Corporate Finance

Capital Budgeting
The four administrative steps in the capital budgeting process are: Idea generation,
Analyzing project proposals, Creating the firm!ide capital budget " #onitoring
decisions and conducting a postaudit$
#andatory regulatory or environmental projects may be re%uired by a governmental
agency or insurance company and typically involve safetyrelated or environmental
concerns$ The projects typically generate little to no revenue, but they accompany other
ne! revenue producing projects and are accepted by the company in order to continue
operating$
b Financing costs are reflected in a project&s re%uired rate of return$ 'roject specific
financing costs should not be included as project cash flo!s$ The firm(s overall !eighted
average cost of capital, adjusted for project ris), should be used to discount e*pected
project cash flo!s$
The timing of e*pected cash flo!s is important for ma)ing correct capital budgeting
decisions$ Capital budgeting decisions account for the time value of money$ Capital
budgeting decisions should be based on incremental afterta* cash flo!s, not net
+accounting, income$
The five )ey principles of the capital budgeting process are: -ecisions are based on cash
flo!s, Cash flo!s are based on opportunity costs, The timing of cash flo!s is important,
Cash flo!s are analyzed on an afterta* basis " Financing costs are reflected in the
project&s re%uired rate of return$
Cash flo!s are based on opportunity costs$ Any cash flo!s that the firm gives up because
a project is underta)en should be charged to the project$
The mar)eting study for a ne! product is a sunk cost, and the possible increase in sales of
a related product is an e*ample of a positive externality$
c #utually e*clusive means that out of the set of possible projects, only one project can
be selected$ .iven t!o mutually e*clusive projects, the company can accept one of the
projects or reject both projects, but cannot accept both projects$
Independent projects are projects for !hich the cash flo!s are independent from one
another and can be evaluated based on each project&s individual profitability$ If the
projects !ere mutually e*clusive, only one of the t!o projects could be accepted$ 'roject
se%uencing means that investing in a project today creates the opportunity to decide to
invest in a related project in the future$
Capital rationing e*ists !hen a company has a fi*ed +ma*imum, amount of funds to
invest$ If profitable project opportunities e*ceed the amount of funds available, the firm
must ration, or prioritize its funds to achieve the ma*imum value for shareholders given
its capital limitations$
'rojects are often se%uenced through time so that investing in a project today may create
the opportunity to invest in other projects in the future$ /ote that funding from the first
project is not a re%uirement for project se%uencing$
d In the process of capital budgeting, a manager is ma)ing decisions about a firm&s
earning assets, !hich provide the basis for the firm&s profit and value$ Capital budgeting
refers to investments e*pected to produce benefits for a period of time greater than one
year$ Financial restructuring is done as a result of ban)ruptcy and monitoring is a critical
assessment aspect of capital budgeting$
The decision rules for net present value, profitability inde*, and internal rate of return are
to invest in a project if /'0 1 2, I33 1 re%uired rate of return, or 'I 1 4$
The paybac) period is the number of years it ta)es to recover the original cost of the
investment$ The paybac) period does not ta)e any cash flo!s after the paybac) point into
consideration$
e The project that ma*imizes the firm(s value is the one that has the highest positive /'0$
For independent projects the I33 and /'0 give the same accept5reject decision$ For
mutually e*clusive projects the I33 and /'0 techni%ues can yield different accept5reject
decisions.
The multiple I33 problem occurs if a project has nonnormal cash flo!s, that is, the sign
of the net cash flo!s changes from negative to positive to negative, or vice versa$ For the
e*am, a shortcut to loo) for is the project cash flo!s changing signs more than once$
I33 is the rate of return for !hich the /'0 of a project is zero$
The I33 method assumes all future cash flo!s can be reinvested at the I33$ This may not
be feasible because the I33 is not based on mar)et rates$ The /'0 method uses the
!eighted average cost of capital +6ACC, as the appropriate discount rate$
If the /'0 for t!o mutually e*clusive projects is negative, both should be rejected$
The /'0 method is al!ays preferred over the I33, because the /'0 method assumes
cash flo!s are reinvested at the cost of capital$ Conversely, the I33 assumes cash flo!s
can be reinvested at the I33$ The I33 is not an actual mar)et rate.
