter 4.)

Electronic commerce increases the timeliness of transactions, including the speed of cash receipts or payments, and it reduceserrors and the expense of paper processing.

D. Investing Excess Cash

Organizations typically invest excess cash to earn a higher rate of return. A comprehensive investment policy and guidelines

establish the objectives and restrictions to be followed in investing short-term excess cash. The guidelines normally address the

questions of safety of principal (default risk), liquidity (difficulty of reconverting to cash) and rate of return (inversely related to the

other factors). Acceptable investments, the degree of diversity, vehicles and particular issues (if known), maturity limitations (length of

time) should be covered.

E. Marketable Securities

Marketable securities consist of investing temporary excess funds in readily marketable forms with a high degree of liquidity.

1. Investment Selection: Risk and return are balanced in selecting marketable securities for investment. The following

variables are considered in evaluating the risk and return of potential investments:

a. Safety: Marketable securities range in terms of their safety or, conversely, their risk. Securities such as U.S. T-

bills are very safe, whereas some corporate stocks and bonds are very risky, in addition, shorter-term securities are usually less risky

than longer-term securities.

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b. Marketability/Liquidity: Some securities are very liquid (e.g., highly traded public company stocks), while

others are not as liquid or impose penalties for early liquidation (e.g., a 5-year certificate of deposit).

c. Yield: Some securities have fixed rates of return (e.g., certificate of deposit), others have a rate of return that

depends on the discounted purchase price (e.g., treasury bills), and others have rates of return that depend on unknown future market

prices (e.g., public company stocks). In general, the expected rate of return is higher for securi ties that are riskier.

d. Maturity: Some securities have no specific maturity (e.g., public company stocks), while others have fixed

maturity dates. Fixed maturity dates can range from extremely short term such as I day, to very long term such as 30 years. In general,

risk and expected return are hitcher for longer-term securities than for shorter-term securities.

e. Taxability: Income taxes affect the return on marketable security investments, so it is necessary to be

-knowledgeable about current income tax law when choosing among investment options. Investments held for a

sufficiently long time period quality for capital gains treatment, which provides for a lower rate than on regular income. In the U.S.,

70% of the dividends received by a corporation from another qualifying corporation are not taxable. Any income tax differences across

investment opportunities must be taken into account when comparing the expected rate of return.

2. Common Types of Marketable Securities:

a. Treasury Bills, Notes, and Bonds: U.S. treasury bills, referred to as T bills, are U.S. debt obligations with

maturities of one year or less. They are sold through a competitive bidding process, carry no coupon rate, and are issued at a discount

from the redemption face or par value. They are offered in 13-, 26-and 52-week maturities. Treasury notes mature in 2 to 10 years,

while treasury bonds mature in 10 or more years. T bills are the asset form most often held as a substitute for cash. Guaranteed by the

Federal government, they are considered the safest of all marketable securities and have a very active secondary market.

b:

collateralized by U.S.

future time and price.

Repurchase Agreements: Repurchase agreements (repos) are effectively short-term loans T bills. The T bills

are sold by dealers or banks who contract to repurchase the bills at a specified These are available over-night

and with few-day maturities at yields close to T bills.

c. Certificates of Deposit: Certificates of deposit (CDs) are deposits with financial institutes for a specific period of

time, usually pay a fixed rate of interest, and require a penalty for early withdrawal. In the U.S., they are typically regulated and insured up to

$100,000 by the FDIC. CD maturities are as short as 30 days and as long as 5 years. The yield is higher than U.S. Treasury bills, with the risk

dependent on the bank's stability.

d. Negotiable Certificates of Deposit: Large denomination ($100,000 or more) CDs that can be

traded.

e. Federal Agency Securities: The U.S. Government does not guarantee debt obligations of federal agencies other than

the U.S. Treasury Department. However, such obligations are usually guaranteed by the federal agency issuing them.

f. Eurodollars: Dollars deposited in financial institutions outside the United States. (Note: The name originated from

deposits at European banks, but now refers to deposits in any part of the world. Eurodollars may also be called offshore dollars or Asian

dollars.) The funds are typically used to settle international transactions.

g. Bankers' Acceptances: A banker's acceptance is a bank draft drawn on deposits at a commercial bank with payment at

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maturity guaranteed by the bank. The issuing bank and the borrower are both liable for payment. They are typically used to finance export,

import, shipment, and storage of inventory, or to facilitate international transactions. Maturities are typically less than six months. They are

sold on a discount basis and traded in an active secondary market.

h. Commercial Paper: Unsecured short-term promissory notes with maturities up to 270 days sold by large corporations.

The purchaser's yield is higher than T-Bills to accommodate the higher risk. The marketability of commercial paper depends upon the issuer's

credit rating; "AAA" is considered the best rating. There is not generally an active secondary market.

i. Other Marketable Securities: Other marketable securities include investments in publicly traded corporate stocks and

bonds, money market funds, mutual funds, and any other investment that can be rapidly liquidated.

F. Accounts Receivable

The primary objective in the management of accounts receivable is to achieve an optimal combination of sales volume, bad debt

experience, and receivables turnover (i.e., cash collections) which maximizes the profit.

1. Decision to Carry Receivables: The decision to carry receivables depends on many factors, including the nature of

products, types of customers, whether competitors carry receivables, availability and cost of financing to cover the receivables, willingness to

assume default risk, and company strategies.

2. Level of Receivables: Given a decision to carry receivables, factors that influence the level of receivables for an individual

company include the following:

· Sales levels, including seasonal fluctuations and long-term trends

· Credit terms--due dates, late payment charges, interest

· Cash discounts offered (e.g., 2% discount for payment within 10 days)

· Credit approval process

· Collection efforts

· Customer financial health

· Product quality

3. Average Collection Period (or Days Sales Outstanding): The average time in days that receivables are

outstanding (date of sale to date of collection). Because this ratio is calculated by dividing 365 days by the receivables turnover,

its interpretation is inversely related to that of the receivables turnover ratio (discussed above)~the ~eater number of daysoutstanding, the ~eater the possibility of delinquencies becoming uncollectible. This ratio should ideally be less than the terms

extended to customers. If you offer net 30 day terms and everybody pays exactly on time, the ratio should be 30 days.

