November 28, 2014

Long Term Finance for Companies - USA

The corporate lending world can, in its simplest form, be divided into two different
approaches: the asset-based credit market and the cash flow-based credit market.
In ABL transactions, the lender’s interest is secured by the borrower’s assets, which then
forms the basis for determining how much credit the borrower can access. In contrast, the
cash flow method of determining credit capacity is principally based on an analysis of
the borrower’s enterprise value.

Asset-based lenders have generally found that, over time, the valuation of a borrower’s
assets is remarkably stable over a variety of business and economic cycles. This makes
calculating a borrower’s credit capacity based on asset values a highly predictable way
of providing capital to clients.

Cash flow-based loans, while also usually a secured form of financing, often use EBITDA
(or a company’s earnings before interest, taxes, depreciation and amortization) along with
a multiplier to determine credit capacity, rather than the value of the underlying collateral
assets. The level of EBITDA can change and the multiplier applied can change significantly during business and economic cycles. During an economic downturn, most companies will see their EBITDA decline, both on a relative and absolute basis. Often, the multiplier being used by lenders will shrink at the same time; this combination of declining EBITDA and a shrinking multiplier can result in a significant decline in available credit capacity at what could be the exact time a company most needs access to capital.

Typical uses

Frequent uses of ABLs

For higher quality, large-corporate borrowers, ABLs are often used simply for financing working capital. These companies will often access the public or private capital markets for long-term forms of financing for the majority of their overall capitalization. They will then use ABLs to fund seasonal changes in working capital, for shareholder value-creating actions such as share repurchase programs, dividends or distributions, and for opportunistic acquisitions.

For midsized companies, in addition to providing working capital financing, ABLs often incorporate
term loans, which are secured by longer-term assets such as machinery and real estate, to provide incremental credit capacity.

ABLs also tend to play a key role in the financing of companies facing cyclical or operating
performance headwinds that have caused their credit profile to deteriorate. They need
patient capital to attempt to execute on their business turnaround or restructuring
plans, or just to weather the current environment, including the possibility of bankruptcy
reorganization. Often, an ABL is “transitional” capital for these companies; for a time it
provides incremental liquidity and structural flexibility characteristics that help owners
and managers reposition the company. Once that is completed, these companies often
refinance again in the cash flow credit market.

There are also times when companies use an ABL as transitional capital only to later
realize that many of the characteristics of ABLs fit their business well. They may see that
both the discipline and freedom associated with these loans can enhance the way they
execute their plans. These companies often never go back to the cash flow loan market.
In fact, there are several Fortune 500 companies that have opted to used ABLs.

Qualifying companies

Manufacturers, wholesale distributors, retailers, and some forms of service companies
are prime candidates for ABLs. Solid ABL candidates will usually have tangible asset-rich
balance sheets, often with at least half of their total assets in working capital assets,
such as accounts receivable and inventory.

Like all lenders, asset-based loan providers look for companies with solid management
teams and a history of being able to effectively manage their businesses, even when
facing difficult circumstances. They also look for companies with excellent financial
accounting information systems that can provide reliable data about both operating and
asset performance.

Does company size matter in qualifying for an ABL?

No. Companies of all sizes can qualify for an ABL as long as their business is a good match
for the characteristics that asset-based lenders look for. For midsized companies, annual
revenues between $35 million and $250 million are typical of today’s borrowers. But ABLs
are also delivered just as easily to multibillion-dollar revenue companies.

What about credit ratings?
Since asset-based lending is always secured, its target market is non-investment grade
companies (companies with an actual or equivalent S&P rating of BB+ and below, or a
Moody’s rating of Ba1 and below). External credit ratings are not required to issue an ABL.

Which assets qualify as collateral under ABL structures?
Accounts receivable and inventory—assets that have a high degree of market liquidity
and can be easily valued and monitored—head the list of qualifying assets. Long-term
assets such as equipment and real estate are often used as additional collateral when
the ABL is structured as a term loan with a fixed amortization schedule.
Some proportion of even the most liquid of asset classes are typically ineligible in ABLs.
Examples include substantially past due accounts receivable, some types of work-inprocess
inventory or assets held for sale not in the ordinary course of business.

Project Finance
Project Finance can be characterised in a variety of ways and there is no universally adopted definition
but as a financing technique, the author’s definition is:
 “the raising of finance on a Limited Recourse basis, for the purposes of developing a large capitalintensive
infrastructure project, where the borrower is a special purpose vehicle and repayment of the
financing by the borrower will be dependent on the internally generated cashflows of the project”
The terms ‘Project Finance’ and ‘Limited Recourse Finance’ are typically used interchangeably and
should be viewed as one in the same. Indeed, it is debatable the extent to which a financing where the
Lenders have significant collateral with (or other form of contractual remedy against) the project
shareholders of the borrower can be truly regarded as a project financing. The ‘limited’ recourse that
financiers have to a project’s shareholders in a true project financing is a major motivation for
corporates adopting this approach to infrastructure investment.
Project financing is largely an exercise in the equitable allocation of a project’s risks between the
various stakeholders of the project.

