CMA Part 2 Financial Decision Making Cram Session Ronald Schmidt, CMA, CFM Jim Clemons, CMA

CMA Exam & Gleim CMA overview pages 3 6 Pass both parts within 3 years Satisfy the experience requirements (see next page) CPEs Gleim website You can create a mock exam on website, and there are ones already created for you

Experience Requirements

Exam format 3 hrs - 100 multiple choice questions = approx. 1.5 minutes per question (on average). Find ways to bank time Look for short-cuts You will find that you most question do not seem easy, dont get discouraged You earn points for each question answered correctly Some questions are test questions that carry no point value. You will not know which ones they are Extra time can be carried forward to the Essay portion 1 hr - 2 Essay questions with up to 8 sub-parts You cant go back to multiple-choice part once you enter this portion of the exam Whatever you have typed on the screen will be saved as your answer, irrespective if the timer runs out on you

Exam format Topics Financial Statement Analysis25% Corporate Finance25% Decision Analysis and Risk Management25% Investment Decisions20% Ethics 5% If you find you have weaknesses in any topic ref. Appendix A for ref. the appropriate sub units

Last minute prep for the exam Focus on what you dont know Realize that you will be more proficient in some topics more than others Practice the Essay questions use the Gleim Essay Wizard Create short mock multiple choice exams (say no more than 50 questions) to condition for the longer 100 question exam, or take the Gleim online CMA Practice Exam that came with your Gleim study material. It is a 4 hour exam. You can also read the question and only the correct answer of questions at the end of each SU. It is a fast way of covering a lot of ground. Make sure your financial calculator has a fresh battery, and that it is not the first time you used it.

Day of the Exam Do not study up to the exam day/time Give yourself plenty of time to get to the testing center. Make sure you have identified exact location prior Make sure you are well rested (probably not a good idea to take exam after a long day of work, for example It is a four hour exam, make sure you are prepared for the duration (eat, etc.) Dress in layers. You can always shed layers when you are there, they have lockers Dont wear a watch into the testing center You can bring your own foam earplugs, so long that they are in a plastic bag Take a copy of the type of calculators that are permitted with you. Ref. the ones listed on the IMA Website You realistically should not plan on any breaks outside of bathroom breaks. Note the timer keeps running if you do take a break. Be optimistic. At this point there is nothing else you can do, and being stressed or discouraged will not help your test results. Relax - NO ONE HAS DIED FROM FAILING THE CMA EXAM, there is life beyond and we will help you pass it!!!!

Exam Budget your time, know your time hacks See how many Essay sub-questions you will be given. There are two parts with different amounts of sub- parts Answer the questions in consecutive order, and limit the number you want to come back to no more than say 10, but make sure you answer it before going on to the next. Never leave a question unanswered, score is based on number of correct answers. Do not allow the answer choices to affect your reading of the question

Most common reasons for missing questions 1.Misreading the requirement (stem) Read the question first 2.Not understanding what is required 3.Making a math error Try to not do calculations of paper first, with the idea of transferring to the exam later. If you know how to use your memory button(s) well on your calculator, use it (i.e. save sub- calculations in your calculator). 4.Applying the wrong rule or concept 5.Being distracted by one or more of the answers the most common wrong answers are the incorrect alternatives 6.Incorrectly eliminating answers from considerations read all answers first, some are more correct or complete then others 7.Not having any knowledge of the topic tested dont agonize over it. If possible try to make an educated guess by eliminating obvious wrong answers. If you guess, use the same letter each time. 8.Employing bad intuition when guessing

The essays Remember, 2 essay questions with up to 8 parts each! Ref. Scenario for Essay Questions 9 -11 The CMA exam uses essays to reflect a more "real-world" environment in which candidates must apply the knowledge they have acquired. Essays are graded on both writing skills and subject matter. Partial credit IS available for essays that have some correct and some incorrect points. Finally, it is important to remember that essays are not intended to test typing ability, so the time you allocated for essay response is adequate to complete the questions even if you do not have the best typing skills. Answering multiple-choice questions is an effective method to study the material for both the multiple-choice and essay sections of the exam. They are an excellent diagnostic tool that will allow you to quickly identify your weak areas. Also, think about what your answer would be if the question were not multiple-choice. When reviewing the correct and incorrect answer explanations, your "essay answers" should be somewhat equivalent to the detailed answer explanations.

Ethics Ethics is tested from: Individual Perspective Part 1 Organizational Perspective Part 2 Questions could be either Multiple Choice or Essay Make sure you study the IMA Framework on Ethics, ref. the IMA website, or following URL: http://www.imanet.org/docs/default-source/press_releases/statement-of-ethical-professional-practice_2-2- 12.pdf?sfvrsn=2 Have it conceptually memorized. Similar to the AICPA version You will then be able to answer any question from there Stay within an objective view, and dont get side-tracked in emotional distractors

SU 1 - Sarbanes-Oxley Act of 2002 Enron, Arthur Andersen Extensive responsibilities on issuers / auditors of publicly traded securities. Sec 406(a) Senior financial officers Code of Ethics Reasonably necessary to promote Honest and ethical conduct Full, fair, accurate, timely, and understandable disclosure Compliance with governmental rules and regulations SOX does not define ethics.

SU 1- Corporate Responsibility for Ethical Behavior Values and Ethics: From Inception to Practice Responsible to : Foster a sense of ethics Written code of Conduct and ethical behavior Pervasive sense of ethical values has benefits. White space vs. Gray area. Tone at the top Human capital - Doing the right thing. Corporate culture Ethics training

SU 2 Some basic understanding Financial Statements, their users and limitations Statement of Financial position Balance sheet Single point in time, a few day changes a lot Assets versus Liabilities and Equity Contingent liabilities Purpose of the Balance Sheet It helps users assess the entitys liquidity, financial flexibility, profitability, and risk. Proprietary theory owners equity Under the proprietary theory, revenues increase capital, while expenses reduce it. Net income belongs to the owner, representing an increase in the proprietor's capital. Usefulness and Limitations Historical cost vs. market value Book value (def.?) does not reflect market value. Estimates Non-measurement of employees, reputations, etc.

SU 2 Some basic understanding Financial Statements, their users and limitations Companies financing structure Liabilities Current versus non-current assets (def., examples?) Equity = Residual balance Types of stock Additional paid in capital Reasons for equity to restricted Treasury stock (def., affect on equity) Notes in the financial statement Purpose Types Def. Real Accounts & Permanent Accounts

SU 2 - SU 2 Some basic understanding Statement of Cashflows Understand: Purpose Indirect method vs. Direct method Categories Operating Activities direct and indirect Investing Activities Financing Activities Two methods to report cash flows Direct method (FASB req.) Indirect method See questions 31 page 53 33 page 54 34 page 55

SU 2 Some basic understanding Statement of Income and Statement of Retained Earnings Understand the different elements of the Income Statement Revenues versus gains Expenses versus losses Transactions that matter and that dont Transactions with owners Prior-period adjustments Items from other comprehensive income Transfers to and from appropriated retained earnings Adjustment made in a quasi-reorganization

SU 2 Some basic understanding Statement of Income and Statement of Retained Earnings Cost of Goods COGS BI + COGM (Purchases for Retailer ) = GAFS EI = COGS COGM (Purchases for Retailer) BWIP + TTL Mfg cost for period EWIP = COGM Similar to COGS + EFG - BFG Statement of Retained Earnings Beg RE + NI Dividends = End RE Dividends Paid or declared?

SU 2 Some basic understanding Statement of Income and Statement of Retained Earnings Other Expenses S, G & A G & A incurred for the benefit of the organization as a whole Interest Expenses based on passage of time; effective interest rate method Irregular Items Discontinued Operations = Income from operations, and gain/loss from disposal of operations Extraordinary Items = both usual in nature and infrequent in occurrence in the environment in which the organization operates Continued

SU 2 Some basic understanding Statement of Income and Statement of Retained Earnings Comprehensive Income Exclude from NI but included in OCI Fair value changes of available-for-sale securities Currency translations Service cost, gains and losses not prev. recognized in pension exp. Must be displayed with other financial statements

SU 2 Some basic understanding Common-Size Financial Statements Percentages and Comparability Restate financial statement line items in terms of percentages of a given amount (baseline figure) Percentage of net sales or Total Asses or Liabilities and Equities Easier to see differences between companies Vertical and Horizontal Analysis Vertical - Explained above Horizontal Several periods also known as trend analysis/percentages, and usually for the same company

SU 2 - Ratio Analysis You need to understand what effects typical business transactions have on a firms liquidity, rather than on the mechanics of calculating the ratios. What is the importance of Ratio Analysis?

