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CMA Part 2

Financial Decision Making


Cram Session
Ronald Schmidt, CMA, CFM
Patti Burnett, CMA

CMA Exam & Gleim


CMA overview pages 3 6
Pass both parts within 3 years
Satisfy the experience requirements (see next page)
CPEs

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

Experience Requirements

Exam format
3 hrs - 100 multiple choice questions = approx. 1.5 minutes per question
(on average).
Find ways to bank time
Look for short-cuts
You will find that you most question do not seem easy, dont get
discouraged
You earn points for each question answered correctly
Some questions are test questions that carry no point value. You will not
know which ones they are
Extra time can be carried forward to the Essay portion

1 hr - 2 Essay questions with up to 8 sub-parts


You cant go back to multiple-choice part once you enter this portion of the
exam
Whatever you have typed on the screen will be saved as your answer,
irrespective if the timer runs out on you

Exam format
Topics
Financial Statement Analysis
Corporate Finance
Decision Analysis and Risk Management
Investment Decisions
Ethics

25%
25%
25%
20%
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 subparts
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.
2.
3.

4.
5.
6.

7.
8.

Misreading the requirement (stem) Read the question first


Not understanding what is required
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 subcalculations in your calculator).
Applying the wrong rule or concept
Being distracted by one or more of the answers the most common
wrong answers are the incorrect alternatives
Incorrectly eliminating answers from considerations read all answers
first, some are more correct or complete then others
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.
Employing bad intuition when guessing

The essays

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

Ref. Scenario for Essay Questions 9 -11

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

Answering multiple-choice questions is an effective method to study the material


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

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

Questions could be either Multiple Choice or Essay


Make sure you study the IMA Framework on Ethics, ref. the
IMA website, or following URL:
http://www.imanet.org/PDFs/Public/Press_Releases/STATEMENT%20OF%20ETHICAL%20PROFESSIONAL%20PRACTICE_2.2.12.pdf
http://www.imanet.org/resources_and_publications/ethics_center_helpline.aspx

Have it conceptually memorized.


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

SU 1 - Sarbanes-Oxley Act of 2002


Enron, Arthur Andersen
Extensive responsibilities on issuers / auditors
of publicly traded securities.
Sec 406(a) Senior financial officers Code of Ethics
Reasonably necessary to promote
Honest and ethical conduct
Full, fair, accurate, timely, and understandable disclosure
Compliance with governmental rules and regulations

SOX does not define ethics.

SU 1- Corporate Responsibility for Ethical


Behavior
Values and Ethics: From Inception to Practice
Responsible to : Foster a sense of ethics
Written code of Conduct and ethical behavior

Pervasive sense of ethical values has benefits.


White space vs. Gray area.

Tone at the top


Human capital - Doing the right thing.
Corporate culture
Ethics training

SU 1- Basic Financial Statements, their


users and limitations

Statement of Financial position Balance sheet


Single point in time, a few day changes a lot

Assets versus Liabilities and Equity


Contingent liabilities

Purpose of the Balance Sheet


It helps users assess the entitys liquidity, financial flexibility, profitability, and risk.
Proprietary theory owners equity Under the proprietary theory, revenues increase capital,
while expenses reduce it. Net income belongs to the owner, representing an increase in the
proprietor's capital.

Usefulness and Limitations

Historical cost vs. market value


Book value (def.?) does not reflect market value.
Estimates
Non-measurement of employees, reputations, etc.

SU 1- Basic Financial Statements, their


users and limitations
Companies financing structure
Liabilities
Current versus non-current assets (def., examples?)

Equity = Residual balance

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

Notes in the financial statement


Purpose
Types

Def. Real Accounts & Permanent Accounts

SU 1 - Statement of Cashflows
Understand:
Purpose
Indirect method vs. Direct method
Categories
Operating Activities direct and indirect
Investing Activities
Financing Activities

Two methods to report cash flows


Direct method (FASB req.)
Indirect method

See questions
31 page 53
33 page 54
34 page 55

SU 1 Statement of Income and Statement of


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

Transactions that matter and that dont

Transactions with owners


Prior-period adjustments
Items from other comprehensive income
Transfers to and from appropriated retained earnings
Adjustment made in a quasi-reorganization

SU 1 Statement of Income and Statement of


Retained Earnings
Cost of Goods
COGS
BI + COGM (Purchases for Retailer ) = GAFS EI = COGS

COGM (Purchases for Retailer)


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

Statement of Retained Earnings


Beg RE + NI Dividends = End RE
Dividends Paid or declared?

S
SU 1 Statement of Income and Statement of
Retained Earnings
Other Expenses
S, G & A
G & A incurred for the benefit of the organization as a
whole
Interest Expenses based on passage of time; effective
interest rate method
Irregular Items
Discontinued Operations = Income from operations, and gain/loss
from disposal of operations
Extraordinary Items = both usual in nature and infrequent in
occurrence in the environment in which the organization operates
Continued

SU 1 Statement of Income and Statement of


Retained Earnings

Comprehensive Income
Exclude from NI but included in OCI
Fair value changes of available-for-sale securities
Currency translations
Service cost, gains and losses not prev. recognized in
pension exp.