Average Collection = 365

Period Receivables Turnover

Where: The receivables remover indicates the efficiency of receivables collection and the quality of receivables. The higher the

quality, the shorter the time between the sale and the collection of cash. Net Credit Sales excludes cash sales and reflects all

other sales.

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Receivables = Net Credit Sales

Turnover Average Trade Receivables (Net)

4. Estimated Cash Discounts Taken: The cost of offering a cash discount is the amount of cash collections

foregone from customers who take advantage of the discount.

Example

:

Good Corporation sales are $60,000,000 of which 80% are on credit. The corporation's CMA has estimated that if the

present credit terms of net 30 are changed to 2/10 net 30 only 40% of the credit sales would take the discount. Assumingno change in uncollectible accounts, the change would result in how much in expected discounts taken?

Answer: Credit Sales = Sales x Credit % = $60,000,000 x 0.80 = $48,000,000

Receivables Collected in Discount Period = $48,000,000 x 0.40 = $19,200,000

Discount Taken = Receivables Collected in Discount Period x Discount = $19,200,000 x 0.02 = $384.000

or Short-cut Answer: $60,000,000 x 0.80 x 0.40 x 0.02 = $384.000

5. Effect of Change in Credit Policy: The effects of changes in credit policies on account receivable

balances are calculated from estimates of how the credit policy changes will affect outstanding balances.

Example

:

Better Corporation sales are $500,000 of which 70% are on credit. The Corporation's CMA estimates that a new credit

policy will reduce the average number of days in collection from 60 to 40 days and decrease the credit sales to 60% of

total sales. Calculate the change in the average accounts receivable (using a 360 day year) which will result from the

change in credit term

Answer: Old Policy:

$500,000 x 70% = $350,000 Credit Sales

360/60 days = 6 times a year turnover

350,000/6 = 58,333 average receivable

New Policy:

$500,000 x 60% = $300,000 Credit Sales

360/40 = 9 times a year turnover

$300,000/9 = $33,333 average receivable

Change (decrease) in average accounts receivable = $58,333 - 33,333 = $25.000

6. Opportunity Cost of Accounts Receivable: The opportunity cost of carrying accounts receivable is the

foregone earnings or foregone reduction in financing costs that could have been achieved if accounts receivables were not

carried.

Example: Best Corporation has an average collection period of 24 days (using a 360 day year) on annual credit sales of $4.5

million. The average cost of goods sold is 70% of sales, and the prevailing money market rate is 12%. What is the

opportunity cost of the accounts receivable investment?

Answer: 360/24 days = 15 times a year turnover

4,500,000/15 = $300,000 average receivables

Cash invested al 70% of average receivables = $210,000

Investment $210,000 x Interest of 12% = $25,200 opportunity cost

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G. Inventory

Inventory accounts include raw materials, work-in-progress, and finished goods.

1. Reasons to Carry Inventory: There are two major reasons why companies carry inventory: (1) they

operate in an industry, such as retail sales, where inventory is needed to generate sales, and (2) time is needed to obtain

or manufacture inventory for delivery to customers.

2. Level of Inventory: Factors that influence the level of inventory for an individual company include the

following:

· Quantities of inventory needed to attract customer sales

· Sales levels, including seasonal fluctuations and long-term trends

· Risks associated with carrying inventory (e.g., theft, damage, obsolescence, style changes, and deterioration)

· Costs of carrying inventory (e.g., storage, handling, obsolescence, property taxes, insurance, and interest on debt

and/or the opportunity cost of capital invested in the inventory)

· Company strategies, including manufacturing processes and supplier relationships

3. Economic Order Quantity: EOQ indicates the optimal quantity of each individual inventory order.

Notice that while the formula minimizes the sum of ordering and carrying expenses it does not measure shortage costs.

a. Formula for EOQ:

b. Lead Time: The amount of time between the request for inventory and the actual receipt or

manufacturing completion of the inventory.

c. Safety Stock: The amount of inventory to be held above planned requirements as a buffer against

problems such as supplier delays, manufacturing problems, and unanticipated customer orders. The safety stock

inventory level is effected by the predictability or variability of delivery times and usage rates, weighed against potential

losses resulting from stockouts.

d. Reorder Point: The level of inventory at which additional inventory is ordered, generally

calculated as the quantity to be used during the lead time plus the safety stock.

e. Average Inventory Level: Assuming that inventory is used uniformly over time, the average

inventory level is one-half EOQ plus the safety stock.

Example: Moon Corporation uses 10,400 units annually and has an order quantity of 2,000 units. Its safety stock level is 1,300

units, and there is an order-delivery lead time of 4 weeks. What is the reorder point?

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Answer: Moon should reorder when the on-hand quantity is 2,100 units. This is calculated by multiplying the average usage of

200/week (10,400/52) x 4 weeks = 800 + 1300 = 2,100

Example

:

Sun Corporation's CMA wants to quantify the annual carrying cost of its safety stock of 50 units. The inventor)'

investment per unit is $20 and the carrying cost approximately 25% of the investment. Inventory is ordered 10 times a

year. The probability of a stockout is 15% and the related cost is $5 per unit. What is the total cost of the 50 units of

safety stock

Answer: Safety Stock Cost = Carrying Cost + Expected Stockout Cost

Carrying Cost = 50 Units x $20 Inventory Investment x 25% carrying cost =$250

Expected Stockout Cost = 15% Probability x 50 Units x $5 Stockout Cost

per unit x 10 orders per year =375

Total Cost of 50 Units of Safety Stock ($250 + $375) $625

4. Just-In-Time Inventory System: A JIT inventory system is one in which the company develops a group

of reliable local vendors who can supply the inventory with minimum lead time just before the item is required in the

manufacturing process. JIT systems are designed to minimize or even eliminate inventory levels. (For more information

about JIT, see CMA Part 3, Chapter 1.)