Remember Common-size statement s recast all items in a particular financial statement as a percentage of a selected (usually the largest and most important) item on the statement. These statements can be used to: Compare elements in a single years financial statements. Analyze trends across a number of years for one business. Compare businesses of differing sizes within an industry (such as Wal- Mart to Target). Compare the companys performance and position with an industry average. Common-size statements are useful when comparing businesses of different sizes because the financial statements of a variety of companies can be recast into the uniform common-size format regardless of the size of individual elements.

Categories of Financial Ratios Activity: how efficiently a company performs day- to-day tasks such as collection of receivables and management of inventory Liquidity: companys ability to meet its short- term obligations Solvency: ability to meet long-term obligations Profitability: companys ability to generate profitable sales from its resources (assets) Valuation: quantity of an asset or flow (earnings) associated with ownership of a specified claim (Share)

SU 2 - Liquidity Ratios Liquidity is the firms ability to pay its current obligations as they come due. - Short run How easy is it to convert assets to cash. Liquidity ratios relates liquid assets to current liabilities. Current assets converted to cash within 1 year or operating cycle. Current asset ratios Firms ability to operate in short term. Current assets/liabilities are shown in descending order of liquidity.

SU 2 - Liquidity Ratios Working Capital Working capital is a measure of a companys ability in the short run to pay its obligations. Working capital is calculated as shown: Current assets Current Liabilities How much capital is left after paying current obligations? Net Working Capital ratio Net Working Capital ratio = Cur. Assets Cur. Liab./Total Assets Most conservative of working capital ratios.

Remember! Current assets are defined as cash or other liquid investments, such as inventory and accounts receivable (A/R), that can be converted to cash within a year. Current liabilities are obligations that will be paid within a year, such as accounts payable and notes and interest payable.

Liquidity Ratios - Current Ratio The current ratio measures the degree to which current assets cover current liabilities. A higher ratio indicates greater ability to pay current liabilities with current assets, thus greater liquidity. Current ratio Current ratio = Current Assets / Current Liabilities Most common liquidity measurement Low ratio = Possible liquidity problems High ratio = Management not investing assets Should be proportional to the operating cycle. Shorter operating cycles may justify lower ratio. Converting to cash quicker. LIFO lowers ratio.

Liquidity Ratios Quick Ratio and other Quick ratio Quick ratio (Acid test) = Cash + Mkt Securities + Net receivables / Current liabilities Avoids inventory valuation issues. Conservative approach. The quick ratio, or acid-test ratio, examines liquidity from a more immediate aspect than does the current ratio by eliminating inventory from current assets. The quick ratio removes inventory because it turns over at a slower rate than receivables or cash and assumes that the company will be able to sell the items to a customer and collect cash. Cash ratio Cash ratio = Cash + Mkt Securities/Current Liab. The cash ratio analyzes liquidity in a more conservative manner than the quick ratio, by looking at a companys immediate liquidity. Cash Flow ratio Cash Flow ratio = C/F from Operations/Cur. Liab. Measures a companies ability to meet its debt obligations with cash generated in the normal course of business.

SU 2.1 Practice Question Given an acid test ratio of 2.0, current assets of $5,000, and inventory of $2,000, the value of current liabilities is A$1,500 B$2,500 C$3,500 D$6,000

SU 2.1 Practice Question Answer Correct Answer: A The acid test, or quick, ratio equals the quick assets (cash, marketable securities, and accounts receivable) divided by current liabilities. Current assets equal the quick assets plus inventory and prepaid expenses. (This question assumes that the entity has no prepaid expenses.) Given current assets of $5,000, inventory of $2,000, and no prepaid expenses, the quick assets must be $3,000. Because the acid test ratio is 2.0, the quick assets are double the current liabilities. Current liabilities therefore are equal to $1,500 ($3,000 quick assets 2.0).

Activity Measures Another way to analyze liquidity is to focus on the management of key current assets, namely inventory and A/R. A manager successfully managing inventory and collecting A/R in a timely manner also will be improving liquidity. Operating activity analysis is done over a period of an operating cyclethe time elapsed between when goods are acquired and when cash is received from the sale of the goods. Measures how quickly noncash assets are converted to cash. Over a period of time. Includes I/S data. The Balance Sheet data should always be an average

Activity Measures - Receivables A/R Turnover A/R Turnover = Net credit sales / Ave. A/R Efficiency of A/R collections. High ratio : Customers pay promptly. Highly seasonal should use monthly A/R average. One of the assumption of this ratio is that sales occur evenly throughout the year, therefore average A/R can be estimated using the average of beginning and ending A/R balances. When sales are seasonal or uneven, the beginning and ending balances may not be indicative of the average A/R balance. This is one of the reasons that most retailers have a fiscal year ending on January 31 and not December 31, because the sales in that industry are seasonal.

Activity Measures A/R turnover also can be analyzed in days instead of times Days Sales Outstanding (DSO) Days Sales Outstanding (DSO) DSO DSO = Days in year / AR turnover Average collection period in days. May use 365, 360 or 300 days Compared to credit terms to determine if customers pay within terms.

Activity Measures Inventory turnover Inventory turnover = COGS / Ave. Inventory Measures efficiency of inventory management. High ratio : Quicker inventory turns Inventory not obsolete, not carrying excess. Highly seasonal should use monthly Inv. average. LIFO valuation not comparable to other methods. Inventory turnover is industry specific. Grocery vs. Concrete Days Sales in Inventory Days Sales in Inventory = Days in year/Inv. Turnover How many days sales are tied up in inventory.

Activity Measures - Payables Accounts Payable Turnover Accounts Payable Turnover = Purchases / Ave. AP Highly seasonal should use monthly Payables average. Days Purchases in Accounts Payable (DPO) Days Purchases in Accounts Payable (DPO) DPO DPO =Days in year / AP Turnover Compared to credit terms to determine if the firm is paying within terms. Continued

Activity Measures Operating Cycle = DSI + DSO Operating Cycle = DSI + DSO The amount of time to convert inventory to cash. Figure 2-2 Page 67 Cash Cycle = Operating Cycle DPO Cash Cycle = Operating Cycle DPO Is the days that cash is tied up as another asset.

Activity Measures Fixed Assets Turnover Ratio = Net Sales / Ave. Net PP&E Fixed Assets Turnover Ratio = Net Sales / Ave. Net PP&E How efficiently the company deploys its investment in plant assets to generate revenues. Higher turnover is preferable. Affected by the capital intensiveness of the company and its industry, by the age of the assets, and by depreciation method used. Total Assets Turnover Ratio = Net Sales / Ave. Total Assets Total Assets Turnover Ratio = Net Sales / Ave. Total Assets Higher turnover is preferable. Exclude assets that do not relate to sales. Ex: investments

SU 2.3 Practice Question Selected data from Sheridan Corporations year-end financial statements are presented below. The difference between average and ending inventory is immaterial. Current ratio2.0 Quick ratio1.5 Current liabilities$120,000 Inventory turnover (based on cost of goods sold) 8 times Gross profit margin Sheridans net sales for the year were 40% A$800,000 B$480,000 C$1,200,000 D$240,000

SU 2.3 Practice Question Answer Correct Answer: A Net sales can be calculated indirectly from the inventory turnover ratio and the other ratios given. If the current ratio is 2.0, and current liabilities are $120,000, current assets must be $240,000 (2.0 $120,000). Similarly, if the quick ratio is 1.5, the total quick assets must be $180,000 (1.5 $120,000). The only major difference between quick assets and current assets is that inventory is not included in the definition of quick assets. Consequently, ending inventory must be $60,000 ($240,000 $180,000). The inventory turnover ratio (COGS average inventory) is 8. Thus, cost of goods sold must be 8 times average inventory, or $480,000, given no material difference between average and ending inventory. If the gross profit margin is 40%, the cost of goods sold percentage is 60%, cost of goods sold equals 60% of sales, and net sales must be $800,000 ($480,000 60%).