Must be displayed with other financial statements

SU 1 Common-Size Financial Statements


Percentages and Comparability
Restate financial statement line items in terms of
percentages of a given amount (baseline figure)
Percentage of net sales or Total Asses or Liabilities and
Equities
Easier to see differences between companies

Vertical and Horizontal Analysis


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

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

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 WalMart 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 dayto-day tasks such as collection of receivables and
management of inventory
Liquidity: companys ability to meet its shortterm obligations
Solvency: ability to meet long-term obligations
Profitability: companys ability to generate
profitable sales from its resources (assets)
Valuation: quantity of an asset or flow (earnings)
associated with ownership of a specified claim
(Share)

SU 2 - Liquidity Ratios
Liquidity is the firms ability to pay its current
obligations as they come due. - Short run
How easy is it to convert assets to cash.

Liquidity ratios relates liquid assets to current


liabilities.
Current assets converted to cash within 1 year or
operating cycle.
Current asset ratios Firms ability to operate in short
term.
Current assets/liabilities are shown in descending order of
liquidity.

SU 2 - Liquidity Ratios Working


Capital
Working capital is a measure of a companys
ability in the short run to pay its obligations.
Working capital is calculated as shown:
Current assets Current Liabilities
How much capital is left after paying current
obligations?

Net Working Capital ratio = Cur. Assets Cur.


Liab./Total Assets
Most conservative of working capital ratios.

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

Liquidity Ratios - Current Ratio


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

Current ratio = Current Assets / Current Liabilities


Most common liquidity measurement
Low ratio = Possible liquidity problems
High ratio = Management not investing assets

Should be proportional to the operating cycle.


Shorter operating cycles may justify lower ratio.
Converting to cash quicker.
LIFO lowers ratio.

Liquidity Ratios Quick Ratio and


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

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

Activity Measures - Receivables


A/R Turnover = Net credit sales / Ave. A/R
Efficiency of A/R collections.
High ratio : Customers pay promptly.
Highly seasonal should use monthly A/R average.

One of the assumption of this ratio is that sales occur evenly throughout the
year, therefore average A/R can be estimated using the average of beginning
and ending A/R balances.
When sales are seasonal or uneven, the beginning and ending balances may
not be indicative of the average A/R balance. This is one of the reasons that
most retailers have a fiscal year ending on January 31 and not December 31,
because the sales in that industry are seasonal.

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

Activity Measures
Inventory turnover = COGS / Ave. Inventory
Measures efficiency of inventory management.
High ratio : Quicker inventory turns
Inventory not obsolete, not carrying excess.

Highly seasonal should use monthly Inv. average.


LIFO valuation not comparable to other methods.
Inventory turnover is industry specific.
Grocery vs. Concrete

Days Sales in Inventory = Days in year/Inv.


Turnover
How many days sales are tied up in inventory.

Activity Measures - Payables


Accounts Payable Turnover = Purchases /
Ave. AP
Highly seasonal should use monthly Payables
average.

Days Purchases in Accounts Payable (DPO)


DPO =Days in year / AP Turnover
Compared to credit terms to determine if the
firm is paying within terms.
Continued

Activity Measures
Operating Cycle = DSI + DSO
The amount of time to convert inventory to cash.
Figure 2-2 Page 67

Cash Cycle = Operating Cycle DPO


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

Activity Measures
Fixed Assets Turnover Ratio = Net Sales / Ave. Net PP&E
How efficiently the company deploys its investment in plant
assets to generate revenues.
Higher turnover is preferable.
Affected by the capital intensiveness of the company and its
industry, by the age of the assets, and by depreciation
method used.

Total Assets Turnover Ratio = Net Sales / Ave. Total Assets


Higher turnover is preferable.
Exclude assets that do not relate to sales. Ex: investments

2.4 Solvency
Solvency is a firms ability to pay its noncurrent obligations
as they come due
Long-run as opposed to liquidity which focuses on short-term (current
items)

Firms capital structure incl.