a. JIT Savings: Savings include the working capital which would otherwise be necessary to carry and

support the inventory, storage, inventory taxes, insurance and security costs. Most of these expenses are shifted to thesupplier under a JIT system. A less visible advantage is that a JIT system requires better overall inventory and

production management which may promote total quality control.

b. JIT Costs: Because it is necessary to receive inputs with minimum lead time, the vendor's

reliability becomes very important. This is especially important if there are no alternative supply sources. The material

and freight costs of multiple small orders may go up on a per unit basis. The supplier networks must be continually

monitored because their variables are usually less controllable than a system involving only the personnel of the

Company. Out-of-stock situations may increase resulting in customer dissatisfaction and possible downtime. Brand

loyalty may deteriorate, and the ultimate effect on a firm's downstream users and distributors may not be fully

measurable.

c. Calculation of Net JIT Savings: The CMA exam has asked questions where it was necessary to

quantify the savings resulting from a corporation changing from an in-house system to a just-in-time system. Savings

include any released funds times the interest rate to be earned, plus insurance and rental savings. Losses include any

additional charges of the new vendors and some measure for out-of-stock costs (including goodwill lost, if it is possible

to measure). The final cash savings or loss must be adjusted by the tax rate if the question asks for the after-tax savings.

Not relevant are expenses that will continue (regardless of whether or not the new system is installed) such as unused

space and employees that cannot be transferred.

5. Kanban: The basic principle of just-in-time production is to produce inventory in each stage just in

time for it to be required by the next stage. The procedure originated in Japan and is based on the "kanban" concept. A

kanban is a communication device, which may be a card, sign, or production bin. When work is completed in one area,

the card, sign, or empty bin is returned to the preceding work area to signal that additional materials/products are

demanded. This demand triggers production at the previous station - hence the name "demand-pull". The ultimate

demand is the customer's order or anticipated orders.

II. FINANCING CURRENT ASSETS

There are a variety of sources of short-term financing. Each has its own characteristics, advantages and

disadvantages.

13



A. Trade Credit

Trade credit (accounts payable, wages payable, accrued taxes, etc.) is readily available and inexpensive. As a

result, many small firms and manufacturing companies rely on this spontaneous source as their primary type of short-

term financing.

1. Usual Situation: Most businesses pay their supplier's accounts 30 to 45 days after receipt. This is time

enough to earn some short-term interest on cash funds but not long enough to risk negative repercussions such as a blot

on the businesses' credit rating, late payment charges, or the suppliers insisting on cash on or before delivery in the

future.

2. Cost of Foregone Discounts: A vendor may offer a substantial discount for payment received within 10

days of the invoice date. This is usually given when it is an industry practice and/or the company has a cash shortage.

The discount represents a very high annualized rate. To calculate the cost of foregoing a discount, offset the discount

cost by the return which could have been earned on the funds if the discount was not taken.

The formula to calculate the annual cost of a discount of a% if payment is received within b days and

payment due no later than c days is (assuming 360 days per year):

a × 360 OR Discount % x 360

1-a c-b I - Discount% Days Money Used

Example: Calculate the annualized rate for each of the following discounts: (a) 2/10, net 30 and (b) 3/10, net 45.

(a) 2/10, net 30:

0.02 × 360 = 0.02 x 360 = 36.7%1 - 0.02 30-10 0.98 20

(b) 3/10, net 45:

0.03 × 360 = 0.03 × 360 = 31.8%

1 - 0.03 45-10 0.97 35

Example: Slippery Slope, Inc. purchases merchandise from major suppliers all of whom have different credit terms and offer different discounts

for prompt payments. Management has had a policy of not taking the discounts but rather paying the invoices on the last day of the

credit period to avoid any finance charges for late payment. The company earns 2% on its cash balance. Determine the average

effective annual net interest rate associated with the policy of not taking the offered discounts below for each of the suppliers.

Answer: Step 1 is to calculate the annual percentage cost of each of the four suppliers' discount:

Average Annual

Supplier Monthly Purchases Credit Terms Calculation Percentage Cost

Acme Co. $ 450,000 2/10, n/30 0.02 × 360 36.7%

O.98 20

Brother Corp. 375,000 1/15, n/30 0.01 x 360 24.2%

0.99 15

Charlie Ltd. 525,000 n/30

14



Dogget & Co. 150.000 5/10, n/120 0.05 x 360

0.95 I10

Total $1.500.000

17.2%

Step 2 is to weigh the proportion of the total dollars provided by each supplier times its cost.

Annual Weighted

Percentage Cost Weight Average Cost

Supplier ( 1 ) (2) (1) x (2)

Acme Co. 36.7% ($450,000/$1,500,000) 30% 11.0%

Brother Corp. 24.2 ($375,000/$1,500,000) 25 6.1

Charlie Ltd. -- ($525,000/$1,500,000) 35 --

Dogget & Co. 17.2 ($375,000/$1,500,000) 10 1.7

Total 100% 18.8%

Step 3 is to reduce the discount lost cost of 18.8% by the earnings on the cash balances of 2%. The net cost is thus 16.8%.

B. Short-Term Bank Loan, Line of Credit, Revolving Credit

Bank loans can be for a fixed term, an unsecured line of credit, or a revolving credit agreement. A revolving

credit line is supposed to be paid off regularly. The bank may require collateral to secure the loan. Loans may be

collateralized by accounts receivable, inventory, and/or equipment.

1. Compensating Balances and Effective Interest: A bank may require a borrower to maintain a minimum

balance in a low or non-interest-bearing account as a condition of the loan. This requirement raises the effective

borrowing cost of the loan because less cash is available for use.

