Corporate Finance

Capital Budgeting
The four administrative steps in the capital budgeting process are: Idea generation,
Analyzing project proposals, Creating the firm-wide capital budget & Monitoring
decisions and conducting a post-audit.
Mandatory regulatory or environmental projects may be required by a governmental
agency or insurance company and typically involve safety-related or environmental
concerns. The projects typically generate little to no revenue, but they accompany other
new revenue producing projects and are accepted by the company in order to continue
operating.
b Financing costs are reflected in a projects required rate of return. Project specific
financing costs should not be included as project cash flows. The firm's overall weighted
average cost of capital, adjusted for project risk, should be used to discount expected
project cash flows.
The timing of expected cash flows is important for making correct capital budgeting
decisions. Capital budgeting decisions account for the time value of money. Capital
budgeting decisions should be based on incremental after-tax cash flows, not net
(accounting) income.
The five key principles of the capital budgeting process are: Decisions are based on cash
flows, Cash flows are based on opportunity costs, The timing of cash flows is important,
Cash flows are analyzed on an after-tax basis & Financing costs are reflected in the
projects required rate of return.
Cash flows are based on opportunity costs. Any cash flows that the firm gives up because
a project is undertaken should be charged to the project.
The marketing study for a new product is a sunk cost, and the possible increase in sales of
a related product is an example of a positive externality.
c Mutually exclusive means that out of the set of possible projects, only one project can
be selected. Given two mutually exclusive projects, the company can accept one of the
projects or reject both projects, but cannot accept both projects.
Independent projects are projects for which the cash flows are independent from one
another and can be evaluated based on each projects individual profitability. If the
projects were mutually exclusive, only one of the two projects could be accepted. Project
sequencing means that investing in a project today creates the opportunity to decide to
invest in a related project in the future.
Capital rationing exists when a company has a fixed (maximum) amount of funds to
invest. If profitable project opportunities exceed the amount of funds available, the firm
must ration, or prioritize its funds to achieve the maximum value for shareholders given
its capital limitations.
Projects are often sequenced through time so that investing in a project today may create
the opportunity to invest in other projects in the future. Note that funding from the first
project is not a requirement for project sequencing.

d In the process of capital budgeting, a manager is making decisions about a firms

earning assets, which provide the basis for the firms profit and value. Capital budgeting
refers to investments expected to produce benefits for a period of time greater than one
year. Financial restructuring is done as a result of bankruptcy and monitoring is a critical
assessment aspect of capital budgeting.
The decision rules for net present value, profitability index, and internal rate of return are
to invest in a project if NPV > 0, IRR > required rate of return, or PI > 1.
The payback period is the number of years it takes to recover the original cost of the
investment. The payback period does not take any cash flows after the payback point into
consideration.
e The project that maximizes the firm's value is the one that has the highest positive NPV.
For independent projects the IRR and NPV give the same accept/reject decision. For
mutually exclusive projects the IRR and NPV techniques can yield different accept/reject
decisions.
The multiple IRR problem occurs if a project has non-normal cash flows, that is, the sign
of the net cash flows changes from negative to positive to negative, or vice versa. For the
exam, a shortcut to look for is the project cash flows changing signs more than once.
IRR is the rate of return for which the NPV of a project is zero.
The IRR method assumes all future cash flows can be reinvested at the IRR. This may not
be feasible because the IRR is not based on market rates. The NPV method uses the
weighted average cost of capital (WACC) as the appropriate discount rate.
If the NPV for two mutually exclusive projects is negative, both should be rejected.
The NPV method is always preferred over the IRR, because the NPV method assumes
cash flows are reinvested at the cost of capital. Conversely, the IRR assumes cash flows
can be reinvested at the IRR. The IRR is not an actual market rate.
The crossover rate is the rate at which the NPV for two projects is the same. That is, it is
the rate at which the two NPV profiles cross.
The IRR encounters difficulties when cash outflows occur throughout the life of the
project. These projects may have multiple IRRs, or no IRR at all. Neither the NPV nor
the PI suffer from these limitations.
Net present value is the preferred criterion when ranking projects because it measures the
firms expected increase in wealth from undertaking a project.
When the NPV = 0, this means the discount rate used is equal to the IRR. If a discount
rate is used that is higher than the IRR, the NPV will be negative. Conversely, if a
discount rate is used that is lower than the IRR, the NPV will be positive.
NPV and IRR lead to the same decision for independent projects, not necessarily for
mutually exclusive projects. IRR assumes that cash flows are reinvested at the IRR rate.
IRR does not ignore time value of money (the payback period does), and the investor
may find multiple IRRs if there are sign changes after time zero (i.e., negative cash flows
after time zero).
Projects with unconventional cash flows (where the sign of the cash flow changes from