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

Capital decisions have consequences


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

2.4 Solvency
Debt = creditors interest
= contractual obligations
Ret > cost of debt = > equity

Equity = permanent capital


Ret. uncertainty even with Pre. Stock

2.4 Solvency

Capital Structure Ratios


Total Debt to Total Capital Ratio

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

Debt to Equity Ratio

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

Long-term Debt to Equity Ratio

Long-term debt/Equity

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

TTL Liabilities/ TTL Assets

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

2.4 Solvency
Earnings Coverage
Times interest earned ratio
EBIT/Interest Expense

??? What does this tell a creditor


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

Earnings to Fixed Charges Ratio


EBIT + Interest portion of operating leases/Int. exp. + Int. portion of
operating leases + Div. on Pre. Stock
More conservative; shows all fixed charges

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

2.5 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

Quiz

Capital Structure Other considerations


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


Join 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. 79

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

Profitability 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

Profitability

Operating
Efficiency

Financial
Leverage

High Turnover Industries = retail, groceries volume


High Margin Industries = fashion, luxury rare,
customized
High Leverage Industries = financial sector, real estate

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

Tax Burden

Interest Burden

ROE = Tax burden X Interest burden X Margin X Turnover


X Leverage
ROE = Tax burden X ROA X Compound Leverage factor

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

Plowback rate = Net Income not distributed =


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

BEPS and DEPS


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

Diluted Earnings per Share: IACS is increased by the amounts that


would not have had to be paid if dilutive potential CS had been
converted:
Dividends on Convertible PS
After-tax interest on Convertible Debt
WACSO is adjusted (increased) by the weighted average number of
additional shares of CS that would have been outstanding if dilutive
potential CS had been converted
Page 132 # 19 and 20

Weighted average number of shares outstanding


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

Dividend Payout Ratio


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

Other Market-based Measures


Objective of Companies = increasing shareholder wealth
Earning Yield = Earning per Share / Market Price per Share

Dividend Payout Ratio = Dividends to CS / IACS


Is it better a high or low ratio?
Growing Companies, mature market, start-up?

Dividend Yield = Dividend per Share / Market Price per


Share

Effect of Accounting Changes


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

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

SU 3 Market Valuations Measures


Book value per share
Market/Book Ratio
Price/Earning Ratio
Price/EBITDA

SU 3 Earnings per Share and Dividend


Payout
EPS
Diluted Earnings per share

SU 3 Factors affecting Reported


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

Income
Revenues
Receivables and Inventories
Recognition Principles

SU 4 Risk and Return


Systematic
Unsystematic

Relationship between Risk and Return


Expected Rate of return calc. p. 146

Security Risk vs. Portfolio Risk


Specific Risk vs. Market Risk

SU 4 - CAPM
In order to measure how a particular security
contributes to the risk and return of a diversified
portfolio, investors can use CAPM.
CAPM quantifies the required return on a security by
relating the securitys level of risk to the average return
available in the market (portfolio)
Investors must be compensated for their investment in
2 ways:
Time value of money
Risk
Know the CAPM formula!

SU 4 Two types of Risk


Business Risk

Financial Risk

Indifference Curve

SU 4 - Standard Deviation
It measures the tightness of the distribution and
the riskiness of the investment
A large deviation reflects a broadly dispersed
probability distribution meaning the range of
possible returns is wide
The smaller the deviation, the tighter the
probability distribution and the lower the risk
The greater the deviation the riskier the
investment

SU 4 - Coefficients
It measures the degree to which any 2 variables
are related
Perfect positive correlation = +1 means that 2
variables always move together
Given perfect negative correlation, risk would in
theory be eliminated
In practice, the existence of market risk makes
the perfect correlation nearly impossible
The normal range for the correlation of 2
randomly selected stocks is 0.5 to 0.7. the result
is a reduction in risk, not elimination.

SU 4 - Covariance
Correlation coefficient of 2 securities can be
combined with their standard deviations to
arrive at their covariance
Covariance = measure of mutual volatility

SU 4 - Diversification and Beta


Portfolio Theory = balancing risk with return
Asset Allocation is a key concept: stocks, bonds, real estate,
cash, etc
The purpose of diversification is to reduce risk while maximizing
returns and therefore reducing market correlation

Expected rate of return of a Portfolio is the weighted


average of the expected rate of return of each individual
assets in the same portfolio

Specific risk = diversifiable risk = unsystematic risk


This risk can be potentially eliminated with diversification
Can risk be 100% eliminated?
Benefits of diversification become extremely low when > 20/30
stocks are held

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

SU 5 - Bonds
Term structure of interest rates
There are three main types of yield curve shapes:
Normal
Inverted
and flat (or humped). A normal yield curve (upward sloping) is
one in which longer maturity bonds have a higher yield
compared to shorter-term bonds due to the risks associated
with time.
The slope of the yield curve is also seen as important: the
greater the slope, the greater the gap between short- and
long-term rates.

SU 5 - Bonds
When plotting yield curves we hold the following
constant:

Default risk
Taxability
Callability
Sinking fund

SU 5 - Bonds
Features of Bonds
Par Value = Maturity amount = Face Amount
State rate = Coupon rate
Indenture = Terms

Issuing bonds takes time and money


> Risk = > Return (yield)
How can you mitigate some of the market
required return?