Example: Sister Corporation borrowed $500,000 at 12.5% with a condition that it keep an average compensating balance in its non-interest bearing

account of $150,000. Sister's loan account balance has ranged from zero to $120,000 and averaged $80,000 over the last two years.

Sister's effective interest rates is

Answer: 0.125 x $500,000 = $62,500 = $62,500 = 14.53%

$500,000 - ($150,000 - $80,000) $500,000- $70,000 $430,000

Note that if the $150,000 minimum compensating balance earned 2%, the numerator would be reduced by $3,000 and the cost would fall to 13.84%.

2. Commitment Fee: A bank may require payment of a commitment fee for a line of credit or revolving credit agreement. This

payment increases the effective borrowing rate under the agreement (the commitment fee would increase the numerator in the preceding calculation).

3. Protective Covenants and Restrictions: Loan protective covenants are provisions in the loan agreement restricting a borrower'soperating and financing flexibility. Such covenants may ensure the debtor does not over-expand, pay dividends, pay excessive salaries, mortgage assets,

or incur additional debt.

C. Commercial Paper

Commercial paper is unsecured short-term promissory notes with maturity dates up to 270 days sold in the

money markets by finance companies, commercial banks and stable corporations.

The exam may require the candidate to calculate the annual cost of commercial paper or to compare the cost to

15



some other source such as a bank loan.

Cost of commercial paper = Costs incurred by using commercial paper

Net funds available from commercial paper

Example: Fancy Flow Inc. can issue three-month commercial paper with a face value of $1,000,000 for $980,000. Transaction costs would be

$1,200. Calculate the annualized percentage cost of the financing.

Answer: (20,000 + 1,200) x 4 -- 21,200 x 4 = 8.65%

$1,000,000 - (20,000 + 1,200) 978,800

Example: Great Expectations, Inc. will need $4 million over the next year to finance its short-term cash requirements. The company could sell $4

million of 90-day maturity commercial paper ever5' three months at a rate of 7.75%. The dealer's fee to place the issue would be an initial

annual 1/8% and will require Great Expectations to maintain a $400,000 compensating balance. Calculate the annual effective cost of

this financing alternative for each quarter of the year.

Answer: Cost of commercial paper in the first quarter

Cost of issuing commercial paper:

Interest ($4,000,000 x 0.0775 x I/4)

Placement fee ($4,000,000 x 0.00125)

$77,500

5.000

Total First quarter cost $82,500

Funds available for use:

Funds raised $4,000,000

Less: Compensating balance $400,000

Interest and placement fees 82.500 482.500

Net funds available in first quarter $3,517,500

D. Banker's Acceptance

A banker's acceptance is a bank draft drawn on deposits at a commercial bank with payment at maturity

guaranteed by the bank. Maturities are typically less than slx months and denominations range from $25,000 to $1

16



million.

E. Factoring of Receivables

A firm may augment working capital by selling its accounts receivables to a factor for cash. Factoring generally

has a higher interest cost than bank loans.

1. Factoring v Pledging: Factoring differs from pledging in that the receivables are sold outright to a

financial institution. With pledging, the accounts receivable are used as collateral for a loan.

a. Features of Factoring:

· The title to the accounts receivable passes to the factor.

· The factor usually assumes the risk of losses from uncollectible accounts.

· Credit acceptability of potential sales on account is determined by the factor.

b. Features of Pledging:

· The borrower retains title to the accounts receivable.

· The borrower retains the risk of losses from uncollectible accounts.

· Decisions regarding credit acceptability of potential sales on account are made by the borrower.

2. Advantages of Factoring: Factoring may allow a fn-m to eliminate its credit department and accounts

receivable staff. Factors may provide services that banks don't. In addition to substantial administrative support and

possible business contacts, factors give clients important financial information about their customers. Bad debts may be

reduced if the factoring is without recourse (the factor does not have the right to return a bad receivable).

3. Disadvantages of Factoring: Often, factors deduct a 3 to 5% charge and/or a 10% reserve which will be

returned after 60 days. This is often the most expensive form of securing working capital but may be the only source of

credit available to a troubled fn-m which has no collateral and is desperate for cash. Finally, customers could react

unfavorably to a firm's factoring their accounts receivable.

4. Cost Calculation: The formula to compute the effective cost to factoring is as follows:

Interest cost + Factoring fee

Accounts Receivable - Reserves - Uncollectibles

Example

:

Insolvent Inc. has $100,000 per month credit sales on 30 day receivables and is in dire need of $100,000 cash. Insolvent

must either borrow from a bank or use a "with recourse" commercial factor to raise the $100,000. The bank will charge

18% annually while the factor will require a 2% discount and a 12% annual interest charge. Compare the monthly costs

under these two alternatives.

Answer:

17



Bank

loan =

$100,00

0 x 18%/12 = $1,500 cost

Factor = ($100,000 x 2%) + ($100,000 x 12°/,/12) = $3,000 cost

Factoring is twice as expensive as the bank loan.

III. RISK AND RETURN

A. Types of Financial Risk

1. Systematic/Market/Non-Diversifiable Risk: Risk that is common to the entire market or economy.

If the entire economy collapses, then most investment prices will fall. This risk is also called non-diversifiable risk because it is

common to all risky securities and cannot be eliminated by diversifying across risky investments.

2. Unsystematic/Asset-Specific/Diversifiable Risk: Risk that is specific to a particular investment and has no

relationship to market-wide risk. This risk is called diversifiable risk because it results from events that are randomly across

investments and can be eliminated through diversification.

3. Other Risk Terms

a. Business Risk: Business risk involves changes in operating income. This results from factors such as operating

leverage and variability in customers' demand or the cost of inputs.

b. Default Risk: Default risk is concerned with the possible inability of the debtor to pay interest on a debt or to

repay principal when due.

c. Interest Rate Risk: Interest rate risk relates to changes in the value of an asset caused by variations in interest

rates. The holders of fixed rate securities bear interest rate risk, and the risk is greater for longer-term securities than for shorter-term

securities.

d. Liquidity Risk: Liquidity risk is the risk that an asset cannot be sold at full value when desired. If the

liquidation discount from the fair market value is substantial, this risk is present.

e. Purchasing Power Risk: Purchasing power risk is also known as the inflation risk. This risk concerns the

reduction in the amount of goods that a fixed dollar amount is able to purchase resulting from an increase in the general price level.