2.4 Solvency Solvency is a firms ability to pay its noncurrent obligations as they come due Long-run as opposed to liquidity which focuses on short-term (current items) Firms capital structure incl. Liabilities (external) Long-term and short-term debt Equity (internal) Residual Capital decisions have consequences > debt = > risk = > cost of capital > equity = < ret. on equity Which det. deg. of leverage

2.4 Solvency Debt = creditors interest = contractual obligations Ret > cost of debt = > equity Equity = permanent capital Ret. uncertainty even with Pre. Stock

2.4 Solvency Capital Structure Ratios Total Debt to Total Capital Ratio TTL Debt/TTL Capital (Debt & Equity) = total leverage Debt to Equity Ratio TTL Debt/Equity = total amount (X) that debt exceeds equity Long-term Debt to Equity Ratio Long-term debt/Equity ??? which is better, increase or decrease of Long-term Debt to Equity Ratio, year over year? Continued

2.4 Solvency Debt to Total Asset Ratio TTL Liabilities/ TTL Assets ??? how is the same as the debt to total capital ratio?

2.4 Solvency Earnings Coverage Times interest earned ratio EBIT/Interest Expense ??? What does this tell a creditor Most common mistake not to add back that years interest payment to NI before taxes Earnings to Fixed Charges Ratio EBIT + Interest portion of operating leases/Int. exp. + Int. portion of operating leases + Div. on Pre. Stock More conservative; shows all fixed charges

2.4 Solvency Cash Flow to Fixed Charges Ratio Pre-tax operating cash flow/Int. exp. + Int. portion of operating leases + Div. on Pre. Stock Eliminates issues associated with accrual accounting

2.5 Leverage Types of Leverage A company uses leverage in two ways: financial and operating. Financial leverage is raising capital through debt rather than equity. While debt holders are entitled to interest, the owners share the earnings of the company. Hence, when a company can earn a higher rate of return on its invested capital through its operations than the interest rate on its debt, it could increase the return for its investors by financing the growth of company operations through borrowed capital. Operating leverage is the existence of fixed operating costs. Because these costs are fixed, the higher the percentage of operating leverage, the greater the effect changes in sales revenues have on operating income. The focus on leverage in this section is on financial leverage. The cost of financial leverage is interest costs, which must be paid regardless of sales.

2.5 Leverage Leverage = relative of fixed cost ??? which fixed cost? ??? what financial statement do we find on? Deg. of leverage = Pre-fixed-cost income amount/Post-fixed-cost income amount

2.5 Leverage Distinguish between variable costing and full-costing Why do we have to have variable costing for measuring the DOL Degree of Op. Lev. Single-Period Version DOL = Contribution Margin/Operating Income or EBIT Contribution Margin = ??? Example page 72

2.5 Leverage Degree of Operating Leverage Perc.-Change Version %Chng. in Op. Inc. or EBIT/%Chng. in Sales Example page 72 Degree of Financial Leverage Single-Period Version EBIT/EBT A variation is the Percentage-change Version

SU 2.5 Practice Question A degree of operating leverage of 3 at 5,000 units means that a A3% change in earnings before interest and taxes will cause a 3% change in sales. B3% change in sales will cause a 3% change in earnings before interest and taxes. C1% change in sales will cause a 3% change in earnings before interest and taxes. D1% change in earnings before interest and taxes will cause a 3% change in sales.

SU 2.5 Practice Question Answer Correct Answer: C The degree of operating leverage (DOL) is the multiple of contribution margin over operating income (also called earnings before interest and taxes, or EBIT). A high multiple indicates heavy use of fixed costs in the firms operations. This firms contribution margin is 3 times EBIT. Thus, a given percentage change in sales will result in a change 3 times as great in EBIT.

SU 2.5 Practice Question Firms with high degrees of financial leverage would be best characterized as having AHigh debt-to-equity ratios. BZero coupon bonds in their capital structures. CLow current ratios. DHigh fixed-charge coverage.

SU 2.5 Practice Question Answer Correct Answer: A The degree of financial leverage (DFL) is the multiple of operating income (or earnings before interest and taxes, called EBIT) over earnings before taxes (EBT). A high multiple indicates heavy use of fixed costs in the firms capital structure, revealed by high interest payments on debt.

Capital Structure Other considerations Consider that increases in debt create higher fixed costs for interest and principal payments. It also results in a higher debt to equity ratio and, therefore, a less favorable position for long-term debt-paying ability. Decreases in equity, as a result of redemption of stock or losses from operations, also would result in a higher debt to equity ratio and higher risk for the companys ability to pay long-term debt. Increases in equity, such as those from profits, without corresponding increases in debt would lower the debt to equity ratio, increasing the companys position for long-term debt-paying ability.

Capital Structure Other considerations What is Off -Balance Sheet Financing, and how does it affect financial rations? Off -balance sheet financing is a form of financing in which large capital expenditures are kept off an organizations balance sheet through various classification methods. Organizations oft en use off -balance sheet financing to keep their debt to equity and leverage ratios low, especially if the inclusion of a large expenditures would violate debt covenants. Four of the common techniques employed to achieve off - balance sheet financing are: factoring of A/Rs, special- purpose entities, leases, and joint ventures.

Capital Structure Other considerations Special-Purpose Entities Many firms create special-purpose entities (SPEs) for a special, sometimes undisclosed, business purpose. For example: SPEs may be created to facilitate leasing activities, loan securitizations, R&D activities, or trading in financial derivatives (i.e. Enron). Because these were created as separate entities from the parent corporation, the financials and business transactions of these SPEs were not consolidated with that of the parent. By excluding such ventures from consolidation, the company is hiding significant business risk from investors

Capital Structure Other considerations Leases Firms usually use leases to get use of an asset without having to show it on the balance sheet as an asset and the corresponding liability. If the firm were to purchase the asset, it might have to use cash, thus converting short-term assets into long-term assets and worsening short-term liquidity ratio. Purchasing the asset on credit would increase the firms accounts payable, again worsening its short-term liquidity ratios. If the firm were to use long-term financing to purchase, it would worsen the debt to equity or other solvency ratios. A way to avoid any of these adverse consequences on the balance sheet, firms sometimes lease the asset. Generally accepted accounting principles require that a determination be made on whether the lease is an operating lease or a capital lease. When the lease meets one of the four conditions established for capital leases, the lease payments are accounted for as a long-term liability. However, sometimes firms are able to structure a lease so as not to meet any of the four conditions. It can then classify the lease as an operating lease. With an operating lease, the firm is able to obtain the use of the asset without having to record its obligation to pay, thus obtaining off-balance sheet financing.

Capital Structure Other considerations Joint Ventures A joint venture is a business entity that is owned, operated, and jointly controlled by a small group of investors with a specific business purpose. Sometimes a corporation is a partner in a venture, which allows it to be active in management and involved in decision making but not report the venture on the financial statement of the corporation. An investment in a corporate joint venture that exceeds 50% of the ventures outstanding shares must be treated as a subsidiary investment, leading to consolidation in the financial statement. However, firms sometimes are careful to hold less than 50% (say 48.5%) of outstanding shares to avoid such consolidation providing off -balance sheet financing.

SU 2 - Liquidity Ratios Effects of Transactions You need to understand what effects typical business transactions have on a firms liquidity, rather than on the mechanics of calculating the ratios. See problems 10 13, p. 56 - 57

Profitability Analysis Profitability is a firms ability to generate earnings over a period of time with a given set of resources. It is analyzed by examining the elements of revenues, the cost of sales, and operating and other expenses. There are a number of ways an investor can look at return on his or her investment. Some returns involve the price of the stock as it trades in the securities markets. Although there are actions a company can take to make its stock more attractive to investors, return on market price depends on when each investor purchases and sells the stock. Thus, the analyst of a companys financial and operating performance cannot make this calculation for the individual investor. An analyst, can, however, examine how the investors contribution to the company performed on a per-share basis. This can be done by measuring earnings per share and the dividend yield.

Profitability Analysis The numerator of the return ratio is some measure of earnings or profits. The measure selected for the numerator should match the investment base in the denominator. For example, if total assets are used in the denominator, the income to all providers of the capital ought to be included in the numerator, which includes interest. Thus, interest usually is added back to the net income when computing the ROA. This leads to a popular measure known as earnings before interest, taxes, depreciation, and amortization (EBITDA). When return on common equity capital is computed, net income after deductions for interest and preferred dividends is used. The final ROI always must reflect all applicable costs and expenses, including income taxes, particularly when the return on shareholders equity is computed. Profit, or the profit motive, is realized when an organization is generating more resources than it consumes during the course of a year. That is, profit is the amount by which revenue from sales exceeds the costs required to achieve those sales. And the profit margin is the percentage of revenues represented by that excess of revenues over costs. Revenues and costs, however, are measured by diverse criteria.