The crossover rate is the rate at !hich the /'0 for t!o projects is the same$ That is, it is
the rate at !hich the t!o /'0 profiles cross$
The I33 encounters difficulties !hen cash outflo!s occur throughout the life of the
project$ These projects may have multiple I33s, or no I33 at all$ /either the /'0 nor
the 'I suffer from these limitations$
/et present value is the preferred criterion !hen ran)ing projects because it measures the
firm&s e*pected increase in !ealth from underta)ing a project$
6hen the /'0 7 2, this means the discount rate used is e%ual to the I33$ If a discount
rate is used that is higher than the I33, the /'0 !ill be negative$ Conversely, if a
discount rate is used that is lo!er than the I33, the /'0 !ill be positive$
/'0 and I33 lead to the same decision for independent projects, not necessarily for
mutually e*clusive projects$ I33 assumes that cash flo!s are reinvested at the I33 rate$
I33 does not ignore time value of money +the paybac) period does,, and the investor
may find multiple I33s if there are sign changes after time zero +i$e$, negative cash flo!s
after time zero,$
'rojects !ith unconventional cash flo!s +!here the sign of the cash flo! changes from
minus to plus to bac) to minus, !ill have multiple internal rates of return$ 8o!ever, one
!ill still be able to calculate a single net present value for the cash flo! pattern$
The multiple I33 problem occurs if a project has an unconventional cash flo! pattern,
that is, the sign of the cash flo!s changes more than once +from negative to positive to
negative, or viceversa,$ 9nly 'roject :outh has this cash flo! pattern$ /either the zero
cash flo! for 'roject 6est nor the li)ely negative net present value for 'roject ;ast
!ould result in multiple I33s.
As discount rates change the net present values change$ The /'0 profile is a graphic
illustration of ho! sensitive net present values are to different discount rates$ By
comparison, every project has a single internal rate of return and paybac) period because
the values are determined solely by the investment&s e*pected cash flo!s$
6here the /'0 intersects the vertical ya*is you have the value of the cash inflo!s less
the cash outflo!s, assuming an absence of money having a time value +i$e$, the discount
rate is zero,$ 6here the /'0 intersects the horizontal x-axis you have the project&s
internal rate of return$ At this cost of financing, the cash inflo!s and cash outflo!s offset
each other$ The /'0 profile is a tool that graphically plots the project&s /'0 as
calculated using different discount rates$ Assuming an appropriate discount rate, one
should accept all projects !ith positive net present values, if the projects are independent$
If projects are mutually e*clusive select the one !ith the higher /'0 at any given level
of the cost of capital$
f 'rivate, ;uropean and smaller firms tend to favor paybac) period$ The more highly
educated a firm&s management, the more li)ely it is to use a -CF capital budgeting
techni%ue as its primary tool$
-espite the theoretical superiority of the /'0 and I33 methods for determining and
ran)ing project profitability, surveys of corporate managers sho! that a variety of
methods are used$ Firms that use the /'0 and I33 methods tend to be larger, publicly
traded, companies$ -espite the theoretical superiority of the /'0 and I33 methods for
determining and ran)ing project profitability, surveys of corporate managers sho! that a
variety of methods are used$ Firms that !ere most li)ely to use the paybac) period
method !ere ;uropean firms and management teams !ith less education$
g :toc) prices reflect investor e*pectations for future investment and gro!th$ A ne!
positive/'0 project !ill increase stoc) price only if it !as not previously anticipated by
investors$
Cost of Capital
The cost of preferred e%uity capital is the preferred dividend divided by the price of
preferred shares$
Afterta* cost of debt 7 bond yield < ta* savings 7 )d < )dt 7 )d+4 < t,
6ACC 7 +6d,+=d +4 < t,, > +6ps,+=ps, > +6ce,+=s,
6ACC 7 ?!d @ )d @ +4 < t,A > +!ps @ )ps, > +!ce @ )s,
6ACC 7 +; 5 0,+)s, > +- 5 0,+)debt,+4 < t,, !here 0 7 debt > e%uity
An increase in either the company&s beta or the mar)et ris) premium !ill cause the
6ACC to increase using the CA'# approach$ A reduction in the mar)et ris) premium
!ill reduce the cost of e%uity for 6ACC$
;%uity and preferred stoc) are not adjusted for ta*es because dividends are not deductible
for corporate ta*es$ 9nly interest e*pense is deductible for corporate ta*es.