B. Individual Security Risk

Each investment security has unique unsystematic factors such as business-specific risks. The exam occasionally requires a

determination of which of two or more stocks is considered to be the most risky or volatile. Depending on the information given in the

fact pattern, this determination can be made by examining the stocks' beta coefficients, standard deviations, or coefficients of variation.

This is more likely to be tested on the CFM exam than on the CMA-CFM exams.

1. Beta Coefficient: Beta is a measure of volatility. The larger the beta coefficient, the more risky the stock. A beta of

1.0 indicates a stock has a risk equal to the market in general.

2. Standard Deviation: For securities that trade frequently, such as publicly traded stocks, the standard deviation of the

rate of return (incorporating changes in the market price as well as dividends) is a measure of security risk. A security with a higher

standard deviation is more risky than a security with a lower standard deviation.

3. Coefficient of Variation: The coefficient of variation is a relative measure of uncertainty expressed as a percentage.

18





E. Risk Tolerance

Risk tolerance refers to an investor's financial ability and emotional willingness to withstand declines in investment

value. Following are common attitudes toward risk and their effect on risk management.

1. Risk Averse: Risk averse investors prefer relatively low risk investments and are willing to give up a higher

return in exchange for more predictable outcomes. When managing risk, these individuals seeks ways to avoid risk.

2. Risk Neutral: Risk neutral investors are indifferent between two investment opportunities that have the same

expected value. When managing risk, these individuals objectively weigh the risk/return trade-off (i.e., costs and benefits of

higher or lower risk).

IV. FINANCIAL INSTRUMENTS

A. Bonds

A bond is a promise to pay a given amount (designated as par, face, or maturity value) on a given date (maturity date).

The bond indenture is the contract between the issuing corporation and the bondholder. The indenture typically provides for

periodic interest payments, stated as a fixed percentage of the face value (coupon rate).

Bonds provide a creditor with security, a priority in both earnings and liquidation and a fixed return that is not

dependent upon earnings (as opposed to common stockholders). The interest is deductible to the corporation and therefore this

source is usually less expensive after-tax than preferred or common stock. While this involves no dilution of equity, it increasesthe debt-to-equity ratio, thus creating more risk to the firrm in the event of an economic downturn. Debt instruments with a

coupon rate of interest less than the current market rate will sell at a discount.

1. Types of Bonds: There are several basic types of bonds, described as follows:

a. Mortgage Bonds: Mortgage bonds are secured by a lien on property. This is the usual way to secure real

property collateral.

b. Debentures: Debentures are bonds with no specific collateral to secure the debt aside from the full faith

and credit of the company issuing the debt instrument. Thus debentures may have a higher yield than other debt instruments.

2. Special Provisions: The bond indenture can also contain the following special provisions:

a. Call Provision: The issuer may reserve the right to call the bond prior to the redemption date. The call

price is generally above the market price and may be exercised if interest rates decrease. A call provision is usually considered

detrimental to the investor and thus may require a higher interest rate at issue.

b. Sinking Fund Provision: A sinking fund provision requires the corporation to make periodic payments to

a trustee and thereby accumulate funds to retire the principle of bonds or the balloon payment(s) when they are due. Such bonds

are usually considered safe because of the orderly retirement provisions and therefore have lower yields.

20



c. Protective Covenants: The bond indenture may also contain one or more required covenants or promises

designed to protect the creditor. These are intended to ensure that the fu-m will be able to meet its obligations to the bondholders

and may include:

· Payment of dividends to shareholders and salaries to officers may be restricted.

The firm may be required to maintain a specified current ratio or minimum level of working capital.

· Further borrowing by the fn-m may be restricted.

B. Convertible Securities

Convertible (Bonds or Preferred Stock) securities are exchangeable for common stock at the owner's option on or before

a stated time in the future.

1. Creditor Advantages: This allows a creditor to receive a fixed income today and the option to become an

equity participant tomorrow. The latter feature provides the attraction of being able to share in possible future superior earnings.

This may be a very attractive feature to an investor. This type of debt-equity investment is very popular with venture capitalists.

2. Debtor Advantages: The issuer may find convertibles easier to float and less expensive than straight debt orequity instruments. The issuer may prefer convertibles because it involves less restrictive loan covenants and it allows a deferral of

equity participation. Because of the conversion feature, the value of bonds with such features may be strongly influenced by the

value of the issuer's common stock and may sell at a lower yield than straight bonds. The conversion premium is the difference

between the issue price and the conversion price.

C. Warrants

A warrant is an option to purchase a stated number of common stock shares at a specified price by a given expiration

date. It is often sold as a detachable companion to a bond. The firm receives cash when the warrant is exercised and the common

stock is issued.

1. Advantages: Warrants make the related bond sale more attractive. Thus, the cost of the indebtedness may belower and/or funds may be raised that could not otherwise. Also, warrants can be used to effect delayed equity financing.

2. Disadvantages: Uncertainty exists as to whether or when outstanding warrants will be exercised. If warrants are

not exercised, there will be no cash inflow from the sale of the stock. In addition, exercise of the warrants when the common stock

market price is substantially higher than the option price can lead to a dilution of earnings per share. Notice that in such a

circumstance the issuer would be better off if the stock had been sold directly and not available at such a "bargain" price.

D. Leases

1. Financing Differences: Leases of equipment (as opposed to purchasing) are an "off balance sheet" source of

21



financing, if the lease is accounted for as an operating lease.