Profitability Analysis Profit margins commonly are calculated using one of three different profit measures: 1. Gross profit, which equals net sales revenue minus the cost of goods sold (COGS). 2. Operating income, which equals gross profit minus various administrative expenses, not including interest or taxes (because they are not part of operations). Operating income is sometimes called earnings before interest and taxes (EBIT). 3. Net income, which reduces revenues by all expenses cost of goods, operating expenses, and interest and taxes.

Profitability Analysis Gross profit margin is what percentage of gross revenues remains with the firm after paying for merchandise. Revenue COGS = GP As with all financial ratios, the gross margin derives its meaning by comparison to performance of the company in past years as well as by comparison to industry averages. One of the things an analyst looks for is the trend of the gross profit margin: Is it increasing, decreasing, or remaining steady? Key That the percentage of GP remains or increases with sales. GP SG&A = Operating Profit

Profitability Analysis Gross Profit Margin = Gross Profit / Net Sales = Net Sales COGS / Net Sales Profit Margin = Net Income / Net Sales = Net Sales COGS G&A Fixed costs Tax Interest What is left to be reinvested or distributed? Net Profit Margin and Profit Margin are the same Difference between Operating Income and EBIT OTHER Other Income Other Loss

Profitability considerations Financial analyst must also look for reasons that explain changes. Here are some reasons that gross profit margin may change: Sales prices have not increased at the same rate as the change in inventory costs. Sales prices have declined due to competition. The mix of products sold has changed to more products with lower profit margins. Inventory is being stolen. (If this is the case, the cost of goods will be higher against the same sales.)

Profitability Analysis EBITDA performance measure that approximates accrual-basis profits from ongoing operations EBITDA / Net Sales adding back 2 major noncash expenses to EBIT ROI: what is Return and what is Investment? ROA: how well Management is deploying the firms assets in the pursuit of a profit NET INCOME / AVG TOTAL Assets That ratio will be very low in High Assets industry (Manufacturing) ROE: measures the return per owner dollar invested NET INCOME / AVG TOTAL Equity The difference between the two are Liabilities, which is why ROE is always larger than ROA

Key Take-Away CMA are expected to be able to determine the profitability of a business by calculating ROA / ROE using the DuPont Model and explain how it helps analysis Demonstrate: That you know the formulas That you are able to properly apply and analyze and evaluate Discussion on inconsistent definitions and what factors contribute to inconsistency

DUPONT Analysis Developed in 1919 as a way to better understand return ratios and why they change over time. The bases for this approach are the linkages made through financial ratios between the Balance Sheet and the I/S Breaking returns into their components

DuPont Model

Dupont Model: Deep Dive ROE = Profit Margin X Asset Turnover X Equity Multiplier High Turnover Industries = retail, groceries volume High Margin Industries = fashion, luxury rare, customized High Leverage Industries = financial sector, real estate Profitability Operating Efficiency Financial Leverage

Return on Assets: ROA ROA = Net Income / Sales X Sales / Total Assets How effectively assets are used? It measures the combine effects of profit margins and asset turnover

Return on Equity: ROE ROE = Net Profit / Equity = Net Profit / Pre-tax Profit X Pre-tax Profit / EBIT ROE = Tax burden X Interest burden X Margin X Turnover X Leverage ROE = Tax burden X ROA X Compound Leverage factor Tax BurdenInterest Burden

ROCE Return on Common Equity = Net Income Preferred Dividends / AVG Common Equity ROCE = IACS / Net Sales X Net Sales / AVG Ttl Assets X Leverage The equity multiplier measures a companys financial leverage High financial leverage means that the company relies more on debt to finance its assets Raising capital with debt, the company can increase its equity multiplier and improve its ROE However, on the other hand, taking on additional debt may worsen the companys solvency and increase the risk of going bankrupt

Other measures Sustainable Equity Growth rate = ROCE x (1 Dividend Payout) Plowback rate = Net Income not distributed = reinvested in RE Net Profit Margin on Sales = Net Income / Sales Plowback rate

BEPS and DEPS Basic Earnings per Share = IACS / WACSO Income available to common shareholders can be income from continuing operations or net income Diluted Earnings per Share: IACS is increased by the amounts that would not have had to be paid if dilutive potential CS had been converted: Dividends on Convertible PS After-tax interest on Convertible Debt WACSO is adjusted (increased) by the weighted average number of additional shares of CS that would have been outstanding if dilutive potential CS had been converted Page 97 # 17 and 18

Weighted average number of shares outstanding example revisited If there were 800,000 shares outstanding from January through June and 1,200,000 shares outstanding between July and August, the weighted average would be calculated as shown next: 800,000 Shares (Jan. 2 June) 3 6 Months / 12 Months = 400,000 Shares 1,200,000 Shares (July 2Dec.) 3 6 / 12 = 600,000 Shares Weighted Average Shares Outstanding (Jan. 2 Dec.) = 400,000 Shares 1 600,000 Shares = 1,000,000 Shares

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

Other Market-based Measures Objective of Companies = increasing shareholder wealth Earning Yield = Earning per Share / Market Price per Share Dividend Payout Ratio = Dividends to CS / IACS Is it better a high or low ratio? Growing Companies, mature market, start-up? Dividend Yield = Dividend per Share / Market Price per Share

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

SU 3 - Effects of Off-Balance-Sheet Financing Purpose Reduce a companies debt load and thereby improving the ratios Examples include: Unconsolidated subsidiaries Special Purpose Entities Operating Leases Factoring Receivables with Recourse

SU 3 Market Valuations Measures Book value per share Market/Book Ratio Price/Earning Ratio Price/EBITDA

SU 3 Earnings per Share and Dividend Payout EPS Diluted Earnings per share

SU 3 Factors affecting Reported Profitability Among the many factors involved in measuring profitability are the definition of income; the stability, sources, and trends of revenues; revenue relationships; and expenses, including cost of sales. Income quality Factors affecting include: Income Revenues Receivables and Inventories Recognition Principles

SU 4.1 Risk and Return Systematic Unsystematic Relationship between Risk and Return Expected Rate of return calc. p. 146 Security Risk vs. Portfolio Risk Specific Risk vs. Market Risk

SU 4.1 - CAPM In order to measure how a particular security contributes to the risk and return of a diversified portfolio, investors can use CAPM. CAPM quantifies the required return on a security by relating the securitys level of risk to the average return available in the market (portfolio) Investors must be compensated for their investment in 2 ways: Time value of money Risk Know the CAPM formula!

SU 4.1 Two types of Risk Business Risk Financial Risk Indifference Curve

SU 4.1 - Standard Deviation It measures the tightness of the distribution and the riskiness of the investment A large deviation reflects a broadly dispersed probability distribution meaning the range of possible returns is wide The smaller the deviation, the tighter the probability distribution and the lower the risk The greater the deviation the riskier the investment

SU 4.1 - Coefficients It measures the degree to which any 2 variables are related Perfect positive correlation = +1 means that 2 variables always move together Given perfect negative correlation, risk would in theory be eliminated In practice, the existence of market risk makes the perfect correlation nearly impossible The normal range for the correlation of 2 randomly selected stocks is 0.5 to 0.7. the result is a reduction in risk, not elimination.

SU 4.1 - Covariance Correlation coefficient of 2 securities can be combined with their standard deviations to arrive at their covariance Covariance = measure of mutual volatility

SU 4.1 - Diversification and Beta Portfolio Theory = balancing risk with return Asset Allocation is a key concept: stocks, bonds, real estate, cash, etc The purpose of diversification is to reduce risk while maximizing returns and therefore reducing market correlation Expected rate of return of a Portfolio is the weighted average of the expected rate of return of each individual assets in the same portfolio Specific risk = diversifiable risk = unsystematic risk This risk can be potentially eliminated with diversification Can risk be 100% eliminated? Benefits of diversification become extremely low when > 20/30 stocks are held

SU 4.2 - Portfolio Management 4 important decisions are involved (not only 2) Amount of money to invest Securities in which to invest (expected net cash flows) Time scale (Liquidity) = maturity matching Objectives: what for? = will dictate appetite for risk Others: transaction costs

SU 5.1 - Bonds Term structure of interest rates There are three main types of yield curve shapes: Normal Inverted and flat (or humped). A normal yield curve (upward sloping) is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.

SU 5.1 - Bonds When plotting yield curves we hold the following constant: Default risk Taxability Callability Sinking fund

SU 5.1 - Bonds Features of Bonds Par Value = Maturity amount = Face Amount State rate = Coupon rate Indenture = Terms Issuing bonds takes time and money > Risk = > Return (yield) How can you mitigate some of the market required return?