The order from cheapest to most e*pensive is: debt, preferred stoc) +!hich acts li)e a
hybrid of debt and e%uity,, and common e%uity$
Then, using the formula for 6ACC 7 +!d,+)d, > +!ps,+)ps, > +!ce,+)ce,
!here !d, !ps, and !e are the !eights used for debt, preferred stoc), and common
e%uity$
)s 7 -4 B '2 > gro!th )ce 7 +-4 5 '2, > g
The cost of preferred stock (kps) 7 -ps 5 '
CA'# 7 3; 7 3F > B+3# < 3F,
b In the C$:$, interest paid on corporate debt is ta* deductible, so the afterta* cost of debt
capital is less than the beforeta* cost of debt capital$ -ividend payments are not ta*
deductible, so ta*es do not decrease the cost of common or preferred e%uity$
A company creates value by producing a higher return on its assets than the cost of
financing those assets$ As such, the 6ACC is the cost of financing a firm&s assets and can
be vie!ed as the firm&s opportunity cost of financing its assets$
:ince a firm&s 6ACC reflects the average ris) of the projects that ma)e up the firm, it is
not appropriate for evaluating all ne! projects$ It should be adjusted up!ard for projects
!ith greaterthanaverage ris) and do!n!ard for projects !ith lessthanaverage ris)$
c The optimal capital budget is determined by the intersection of a firm&s marginal cost of
capital curve and its investment opportunity schedule$ A brea) point occurs at a level of
capital e*penditure !here one of the component costs of capital increases$ If a firm&s
capital structure remains constant, the #CC +6ACC, increases as additional capital is
raised$
The !eighted average cost of capital +6ACC, should be based on mar)et values for the
firm&s outstanding securities$ A firm&s marginal cost of capital, or 6ACC, is only
appropriate for computing a project&s /'0 if the project has the same ris) as the firm$
d The DmarginalE cost refers to the last dollar of financing ac%uired 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 re%uired by the last bondholders and stoc)holders to
provide capital to the firm$ 3egardless of !hether the funding came from bondholders or
stoc)holders, both debt and e%uity 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 !ould only be appropriate if the company avoided creditor
supplied financing or the issuance of ne! common or preferred stoc) +and preferred
stoc) financing,$ The afterta* cost of debt is never sufficient, because a business,
regardless of their size, al!ays has a residual o!ner, and hence a cost of e%uity$ ?FGG4HA
e The 6ACC is the appropriate discount rate for projects that have appro*imately the
same level of ris) as the firm&s e*isting projects$ This is because the component costs of
capital used to calculate the firm&s 6ACC are based on the e*isting level of firm ris)$ To
evaluate a project !ith above +the firm&s, average ris), a discount rate greater than the
firm&s e*isting 6ACC should be used$ 'rojects !ith belo!average ris) should be
evaluated using a discount rate less than the firm&s 6ACC$
/et present values of projects !ith the average ris) for the firm should be determined
using the firm&s marginal cost of capital$ The discount rate should be adjusted for projects
!ith aboveaverage or belo!average ris)$ Csing the marginal cost of capital assumes the
firm&s capital structure does not change over the life of the project$
f Ideally, an analyst !ould use the IT# of a firm&s e*isting debt as the preta* cost of
ne! debt$ 6hen a firm&s debt is not publicly traded, ho!ever, a mar)et IT# may not be
available$ In this case, an analyst may use the yield curve for debt !ith the same rating
and maturity to estimate the mar)et IT#$ If the anticipated debt has uni%ue
characteristics that affect IT#, these characteristics should be accounted for !hen
estimating the preta* cost of debt$
The afterta* cost of debt 7 )d+4 J t, 7 )d J )d+t,, !here )d is the preta* cost of debt and t
is the effective corporate ta* rate$ :o the ta* savings from the ta* treatment of debt is
)d+t,$ Capital component !eights should be based on mar)et !eights, not boo) values$
And, the appropriate preta* cost of debt is the yield to maturity on the firm&s e*isting
debt$
g The ne!lyissued preferred shares of most companies generally sell at par$ As such, the
dividend yield on a firm&s ne!lyissued preferred shares is the mar)et&s re%uired rate of
return$ The yield on a BBB corporate bond reflects a preta* cost of debt$
The cost of preferred stoc), )ps is e*pressed as:
)ps 7 -ps 5 '
!here:
-ps 7 divided per share 7 dividend rate @ stated par value
' 7 mar)et price
Corporate ta*es do not affect the cost of preferred stoc) to the issuing firm$ 6aterbury&s
afterta* cost of debt, and conse%uently, its !eighted average cost of capital !ill decrease
because the ta* savings on interest !ill increase$
h )s 7 3F3 > K+3m < 3F3,
6ACC 7 ?-5+- > ;,A @ )d+4 < t, > ?;5+- > ;,A @ )s
An increase in the ris)free rate !ill cause the cost of e%uity to increase$ It !ould also
cause the cost of debt to increase$ In either case, the nominal cost of capital is the ris)
free rate plus the appropriate premium for ris)$
=s 7 +-4 5 '2, > g
The cost of preferred stoc), )ps, is -ps B price.