2. Advantages and Disadvantages: The advantage to leasing is that 100% financing is possible, thus conserving

cash. The risk of obsolescence decreases, credit lines are preserved thus providing flexibility, and there is no violation of

restrictive loan covenants which may prohibit the issuing of new debt securities. The disadvantage is that the real cost of leasing

usually exceeds that of a term loan.

3. Lease vs. Term Borrowing Decision: Take the after-tax present value of the expected cash outflow under both

alternatives. The lease payment and interest portion of the term loan and related depreciation are usually net of tax. The present

value factor is divided into the face amount of the net obligation to determine the payment amount. This calculation may become

quite complicated.

E. Preferred Stock

Preferred stock has features that are characteristic of both debt and equity instruments. It is generally preferable to

straight debt because it is legally equity and has no maturity date. The dividend received deduction makes holding preferred stock

more attractive than debt instruments to corporations.

1. Preferential Quality Specified: Preferred stock is defined in the corporate articles or bylaws as having some

preferential quality(ies) over common shares. Usually they have superior rights upon liquidation and/or to dividends.

2. Cumulative Preferred: Preferred stock dividends may accumulate and must be paid current before any

dividends may be paid to common shareholders.

3. Participating Preferred: Preferred shareholders may participate with common in additional dividends above a

preset level.

4. Convertible Preferred: Preferred may also be convertible into common shares either at the end of a given

period or upon the occurrence of some other condition.

5. Not a Legal Obligation: Preferred dividends are usually not legal obligations until declared by the Board of

Directors.

6. No Voting Rights: Unlike common shareholders, preferred shareholders do not usually have voting rights as

long as all conditions of the issue are met.

F. Common Stock

Common stock has the last priority in liquidation and exposes investors to greater r isk than debt. It is purchased for

capital appreciation and dividend objectives. Common shares may increase in value quicker than other securities and generally

have no right to dividends. But additional common stock issuances will decrease earnings per share and dilute existing

shareholders' voting power.

1. Different Classes of Common Stock: Companies may issue more than one class of common stock. One class

may be voting, while the other is non-voting.

22



2. Stated Capital: Stated or legal capital is that portion of corporate capital required by state law to be retained in

the business to afford creditors a minimum degree of protection. The outstanding shares times par or stated value constitutes the

dollar amount of legal capital. Stock dividends will increase stated capital by shares times par value. A stock split does not affect

stated capital. Dividends paid out of legal capital are unlawful.

3. Paid-In Surplus: Paid-in surplus is the excess of the consideration received by the corporation for its shares less

the par or stated capital amount.

4. Authorized Shares: Authorized shares are detailed in the articles of incorporation. To issue a larger amount

requires that the articles be amended by the shareholders.

5. Outstanding Shares: Outstanding shares are that portion of issued shares which have not been

redeemed.

6. Stock Options: Options to purchase common shares may be sold or granted to executives or other employees as

additional compensation. This may encourage employees to increase earnings and align their interests with the stockholders. The

option price may be fixed or depend upon future conditions such as earning levels of the company.

There is an active put and calls market for most listed corporations. Stock options may be a deterrent to a corporate raider.

G. Treasury Shares

Treasury stock is corporate stock which has been issued and later reacquired by the issuing firm. As long as the articles

of incorporation so provide, a corporation may repurchase or redeem its own shares. Redeemed shares may be cancelled or held

in the treasury. There is no taxable gain or loss recognized by a corporation from transactions in its own treasury shares. Such

transactions also have no affect on stated capital. Treasury shares do not have voting rights and cannot receive dividends.

1. Reasons for Reacquiring Stock: There are a number of reasons why a firm reacquires its own stock, including

the following:

a. Provide Cash and Tax Savings for Shareholders: By repurchasing its stock from its shareholders, the

corporation can both pay cash and provide a tax benefit to the shareholders. The shareholders are taxed only on the gain (amount

that the transaction price exceeds their original basis in the stock). In contrast, cash dividends paid to shareholders are usually

fully taxable.

b. Employee Stock Ownership Plans (ESOPs): Federal corporate tax law provides for the deductibility of contributions made to qualified ESOPs~ An ESOP typically borrows funds from a bank to purchase shares of the corporation's

stock to be held in the name and for the benefit of the firm's employees. These shares may be treasury shares accumulated and

held by the corporation as well as those shares newly issued by the corporation or purchased on the open market. The corporation

makes annual tax-deductible contributions to the ESOP, which uses the funds to repay the bank loan. Employees may also

contribute to the ESOP. The firm benefits by receiving the proceeds from the sale of either treasury stock or new/y-issued shares

to the ESOP.

c. Automatic Dividend Reinvestment Plans (ADRIPs):

additional shares to shareholders in lieu of cash dividends under an ADRIP.

section of this chapter.

Treasury stock may be used to provide See the

detailed discussion in the next

23



d. Stock Repurchase Programs: The corporation may choose to purchase some of its own shares from the

market, thus increasing the proportional ownership of the remaining shareholders. Earnings per share of outstanding stock is then

increased which, together with the stimulative buying activity, is expected to result in a higher market value per share.

Shareholders have the potential of realizing capital gains upon eventually selling their shares, which may be taxable at lower rates

than ordinary dividends. Such a program is especially desirable if the book value per share exceeds the market value per share of

the stock.

2. Advantages and Disadvantages of Holding Treasury Stock:

Advanta ges

Increase EPS to Remaining

Shareholders

Increase Market Price Per Share

Obtain Control

Accumulate for Potential Merger

No Taxable Gain upon Resale

Buyout of Dissident Stockholder

Fund Pension Plans

Disadvantages

May Create Liquidity Problem

Increase Debt to Equity Ratio

Increase Financial Leveraging Risk

Precludes Other Opportunities

Increase Risk of Takeover

Decrease a Firm's Current Assets

H. Retained Earnings

Retained Earnings, an internal source of funds, are the accumulated earnings of the firm which have not been distributed as

dividends.