SU 5.1 - Bonds Following are means to reduce the required rate of return for bonds: Sinking Fund payments to a segregated fund which will equal the maturity value Insured Secured

SU 5.1 - Bonds Advantages of Bonds Interest is tax deductible Retain corporate control Disadvantages of Bonds Interest is considered legal obligation Raises risk level Raises risk profiles Contractual requirements (e.g. required debt to equity) Debt financing limits

SU 5.1 - Bonds Types of Bonds Maturity Term bond single maturity Serial bond Valuation Variable rate Zero-coupon or deep-discount bonds Commodity-backed bonds Redemption Provisions Callable bonds by the issuer Convertible bonds into equities Securitization Mortgage bonds specific Debentures borrowers general credit but not specific collateral

SU 5.1 - Bonds Bond valuation and sales price Several components to determining the fair price of a bond: Risk Duration Face amount Interest payment Other features such as callable, convertibility Stated versus Market rate Mkt rate is = state rate Mkt rate is < state rate Mkt rate is > state rate 5.3 Corporate/Stock Valuation Methods P. 181

SU 5.1 Equity Common Stock Advantages to the issuer No fixed dividend (Common Stock only) No maturity date Increases creditworthiness Disadvantages to the issuer No tax deductible distribution Diluted controlling rights Diluted earnings Higher underwriting costs Increase average cost of capital What is a preemptive rights?

SU 5.1 Equity Preferred Stock = hybrid of debt and equity Advantages to the issuer Form of equity Does not dilute control Superior earning still go to CS Disadvantages to the issuer No tax deductible distribution and therefore greater cost to bonds Dividends in arrears can cause issues

SU 5.1 Equity Characteristics of Preferred Stock Priority in assets and earnings Potential accumulation of dividends Convertibility Participation Par value Redeemability Voting rights Callability Maturity Sinking fund Stock Valuations Preferred is similar to Bonds in valuation Discount rate will probably be higher then bonds due to riskiness Common stock valued also the same way except based on earnings (per share)

SU 5 Corporate/Stock Valuation Methods Dividend Discount Model Based on PV of expected dividends per share Can only be used when dividends are expected to grow at constant rate Dividend per share Cost of Capital dividend growth rate

SU 5 Corporate/Stock Valuation Methods Preferred Stock Valuation Dividend per share Cost of Capital

SU 5 Corporate/Stock Valuation Methods Common Stock with Variable Dividend Growth 3 Step process Step 1 Calculate and sum the PV of Dividends in the period of high growth Step 2 Calculate the PV of the stock based on the period of steady growth discounted back to year 1 using the dividend discount method. Step 3 Sum the totals from Step 1 and 2

SU 5 Cost of Capital - Current Investor Required Rate of Return Components of Capital Debt after-tax interest rate on the debt Preferred Stock dividend yield ratio Common Stock dividend yield ratio Retained Earnings cost = Common Stock Why?

SU 5.6 Cost of Capital - Current Weighted Average Cost of Capital WACC Target Capital Structure Firms WACC is a single, composite rate of return on its combined components of capital. Min. WACC = Shareholder Wealth Maximizing Impact of taxes on Capital Structure and Capital Decisions

SU 6.1 Working Capital Working capital and types of capital policies? Working capital (or current capital) generally refers to the funds a company holds in current (short-term) asset accounts, and includes cash, marketable securities, receivables, and inventories. Net working capital provides a measure of immediate liquidity and indicates how much cash a firm has available to sustain and build its business, and refers specifically (from an accounting perspective ) to the difference between a firms current assets and its current liabilities. Depending on a firms level of current liabilities, the number may be positive or negative.

SU 6.1 Working Capital Working Capital policies include: Conservative = minimize risk = Higher current ratio & acid test ratio - focuses on low-risk, low return working capital investment and financing greater proportion of capital in liquid assets but at the sacrifice of some profitability; uses higher-cost capital but postpones the principal repayment of debt or avoids it entirely by using equity; current assets will be much greater than current liabilities. Moderate = average risk - uses risk and return and financing strategies that match the maturity of the assets with the maturity of the financing; seeks a balance between current assets and current liabilities. Aggressive = more (max) risk = Lower current ratio & acid test ratio - focuses on high profitability potential, despite the cost of high risk and low liquidity. Capital being minimized in current assets versus long-term investments ; higher levels of lower-cost short-term debt and less long-term capital investments. With an aggressive policy, current assets will be less than current liabilities.

SU 6.1 Working Capital What is the optimal level of working capital? Varies with industry! Contrast a grocery chain which has to rotate its inventory and probably has no receivables versus a manufacturer Consequently ratios are only meaningful in terms of norms and trends and relative its competitors or the industry it which it operates Permanent and Temporary Working Capital Def. The minimum level of current assets maintained by a firm (which could fluctuate with seasonality). It should increase as the company grows Permanent financed with long-term debt

SU 6.2 Cash Management Managing the cash levels What are the motives for holding cash? Transactional Precautionary Speculative What is the firms optimal cash? Economic Order Quantity (EOQ) As applied to cash (as opposed to inventory) Questions you will have to answer How much cash Transaction cost Return on marketable securities

SU 6.2 Cash Management Cash Management EOQ Model P. 161 Review examples forecasting future cash flows (see examples on page 161, very typical test questions!) Lockbox benefit analysis = Net Benefit from Lockbox = Reduction in Float Opportunity Cost + Reduction in Internal Processing Costs - Lockbox Processing Costs

SU 6 Marketable Securities Management Remember! Companies invest in marketable securities for three main reasons: 1.Reserve liquidity. To provide a source of near cash (or instant cash) and cover any working capital imbalances resulting from insufficient cash inflows or unforeseen cash needs 2.Controllable outflows. To earn interest on funds that are being held for predictable downstream cash outflows (such as interest payments, taxes, dividends, or insurance policies) 3.Income generation. To earn interest on surplus cash for which the company has no immediate use

SU 6.4 Receivable Management Overview A firm must balance default risk and sales maximization Basic Receivable Formulas Average collection period Accounts Rec. days vs. dollars Assessing impact of a credit term change (see example page 166 - 167)

SU 6.5 Inventory Management Inventory management refers to the process of determining and maintaining the required level of inventory that will ensure that customer orders are properly filled on time. 1.What to order (or make)? 2.When to order (or make)? 3.How much to order (or make)? Reasons for carrying inventory include: Hedging against supply uncertainty Hedging against demand uncertainty Ensuring that operations are not interrupted (ref. JIT)

SU 6.5 Inventory Management Inventory costs Purchase cost actual invoice amounts Carrying cost incl. Storage, Insurance, Security, Inventory taxes, Depreciation or rent, Interest, Obsolescence and/or spoilage and Opportunity cost. Inventory costs incl. - Ordering costs and Stockout costs (see example page 226).

SU 6 Inventory Management Inventory Replenishment Models With Certainty = Average daily demand X Lead time in days Without Certainty = Average daily demand X Lead time in days) + Safety Stock Cost of Safety Stock = Expected stockout cost + Carrying Cost See example on page 170 Economic order quantity (EOQ) Represents the optimum order sizethe quantity of a regularly ordered item to be purchased at a point in time that results in minimum total cost (i.e., the sum of ordering costs and carrying costs).