SU 5 - Bonds
Following are means to reduce the required
rate of return for bonds:
Sinking Fund payments to a segregated fund
which will equal the maturity value
Insured
Secured

SU 5 - Bonds
Advantages of Bonds
Interest is tax deductible
Retain corporate control

Disadvantages of Bonds

Interest is considered legal obligation


Raises risk level
Raises risk profiles
Contractual requirements (e.g. required debt to
equity)
Debt financing limits

SU 5 - Bonds
Types of Bonds
Maturity
Term bond single maturity
Serial bond

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

Redemption Provisions
Callable bonds by the issuer
Convertible bonds into equities

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

SU 5 - Bonds
Bond valuation and sales price
Several components to determining the fair price of a bond:

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

Stated versus Market rate


Mkt rate is = state rate
Mkt rate is < state rate
Mkt rate is > state rate

5.3 Corporate/Stock Valuation Methods P. 181

SU 5 Equity
Common Stock
Advantages to the issuer
No fixed dividend (Common Stock only)
No maturity date
Increases creditworthiness

Disadvantages to the issuer

No tax deductible distribution


Diluted controlling rights
Diluted earnings
Higher underwriting costs
Increase average cost of capital

What is a preemptive rights?

SU 5 Equity
Preferred Stock = hybrid of debt and equity
Advantages to the issuer
Form of equity
Does not dilute control
Superior earning still go to CS

Disadvantages to the issuer


No tax deductible distribution and therefore greater
cost to bonds
Dividends in arrears can cause issues

SU 5 Equity
Characteristics of Preferred Stock

Priority in assets and earnings


Potential accumulation of dividends
Convertibility
Participation
Par value
Redeemability
Voting rights
Callability
Maturity Sinking fund

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

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

Dividend per share


Cost of Capital dividend growth rate
See example on p 182

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

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

Per-share Ratios on page 183

SU 5 Cost of Capital - Current


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

SU 5.6 Cost of Capital - Current


Weighted Average Cost of Capital WACC
Target Capital Structure

Firms WACC is a single, composite rate of return on its


combined components of capital.

Min. WACC = Shareholder Wealth Maximizing


Impact of taxes on Capital Structure and Capital Decisions

SU 6 Working Capital
Working capital and types of capital policies?
Working capital (or current capital) generally refers to the funds
a company holds in current (short-term) asset accounts, and
includes cash, marketable securities, receivables, and
inventories.
Net working capital provides a measure of immediate liquidity
and indicates how much cash a firm has available to sustain and
build its business, and refers specifically (from an accounting
perspective ) to the difference between a firms current assets
and its current liabilities. Depending on a firms level of current
liabilities, the number may be positive or negative.

SU 6 Working Capital
Working Capital policies include:
Conservative = minimize risk = Higher current ratio & acid test ratio focuses on low-risk, low return working capital investment and
financing greater proportion of capital in liquid assets but at the
sacrifice of some profitability; uses higher-cost capital but
postpones the principal repayment of debt or avoids it entirely by
using equity; current assets will be much greater than current
liabilities.
Moderate = average risk - uses risk and return and financing
strategies that match the maturity of the assets with the maturity of
the financing; seeks a balance between current assets and current
liabilities.
Aggressive = more (max) risk = Lower current ratio & acid test ratio focuses on high profitability potential, despite the cost of high risk
and low liquidity. Capital being minimized in current assets versus
long-term investments ; higher levels of lower-cost short-term debt
and less long-term capital investments. With an aggressive policy,
current assets will be less than current liabilities.

SU 6 Working Capital
What is the optimal level of working capital?
Varies with industry!
Contrast a grocery chain which has to rotate its inventory
and probably has no receivables versus a manufacturer
Consequently ratios are only meaningful in terms of norms
and trends and relative its competitors or the industry it
which it operates

Permanent and Temporary Working Capital


Def. The minimum level of current assets maintained by
a firm (which could fluctuate with seasonality).
It should increase as the company grows
Permanent financed with long-term debt

SU 6 Cash Management
Managing the cash levels
What are the motives for holding cash?
Transactional
Precautionary
Speculative

What is the firms optimal cash?


Economic Order Quantity (EOQ) As applied to cash (as
opposed to inventory)
Questions you will have to answer
How much cash
Transaction cost
Return on marketable securities

SU 6 Cash Management
Cash Management EOQ Model P. 218
Review examples forecasting future cash
flows (see examples on page 219, very typical
test questions!)
Lockbox benefit analysis = Net Benefit from
Lockbox = Reduction in Float Opportunity Cost
+ Reduction in Internal Processing Costs Lockbox Processing Costs

SU 6 Marketable Securities
Management
Remember!
Companies invest in marketable securities for three main
reasons:
1.
2.
3.

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

SU 6 Receivable Management
Overview
A firm must balance default risk and sales
maximization

Basic Receivable Formulas


Average collection period (see example on page 224)
Accounts Rec. days vs. dollars (see page 224)

Assessing impact of a credit term change (see


example page 225)

SU 6 Inventory Management
Inventory management refers to the process of
determining and maintaining the required level of
inventory that will ensure that customer orders
are properly filled on time.
1.
2.
3.

What to order (or make)?


When to order (or make)?
How much to order (or make)?