1. Advantages: One advantage to retention is that there is no disturbance of present ownership. Also, the price/earnings

ratio of listed corporations may mean the net appreciation in share market value derived from the increased capital. Historically

retention of earnings has been the major source of capital investment for large business firms. This may be especially valuable during

periods of capital rationing.

2. Disadvantages: The amount available from this source is limited, as it depends on the firm's earnings and dividend

policy. Financing in this manner can reduce the amount of dividends available to shareholders, and the dividends can become variable.

I. Dividends

Dividend Policy addresses what percentage of net income to pay out and what to retain for internal growth. According to the

residual financing theory, if a firm earns a high return on investment, it should retain more. The higher the capitalization factor or

market price-to-earnings ratio, the more the increase in earnings will be multiplied to a higher stock market price. This may exceed the

return a shareholder could realize by investing the dividend.

1. Relevant Dates

a. Declaration Date: The date the Board declares the dividend and it becomes a corporate liability. For cumulative

preferred stock, this action may not be necessary to create a liability. The Board, however, would be the responsible party indetermining whether to pass the dividend.

24



b. Ex-Dividend Date: Because of the necessity to process buying and selling orders, stock exchanges set a date

before the holder-of-record date to determine the identity of the dividend recipient. This is usually four days, and on that date, the

market price of the stock usually falls by the dividend amount.

c. Holder-of-Record Date: Stock traders forward their final transfers to the corporation or its transfer agent. The

share ledger is then brought current. The corporation then closes its share ledger and produces a list of shareholders entitled to receive

the dividend.

d. Payment Date: The date the check is mailed to the shareholder.

2. Factors Restricting Dividends: A corporation may find difficulty in paying cash dividends if it lacks liquidity.

Corporations can only legally pay dividends up to earnings and profits (roughly retained earnings). Loan agreements or bond

indentures may further restrict or prohibit dividends. Investment opportunities may not be available if cash dividends are paid. The type

of investor desired may affect dividend policy such as a company owned predominantly by pensioners or masts which maintains a large

regular dividend.

3. Non-Cash Dividend

a. Usefulness: A non-cash dividend is a way a corporation can placate shareholders without using cash that may be

used in the business. This method is especially appropriate if the business can earn a higher return on its investments than shareholders

on theirs.

b. Stock Dividend: New shares of stock are issued to existing shareholder. The corporation must transfer the par

value of the new shares (or stated value for no-par stock) from retained earnings to capital stock. Net worth and ownership interest are

unchanged but future earnings per share are reduced. A stock dividend is non-taxable to shareholders unless they receive the right to

receive cash instead of the stock dividend.

c. Stock Split: There is no change in capital accounts because mechanically the reduction in the legal par or stated

value of the shares outstanding is offset by an increase in the number of shares outstanding. This may make the share trading range

more attractive and lead to a market price above the split level price. In addition, there may be an "information value" to a stock split

because a growth in earnings is expected. A stock split is non-taxable to shareholders.

d. Reverse Stock Split: This is the reverse of a split. It may be used when a company desires to increase the marke

value per share.

J. Valuation of Stocks~ Options~ and Bonds

stock value.

investment.

1. Intrinsic Value of Stock: Modigliani and Miller authored a future dividend model focusing on the Under this model

the value of a stock is equal to the present value of expected future cash flows from the

a. Without Taxes: The intrinsic value of an investment in the stock of a corporation today is dependent upon future

dividends and/or appreciation potential. Because these are future (as opposed to present) betterments, the candidate must apply the

present value discount factor in quantitatively measuring these items. The question will give you the relevant present value factor to

calculate the discount.

Example

:

An investor is considering buying common shares of High Flyer, Inc. and anticipates with reasonable assuredness selling

them three years hence for $25 per share. The expected dividends and present value factor (for the future value of $1) for

the next three years are $2.00/.909, $2.10/.826 and $2.25/.751 respectively. What is the present intrinsic value of a share

of High Flyer, Inc?

Answer:

Final

value discounted to present ($25 x .75 I)

Dividend at end of first period (2.00 x .909)

Dividend at end of second period (2.10 x .826)

Dividend at end of third period (2.25 x .751)

25



Total

Present

Intrinsic

Value

$18.78750

1.81800

1.73460

1.68975

$24.01735 = $24.02 (rounded)

b. After Tax Effect: Calculate the difference between the individual income tax and the capital gain tax rates. This

savings is the advantage of the corporation retaining capital for future appreciation rather than paying it out in dividends to the

shareholders.

2. Value of Stock Options: Acceptable valuation models for determining the value of stock options include

the Black-Scholes Model and the binomial method.

3. Value of a Bond: The market value of a bond is simply the present value of the expected future cash

flows (interest and principal), discounted using a rate that reflects the current risk of the bond (the risk-free rate plus a

risk premium).

K. Derivatives

1. Background: The markets for derivatives began as a form of hedge against changes in currency exchange

rates. An investor with appreciated stocks overseas may desire to ensure that the fluctuations of foreign currencies

wouldn't dissipate the gains. So a forward instrument was created allowing the investor (for a small fee) to freeze the value

of the foreign currency.

2. Definition: A derivative is a contract whose value is tied to, or derived from, the price of an underlying

security, currency, or commodity. They are artificial and synthetic and became popular because the yields are higher than

the prevailing market. Sophisticated investors may engage in arbitrage (profiting from the differences in prices) and use

leverage. There is an estimated $12 trillion invested in over 2,000 different varieties of derivatives.