The marginal cost of capital schedule sho!s the 6ACC at different levels of capital
investment$ It is usually up!ard sloping and is a function of a firm&s 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 !hich a component(s cost
of capital changes by the !eight of that component in the capital structure$
The marginal cost of capital +#CC, is defined as the !eighted average cost of the last
dollar raised by the company$ Typically, the marginal cost of capital !ill increase as more
capital is raised by the firm$ The marginal cost of capital is the !eighted average rate
across all sources of longterm financingsLbonds, preferred stoc), and common stoc)L
!hen the final dollar !as obtained, regardless of its specific source$
An increase in the afterta* cost of debt may occur at a brea) point$ Any given project&s
/'0 !ill decline !hen a brea)point is reached$
Adjusting the cost of e%uity for flotation costs is incorrect because doing so entails
adjusting the present value of cash flo!s by a fi*ed percentage over the life of the
project$ In reality, flotation costs are a cash outflo! that occurs at the initiation of a
project$ Therefore, the correct !ay to account for flotation costs is to adjust the cash
flo!s in the computation of project /'0, not the cost of e%uity$ The dollar amt$ of the
flotation cost should be considered an additional cash outflo! at initiation of project$
#easures of Meverage
The higher the percentage of a firm(s costs that are fi*ed, the higher the operating
leverage, and the greater the firm(s business ris) and the more susceptible it is to business
cycle fluctuations$
Business ris) is the ris)iness of the company(s assets if it uses no debt$ Factors that affect
business ris) are demand, sales price, and input price variability$ The greater a company&s
business ris), 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 firm&s return on assets +39A,$ Business ris) is a
function of the firm(s revenue and e*penses, resulting in operating income, or earnings
before interest and ta*es +;BIT,$ The main factors affecting business ris) 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 fi*ed cost
associated !ith borro!ed money$
Common shareholders are the residual o!ners of the company$ As such, they e*perience
the benefits of abovenormal gains in good times and the pain of losses !hen the business
is in a slo! period$ Financial leverage magnifies the variability of earnings per share due
to the e*istence of the re%uired interest payments$
b If a high percentage of a firm(s total costs are fi*ed, the firm is said to have high
operating leverage$ 8igh operating leverage, other things held constant, means that a
relatively small change in sales !ill result in a large change in operating income$
Therefore, during an e*pansionary phase in the economy a highly leveraged firm !ill
have higher earnings gro!th than a lesser leveraged firm$ The opposite !ill happen
during an economic contraction$
A higher brea)even point resulting from increased interest costs associated !ith debt
financing increases the ris) of the company$ :ince the ris) is tied to firm financing, it is
referred to as financial ris)$ .iven the positive ris)return relationship, the e*pected
return of the company&s common stoc) also rises$
-TM 7 NO;':5NO:ales 7 -TM 7 ?P+' 0, 5 P+' 0, F IA
-FM 7 ;BIT5+;BITI,
-TM 7 +-9M,+-FM,
-9M 7 P+' J 0, 5 ?P+' J 0, J FA
If debt 7 2 then -FM 7 4 because -FM 7 ;BIT5+;BIT I,
If debt 7 2 then I 7 2 and -FM 7 ;BIT5+;BIT 2, 7 ;BIT5;BIT 7 4
-TM 7 +-9M,+-FM,
If -FM 7 4 then -TM 7 +-9M,+4, !hich complies to -TM 7 -9M
A decrease in interest e*pense !ill decrease -FM, !hich !ill decrease -TM$ An increase
in fi*ed costs !ill increase the company&s -9M$
9perating leverage is the trade off bet!een fi*ed and variable costs$ 8igher operating
leverage typically is indicative of a firm !ith higher levels of ris) +greater income
variance,$ .iven the positive ris)5return relationship, higher operating leverage firms are
e*pected to have a higher rate of return$ And, lo!er operating leverage firms are e*pected
to have a lo!er rate of return$
A firm !ith high operating leverage has a high percentage of its total costs in fi*ed costs$
-TM 7 +:ales < 0ariable Costs, 5 +:ales < 0ariable Costs < Fi*ed Costs < Interest
;*pense,
0ariable Costs +0C, 7 :ales < +Q @ Fi*ed Costs, < +Q @ Interest ;*pense,
9perating leverage is the result of a greater proportion of fi*ed costs compared to
variable costs in a firm&s capital structure and is characterized by the sensitivity in
operating income +earnings before interest and ta*es, to change in sales$ A firm that has