Reasons for carrying inventory include:


Hedging against supply uncertainty
Hedging against demand uncertainty
Ensuring that operations are not interrupted (ref. JIT)

SU 6 Inventory Management
Inventory costs
Purchase cost actual invoice amounts
Carrying cost incl. Storage, Insurance, Security,
Inventory taxes, Depreciation or rent, Interest,
Obsolescence and/or spoilage and Opportunity
cost.

Inventory costs incl. - Ordering costs and 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 228

Economic order quantity (EOQ) Represents the optimum


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

SU 6 - Short-term Financing

Sources

Spontaneous Forms of Financing

Trade credit
Accrued expenses

Commercial banks, and


Market-based instruments

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

Short-term bank loans

In addition to trade credit sources


Increased risk
May not renew
Contractual restrictions
Prime interest rate best customers only

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

Effective Interest Rate on a 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

SU 7 - Financial Markets and Security Offerings


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

Money Markets
Dealer driven Dealer buy and sell at their own risk.
Dealer is principal in transaction vs. stockbroker is an
agent
Short term and marketable
Low default risk
Exist in New York, London, & Tokyo
Government T-bills, T-notes and bonds, Federal agency and S-T
tax exempt securities, Commercial paper, CDs US and
Eurodollar, Repurchase agreements, Bankers acceptances

Capital Markets LT debt & equities NY Stock


Exchange

SU 7 - Financial Markets and Security Offerings


Primary Markets, Secondary Markets and
Financial Intermediaries
Primary market IPO / Issuer receives the
proceeds
Secondary market Trading among investors
Pros
Company prestige
Increased liquidity of firms securities

Cons
Reporting requirement
Hostile takeovers

Provide market makers

SU 7 - Financial Markets and Security Offerings


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

Bonds US companies, federal, state, & local governments


Open-end investment company shares of mutual funds
New securities issues
Secondary stock distributions whether of not listed on the
exchange

NASD National Association of Securities Dealers


NASDAQ NASD Automated Quotation system
Transaction happen in virtual space
Price quotes and volume

Auction markets NY Stock Exchange


Transaction happen at NYSE by floor traders

Financial Intermediaries Use funds from savers


Banks, CUs, Insurance co., Pension funds, etc.

SU 7 - Financial Markets and Security Offerings


Efficient Markets Hypothesis
Current stock prices immediately and fully reflect all
relevant information. Impossible to obtain consistently
abnormal returns with fundamental or technical analysis.
Three forms of efficient markets hypothesis
1) Strong form
All public and private information is instantaneously reflected in
securities price.
Insider trading would not result in abnormal returns.

2) Semi-strong form
All publicly available data are reflected in security price, but private or
insider data are not immediately reflected.
Insider trading can result in abnormal returns.

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

Data does not support the strong form.

SU 7 - Financial Markets and Security Offerings


Investment Banking
Intermediary between businesses and capital providers.
Sell new securities | Business combinations | Brokers & Traders

With new securities - Help determine method of


issuance, pricing, distributing, advice, and certification.
Signal sourced, Negotiates deal sets price and fees
Sold by best efforts sales No guarantee
Underwritten deal IB purchases securities from issuer and
resells them
IB makes the process easier, because of resources and
reputation.
Buyers look to IB reputation for fair deals.

Structuring of the floatation.


Terms of arrangement, capital type and amount

Flotation costs Higher for common, then preferred,


lower for bonds.

SU 7 - Financial Markets and Security Offerings


IPOs
Advantages of going public
Raise additional funds, establish value in market, stock liquidity

Disadvantages
Costs, data public, shareholder information public, insider limitations,
earning growth pressure, stock price doesnt reflect firm net worth, loss of
control, growth brings move management control, shareholder costs

Steps involved in going public


Prefiling period Negotiate and agreements with underwriters. Buying or
selling securities is prohibited.
Apply to a stock exchange, pay fee, fulfill membership requirements,
Waiting period - File registration statement and prospectus with SEC. May
make oral offers to buy and sell securities. Tombstone ads
In large red ink Preliminary prospectus, date, and legend must be marked. SEC 20
day review period. Debug letter Fix or withdraw.
A Preliminary prospectus is called a Red-Herring

Post effective period Registration statement is effective. Securities may


be sold.

SU 7 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 Dividend Policy and Share Repurchase


Dividend dates
Date of declaration formal vote to declare a dividend. Dividend
becomes a liability to the company.
Date of record Shareholder on that date will receive the dividend.
2-6 weeks after Date of declaration

Date of distribution Dividend is paid. 2-4 weeks after date of record


Ex-dividend date Purchase before date will receive dividend
Established by stock exchange

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


dividend

Stock dividends vs. stock splits

More stock is issued, but no value increase or decrease occurs.


Stock dividend transfers amount from RE to Paid-in capital
Stock split no accounting entry
Lowers stock price

SU 7 Dividend Policy and Share Repurchase

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

Dividend Reinvestment Plans - DRPs or DRIPS


Dividends owed to shareholders are reinvested into
shares.