minus to plus to back to minus) will have multiple internal rates of return. However, one
will still be able to calculate a single net present value for the cash flow pattern.
The multiple IRR problem occurs if a project has an unconventional cash flow pattern,
that is, the sign of the cash flows changes more than once (from negative to positive to
negative, or vice-versa). Only Project South has this cash flow pattern. Neither the zero
cash flow for Project West nor the likely negative net present value for Project East
would result in multiple IRRs.
As discount rates change the net present values change. The NPV profile is a graphic
illustration of how sensitive net present values are to different discount rates. By
comparison, every project has a single internal rate of return and payback period because
the values are determined solely by the investments expected cash flows.
Where the NPV intersects the vertical y-axis you have the value of the cash inflows less
the cash outflows, assuming an absence of money having a time value (i.e., the discount
rate is zero). Where the NPV intersects the horizontal x-axis you have the projects
internal rate of return. At this cost of financing, the cash inflows and cash outflows offset
each other. The NPV profile is a tool that graphically plots the projects NPV as
calculated using different discount rates. Assuming an appropriate discount rate, one
should accept all projects with positive net present values, if the projects are independent.
If projects are mutually exclusive select the one with the higher NPV at any given level
of the cost of capital.
f Private, European and smaller firms tend to favor payback period. The more highly

educated a firms management, the more likely it is to use a DCF capital budgeting
technique as its primary tool.
Despite the theoretical superiority of the NPV and IRR methods for determining and
ranking project profitability, surveys of corporate managers show that a variety of
methods are used. Firms that use the NPV and IRR methods tend to be larger, publiclytraded, companies. Despite the theoretical superiority of the NPV and IRR methods for
determining and ranking project profitability, surveys of corporate managers show that a
variety of methods are used. Firms that were most likely to use the payback period
method were European firms and management teams with less education.
g Stock prices reflect investor expectations for future investment and growth. A new
positive-NPV project will increase stock price only if it was not previously anticipated by
investors.

Cost of Capital
The cost of preferred equity capital is the preferred dividend divided by the price of
preferred shares.
After-tax cost of debt = bond yield tax savings = kd kdt = kd(1 t)
WACC = (Wd)(Kd (1 t)) + (Wps)(Kps) + (Wce)(Ks)
WACC = [wd kd (1 t)] + (wps kps) + (wce ks)
WACC = (E / V)(ks) + (D / V)(kdebt)(1 t), where V = debt + equity
An increase in either the companys beta or the market risk premium will cause the
WACC to increase using the CAPM approach. A reduction in the market risk premium

will reduce the cost of equity for WACC.