3. Varieties: The range is from a simple stock option to:

a. Forward Contracts: An asset is sold at a price determined today but the seller is committed by

contract to delivery at a later date. This eliminates the purchaser's fluctuation risk.

b. Futures: Similar to forward contracts, except futures are standardized and traded on an organized

future exchange. Normally, futures are settled in cash rather than delivery of the underlying commodity.

c. Swaps: This is an exchange of contracts; usually it is the responsibility to make interest payments. An

example is exchanging a fixed rate of return obligation for an adjustable rate obligation. Interest rate swaps enable

management to hedge interest rate risk. Because swaps do not involve an exchange of principal, liquidity and riskmanagement are increased.

d. Structured Notes: A debt instrument with an interest rate tied to an unrelated indicator. For example

the interest rate could depend upon the price of oil.

e. Inverse Floaters: The two variable factors are opposite one another. An example would involve

mortgages with one pool representing interest payments and another representing principal payments.

f. Collateralized Mortgage Obligations: These are high-quality, low-risk pools of mortgages. The

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derivatives are set up in three pools: short-term to 5 years; 5 to 15 years; and 30 years.

V. COST OF CAPITAL

The objective of the individual firm is an optimal capital structure because it will maximize the net worth of the

firm. This target is usually the lowest overall weighted average cost of capital after-tax. A corporation's cost of capital is

the rate of return a project must earn to exactly equal the weighted average of the firm's source of funds. A firm's capital

structure includes both internal and external sources (see the preceding section of this chapter).

A. Weighted Average Cost of Capital After Tax

The historical weighted average cost of capital measures the cost of the fn-m's existing capital structure, and thus

reflects a composite rate of past financing decisions. It is a very frequent CMA exam calculation. The cost of capital rate

is the product of the after-tax cost times the weighted percentage for each of the corporate capital sources.

1. Fixed Interest Debt Instruments: The cost is the stated rate of interest if there was no premium or

discount from the instrument's face value.

a. Calculations With Premium/Discount: Alternative formulas to compute the cost of debt when premium or

discount exist are as follows:

1) Simple: Coupon % OR

$ Net Proceeds

$ Par or Face Value

2) Complex: $ Interest + Premium or - Discount Amortized Per Year

$ Face Value + $ Net Proceeds

2

b. Adjustment for Tax: The after-tax cost is net of the tax savings. This is calculated as the interest rate (or the

results of one of the alternative formulas above) x (1 - corporate marginal tax rate). Debt instruments usually have a lower cost of

capital than other sources.

2. Preferred Stock: The cost is the percentage of the preferred dividend rate~ If the preferred stock participates with

common, the actual amount paid should be used.

a. Formulas: Alternative formulas to compute the cost of present or proposed preferred stock are as

follows:

1) Market:

Preferred dividend per $share

$ Market price per share

2) New Issue:

$ Preferred dividend per share

$ Net proceeds of new sale per share

b. Adjustment for Tax: No adjustment for tax is made to the cost of preferred stock.

3. Common Stock: The cost can be computed by various formulas, depending upon information given in a particular

fact pattern.

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a. Formulas:

1) Dividend growth rate model without flotation costs:

$ Dividend per share + dividend growth rate

$ Market Value per share

Note that the anticipated dividend for next period should be used, if available.

2) Dividend growth rate model with flotation costs:

$Dividend per share + dividend growth rate

$ Market Value per share - flotation cost per share

3) CAPM Model: can be used, if all elements are known. The formula is:

Risk-Free Return + [Beta Coefficient x (Market Return - Risk-Free Return)]

b. No Adjustment for Tax: No adjustment is made to the cost of common stock for tax- This follows becausedividends are not deductible for tax purposes.

4. Retained Earnings: The cost is the opportunity cost of the business. This is the rate of return which could be

earned elsewhere assuming the same risk factor. The current period's net income after tax is assumed included in the Retained Earnings

value used in the calculation. There are at least three alternative methods to calculate the cost of retained earnings.

a. Formulas:

1) Retained Earnings: The same cost is used for retained earnings as is used for common stock

if no specific information is given as to rate of return possible elsewhere,

2) Dividend Growth: The Dividend growth rate model, without flotation costs, may be used.

3) CAPM: CAPM Model may be used for this calculation.

b. Adjustment for Tax: Experts differ concerning whether there should be a tax adjustment for retained earnings.

If the facts in the question give a personal tax rate, multiply the cost x (1 - personal shareholder tax rate).

Example

:

Upward Bounty, Inc. has outstanding $10,000 of 8% bonds which were sold at face value; $5,000 of preferred stock paying $500 annual dividends; $15,000 of common stock paying $1,200 dividends with an expected growth rate of 5%.

The account for retained earnings is $20,000. The corporate tax is 50%, and the individual rate is 35%. What is the

Weighted Average Cost of Capital after Tax?

Answer: Cost % Cost % Weighted % x

Source Amount Weight (before tax) (after tax) After-tax cost

Bonds $10,000 $10/$50 8%* 4%* 0.80%

Preferred Stock 5,000 $5/$50 10%*** 1.00

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Commo

n

Stock**

15,000 $15/$50 13%*** 3.90

Retained Earnings 20.000 $20/$50 13%* ** * 8.45% 3.38

$50,000 $50/$50

WEIGHTED AVERAGE COST OF CAPITAL AFTER TAX 9.08%

* If the bonds are sold at a premium or discount, the cost would be yield divided by issue price.

** Common Stock cost is calculated by dividing current dividends by current price plus expected growth rate.In this example, this would be (1,200/15,000) + 5% = 8% + 5% = 13%.

*** If the preferred or common stock had a flotation cost, the yield would decrease and the cost would increase

proportionately.

**** In this example, the cost of common stock has been used for retained earnings because no other rate of

return possible elsewhere was given.

B. Marginal Cost of Capital

The marginal cost of capital is the required market cost of the firm's next dollar of financing. The weighted

marginal cost of capital is the weighted average of returns that investors require on the firm's debt and equity in order to

supply additional capital to the firm.

1. Increasing Costs: The marginal cost of capital eventually increases as a fn-m's lower-cost sources of capital

are used first before increasingly higher-cost sources.

2. Investment Decision: In theory, as long as the marginal cost of capital is less than the return expected on an

investment, the firm should invest. To increase the value of the enterprise, future projects must earn a rate of return higher

than the marginal cost of capital.

Documents

3.Corporate Finance