Insider Trading laws


SEC Rule 10b-5

Leases

SU 7 - Mergers and Acquisitions


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

Horizontal Companies of same business line merge.


Vertical Combine supplier with customer
Congeneric Related products or services
Conglomerate Unrelated companies merge.

Advantages and disadvantages

Acquisition Acquiring firm purchases all of 2nd firms assets or


stock.

Requires shareholder vote.


Hostile takeover
5% ownership of any stock class requires SEC filing.
Advantages and disadvantages
Proxy File with SEC 10 days prior, furnish shareholder with all material
subject to vote, The Proxy form, Proxies for Directors in Annual Report
Going private - LBO

SU 7 - Mergers and Acquisitions


Opposition to Combinations

Greenmail Targeted Repurchase


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

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

SU 7 - Mergers and Acquisitions


Motivations of mergers and subsequent
synergies

Undervaluation of firm
Managerial motivation
Break up Parts are worth more than the whole.
Diversification

Synergies
Combined firms are worth more than separate.

Operational
Financial
Reduced competition Antitrust
Strategic position
Tax benefits

SU 7 Dividend Policy and Share


Repurchase
7.2 Dividend Policy and Share Repurchase P.
265

SU 7 Currency Exchange Rates


7.5 Currency Exchange Rates Systems and
Calculations P. 279

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


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

Sales volume
Sales price
Product mixes
What else?

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

CVP analysis is done with what assumptions?


Cost and revenue relationships are predictable
Unit selling prices are constant
Changes in inventory are insignificant
Fixed costs remain constant over relevant range
(see slide 5 & 6)
Total variable cost change proportional with
volume (see slide 7 & 8)
Continued

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


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

Number of Local Calls

Total fixed costs


remain constant as
activity increases.

Monthly Basic Telephone


Bill per Local Call

Monthly Basic
Telephone Bill

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

Number of Local Calls

Cost per call


declines as
activity increases.

Total Costs

Cost per Minute

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

Minutes Talked

Total variable costs


increase as
activity increases.

Minutes Talked

Cost per Minute


is constant as
activity increases.

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

Total Cost in
1,000s of Dollars

20

* ** *
**

* *
* *

10

Estimated fixed cost = 10,000


0
0

Activity, 1,000s of Units Produced

Scatter Diagrams
in cost
in units

Unit Variable Cost = Slope =

Total Cost in
1,000s of Dollars

20

* ** *
**

* *
* *

10

Horizontal distance is the


change in activity.
0
0

Activity, 1,000s of Units Produced

Vertical
distance is
the change
in cost.

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 = 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

Remember
Computing the Break-Even Point
We have just seen one of the basic CVP relationships
the break-even computation.
Fixed costs
Break-even point in units =
Contribution margin per unit

Unit sales price less unit variable cost


($30 in previous example)

REMEMBER
COMPUTING THE BREAK-EVEN POINT
The break-even formula may also be
expressed in sales dollars.
Break-even point in dollars =

Fixed costs
Contribution margin ratio

Unit contribution margin


Unit sales price

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

Computing a Multiproduct
Break-Even Point
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.

SU 8 - CVP Analysis Multiproduct Calculations

Multiple Products (or Services)


S = FC + VC = Calculated Weighted Average Contribution Margin

See example page 318

SU 8 -CVP Analysis Choice of Product


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

SU 8 -CVP Analysis Special Order


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

SU 8 - Marginal Analysis

Accounting Costs vs. Economic Costs


Accounting Costs = The total amount of money or goods expended in an endeavor. It is money
paid out at some time in the past and recorded in journal entries and ledgers.

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

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

SU 8 - Marginal Analysis
Accounting vs. Economic Profit
See Utorial at http://www.khanacademy.org/economics-finance-domain/microeconomics/firmeconomic-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

Monopolistic Competition - A market structure in which many firms sell a


differentiated product into which entry is relatively easy in which the firm
has some control over its product price and in which there is considerable
non-price competition. Examples are grocery stores and gas stations

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

SU 8 - Short-run Profit Maximization

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

SU 9 - Decision Making: Applying Marginal


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

SU 9 - Decision Making: Applying Marginal


Analysis
Marginal / Differential / Incremental Analysis
Problem in CMA will be an evaluation of choices
among courses of action
What are the relevant and irrelevant costs?
Quantitative analysis = ways in which revenues
and costs vary with the option chosen.
Focus on incremental rev & costs, not total rev &
cost
Example page 347 idle capacity (incremental
impact)
Compare Marginal revenue / Marginal Cost
(contribution Margin) Fixed costs have already
been absorbed

SU 9 - Decision Making: Applying


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

SU 9 - Decision Making: Applying


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

4 Steps to be taken:
1/ Identify fixed costs that will be eliminated if 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 348