Equity and preferred stock are not adjusted for taxes because dividends are not deductible
for corporate taxes. Only interest expense is deductible for corporate taxes.
The order from cheapest to most expensive is: debt, preferred stock (which acts like a
hybrid of debt and equity), and common equity.
Then, using the formula for WACC = (wd)(kd) + (wps)(kps) + (wce)(kce)
where wd, wps, and we are the weights used for debt, preferred stock, and common
equity.
ks = D1 P0 + growth kce = (D1 / P0) + g
The cost of preferred stock (kps) = Dps / P
CAPM = RE = RF + B(RM RF)
b In the U.S., interest paid on corporate debt is tax deductible, so the after-tax cost of debt
capital is less than the before-tax cost of debt capital. Dividend payments are not tax
deductible, so taxes do not decrease the cost of common or preferred equity.
A company creates value by producing a higher return on its assets than the cost of
financing those assets. As such, the WACC is the cost of financing a firms assets and can
be viewed as the firms opportunity cost of financing its assets.
Since a firms WACC reflects the average risk of the projects that make up the firm, it is
not appropriate for evaluating all new projects. It should be adjusted upward for projects
with greater-than-average risk and downward for projects with less-than-average risk.
c The optimal capital budget is determined by the intersection of a firms marginal cost of
capital curve and its investment opportunity schedule. A break point occurs at a level of
capital expenditure where one of the component costs of capital increases. If a firms
capital structure remains constant, the MCC (WACC) increases as additional capital is
raised.
The weighted average cost of capital (WACC) should be based on market values for the
firms outstanding securities. A firms marginal cost of capital, or WACC, is only
appropriate for computing a projects NPV if the project has the same risk as the firm.
d The marginal cost refers to the last dollar of financing acquired by the firm assuming
funds are raised in the same proportion as the target capital structure. It is a percentage
value based on both the returns required by the last bondholders and stockholders to
provide capital to the firm. Regardless of whether the funding came from bondholders or
stockholders, both debt and equity are needed to fund projects.
The marginal cost of capital represents the cost of raising an additional dollar of capital.
The cost of retained earnings would only be appropriate if the company avoided creditorsupplied financing or the issuance of new common or preferred stock (and preferred
stock financing). The after-tax cost of debt is never sufficient, because a business,
regardless of their size, always has a residual owner, and hence a cost of equity. [96615]
e The WACC is the appropriate discount rate for projects that have approximately the
same level of risk as the firms existing projects. This is because the component costs of
capital used to calculate the firms WACC are based on the existing level of firm risk. To

evaluate a project with above (the firms) average risk, a discount rate greater than the
firms existing WACC should be used. Projects with below-average risk should be
evaluated using a discount rate less than the firms WACC.
Net present values of projects with the average risk for the firm should be determined
using the firms marginal cost of capital. The discount rate should be adjusted for projects
with above-average or below-average risk. Using the marginal cost of capital assumes the
firms capital structure does not change over the life of the project.
f Ideally, an analyst would use the YTM of a firms existing debt as the pretax cost of
new debt. When a firms debt is not publicly traded, however, a market YTM may not be
available. In this case, an analyst may use the yield curve for debt with the same rating
and maturity to estimate the market YTM. If the anticipated debt has unique
characteristics that affect YTM, these characteristics should be accounted for when
estimating the pretax cost of debt.
The after-tax cost of debt = kd(1 t) = kd kd(t), where kd is the pretax cost of debt and t
is the effective corporate tax rate. So the tax savings from the tax treatment of debt is
kd(t). Capital component weights should be based on market weights, not book values.
And, the appropriate pre-tax cost of debt is the yield to maturity on the firms existing
debt.
g The newly-issued preferred shares of most companies generally sell at par. As such, the
dividend yield on a firms newly-issued preferred shares is the markets required rate of
return. The yield on a BBB corporate bond reflects a pre-tax cost of debt.
The cost of preferred stock, kps is expressed as:
kps = Dps / P
where:
Dps = divided per share = dividend rate stated par value
P = market price
Corporate taxes do not affect the cost of preferred stock to the issuing firm. Waterburys
after-tax cost of debt, and consequently, its weighted average cost of capital will decrease
because the tax savings on interest will increase.
h ks = RFR + (Rm RFR)
WACC = [D/(D + E)] kd(1 t) + [E/(D + E)] ks
An increase in the risk-free rate will cause the cost of equity to increase. It would also
cause the cost of debt to increase. In either case, the nominal cost of capital is the riskfree rate plus the appropriate premium for risk.
Ks = (D1 / P0) + g
The cost of preferred stock, kps, is Dps price.
The marginal cost of capital schedule shows the WACC at different levels of capital
investment. It is usually upward sloping and is a function of a firms capital structure and
its cost of capital at different levels of total capital investment.
A breakpoint is calculated by dividing the amount of capital at which a component's cost
of capital changes by the weight of that component in the capital structure.