SU 6.6 - Short-term Financing Sources Spontaneous Forms of Financing Trade credit Accrued expenses Commercial banks, and Market-based instruments Cost of not taking a discount (see example page 230) Short-term bank loans In addition to trade credit sources Increased risk May not renew Contractual restrictions Prime interest rate best customers only Continued

SU 6.6 - Short-term Financing Simple interest loans Interest paid at the end of the term; stated is same as nominal Effective Interest Rate on a Loan Net interest expense Usable funds

SU 6 - Short-term Financing Discounted Loans Amount needed (1.0 Stated rate) Loans with compensating balances increases effective interest rate Lines of Credit with Commitment Fees

SU 7 - Financial Markets and Security Offerings Benefits of Financial Markets Facilitate the transfer of funds from those that need to invest to those that need to borrow. Direct or indirect Intermediate entities & financial markets special expertise. Aggregate view of Financial Markets Demand/Supply of Securities Some of the securities included are Stocks, Corporate bonds, Mortgages, Consumer loans, Leases, Commercial paper, CDs, Governmental securities, Derivatives

Money Markets vs. Capital Markets Short term vs. Long term Money Markets Dealer driven Dealer buy and sell at their own risk. Dealer is principal in transaction vs. stockbroker is an agent Short term and marketable Low default risk Continued SU 7.1 - Financial Markets and Security Offerings

Exist in New York, London, & Tokyo Government T-bills, T-notes and bonds, Federal agency and S-T tax exempt securities, Commercial paper, CDs US and Eurodollar, Repurchase agreements, Bankers acceptances Capital Markets LT debt & equities NY Stock Exchange

Primary Markets, Secondary Markets and Financial Intermediaries Primary market IPO / Issuer receives the proceeds Secondary market Trading among investors Pros Company prestige Increased liquidity of firms securities Cons Reporting requirement Hostile takeovers Provide market makers SU 7.1 - Financial Markets and Security Offerings

Secondary market continued.. Over-the-counter markets Broker & Dealer market Bonds US companies, federal, state, & local governments Open-end investment company shares of mutual funds New securities issues Secondary stock distributions whether of not listed on the exchange NASD National Association of Securities Dealers NASDAQ NASD Automated Quotation system Transaction happen in virtual space Price quotes and volume Auction markets NY Stock Exchange Transaction happen at NYSE by floor traders Financial Intermediaries Use funds from savers Banks, CUs, Insurance co., Pension funds, etc. SU 7.1 - Financial Markets and Security Offerings

Efficient Markets Hypothesis Current stock prices immediately and fully reflect all relevant information. Impossible to obtain consistently abnormal returns with fundamental or technical analysis. Three forms of efficient markets hypothesis 1) Strong form All public and private information is instantaneously reflected in securities price. Insider trading would not result in abnormal returns. 2) Semi-strong form All publicly available data are reflected in security price, but private or insider data are not immediately reflected. Insider trading can result in abnormal returns. 3) Weak form Prices reflect all recent past price movement data. Technical analysis will not provide a basis for abnormal returns. Data does not support the strong form. SU 7.1 - Financial Markets and Security Offerings

Investment Banking Intermediary between businesses and capital providers. Sell new securities | Business combinations | Brokers & Traders With new securities - Help determine method of issuance, pricing, distributing, advice, and certification. Signal sourced, Negotiates deal sets price and fees Sold by best efforts sales No guarantee Underwritten deal IB purchases securities from issuer and resells them IB makes the process easier, because of resources and reputation. Buyers look to IB reputation for fair deals. Structuring of the floatation. Terms of arrangement, capital type and amount Flotation costs Higher for common, then preferred, lower for bonds. SU 7.1 - Financial Markets and Security Offerings

IPOs Advantages of going public Raise additional funds, establish value in market, stock liquidity Disadvantages Costs, data public, shareholder information public, insider limitations, earning growth pressure, stock price doesnt reflect firm net worth, loss of control, growth brings move management control, shareholder costs Steps involved in going public Prefiling period Negotiate and agreements with underwriters. Buying or selling securities is prohibited. Apply to a stock exchange, pay fee, fulfill membership requirements, Continued SU 7.1 - Financial Markets and Security Offerings

Waiting period - File registration statement and prospectus with SEC. May make oral offers to buy and sell securities. Tombstone ads In large red ink Preliminary prospectus, date, and legend must be marked. SEC 20 day review period. Debug letter Fix or withdraw. A Preliminary prospectus is called a Red-Herring Post effective period Registration statement is effective. Securities may be sold.

SU 7.2 Dividend Policy and Share Repurchase Dividend Policy To distribute or not to distribute? Higher dividend lower growth rate, finding the balance Stable dividends are desirable Factors influencing Company Dividend Policy Legal Restrictions- Dividend amount must be in RE. Stability of Earnings Rate of Growth Cash Position Restrictions in Debt Agreements Tax Position of Shareholders Residual Theory of Dividends Minimize Cost of Capital

SU 7.2 Dividend Policy and Share Repurchase Dividend dates Date of declaration formal vote to declare a dividend. Dividend becomes a liability to the company. Date of record Shareholder on that date will receive the dividend. 2-6 weeks after Date of declaration Date of distribution Dividend is paid. 2-4 weeks after date of record Ex-dividend date Purchase before date will receive dividend Established by stock exchange Stock price will usually drop on ex-dividend date in the amount of dividend Stock dividends vs. stock splits More stock is issued, but no value increase or decrease occurs. Stock dividend transfers amount from RE to Paid-in capital Stock split no accounting entry Lowers stock price

SU 7.2 Dividend Policy and Share Repurchase Repurchase Treasury shares Mergers, Share options, Stock dividends, Tax reasons, increase EPS, prevent hostile takeovers, eliminate a particular ownership interest Dividend Reinvestment Plans - DRPs or DRIPS Dividends owed to shareholders are reinvested into shares. Insider Trading laws SEC Rule 10b-5 Leases

SU 7.2 Dividend Policy and Share Repurchase 7.2 Dividend Policy and Share Repurchase P. # 7 on page 229

SU 7.3 - Mergers and Acquisitions Merger vs. Acquisitions Mergers Acquiring firm absorbs a 2 nd firm. Types Horizontal Companies of same business line merge. Vertical Combine supplier with customer Congeneric Related products or services Conglomerate Unrelated companies merge. Advantages and disadvantages Acquisition Acquiring firm purchases all of 2 nd firms assets or stock. Requires shareholder vote. Hostile takeover 5% ownership of any stock class requires SEC filing. Advantages and disadvantages Proxy File with SEC 10 days prior, furnish shareholder with all material subject to vote, The Proxy form, Proxies for Directors in Annual Report Going private - LBO

SU 7.3 - Mergers and Acquisitions Opposition to Combinations Greenmail Targeted Repurchase Staggered Directors or Supermajority vote requirements Golden Parachutes Fair Price Provisions Ensures all stockholder are treated equally. Going Private and LBOs Poison Pill Kills the company value. Flip-over Rights Shareholder exchange for greater value. Flip-in Rights Gives existing shareholders more rights than large acquirer. Issuing Stock - Reverse Tender ESOP White Knight Merger Crown Jewel Transfer Legal Actions Other Restructurings Spin off, divestiture, asset liquidation, carve-outs, Letter stock- separate valuation

SU 7.3 - Mergers and Acquisitions Motivations of mergers and subsequent synergies Undervaluation of firm Managerial motivation Break up Parts are worth more than the whole. Diversification Synergies Combined firms are worth more than separate. Operational Financial Reduced competition Antitrust Strategic position Tax benefits

Su7.4 Bankruptcy Chapter 7 vs Chapter 11

SU 7.5 Currency Exchange Rates Systems and Calculations Foreign Currency Markets are needed due to transactions with foreign entities Trade increases = demand for that countries currency increases Currencies must be easily convertible at some prevailing rate Four systems for exchange rates: Fixed Rate Freely floating rates Managed floating rates Pegged rates

SU 7.5 Currency Exchange Rates Systems and Calculations Fixed Exchange Rates vs. Freely Floating Rate Systems Fixed is fixed or almost fixed Governments help to maintain exchange rates Very predictable and minimizes uncertainty re. exchange rate loses (gains) Governments can manipulate (like China has been accused of doing so) Freely floating helps correct disequilibrium's in the balance of payments

SU 7.5 Currency Exchange Rates Systems and Calculations Managed Float Exchange Rate Systems Government allows market forces to determine exchange rates until they move to far, in which case they intervene Pegged Exchange Rate Systems One country fixes the rate of exchange for its currency with respect to another countrys currency (or basket of several currencies)

SU 7.5 Currency Exchange Rates Systems and Calculations Exchange Rate Basics Spot rate = exchange rate today Forward rate = some definite date in the future Domestic currency forward rate is greater than its spot rate, it is trading at a forward premium Opposite would be a forward discount See Forward premium/discount calculation on page 282 Forward Rate Spot RateX Days in year Spot RateDays in forward period Cross rate used when two currencies are not stated in terms of each other

SU 7.5 Currency Exchange Rates Systems and Calculations Exchange Rates and Purchasing Power Understand graph on page 214 Understand if a currency has appreciated or depreciated

SU 7.5 Currency Exchange Rates 7.5 Currency Exchange Rates Systems and Calculations Example on page 213 Question 20 on page 232

SU 7.5 Currency Exchange Rates Factors Affecting Rates and Risk Mitigation Techniques Exchange Rate Fluctuations over time page 220 Risk of Exchange Rate Fluctuations page 221 Hedging in Response to Exchange Rate Risk page 221, see examples on 222 Tools for Mitigating Exchange Rate Risk Long-term - page 223, see example of page 223

SU 8 Cost-Volume-Profit (CVP) Analysis - Theory CVP = Break-even analysis Allows us to analyze the relationship between revenue and fixed and variable expenses It allows us to study the effects of changes in assumptions about cost behavior and the relevant ranges (in which those assumption are valid) may affect the relationships among revenues, variable costs, and fixed costs at various production levels Cost-volume-profit analysis is a tool to predict how changes in costs and sales levels affect income; conventional CVP analysis requires that all costs must be classified as either fixed or variable with respect to production or sales volume before CVP analysis can be used. It considers the effects of: Sales volume Sales price Product mixes What else?