Special Orders when no excess capacity exists


Differential (marginal or incremental) cost must be
considered.
Page 349

SU 9 - Decision Making Make or Buy


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

Consider relevant costs to the investment decision


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

Capacity constraint Use marginal analysis maximize CM


Product Mix

Sell-or-Process Further Decisions sell at split off point or process


Joint cost of product is irrelevant.
Based on relationship between incremental cost and revenue

SU 9 - Price Elasticity of Demand


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

Most accurate way to calculate elasticity = ARC method


% Q / % P = [(Q1 Q2) / (Q1+Q2) ] / [(P1 P2) / (P1+P2)]
Example page 380 # 19

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


change in quantity)
Elasticity = 1 (unitary elastic)
Elasticity < 1 = perfectly inelastic (large change in price = small
change in quantity)
Infinite = perfectly elastic (horizontal line) Firm has no
influence on market price (pure competition)
Equal to zero = perfectly inelastic (vertical line) Consumer
will pay

SU 9 - Pricing Theory
Pricing Objectives: profit maximization / target
margin / forecasted volume / image (segmentation
positioning) / stabilization
Price-setting factors
Supply & Demand = Economic (external factors)

Type of market
Customer perceptions
Elasticity
Competition

Internal Factors

Marketing & Mix


Relevant cost
Strategy
Capacity

SU 9 - Pricing Theory
External Factors
Type of market (pure competition, monopolistic,
oligopolistic or monopoly)
Customer perceptions of price and value
Price / demand relationship
Competitors products, costs, prices and amount
supplied.

Timing of demand
Cartels = illegal practice except in international
markets
Cartel = collusive oligopoly restrict output, charge
higher $$

SU 9 - Pricing Theory

Cost-based pricing differs from Target pricing (page 358)


4 basic formulas
Target pricing
Life cycle costing

Market-based pricing What consumer will pay


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

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

SU 9 - Pricing Theory
Product-mix pricing

Product line
Optional product
Captive product
By-product
Product bundle

Illegal pricing

Pricing products below cost


Price discrimination among customers
Collusive pricing
Dumping

SU 9 - Pricing Theory
Exercise page 376
Questions 10 to 12

SU 9 - Risk Management
4 Types of Risk:

Hazard risks insurable


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

Volatility and Time


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

Risk avoidance End the activity that establishes the risk


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

SU 9 - Risk Management
Residual risk The risk that remains after the effects of
avoidance, sharing, or mitigation efforts.
Inherent risk The risk that arises for the activity itself.
Benefits:
- Efficient use of resources
- Fewer surprises
- Reassuring investors

5 Key Steps in Risk Management 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 351
Change in Demand Page 352
Price Elasticity of Demand
Percentage change in Quantity Demanded
Percentage change in price

See Price Elasticity of Demand Graph on page 353 and


understand between
Elastic
Inelastic

SU 10 The Capital Budgeting Process


Definition Planning and controlling investment for
long-term projects.
Capital budgeting unlike other considerations will affect
the company for many periods going forward long-term,
multiple accounting periods, relatively inflexible once
made.
Predicting the need for future capital assets is one of the
more challenging task, which can be affected by:

Inflation
Interest rates
Cash availability
Market demands

Production capacity is a key driver

SU 10 The Capital Budgeting Process


Applications for capital budgeting

Buying equipment
Building facilities
Acquiring a business
Developing a product of product line
Expanding into new markets

Important to correctly forecast future changes in demand


in order to have the correct capacity.
Planning is crucial to anticipate changes in capital markets,
inflation, interest rates and money supply.

SU 10 The Capital Budgeting Process


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

Considered costs in Capital Budgeting


Avoidable cost May be eliminated by ceasing or
improving an activity.
Common cost Shared by all options and is not clearly
allocable.
Deferrable cost May be shifted to the future.
Fixed cost Does not very within relevant range.
Imputed cost May not have a specific cash outlay in
accounting
Incremental cost Difference in cost of two options.

SU 10 The Capital Budgeting Process


Opportunity cost Maximum benefit forgone based
on next alternative, including that of the stockholders
(which also establishes the firms hurdle rate).
Relevant cost Vary with action. Constant cost dont
affect decision.
Sunk Cannot be avoided.
Weighted-average Cost of Capital Weighted average
of the interest cost of debt (net of tax) and the costs
(implicit or explicit) of the components of equity
capital to be invested in long-term assets. It is also
the hurdle rate.

SU 10 The Capital Budgeting Process


Stages in Capital Budgeting
Identification and definition Id What is the strategy?
Definition Define the projects Revenue, costs, and cash flow
Most difficult stage

Search Each investment to be evaluated be each function of the firms


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

Selection Increase shareholder value. NPV, IRR..


Financing Debt or equity
Implementation and monitoring Feedback and reporting

SU 10 The Capital Budgeting Process


Investment Ranking Steps
Determine Net Investment Costs Gross cash requirement less cash
recovered from trade or sale of existing assets, adjusted for taxes
Investment required includes funds to provide for increases in working
capital, i.e. additional receivables and inventories.