The marginal cost of capital (MCC) is defined as the weighted average cost of the last
dollar raised by the company. Typically, the marginal cost of capital will increase as more
capital is raised by the firm. The marginal cost of capital is the weighted average rate
across all sources of long-term financingsbonds, preferred stock, and common stock
when the final dollar was obtained, regardless of its specific source.
An increase in the after-tax cost of debt may occur at a break point. Any given projects
NPV will decline when a breakpoint is reached.
Adjusting the cost of equity for flotation costs is incorrect because doing so entails
adjusting the present value of cash flows by a fixed percentage over the life of the
project. In reality, flotation costs are a cash outflow that occurs at the initiation of a
project. Therefore, the correct way to account for flotation costs is to adjust the cash
flows in the computation of project NPV, not the cost of equity. The dollar amt. of the
flotation cost should be considered an additional cash outflow at initiation of project.

Measures of Leverage
The higher the percentage of a firm's costs that are fixed, the higher the operating
leverage, and the greater the firm's business risk and the more susceptible it is to business
cycle fluctuations.
Business risk is the riskiness of the company's assets if it uses no debt. Factors that affect
business risk are demand, sales price, and input price variability. The greater a companys
business risk, the lower its optimal debt ratio.
Business risk is the uncertainty regarding the operating income of a company. It can be
defined as the uncertainty inherent in a firms return on assets (ROA). Business risk is a
function of the firm's revenue and expenses, resulting in operating income, or earnings
before interest and taxes (EBIT). The main factors affecting business risk are demand
variability, sales price variability, input price variability, ability to adjust output prices,
and operating leverage. Financial risk refers to the uncertainty caused by the fixed cost
associated with borrowed money.
Common shareholders are the residual owners of the company. As such, they experience
the benefits of above-normal gains in good times and the pain of losses when the business
is in a slow period. Financial leverage magnifies the variability of earnings per share due
to the existence of the required interest payments.
b If a high percentage of a firm's total costs are fixed, the firm is said to have high
operating leverage. High operating leverage, other things held constant, means that a
relatively small change in sales will result in a large change in operating income.
Therefore, during an expansionary phase in the economy a highly leveraged firm will
have higher earnings growth than a lesser leveraged firm. The opposite will happen
during an economic contraction.
A higher breakeven point resulting from increased interest costs associated with debt
financing increases the risk of the company. Since the risk is tied to firm financing, it is
referred to as financial risk. Given the positive risk-return relationship, the expected
return of the companys common stock also rises.

DTL = %EPS/%Sales = DTL = [Q(P - V) / Q(P - V) - F - I]

