BEC 2 Unit Outline

BEC 2
Unit Outline

Module 1—Capital Structure: Part 1

Capital Structure Components
 An entity's capital structure is the mix of debt (long-term and short-term) and equity (common and
preferred) used to finance operations and growth.
Weighted Average Cost of Capital
 A firm's weighted average cost of capital (WACC) is calculated using the weighted proportion of the
entity's after-tax cost of debt, preferred stock, and common equity. Equity cost may be the cost of
internal retained earnings or issuing new common stock. WACC is often used as a "hurdle" rate in
capital investment decisions.
 The cost of retained earnings can be calculated using the capital asset pricing model (CAPM),
discounted cash flow (DCF), or bond yield plus risk premium (BYRP) method.

Module 2—Capital Structure: Part 2

Optimal Capital Structure
 The optimal capital structure is the one that produces the lowest WACC for the firm.
Asset Structure
 A firm's capital structure relates to the debt and equity components of its balance sheet; asset
structure relates to the composition of assets on its balance sheet.
Loan Covenants and Capital Structure
 Lenders use debt covenants to protect their interests by limiting or prohibiting the actions of
borrowers that might negatively affect the position of the lenders.
Growth and Profitability
 Both growth and profitability are affected by an entity's capital structure.
 Growth rate (g) is calculated as [the retention ratio (rr) times return on assets ROA)] divided by [1 –
(the retention ratio times ROA)].
 Key measures of a firm's profitability include return on investment (ROI), return on assets (ROA), and
return on equity (ROE). Net income is in the numerator of each of these profitability ratios.
Leverage and Risk
 Operating leverage measures the effect on a firm's profitability caused by a change in sales. Firms
that rely more heavily on fixed costs as opposed to variable costs will have higher leverage. High
leverage means greater return on the upside with higher risk on the downside.
 Financial leverage is the degree to which a firm uses debt to finance operations. High financial
leverage means high risk/return.
Impact of Capital Structure on Financial Ratios
 An entity's solvency, or ability to meet its long-term obligations, is affected by the amount of debt in its
capital structure.

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 BEC 2 Unit Outline

Module 3—Working Capital Metrics

Working Capital
 Working capital policy and working capital management involve managing cash so a company can
meet its short-term obligations.
Working Capital Ratios
 The current ratio demonstrates a firm's ability to generate cash to meet its short-term obligations.
 The quick ratio is a more rigorous test of liquidity than the current ratio because inventory and prepaid
assets are excluded from current assets.
 The cash conversion cycle (CCC) measures the time from cash outlay to cash collection in days. The
CCC period can be shortened by increasing inventory turnover, collecting receivables more quickly,
or deferring remittances on payables for a longer period.
 The candidate should be able to calculate the CCC using the formula that includes inventory turnover,
accounts receivable turnover, and accounts payable turnover, converted to a 365-days basis.

Module 4—Working Capital Management: Part I

Inventory Management
 Inventory is valued at lower of cost or market (or net realizable value).
 When a periodic inventory system is used, inventory quantities are determined by physical counts
performed at least on an annual basis. In a perpetual inventory system, the inventory balance is
updated for each purchase and sale, making it always current.
 Inventory valuation depends on the inventory system used and the cost flow assumption (specific
identification, FIFO, LIFO, weighted average, moving average) selected by the company.
Inventory Management Strategies
 Inventory management attempts to balance the costs of carrying inventory against the costs of
"stocking out."
 Safety stock, reorder point, and economic order quantity (EOQ) are tools used to control inventory
quantities.
 Technology has made significant improvements in inventory control possible. Materials requirement
planning (MRP), just-in-time, and Kanban are some of these contemporary techniques.
Supply Chain Management/Integrated Supply Chain Management (ISCM)
 A supply chain management (SCM) system is the integration of business processes from the
customer to original supplier.
Accounts Payable Management
 Trade credit (or accounts payable) is usually the largest source of short-term credit for small firms.
Trade credit involves purchasing goods or services from a vendor with payment due 30–45 days after
the transaction.
 Methods to delay disbursements include requesting a payment deferment from the vendor and using
a bank line of credit to make payments to the vendor.

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 BEC 2 Unit Outline

Module 5—Working Capital Management: Part 2

Cash and Credit Management
 Motives for holding cash are transaction, speculation, and precautionary related.
 Effective cash management synchronizes inflows and outflows. Float, overdraft protection, and
compensating balances are additional tools for cash management.
Accounts receivable management involves effectively balancing credit and collection policies to
optimize the average collection period and number of days' sales in receivables. A company can also
factor (sell) its receivables to get cash more quickly; however, this is generally costly and only should
be used if no other alternatives are available.
Corporate Banking Arrangements
 A letter of credit represents a third-party guarantee (usually a bank) of a financial obligation incurred
by a company.
 A line of credit is a revolving loan with a bank or group of banks that is up to a maximum dollar
amount and is renewable on the maturity date.
 Institutional short-term credit arrangements usually will contain many covenants and rate provisions
(fixed versus variable). In general, these vary with the creditworthiness of the borrower and must be
disclosed in the entity's financial statements.
Financing Decisions and Working Capital
 Short-term financing, because it generally carries lower interest rates than long-term financing, offers
the advantages of increased liquidity, lower financing costs, and increased profitability.
Disadvantages are increased interest rate risk and decreased capital availability.
 The advantages of long-term financing include decreased interest rate risk and increased capital
availability; the disadvantages include decreased liquidity and increased financing costs (lower
profitability).