Calculating estimated cash flows

Capture increase in revenue, decrease costs


Net cashflow period by period from investment
Economic life of the investment
Depreciable life

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


Continued

SU 10 The Capital Budgeting Process


Ranking investments NPV, IRR, Payback
Other considerations
Book Rate of Return

GAAP NI from Investment


Book Value of Investment

Also called accrual accounting rate of return


Dont use accrual accounting numbers, instead use cash flow
Reason Net Income are affected by companys choices of
accounting methods
Also, do not compare project book rate to companys book rate of
return for investments which could be distorted
Continued

SU 10 The Capital Budgeting Process


Relevant cash flows
Net initial investment
New equipment cost
Working capital requirements,
After tax disposals proceeds
Annual net cash flows
After tax cash collections for operations
Depreciation tax savings
Project termination cash flows
After tax disposal
Working capital recovery

See example on page 393

SU 10 The Capital Budgeting Process


Other Considerations
Inflation Raises hurdle rate.
Post-audits Deterrent of bad projects.
Actual to expected cashflow
Identify sources of unrealistic estimates
Avoid premature evaluations of projects
Non-quantitiative benefits

SU 10 - Discounted Cash flow Analysis


Time Value of Money
Concepts A dollar received in the future is worth less
than today.
Present Value (PV) Value today of future payment
Future Value (FV) Future value of an investment today.
Annuities equal payments at equal intervals
Ordinary annuity (in arrears)
Annuity due (in advance) PV & FV is always greater than ordinary
annuity

See examples on page 394 through 396

SU 10 - Discounted Cash flow Analysis


Hurdle rate Goal is for companies discount rate
to be as low as possible.
WACC or Shareholders opportunity cost of capital.
The lower the firms discount rate, the lower the
hurdle the company must clear to achieve
profitability

Net Present Value (NPV) Project return in $$


See example on 397

SU 10 - Discounted Cash flow Analysis


Internal Rate of Return (IRR) Project return
in %
+
+
IRR shortcomings

Directional changes of cash flows


Mutually exclusive projects
Varying rates of return
Multiple investments

SU 10 - Discounted Cash flow Analysis


Cash flows and discounting
NPV =

Cash flow0
(1 + r)0

Cash flow1 Cash flow2


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

Comparing Cash flow Patterns Pg 399

SU 10 - Discounted Cash flow Analysis


NPV vs IRR comparison
Reinvestment rate NPV assumes the cash flow can be reinvested at projects
discount rate.
Independent projects:
NPV and IRR give same accept/reject decision if projects are independent.
All acceptable independent projects can be undertaken.

Mutually exclusive projects.

Cost of one greater than other


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

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

Select greatest NPV over greatest IRR

SU 10 - Payback and discounted payback


Payback period = Number of years to pay for
itself.
Pro - Simple
Cons - No consideration for time value of money.
Does not consider cash flow after payback period.

Payback and constant cash flows vs variable


cash flows
See example on page 402

SU 10 - Payback and discounted payback


Discounted payback method is used to
overcome the payback methods disregard for
time value of money
Pro More conservative yet still simple
Con Does not consider cash flow after payback
period.

See example on page 403

SU 10 - Payback and discounted payback


Other payback methods
Bailout payback = Considers salvage value
Payback reciprocal (1 divided by payback)
estimate of IRR
Breakeven time = Time require for discounted
cash flows to = 0.
Alternative is to consider the time required for the
present value of the cumulative cash inflows to equal
the present value of all the expected future cash flows

SU 10 - Ranking investment projects


Why should we rank investment projects
Capital rationing
Reasons include lack of financial resources, control
estimation bias, and unwillingness to issue new equity
(to raise new capital)

SU 10 - Ranking investment projects


Methods
Profitability index = NPV / Net Investment
See example on page 404

Internal capital markets Internal funding

Linear programming Technique for optimizing


resource allocation.

SU 10 - Risk Analysis and real options in Capital


Investments
Risk analysis Attempt to measure the variability of future
returns from proposed investment.
Informal method NPV is calculated and reviewed.
Risk-adjusted discount rates Adjust rate of return upwards as
project becomes more risky.
Certainty equivalent adjustments- from Utility theory the
point where you are indifferent to a choice between a certain
sum of money and the expected value of a risky sum.
Simulation analysis Computer is used to generate many
results based upon various assumptions.
Pilot plants

Sensitivity analysis An iterative process of recalculated returns


based on changing assumptions.

SU 10 - Risk Analysis and real options in Capital


Investments
Real (managerial or strategic) options
Value of a real option The difference between the
projects NPV with the option vs. without the option.
Usually more valuable the later it is exercised.

Types of real options:

Abandonment (Put option)


Follow-up investment
Wait and Learn (call option)
Flexibility option vary an input
Capacity option vary an output
New geographical markets
New product option follow on products