SU 8 Cost-Volume-Profit (CVP) Analysis - Theory CVP analysis is done with what assumptions? Cost and revenue relationships are predictable Unit selling prices are constant Changes in inventory are insignificant Fixed costs remain constant over relevant range (see slide 5 & 6) Total variable cost change proportional with volume (see slide 7 & 8) Continued

SU 8 Cost-Volume-Profit (CVP) Analysis - Theory The revenue (sales) mix is constant All costs are either fixed or variable (long-term all costs are considered as variable) Volume is the sole revenue driver and cost driver The breakeven point is directly related to costs and inversely related to the budgeted margin of safety and the contribution margin Time value of money is ignored

SU 8 Cost-Volume-Profit (CVP) Analysis - Theory Total fixed costs remain constant as activity increases. remain constant as activity increases. Number of Local Calls Monthly Basic Telephone Bill Cost per call declines as activity increases. Number of Local Calls Monthly Basic Telephone Bill per Local Call

SU 8 Cost-Volume-Profit (CVP) Analysis - Theory Total variable costs increase as activity increases. Total variable costs increase as activity increases. Minutes Talked Total Costs Cost per Minute Minutes Talked Cost per Minute is constant as increases. Cost per Minute is constant as activity increases.

0 1 2 3 4 5 6 * Total Cost in 1,000s of Dollars 10 20 0 * * * * * * * * * Activity, 1,000s of Units Produced Estimated fixed cost = 10,000 Draw a line through the plotted data points so that about equal numbers of points fall above and below the line. Scatter Diagrams

Vertical distance is the change in cost. Horizontal distance is the change in activity. Unit Variable Cost = Slope = in cost in units 0 1 2 3 4 5 6 * Total Cost in 1,000s of Dollars 10 20 0 * * * * * * * * * Activity, 1,000s of Units Produced Scatter Diagrams

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

SU 8 Cost-Volume-Profit (CVP) Analysis - Theory Breakeven point def. Level of output where total revenues equals total expenses; the point at which all fixed costs have been covered and operating income is zero. What is the break-even point and where is it on a graph on the next page?

CVP Graph Break-Even Point

SU 8 Cost-Volume-Profit (CVP) Analysis - Theory Other terms and def. Margin of safety = excess of budgeted sales over BE Sales Mixed costs (See slide 11) Costs that have both a fixed and variable component. For example, the cost of operating an automobile includes some fixed costs that do not change with the number of miles driven (e.g., operating license, insurance, parking, some of the depreciation, etc.) Other costs vary with the number of miles driven (e.g., gasoline, oil changes, tire wear, etc.). Revenue or sales mix is the composition of total revenues in terms of various products Sensitivity analysis (See slide 12) Examines the effect on the outcome of not achieving the original forecast or of changing an assumption. Since many decisions must be made due to uncertainty, probabilities can be assigned to different outcomes (what-if).

SU 8 Cost-Volume-Profit (CVP) Analysis - Theory Unit Contribution Margin (UCM) is an important term used with break-even point or break-even analysis is contribution margin. In equation format it is defined as follows:contribution margin Contribution Margin = Revenues Variable Expenses The contribution margin for one unit of product or one unit of service is defined as: Contribution Margin per Unit = Revenues per Unit (Sales price) Variable Expenses per Unit Expressed in either percentage of the selling price (contribution margin ratio) or dollar amount Slope of total cost curve plotted so that volume is on the x-axis and dollar value is on the y-axis

SU 8 Cost-Volume-Profit (CVP) Analysis - Theory Break-even point in units Fixed costs UCM Break-even point in dollars Fixed costs CMR

Unit sales price less unit variable cost ($30 in previous example) We have just seen one of the basic CVP relationships the break-even computation. Remember Computing the Break-Even Point Break-even point in units = Fixed costs Contribution margin per unit

The break-even formula may also be expressed in sales dollars. R EMEMBER C OMPUTING THE B REAK -E VEN P OINT Unit contribution margin Unit sales price Break-even point in dollars = Fixed costs Contribution margin ratio

SU 8 - CVP Analysis Basic Calculations CVP Applications Target Operating Income Multiple products Choice of products Degree of Operating Leverage (DOL)

SU 8 - CVP Analysis Target Income Calculations Target Operating Income Fixed costs + Target operating income UCM Target Net Income Fixed costs + Target net income / (1.0 tax rate) UCM Problem 15, 16 and 18 on page 333

The CVP formulas can be modified for use when a company sells more than one product. The unit contribution margin is replaced with the contribution margin for a composite unit. A composite unit is composed of specific numbers of each product in proportion to the product sales mix. Sales mix is the ratio of the volumes of the various products. Computing a Multiproduct Break-Even Point

SU 8 - CVP Analysis Multiproduct Calculations Multiple Products (or Services) S = FC + VC = Calculated Weighted Average Contribution Margin See example page 318

SU 8 -CVP Analysis Choice of Product Calculations Choice of Product decisions When resources are limited companies have to choose which products to produce A breakeven analysis of the point where the same operating income or loss will result See example page 318

SU 8 -CVP Analysis Special Order Calculations Special Orders (usually lower price than std.) The assumption are that idle capacity is sufficient to manufacture extra units of a special order.

SU 8 - Marginal Analysis Accounting Costs vs. Economic Costs Accounting Costs = The total amount of money or goods expended in an endeavor. It is money paid out at some time in the past and recorded in journal entries and ledgers.moneygoods Economic Costs = The economic cost of a decision depends on both the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen. Economic cost differs from accounting cost because it includes opportunity cost.accounting cost opportunity cost As an example, consider the economic cost of attending college. The accounting cost of attending college includes tuition, room and board, books, food, and other incidental expenditures while there. The opportunity cost of college also includes the salary or wage that otherwise could be earning during the period. So for the two to four years an individual spends in school, the opportunity cost includes the money that one could have been making at the best possible job. The economic cost of college is the accounting cost plus the opportunity cost. Thus, if attending college has a direct cost of $20,000 dollars a year for four years, and the lost wages from not working during that period equals $25,000 dollars a year, then the total economic cost of going to college would be $180,000 dollars ($20,000 x 4 years + the interest of $20,000 for 4 years + $25,000 x 4 years).

SU 8 - Marginal Analysis Explicit vs. Implicit Costs Implicit Costs = implicit cost, also called an imputed cost, implied cost, or notional cost, is the opportunity cost equal to what a firm must give up in order to use factors which it neither purchases nor hires.opportunity cost Explicit Costs = An explicit cost is a direct payment made to others in the course of running a business, such as wage, rent and materials.

SU 8 - Marginal Analysis Accounting vs. Economic Profit See Utorial at http://www.khanacademy.org/economics-finance-domain/microeconomics/firm- economic-profit/economic-profit-tutorial/v/economic-profit-vs-accounting-profit Accounting Profit = book income exceeds book expenses Economic Profit = includes Accounting Profit + Implicit costs

SU 8 - Marginal Analysis Marginal Revenue and Marginal Cost Marginal Revenue is the additional or incremental revenue of one additional unit of output. See page 321 See that Marginal Revenue is $540 between generating 4 vs. 5 units of output. Marginal Cost is the additional or incremental cost incurred of one additional unit of output. Note that while cost decrease over some range they will at some point begin to increase due to the process becoming lest efficient. Profit Maximization is where MR = MC (see page 322)

SU 8 - Marginal Analysis Short-Run Cost Relationship See graph on page 323 Other considerations/applications of CVP Make-or-Buy Capacity Constraints and Product Mix Disinvestments Sell-or-Process further

SU 8 - Short-run Profit Maximization Pure Competition - A market structure in which a very large number of firms sell a standardized product into which entry is very easy in which the individual seller has no control over the product price and in which there is no nonprice competition; a market characterized by a very large number of buyers and sellers. Examples: Agricultural products Monopoly - A market structure in which one firm sells a unique product into which entry is blocked in which the single firm has considerable control over product price and in which non-price competition may or may not be found. Examples: Public utilities

SU 8 - Short-run Profit Maximization Monopolistic Competition - A market structure in which many firms sell a differentiated product into which entry is relatively easy in which the firm has some control over its product price and in which there is considerable non-price competition. Examples are grocery stores and gas stations Oligopoly - A market structure in which a few firms sell either a standardized or differentiated product into which entry is difficult in which the firm has limited control over product price because of mutual interdependence (except when there is collusion among firms) and in which there is typically non- price competition.