Module 6—Financial Valuation Methods: Part 1

Security Valuation
 Absolute valuation models assign an intrinsic value to an asset based on the present value of its
future cash flows.
 An annuity is a series of equal cash flows to be received over a number of periods. When the periodic
cash flows paid by an annuity last forever, the annuity is called a perpetuity or perpetual annuity.
 The dividend discount model (DDM) assumes that dividend payments are the cash flows of an equity security
and that the intrinsic value of the company's stock is the present value of the expected future dividends.
 Relative valuation models use the value of comparable stocks to determine the value of similar
stocks. Price multiples are useful metrics in relative valuation.
 The P/E ratio is the most widely used price multiple when valuing equity securities. The rationale for
using this measure is that earnings are a key driver of investment value.
 The PEG ratio is a measure that shows the effect of earnings growth on a company's P/E, assuming
a linear relationship between P/E and growth.
 The price-to-sales ratio can be used to estimate the current stock price. The rationale for using this
ratio is that sales are less subject to manipulation than earnings.
 The price-to-cash-flow ratio can also be used to calculate the current stock price.
 The price-to-book (P/B) ratio is another price multiple used by analysts that focuses on the balance
sheet rather than the income statement or statement of cash flows.

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 BEC 2 Unit Outline

Module 7—Financial Valuation Methods: Part 2

Option Pricing Models
 An option is a contract that entitles the owner (holder) to buy (call option) or sell (put options) a stock
(or some other asset) at a given price within a stated period of time.
 A commonly used method for option valuation is the Black-Scholes model. The calculation is
extremely complex. The Black-Scholes model considers the value of the underlying security at one
point in time.
 Another option pricing model is the binomial or Cox-Ross-Rubinstein model. The binomial model
considers the underlying security over a period of time.
Valuing Debt Instruments
 The value of a bond is equal to the present value of its future cash flows. The cash flows may be
discounted using a single interest rate or multiple interest rates aligned with the degree of risk for
each cash flow.
Valuing Tangible Assets
 Tangible assets (property, plant, and equipment) can be valued using the cost method, the market
value method, the appraisal method, or liquidation value.
Valuing Intangible Assets
 Intangible assets can be valued using the market approach, income approach, or cost approach.
Valuation Using Accounting Estimates
 Certain financial statement line items are valued using accounting estimates.

Module 8—Financial Decision Models: Part 1

Cash Flows Related to Capital Budgeting
 After-tax cash flows over the life of the project, both direct and indirect, are analyzed in the capital
budgeting process. When a company pays out cash, receives cash, or makes a cash commitment
that is directly related to the capital investment, that effect is termed the direct effect. Indirect cash
flow effects include transactions that are indirectly associated with a capital project or represent a
noncash activity that produces cash benefits or obligations.
 Stages of cash flows in a capital investment project include the inception of the project (at time period
zero), the ongoing periodic cash flows generated by the project, and the terminal value associated
with the disposal or winding down of a project.
 The candidate should know the steps in calculating a capital budgeting project's annual after-tax cash
flows, including: estimating net cash inflows; subtracting noncash tax deductible expenses to arrive at
pretax income; computing income tax expense based on the tax rate; and subtracting tax expense
from net cash inflows to derive after-tax cash flows.
Discounted Cash Flow (DCF)
 DCF valuation methods determine the present value of all expected future cash flows using a
predetermined discount rate (e.g., WACC, required rate of return).
Net Present Value Method (NPV)
 The net present value (NPV) method compares the PV of future cash flows to the initial investment. If
NPV is positive, the investment should be made. If NPV is negative, the investment should not be made.
 NPV method is flexible and can be used when there is no constant rate of return required for each
year of the project.

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 BEC 2 Unit Outline

 Even though NPV is considered the best single technique for capital budgeting, the net present value
method is limited by not providing the true rate of return on the investment.
 Capital rationing attempts to spend limited (rationed) funds in the most efficient manner in order to
select the combination of projects that will maximize net present value.
 The profitability index (PI) divides the PV of the net future cash flows by the initial investment. The
profitability index is computed for each project alternative with each project ranked in order of the
highest score. Projects with a PI < 1.0 are undesirable.

Module 9—Financial Decision Models: Part 2

Application of NPV: Lease-vs.-Buy Decisions
 The NPV method can be used to evaluate lease-vs.-buy decisions. The important issue for financial
decision-making is the cash flows created by a lease, as compared with purchasing the asset.
Internal Rate of Return (IRR)
 The internal rate of return (IRR) method determines the present value factor (and related interest
rate) that yields an NPV equal to zero. Only projects with an IRR greater than the hurdle rate should
be accepted.
 The IRR method has several limitations, including an unreasonable reinvestment assumption (cash
flows reinvested at the IRR) and inflexible cash flow assumptions (alternating positive and negative
cash flows create IRR errors), and it is a relative measure that is compared to a hurdle rate (versus
NPV, which provides the absolute dollar contribution of the project).
Payback Period Method
 The payback period method calculates the time it will take to recover the initial investment,
disregarding time value of money.
 The advantages of the payback period method are that it is easy to use and understand and that it
emphasizes liquidity. However, the payback period method ignores the time value of money and total
project profitability (cash flows after the payback period).
Discounted Payback Method
 The discounted payback period method uses PV factors to discount the expected cash flows. This
method also ignores the total profitability of the entire project.

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Registered to Daljeet Singh (#1410156)