DFL = EBIT/(EBIT-I)
DTL = (DOL)(DFL)
DOL = Q(P V) / [Q(P V) F]
If debt = 0 then DFL = 1 because DFL = EBIT/(EBIT - I)
If debt = 0 then I = 0 and DFL = EBIT/(EBIT - 0) = EBIT/EBIT = 1
DTL = (DOL)(DFL)
If DFL = 1 then DTL = (DOL)(1) which complies to DTL = DOL
A decrease in interest expense will decrease DFL, which will decrease DTL. An increase
in fixed costs will increase the companys DOL.
Operating leverage is the trade off between fixed and variable costs. Higher operating
leverage typically is indicative of a firm with higher levels of risk (greater income
variance). Given the positive risk/return relationship, higher operating leverage firms are
expected to have a higher rate of return. And, lower operating leverage firms are expected
to have a lower rate of return.
A firm with high operating leverage has a high percentage of its total costs in fixed costs.
DTL = (Sales Variable Costs) / (Sales Variable Costs Fixed Costs Interest
Expense)
Variable Costs (VC) = Sales (2 Fixed Costs) (2 Interest Expense)
Operating leverage is the result of a greater proportion of fixed costs compared to
variable costs in a firms capital structure and is characterized by the sensitivity in
operating income (earnings before interest and taxes) to change in sales. A firm that has
equal changes in sales and operating income would have low operating leverage (the least
it can be is one).
c The key to finding the optimal capital structure is identifying the level of debt that will
maximize firm value.
Financial leverage results in the existence of required interest payments and, hence,
increased earnings per share variability. Higher debt ratios, given a fixed asset base, result
in a greater earnings per share variability. Operating income is based on the products and
assets of the firm and not on the firms financing and, hence, has no impact on financial
leverage. Greater financial leverage is likely to reduce taxes due to the tax deductibility
of interest payments.
Using financial leverage increases the volatility of ROE for a level of volatility in
operating income. If a firm is financed with 100% equity, there is a direct relationship
between changes in the firms ROE and changes in operating income. Adding financial
leverage (debt) to the firms capital structure will cause ROE to become much more
volatile and ROE will change more rapidly for a given change in operating income. The
increased volatility in ROE reflects an increase in both risk and potential return for equity
holders. Note that financial leverage results in increased default risk, but since existing
bond holders are compensated by coupon interest and return of principal, their potential
return is unchanged. Although financial leverage will generally increase ROE if a firm

has a positive operating margin (EBIT/Sales), if the operating margin were small, the
added interest expense could turn the firms net profit margin negative, which would in
turn make ROE negative. [87202]
QBreakeven = Fixed Cost / (Price Variable Cost)
Break-even quantity = Fixed Costs / (Price - Variable cost)
The operating breakeven point is the quantity of product sold at which operating income
is zero (revenue equals operating cost). Operating breakeven quantity = F / (P V)
Operating breakeven quantity = fixed operating costs / (price variable cost per unit)

Dividends and Share Repurchases: Basics

A cash dividend will increase leverage ratios such as debt-to-equity and debt-to-assets,
reflecting a decrease in the denominator. A cash dividend should decrease liquidity ratios
such as the current ratio and cash ratio, due to the decrease in cash in the numerator.
Unlike a cash dividend, a stock dividend or a stock split has no impact on liquidity or
financial leverage ratios.
Stock dividends are dividends paid out in new shares of stock instead of cash. In the case
of stock repurchases, the company is buying back shares so the number of shares in the
investment publics hands is declining.
Stock splits divide up each existing share into multiple shares. The price of each share
will drop correspondingly to the number of shares created, so there is no change in the
owners wealth. Empirical research has shown that in the absence of a dividend yield
increase, the stock price falls to the stock split ratio of the original price (i.e., to 25% of
the original price in a 4-for-1 stock split). This makes sense, given that the investors
percentage ownership of the company has not changed.
Financial managers utilize stock splits and stock dividends because they perceive that an
optimal trading range exists. Although there is little empirical evidence to support the
contention, there is nevertheless a widespread belief in financial circles that an optimal
price range exists for stocks. Optimal means that if the price is within this range, the
price/earnings ratio, price/sales and other relevant ratios will be maximized. Hence, the
value of the firm will be maximized.
The cut-off date for receiving the dividend is known as the ex-dividend date. The exdividend date is now two business days prior to the date of record. The holder of record
date is the date on which the shareholders of record are designated. The date the checks
are mailed out is known as the date of payment.
The date of record is the date on which the shareholders of record are designated to
receive the dividend. The ex-dividend date is the cut-off date for receiving the dividend.
Shares sold after the ex-dividend date are sold without claim to the dividend, even if they
are sold prior to the date of record. The dividend would be paid to the holder as of the
close of trading on the day prior to the ex-dividend date.
The board of directors announce the amount of the dividend, the holder-of-record date,
and payment date. The ex-dividend date is two business days prior to the holder-of-record
date, giving the firm time to identify the rightful owner of the dividends.
Repurchases offer shareholders the choice of tendering or not tendering their stock, while