e%ual changes in sales and operating income !ould have lo! operating leverage +the least
it can be is one,$
c The )ey to finding the optimal capital structure is identifying the level of debt that !ill
ma*imize firm value$
Financial leverage results in the e*istence of re%uired interest payments and, hence,
increased earnings per share variability$ 8igher debt ratios, given a fi*ed asset base, result
in a greater earnings per share variability$ 9perating income is based on the products and
assets of the firm and not on the firm&s financing and, hence, has no impact on financial
leverage$ .reater financial leverage is li)ely to reduce ta*es due to the ta* deductibility
of interest payments$
Csing financial leverage increases the volatility of 39; for a level of volatility in
operating income$ If a firm is financed !ith 422N e%uity, there is a direct relationship
bet!een changes in the firm&s 39; and changes in operating income$ Adding financial
leverage +debt, to the firm&s capital structure !ill cause 39; to become much more
volatile and 39; !ill change more rapidly for a given change in operating income$ The
increased volatility in 39; reflects an increase in both ris) and potential return for e%uity
holders$ /ote that financial leverage results in increased default ris), but since e*isting
bond holders are compensated by coupon interest and return of principal, their potential
return is unchanged$ Although financial leverage !ill generally increase 39; if a firm
has a positive operating margin +;BIT5:ales,, if the operating margin !ere small, the
added interest e*pense could turn the firm&s net profit margin negative, !hich !ould in
turn ma)e 39; negative$ ?RSQ2QA
PBrea)even 7 Fi*ed Cost 5 +'rice J 0ariable Cost,
Brea)even %uantity 7 Fi*ed Costs 5 +'rice 0ariable cost,
The operating brea)even point is the %uantity of product sold at !hich operating income
is zero +revenue e%uals operating cost,$ 9perating brea)even %uantity 7 F 5 +' < 0,
9perating brea)even %uantity 7 fi*ed operating costs 5 +price J variable cost per unit,
-ividends and :hare 3epurchases: Basics
A cash dividend !ill increase leverage ratios such as debttoe%uity and debttoassets,
reflecting a decrease in the denominator$ A cash dividend should decrease li%uidity ratios
such as the current ratio and cash ratio, due to the decrease in cash in the numerator$
Cnli)e a cash dividend, a stoc) dividend or a stoc) split has no impact on li%uidity or
financial leverage ratios$
tock dividends are dividends paid out in ne! shares of stoc) instead of cash$ In the case
of stoc) repurchases, the company is buying bac) shares so the number of shares in the
investment public&s hands is declining$
:toc) splits divide up each e*isting share into multiple shares$ The price of each share
!ill drop correspondingly to the number of shares created, so there is no change in the
o!ner&s !ealth$ ;mpirical research has sho!n that in the absence of a dividend yield
increase, the stoc) price falls to the stoc) split ratio of the original price +i$e$, to QHN of
the original price in a Tfor4 stoc) split,$ This ma)es sense, given that the investor&s
percentage o!nership of the company has not changed$
Financial managers utilize stoc) splits and stoc) dividends because they perceive that an
optimal trading range e*ists$ Although there is little empirical evidence to support the
contention, there is nevertheless a !idespread belief in financial circles that an optimal
price range e*ists for stoc)s$ D9ptimalE means that if the price is !ithin this range, the
price5earnings ratio, price5sales and other relevant ratios !ill be ma*imized$ 8ence, the
value of the firm !ill be ma*imized$
The cutoff date for receiving the dividend is )no!n as the e*dividend date$ The e*
dividend date is no! t!o business days prior to the date of record$ The holder of record
date is the date on !hich the shareholders of record are designated$ The date the chec)s
are mailed out is )no!n as the date of payment$
The date of record is the date on !hich the shareholders of record are designated to
receive the dividend$ The e*dividend date is the cutoff date for receiving the dividend$
:hares sold after the e*dividend date are sold !ithout claim to the dividend, even if they
are sold prior to the date of record$ The dividend !ould be paid to the holder as of the
close of trading on the day prior to the e*dividend date$
The board of directors announce the amount of the dividend, the holderofrecord date,
and payment date$ The e*dividend date is t!o business days prior to the holderofrecord