SU 8 - Short-run Profit Maximization Law of Demand - Law of demand states that ' all other things remaining unchanged, people demand (buy) more of any good / service if the price of that good / service falls and demand (buy) less if the price increases. Elasticity of demand measures how responsive a products demand is to changes in its price level. When we have inelastic demand, a consumer will pay almost any price for the good. Generally goods which have elastic demand tend to have many substitutes Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. Elasticity > 1 : elastic (% change in demand is greater than % change in price e.g. luxury goods such as cars etc.) Elasticity < 1 : inelastic (% change in demand is less than % change in price e.g. essential goods such as food) Elasticity = 1 : unitary elastic (% change in demand is equal to the % change in price)

SU 9 - Decision Making: Applying Marginal Analysis Relevant = be made in the future (not SUNK costs) Committed costs are not part of the decision making process Relevant = differ among the possible alternative courses of action Relevant = avoidable costs (controllable = subject to Management decision / strategy) Relevant = incremental (marginal or differential) Relevant Range = incremental cost of an additional unit of output is the same. Outside range incremental cost change. Be careful using UNIT revenue and cost Emphasis to be on TOTAL relevant revenues and costs

SU 9 - Decision Making: Applying Marginal Analysis Marginal / Differential / Incremental Analysis Problem in CMA will be an evaluation of choices among courses of action What are the relevant and irrelevant costs? Quantitative analysis = ways in which revenues and costs vary with the option chosen. Focus on incremental rev & costs, not total rev & cost Example page 266 idle capacity (incremental impact) Compare Marginal revenue / Marginal Cost (contribution Margin) Fixed costs have already been absorbed

SU 9 - Decision Making: Applying Marginal Analysis Qualitative Factors to consider: -Pricing rules -Government Regulation -Cannibalization between products (stealing MS from yourself) -Outsourcing -Employee Morale

SU 9 - Decision Making: Applying Marginal Analysis Add-or-drop-a-segment decisions Disinvestment / capital budgeting decisions Marginal cost > Marginal revenue = Firm should disinvest 4 Steps to be taken: 1/ Identify fixed costs that will be eliminated if disinvesting 2/ Determine the revenue needed to justify continuing operations 3/ Establish the opportunity cost of funds that will be received 4/ Determine whether the carrying amount of the asset = economic value. If not revalue use market fair value and not carrying amount Cost of idle capacity is relevant cost. Special Orders when excess capacity No opportunity costs Accept order = Variable costs (Contribution Margin)

SU 9 - Decision Making Special Orders Special Orders when excess capacity exists Differential (marginal or incremental) cost must be considered. Page 268 Special Orders when no excess capacity exists Differential (marginal or incremental) cost must be considered. Page 268

SU 9 - Decision Making Make or Buy Make or Buy = insourcing or outsourcing (critical mass) Not enough capacity Outsource least efficient product Support services can be outsourced. Consider relevant costs to the investment decision Key variable is total relevant costs, not all total costs. Sunk cost & Costs that do not change between choices are irrelevant. Opportunity costs are considered when at full capacity. Capacity constraint Use marginal analysis maximize CM Product Mix Sell-or-Process Further Decisions sell at split off point or process Joint cost of product is irrelevant. Based on relationship between incremental cost and revenue

SU 9 - Price Elasticity of Demand Demand increases when Price goes down (in theory) Price of product and Quantity demanded are inversely related Price Elasticity of Demand = sensitivity % change in Q / % change in P Most accurate way to calculate elasticity = ARC method % Q / % P = [(Q1 Q2) / (Q1+Q2) ] / [(P1 P2) / (P1+P2)] Example page 297 # 19 Demand elasticity > 1 = elastic (small change in price = large change in quantity) Elasticity = 1 (unitary elastic) Elasticity < 1 = perfectly inelastic (large change in price = small change in quantity) Infinite = perfectly elastic (horizontal line) Firm has no influence on market price (pure competition) Equal to zero = perfectly inelastic (vertical line) Consumer will pay

SU 9 - Pricing Theory Pricing Objectives: profit maximization / target margin / forecasted volume / image (segmentation positioning) / stabilization Price-setting factors Supply & Demand = Economic (external factors) Type of market Customer perceptions Elasticity Competition Internal Factors Marketing & Mix Relevant cost Strategy Capacity

SU 9 - Pricing Theory External Factors Type of market (pure competition, monopolistic, oligopolistic or monopoly) Customer perceptions of price and value Price / demand relationship Competitors products, costs, prices and amount supplied. Timing of demand Cartels = illegal practice except in international markets Cartel = collusive oligopoly restrict output, charge higher $$

SU 9 - Pricing Theory Cost-based pricing differs from Target pricing (page 358) 4 basic formulas Target pricing Life cycle costing Market-based pricing What consumer will pay Competition-based pricing Going rate & Sealed bids New product pricing Skimming & Penetration pricing Pricing by intermediaries Markups & downs Price adjustments Geographical pricing Discounts & Allowances Discriminatory pricing Psychological pricing Promotional pricing Value Pricing International pricing

SU 9 - Pricing Theory Product-mix pricing Product line Optional product Captive product By-product Product bundle Illegal pricing Pricing products below cost Price discrimination among customers Collusive pricing Dumping

SU 9 - Pricing Theory Exercise page 300, questions 25 to 26

SU 9 - Risk Management 4 Types of Risk: Hazard risks insurable Financial risks interest rates Operational risks procedural failure Strategic risks global, political and regulatory Volatility and Time Capital adequacy = solvency (cash flows) / liquidity (reserves) Risk = severity of consequences + likelihood of occurrence 5 strategies for Risk response: Risk avoidance End the activity that establishes the risk Risk retention Acceptance of risk. Self insurance Risk reduction - Mitigation Risk sharing Moving risk to 3 rd party Insurance, hedging, JV Risk exploitation Deliberately entering to pursue high return.

SU 9 - Risk Management Residual risk The risk that remains after the effects of avoidance, sharing, or mitigation efforts. Inherent risk The risk that arises for the activity itself. Benefits: -Efficient use of resources -Fewer surprises -Reassuring investors 5 Key Steps in Risk Management Process 1/ Identify risks 2/ Assess risks 3/ Prioritize risks 4/ Formulate risk responses 5/ Monitor risk responses Risk appetite

SU 9 - Risk Management Hazard risk management Insurance Financial risk management Hedging Sinking funds Rigid policies (maturity matching) Qualitative risk assessment tools Identification Ranking Mapping Quantitative risk assessment tools Value at risk (VaR) Page 364

SU 9 Price elasticity and demand 9.4 Understand the difference in effect between an Change in Price Page 271 Change in Demand Page 271 Price Elasticity of Demand Percentage change in Quantity Demanded Percentage change in price See Price Elasticity of Demand Graph on page 272 and understand between Elastic Inelastic

SU 10 The Capital Budgeting Process Definition Planning and controlling investment for long-term projects. Capital budgeting unlike other considerations will affect the company for many periods going forward long-term, multiple accounting periods, relatively inflexible once made. Predicting the need for future capital assets is one of the more challenging task, which can be affected by: Inflation Interest rates Cash availability Market demands Production capacity is a key driver

SU 10 The Capital Budgeting Process Applications for capital budgeting Buying equipment Building facilities Acquiring a business Developing a product of product line Expanding into new markets Important to correctly forecast future changes in demand in order to have the correct capacity. Planning is crucial to anticipate changes in capital markets, inflation, interest rates and money supply.

SU 10 The Capital Budgeting Process Consider the tax consequences All decisions should be done on an after tax basis Considered costs in Capital Budgeting Avoidable cost May be eliminated by ceasing or improving an activity. Common cost Shared by all options and is not clearly allocable. Deferrable cost May be shifted to the future. Fixed cost Does not very within relevant range. Imputed cost May not have a specific cash outlay in accounting Incremental cost Difference in cost of two options.

SU 10 The Capi

Documents

CMA Part 2 Financial Decision Making Cram Session Ronald Schmidt, CMA, CFM Jim Clemons, CMA