cash dividends represent a payment they cannot refuse. Raising dividends is often seen as
a positive signal, but an increase funded by short-term cash flows may not be sustainable,
forcing the company to reduce the dividend later.
There are three repurchase methods. The first is to buy in the open market. Buying in the
open market gives the company the flexibility to choose the timing of the transaction. A
company may repurchase stock by making a tender offer to repurchase a specific number
of shares at a price that is usually at a premium to the current market price. The third way
is to repurchase by direct negotiation. Companies may negotiate directly with a large
shareholder to buy back a block of shares, usually at a premium to the market price. A
tender offer refers to buying a fixed number of shares at a fixed price (usually at a
premium to the current market price).
Assuming that the tax treatment of a share repurchase and a cash dividend of equal
amount is the same, a share repurchase is equivalent to a cash dividend payment, and
shareholder wealth will be the same.

Working Capital Management

Primary sources of liquidity include ready cash balances, short-term funds (e.g., trade
credit and bank lines of credit), and cash flow management. Secondary sources of
liquidity include negotiating debt contracts, liquidating assets, and filing for bankruptcy
protection and reorganization.
When cash payments are made too quickly, the condition is known as a pull on liquidity.
A drag on liquidity occurs when cash inflows lag.
b If a firm operates in multiple industries, this would limit the value of financial ratio
analysis by making it difficult to find comparable industry ratios.
Higher receivables turnover is an indicator of better receivables liquidity since
receivables are converted to cash more rapidly. A lower quick ratio is an indication of less
liquidity. Lower trade payables could be related to better liquidity, but could also be
consistent with very poor liquidity and a requirement from its suppliers of cash payment.
The firms average days of receivables should be close to the industry average. A
significantly lower average days receivables outstanding, compared to its peers, is an
indication that the firms credit policy may be too strict and that sales are being lost to
peers because of this.
The quick ratio is usually defined as (current assets inventory) / current liabilities. It is a
more restrictive measure of liquidity than the current ratio, which equals current assets /
current liabilities. The numerator of the quick ratio includes cash, receivables, and shortterm marketable securities. Cash as a proportion of sales and inventory turnover are
indicators of liquidity.
Financial ratios are meaningless by themselves. To have meaning an analyst must use
them with other information. An analyst should evaluate financial ratios based on
industry norms and economic conditions. Financial ratios tend to improve when the
economy is strong and weaken when the economy is in a recession. So, financial ratios
should be reviewed in light of the current stage of the business cycle.
c The cash conversion cycle measures the length of time required to convert a firms cash