date, giving the firm time to identify the rightful o!ner of the dividends$
3epurchases offer shareholders the choice of tendering or not tendering their stoc), !hile
cash dividends represent a payment they cannot refuse$ 3aising dividends is often seen as
a positive signal, but an increase funded by shortterm cash flo!s 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 mar)et$ Buying in the
open mar)et gives the company the fle*ibility to choose the timing of the transaction$ A
company may repurchase stoc) by ma)ing a tender offer to repurchase a specific number
of shares at a price that is usually at a premium to the current mar)et price$ The third !ay
is to repurchase by direct negotiation$ Companies may negotiate directly !ith a large
shareholder to buy bac) a bloc) of shares, usually at a premium to the mar)et price$ A
tender offer refers to buying a fi*ed number of shares at a fi*ed price +usually at a
premium to the current mar)et price,$
Assuming that the ta* treatment of a share repurchase and a cash dividend of e%ual
amount is the same, a share repurchase is e%uivalent to a cash dividend payment, and
shareholder !ealth !ill be the same$
6or)ing Capital #anagement
'rimary sources of li%uidity include ready cash balances, shortterm funds +e$g$, trade
credit and ban) lines of credit,, and cash flo! management$ :econdary sources of
li%uidity include negotiating debt contracts, li%uidating assets, and filing for ban)ruptcy
protection and reorganization$
6hen cash payments are made too %uic)ly, the condition is )no!n as a pull on li%uidity$
A drag on li%uidity occurs !hen cash inflo!s lag$
b If a firm operates in multiple industries, this !ould limit the value of financial ratio
analysis by ma)ing it difficult to find comparable industry ratios$
8igher receivables turnover is an indicator of better receivables li%uidity since
receivables are converted to cash more rapidly$ A lo!er %uic) ratio is an indication of less
li%uidity$ Mo!er trade payables could be related to better li%uidity, but could also be
consistent !ith very poor li%uidity and a re%uirement from its suppliers of cash payment$
The firm&s average days of receivables should be close to the industry average$ A
significantly lo!er average days receivables outstanding, compared to its peers, is an
indication that the firm&s credit policy may be too strict and that sales are being lost to
peers because of this$
The %uic) ratio is usually defined as +current assets J inventory, 5 current liabilities$ It is a
more restrictive measure of li%uidity than the current ratio, !hich e%uals current assets 5
current liabilities$ The numerator of the %uic) ratio includes cash, receivables, and short
term mar)etable securities$ Cash as a proportion of sales and inventory turnover are
indicators of li%uidity$
Financial ratios are meaningless by themselves$ To have meaning an analyst must use
them !ith other information$ An analyst should evaluate financial ratios based on
industry norms and economic conditions$ Financial ratios tend to improve !hen the
economy is strong and !ea)en !hen the economy is in a recession$ :o, financial ratios
should be revie!ed in light of the current stage of the business cycle$
c The cash conversion cycle measures the length of time re%uired to convert a firm&s cash
investment in inventory bac) into cash resulting from the sale of the inventory$ A short
cash conversion cycle is good because it indicates a relatively lo! investment in !or)ing
capital$
The cash conversion cycle is its operating cycle minus its average days payables
outstanding$ Therefore, the firm&s average days payables must have increased, a clear
indication that the firm is relying more heavily on credit from its suppliers$ Improved
inventory turnover !ould tend to increase both the operating and cash conversion cycles$
3ela*ed credit policies !ould tend to increase the firm&s operating cycle as receivables
turnover !ould tend to decrease$
A shorter operating cycle !ill lead to a shorter cash conversion cycle, other things e%ual,
!hich is an indication of better !or)ing capital management$ 8igher days inventory on
hand, compared to peer company averages, !ill lengthen the cash conversion cycle, an
indication of poorer !or)ing capital management$ .ood !or)ing capital management
!ould tend to increase a firm&s total asset turnover since a given amount of sales can be
supported !ith less !or)ing capital +less current assets,$ ?FGHHFA
d Allo!ing shortterm securities to mature !ithout reinvesting the cash generated !ould
be one !ay to meet seasonal cash needs$ :hortterm ban) borro!ing or issuing