MBA Core Management Knowledge - One Year Revision Schedule

November 27, 2014

Role of Finance Managers in Enterprise Risk Management

Companies should be managed so that they do not go into financial distress. Benjamin Graham tells conservative investors not to invest in a company that made a loss in the last ten years.

Financial distress is associated with having operating cash flows fall below minimum required levels. Risk management can reduce the likelihood of low cash flows and hence of financial distress.

Risk management meant buying insurance against fire, theft, and liability losses sometime back. Now finance managers have more alternatives.

 In an article in CFO, Scott Lange, who was head of Microsoft Risk at the time the article appeared, identified these 12 major sources of risk:

1. Business partners (interdependency, confidentiality, cultural conflict, contractual risks).
2. Competition (market share, price wars, industrial espionage, antitrust allegations).
3. Customers (product liability, credit risk, poor market timing, inadequate customer support).
4. Distribution systems (transportation, service availability, cost, dependence on distributors).
5. Financial (foreign exchange, portfolio, cash, interest rate, stock market).
6. Operations (facilities, contractual risks, natural hazards, internal processes and control).
7. People (employees, independent contractors, training, staffing inadequacy).
8. Political (civil unrest, war, terrorism, enforcement of intellectual property rights, change in leadership,
revised economic policies).
9. Regulatory and legislative (antitrust, export licensing, jurisdiction, reporting and compliance, environmental).
10. Reputations (corporate image, brands, reputations of key employees).
11. Strategic (mergers and acquisitions, joint ventures and alliances, resource allocation and planning, organizational agility).
12. Technological (complexity, obsolescence, workforce skill sets).

 Lange defined the role of finance in risk management: The role of finance is to put on paper all of
the risks that can be identified and to try to quantify them. When possible, use a number—one number perhaps or a probability distribution. For example, what is the probability of losing $1 million on a product? $10 million?

MBA Core Management Knowledge - One Year Revision Schedule

Market Development for New Products, Processes and System

Market development is the last mile of  any innovation.  The authors proposed  two very
different kinds of market development. Accelerating adoption applies to individual products, services, and business models, while creating new markets is a more fundamental process that supports the success of revolutionary business ideas.

Accelerating Adoption

For introducing a single innovation to the marketplace, firms often rely on proven techniques such as
advertising, public relations, and trade shows to persuade potential customers that the new products or services are worth paying attention to. One of the reasons for the increased sophistication required for breakthrough innovations is that their users make fundamental change to how they function or how they behave, changes that involve switching costs incurred by the end user to make use of the new product or service. This cost is the most significant factor in new product adoption and may inhibit the adoption.

The development of principles in this area  has been significantly influenced by Everett Rogers, a Stanford professor whose book "Diffusion of Innovations" pioneered the study of the critical relationship between innovations and the customers who adopt them. Rogers showed that the rate
of new product adadoption commonly follows a bell curve, and defined different groups within a total population according to how quickly or slowly they tended to adopt innovations. He also explored issues such as opinion leadership, diffusion networks, change agents, and innovation in
organizations, all of which are significant factors in market development. Consultant Geoffrey Moore subsequently applied Rogers’ ideas in a model that has become widely used in high tech industries. Moore’s book, "Crossing the Chasm", explains how the adoption curve can be applied to
understand how and why new high tech products succeed or fail in the market. It also examines how differing psychological factors affect different groups of buyers, and therefore how marketing, advertising, and sales have to be adapted at each different phase of the adoption curve.
Moore identifies four groups of adopters: early adopters who in the technology world tend to be technology enthusiasts, and then visionaries, pragmatists, and conservatives. The mass market that is your goal begins with the pragmatists,  The important principle is that marketing communications have to be different for different groups. Hence the organization has to identify when the product is moving into the hands of the next group and change its marketing communications to create awareness first and then attract the persons in the target group to sample the product and then become advocates of the product.

Malcolm Gladwell’s concept of the “tipping point,” described in his book of the same name, also explores the factors underlying the adoption of new ideas and new products.   The book
shows how contagious behavior—like a fashion trend or the sudden emergence of a bestselling book—starts in an organic fashion and then suddenly takes off exponentially, much like a virus, without any central control or master plan. The idea from which the book takes its title is that moment in a
system’s development when a small change leads to a huge effect in a very rapid time frame, and spreads contagiously. For those who want to instigate rapid change, the principles of the
tipping point model are important.

The rapid growth is usually started by a handful of people who exhibit some kind of exceptional behavior. In the propagation of infectious diseases, some people, who by the nature of what they do or the lifestyle they lead, allow the growth of the disease to tip so that it becomes an epidemic.
The same can be said for many other trends—a small number of people (like skateboarders) have the ability to infect a large number of other people with a new idea (like a style of clothing or shoes). Gladwell suggests that there are three types of exceptional people whose disproportional influence can make a change tip and become a trend. They’re Connectors, Mavens and Salesmen.