investment in inventory back into cash resulting from the sale of the inventory. A short
cash conversion cycle is good because it indicates a relatively low investment in working
capital.
The cash conversion cycle is its operating cycle minus its average days payables
outstanding. Therefore, the firms average days payables must have increased, a clear
indication that the firm is relying more heavily on credit from its suppliers. Improved
inventory turnover would tend to increase both the operating and cash conversion cycles.
Relaxed credit policies would tend to increase the firms operating cycle as receivables
turnover would tend to decrease.
A shorter operating cycle will lead to a shorter cash conversion cycle, other things equal,
which is an indication of better working capital management. Higher days inventory on
hand, compared to peer company averages, will lengthen the cash conversion cycle, an
indication of poorer working capital management. Good working capital management
would tend to increase a firms total asset turnover since a given amount of sales can be
supported with less working capital (less current assets). [96559]
d Allowing short-term securities to mature without reinvesting the cash generated would
be one way to meet seasonal cash needs. Short-term bank borrowing or issuing
commercial paper that can be paid off when holiday sales generate cash would be
appropriate strategies for dealing with a predictable short-term need for cash.
Firms with operating cash inflows that fluctuate seasonally are likely to experience shortterm imbalances between cash inflows and cash outflows and must forecast these
imbalances to manage their net daily cash positions, for example by arranging short-term
borrowing over seasons when operating cash inflows are expected to be relatively low
and operating cash outflows are relatively high.
Increasing a cash inflow or decreasing a cash outflow would improve a firms net daily
cash position. Stretching accounts payable (i.e., waiting longer to pay suppliers) would
decrease cash outflows in the short term.
e The money market yield is the holding period yield times 360/72 and is always greater
than the discount yield which is the actual discount from face value times 360/72, since
the holding period yield is always greater than the percentage discount from face value. A
securitys discount yield and its money market yield are always less than its bond
equivalent yield, and its effective annual yield is always greater than its bond equivalent
yield.
When evaluating the performance of its short-term securities investments, a company
should compare them on a bond equivalent yield basis.
The yields on investments in short-term securities should be stated as bond equivalent
yields (BEYs), and returns on portfolios of these securities should be stated as a weighted
average of BEYs. The BEY, which is holding period yield (HPY) (365/days), allows
fixed-income securities whose payments are not annual to be compared with securities
with annual yields.
An investment policy statement typically begins with a statement of the purpose and
objective of the investment portfolio, some general guidelines about the strategy to be
employed to achieve those objectives, and the types of securities that will be used.

f Paying invoices on the last day to get a discount (for early payment) is often the most
advantageous strategy for a firm. If the annualized percentage cost of not taking
advantage of the discount is less than the firms short-term cost of funds, it would be
advantageous to pay on the due date. Paying prior to the discount cut-off date or prior to
the due date sacrifices interest income for no advantage.
The weighted average collection period is the average number of days it takes to collect a
dollar of receivables. A decreased percentage of sales made on credit or an increase in the
receivables turnover ratio might result from more strict credit terms. Inventory turnover is
not directly affected by credit terms, only though the effect of credit terms on overall
sales.
An increase in days of inventory on hand can be the result of either good or poor
inventory management. An increase in inventory could indicate poor sales and an
accumulation of obsolete items or could be the result of a conscious effort to have
adequate supplies to avoid losses from not having items to satisfy customer orders (stock
outs). Higher-than-average inventory turnover could indicate better inventory
management or could indicate that a less than optimal inventory is being maintained by
the company.
g Large, creditworthy firms can get the lowest cost of financing by issuing commercial
paper. Selling receivables to a factor is a higher cost source of funds used by firms with
poor credit quality. A committed line of credit requires payment of a fee and represents
bank borrowing, which would be attractive to a firm that did not have the size or
creditworthiness to issue commercial paper.
Committed lines and revolving lines of credit all contain a commitment by a lender to
lend up to a maximum amount, at the borrowers option for some period of time. A firm
with lower credit quality may have an uncommitted line of credit which offers no
guarantee from the lender to provide any specific amount of funds in the future.
With an uncommitted line of credit, the lender is not committed to make loans in any
amount. A revolving line of credit is typically for a longer period and involves an
agreement to lend funds in the future up to some maximum amount.
A revolving line of credit is typically for a longer term than an uncommitted or
committed line of credit and thus is considered a more reliable source of liquidity. With
an uncommitted line of credit, the issuing bank may refuse to lend if conditions of the
firm change. An overdraft line of credit is similar to a committed line of credit agreement
between banks and firms outside of the U.S. Both committed and revolving lines of credit
can be verified and can be listed in the footnotes to a firms financial statements as
sources of liquidity.