commercial paper that can be paid off !hen holiday sales generate cash !ould be
appropriate strategies for dealing !ith a predictable shortterm need for cash$
Firms !ith operating cash inflo!s that fluctuate seasonally are li)ely to e*perience short
term imbalances bet!een cash inflo!s and cash outflo!s and must forecast these
imbalances to manage their net daily cash positions, for e*ample by arranging shortterm
borro!ing over seasons !hen operating cash inflo!s are e*pected to be relatively lo!
and operating cash outflo!s are relatively high$
Increasing a cash inflo! or decreasing a cash outflo! !ould improve a firm&s net daily
cash position$ :tretching accounts payable +i$e$, !aiting longer to pay suppliers, !ould
decrease cash outflo!s in the short term$
e The money mar)et yield is the holding period yield times UG25SQ and is al!ays greater
than the discount yield !hich is the actual discount from face value times UG25SQ, since
the holding period yield is al!ays greater than the percentage discount from face value$ A
security&s discount yield and its money mar)et yield are al!ays less than its bond
e%uivalent yield, and its effective annual yield is al!ays greater than its bond e%uivalent
yield$
6hen evaluating the performance of its shortterm securities investments, a company
should compare them on a bond e%uivalent yield basis$
The yields on investments in shortterm securities should be stated as bond e%uivalent
yields +B;Is,, and returns on portfolios of these securities should be stated as a !eighted
average of B;Is$ The B;I, !hich is holding period yield +8'I, @ +UGH5days,, allo!s
fi*edincome securities !hose payments are not annual to be compared !ith securities
!ith annual yields$
An investment policy statement typically begins !ith 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 !ill be used$
f 'aying 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 ta)ing
advantage of the discount is less than the firm&s shortterm cost of funds, it !ould be
advantageous to pay on the due date$ 'aying prior to the discount cutoff date or prior to
the due date sacrifices interest income for no advantage$
The !eighted average collection period is the average number of days it ta)es 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
ade%uate supplies to avoid losses from not having items to satisfy customer orders +stoc)
outs,$ 8igherthanaverage inventory turnover could indicate better inventory
management or could indicate that a less than optimal inventory is being maintained by
the company$
g Marge, credit!orthy firms can get the lo!est cost of financing by issuing commercial
paper$ :elling receivables to a factor is a higher cost source of funds used by firms !ith
poor credit %uality$ A committed line of credit re%uires payment of a fee and represents
ban) borro!ing, !hich !ould be attractive to a firm that did not have the size or
credit!orthiness to issue commercial paper$
Committed lines and revolving lines of credit all contain a commitment by a lender to
lend up to a ma*imum amount, at the borro!er&s option for some period of time$ A firm
!ith lo!er credit %uality may have an uncommitted line of credit !hich offers no
guarantee from the lender to provide any specific amount of funds in the future$
6ith an uncommitted line of credit, the lender is not committed to ma)e 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 ma*imum 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 li%uidity$ 6ith
an uncommitted line of credit, the issuing ban) may refuse to lend if conditions of the
firm change$ An overdraft line of credit is similar to a committed line of credit agreement
bet!een ban)s and firms outside of the C$:$ Both committed and revolving lines of credit
can be verified and can be listed in the footnotes to a firm&s financial statements as
sources of li%uidity$
The Corporate .overnance of Misted Companies: A #anual for Investors
Corporate governance defines the appropriate rights, roles, and responsibilities of a
corporation&s management, the board of directors, and shareholders$ The board of
directors should be allo!ed to act independently of management$ #anagement should not
be allo!ed to act independently from the board$ Ideally, independent board members can
hire e*ternal consultants !ithout management&s 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 see) specialized advice by hiring
outside consultants !ithout management approval$ The size of the board should be
appropriate for the facts and circumstances of the firmV having more members does not