The Corporate Governance of Listed Companies: A Manual for Investors

Corporate governance defines the appropriate rights, roles, and responsibilities of a
corporations management, the board of directors, and shareholders. The board of
directors should be allowed to act independently of management. Management should not
be allowed to act independently from the board. Ideally, independent board members can
hire external consultants without managements approval. This enables the board to
obtain advice on specialized issues not biased by the interests of mgmt.

b An independent board should have the ability to seek specialized advice by hiring
outside consultants without management approval. The size of the board should be
appropriate for the facts and circumstances of the firm; having more members does not
imply that the board will be more independent if the additional members are aligned
closely with management or are less well qualified.
Especially in cases where the chairman of the board is closely aligned with the firm,
independent board members are more able to protect shareholders interests when they
have a leading or primary independent member. The board should meet regularly outside
the presence of management. Board members who represent the firms customers and
suppliers may have interests that conflict with those of shareholders.
c Independence, as it relates to board members, refers to the degree to which these
persons are not biased or otherwise controlled by firm management or other groups
which may have some degree of control over management.
The willingness of independent board members to express opinions that are not aligned
with managements may be impaired when the chairman is the firms current CEO or a
former CEO.
d Board members must be properly qualified, having the knowledge and experience
which is required to advise management in light of the firms specific situations
encountered.
Service on the board for more than 10 years may indicate knowledge and experience, but
may result in a member becoming too close to management. Board members should have
experience with include financial operations, accounting and auditing topics, and
business risks the firm faces.
e The audit committee is responsible for evaluating the financial information that the
company provides to shareholders. This committee should be able to approve or reject the
companys proposed non-audit engagements with its external auditing firm. The audit
committee should control the audit budget, and there should be no restrictions on
communication between the committee and the companys internal auditors.
The audit committee is responsible for hiring and supervising the independent external
auditors, in order to ensure that the auditors priorities are consistent with the best
interests of shareholders.
A committee responsible for takeover defense would most likely be acting in the interests
of the company's current management rather than in the interests of shareholders.
Members of the audit committee should be independent experts in accounting and
finance. The nominations committee is responsible for recruiting qualified board
members and preparing an executive management succession plan. The independent
auditor has authority over the audit procedures. The audit committee is responsible for
hiring and supervising the independent auditor.
f The firms code of ethics should prohibit practices that give advantages to company
insiders that are not also offered to shareholders.
The firms code of ethics establishes the basic principles of integrity, trust, and honesty.
Two of the practices listed in the reading discuss providing the board with relevant

corporate information in a timely manner and prohibiting board members or other

insiders from purchasing stock before shareholders can make purchases.
g Anything beyond 2- or 3-year term limits on board membership has the potential to
restrict the ability for shareholders to change the composition of the board if its members
are not acting in the shareholders best interest.
Adopting a golden parachute, poison pill, or greenmail are all take-over defenses used to
frustrate an acquisition attempt. The barriers created by such defenses are likely to
decrease the value of the stock.
Shareholders will be more likely to vote and vote conscientiously if they are sure that
board members and/or management will not find out how they voted.
Newly created anti-takeover provisions may or may not require stakeholder
authorization/approval. These provisions may or may not require such approval. In either
case, the firm may have to, at a minimum, provide information to its shareholders about
any amendments to existing takeover defenses. A firms articles of organization are the
most likely places to locate information about present takeover defenses.
Super-voting rights by certain classes of shareholders impair the firms ability to raise
capital for the future. Firms with dual classes of common equity could encourage
prospective acquirers to only deal directly with shareholders with the supermajority
rights. If the firm has a significant minority ownership group, such as a founding family,
use of cumulative voting to elect board members can favor specific interests at the
expense of the interests of other shareholders.
Investors need the power to put forth an independent board nominee. In addition, the
right to propose initiatives for consideration at the annual meeting is an important method
to send a message to management.
Firms with dual classes of equity can have a negative effect on shareholder value as the
shareholder may have inferior voting rights. Takeover measures such as poison pills,
golden parachutes, and greenmail typically have a negative effect on shareholder value.
Annual elections are preferred for board members as it increases accountability.
Executive board members regularly attending the meetings can potentially prevent free
discussion among the independent members.
Firms that assign one vote to each share are more likely to have a board that considers the
best interest of all shareholders. Firms with dual classes of common equity where
supermajority rights are given to one class are likely to have boards that focus on the
interests of the supermajority shareholders.