imply that the board !ill be more independent if the additional members are aligned
closely !ith management or are less !ell %ualified$
;specially in cases !here the chairman of the board is closely aligned !ith the firm,
independent board members are more able to protect shareholders& interests !hen they
have a leading or primary independent member$ The board should meet regularly outside
the presence of management$ Board members !ho represent the firm&s customers and
suppliers may have interests that conflict !ith those of shareholders$
c Independence, as it relates to board members, refers to the degree to !hich these
persons are not biased or other!ise controlled by firm management or other groups
!hich may have some degree of control over management$
The !illingness of independent board members to e*press opinions that are not aligned
!ith managements& may be impaired !hen the chairman is the firm&s current C;9 or a
former C;9$
d Board members must be properly %ualified, having the )no!ledge and e*perience
!hich is re%uired to advise management in light of the firm&s specific situations
encountered$
:ervice on the board for more than 42 years may indicate )no!ledge and e*perience, but
may result in a member becoming too close to management$ Board members should have
e*perience !ith include financial operations, accounting and auditing topics, and
business ris)s 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
company&s proposed nonaudit engagements !ith its e*ternal auditing firm$ The audit
committee should control the audit budget, and there should be no restrictions on
communication bet!een the committee and the company&s internal auditors$
The audit committee is responsible for hiring and supervising the independent e*ternal
auditors, in order to ensure that the auditors& priorities are consistent !ith the best
interests of shareholders$
A committee responsible for ta)eover defense !ould most li)ely be acting in the interests
of the company(s current management rather than in the interests of shareholders$
#embers of the audit committee should be independent e*perts in accounting and
finance$ The nominations committee is responsible for recruiting %ualified board
members and preparing an e*ecutive 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 firm&s code of ethics should prohibit practices that give advantages to company
insiders that are not also offered to shareholders$
The firm&s code of ethics establishes the basic principles of integrity, trust, and honesty$
T!o of the practices listed in the reading discuss providing the board !ith relevant
corporate information in a timely manner and prohibiting board members or other
insiders from purchasing stoc) before shareholders can ma)e purchases$
g Anything beyond Q or Uyear 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 ta)eover defenses used to
frustrate an ac%uisition attempt$ The barriers created by such defenses are li)ely to
decrease the value of the stoc)$
:hareholders !ill be more li)ely to vote and vote conscientiously if they are sure that
board members and5or management !ill not find out ho! they voted$
/e!ly created antita)eover provisions may or may not re%uire sta)eholder
authorization5approval$ These provisions may or may not re%uire such approval$ In either
case, the firm may have to, at a minimum, provide information to its shareholders about
any amendments to e*isting ta)eover defenses$ A firm&s articles of organization are the
most li)ely places to locate information about present ta)eover defenses$
:upervoting rights by certain classes of shareholders impair the firm&s ability to raise
capital for the future$ Firms !ith dual classes of common e%uity could encourage
prospective ac%uirers to only deal directly !ith shareholders !ith the supermajority
rights$ If the firm has a significant minority o!nership group, such as a founding family,
use of cumulative voting to elect board members can favor specific interests at the
e*pense of the interests of other shareholders$
Investors need the po!er 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 !ith dual classes of e%uity can have a negative effect on shareholder value as the
shareholder may have inferior voting rights$ Ta)eover 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$
;*ecutive 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 li)ely to have a board that considers the
best interest of all shareholders$ Firms !ith dual classes of common e%uity !here
supermajority rights are given to one class are li)ely to have boards that focus on the
interests of the supermajority shareholders$