Connectors are people who seem to know everyone. As information travels through networks it’s highly likely to come in contact with a connector, and if the information engages the connector’s interest, he or she will distribute it to a huge number of other individuals in a short period of time, creating a tipping point. Only a small number of connectors are needed in any system to propagate a new trend.

Mavens are information specialists. They’re the people who seem to know everything there is to know about a certain topic, and they have one additional characteristic that makes them different from ordinary experts: they love to share what they know with others. If somebody asks them, they ar willing to explain and share.  Mavens are important as tipping points because they’re on the leading edge of acquiring new information.

Salesmen are the quintessential persuaders who can get people to make decisions and take actions that they ordinarily wouldn’t take if left to themselves. They’re individuals who have the ability to persuade in part because they can get another person to root for them in the same way that an audience roots for a performer on stage. Their ability to persuade makes them strong carriers of infectious ideas, concepts, trends and changes.

Creating New Markets

When new markets or industries emerge, it’s often because someone has been able to catalyze the connectors, mavens, and salesmen in a community, although this doesn’t necessarily happen quickly.

If you look down the list of breakthrough technologies, you’ll notice that just about every breakthrough, and many of the new business models, was supported by focused market development efforts that articulated existing needs and defined new possibilities for meeting them.

Autos: Minivans
Computer: Personal Computers
Banking: ATMs
Food: Genetic Engineering (still an ongoing development process)
Airlines: Online reservations
Telecommunications: Cell phones
Health Care: MRI / CAT Scan
Retail: Bar codes
Office Supply: Post-it Notes
Media: BLOGs

Early adopters bought the first versions of nearly all these products, and gradually the value was proven as more and more users were satisfied. Mainstream buyers eventually became interested, leading to the development of a large customer base. All this was supported by advertising, and constant effort to gain favorable (and free) media publicity.

From Permanent Innovation - Langdon Morris

Permanent Innovation
The Definitive Guide to the Principles, Strategies, and Methods of
Successful Innovators
Langdon Morris

Langdon Morris is a co-founder and principal of InnovationLabs LLC and Senior Practice Scholar at the Ackoff Center of the University of Pennsylvania and Senior Fellow of the Economic Opportunities Program of the Aspen Institute.

MBA Core Management Knowledge - One Year Revision Schedule

Opportunities or Areas for Innovation

Every activity done by an organization provides an opportunity for innovation. Porter brought out this idea strongly in his value chain model of an organization. Every activity can become a differentiator and a differentiation in multiple activities becomes difficult for competitors to imitate because they will take time to understand.

Business structure

alliances & partnerships
capital formation


information flow
insourcing / outsourcing services


structure type
facilities infrastructure
 IT infrastructure
employee / contractor mix
employee experience
decision making processes
facilities effectiveness
process to improve processes
 education & training

Customer experience

communication process
brand / image

Customer service

service process

Supply chain

distribution system


product offering
product availability
technology (hidden)
technology (evident)
user interface
life cycle model
sales model
after-sale service

Production Processes and Technology

Maintenance Processes

Inspection and Quality Control Processes

Pollution Control Process

Industrial Engineering

From Permanent Innovation - Langdon Morris

Permanent Innovation
The Definitive Guide to the Principles, Strategies, and Methods of
Successful Innovators
Langdon Morris

Langdon Morris is a co-founder and principal of InnovationLabs LLC and Senior Practice Scholar at the Ackoff Center of the University of Pennsylvania and Senior Fellow of the Economic Opportunities Program of the Aspen Institute.

MBA Core Management Knowledge - One Year Revision Schedule

Financial Management Aspects of Mergers and Acquisitions

An acquisition of a company or substantial portion of its shares is an investment. Financial managers have to appraise it to see whether return on such investment is higher than the cost of the capital for the company.

Financial managers and theorists have proposed many reasons for acquisitions and merger activity. The primary economic motives mentioned are:


Synergistic effects can arise from four sources: (1) operating economies, which result from economies of scale in management, marketing, production, or distribution due to combining operations; (2) financial economies, including lower transactions costs and better coverage by security analysts; (3) differential efficiency, which implies that the management of one firm is more
efficient and  will increase the return from that the weaker firm’s assets after the acquisition or  merger; and (4) increased market power due to reduced competition.

Tax Considerations
Tax considerations have stimulated a number of mergers. For example, a profitable firm in the highest tax bracket could acquire a firm with large accumulated tax losses. These losses could then be turned into immediate tax savings rather than carried forward and used in the future. Thus excess cash can be used  as a way of minimizing taxes.

Purchase of Assets below Their Replacement Cost
Sometimes a firm acquires a company because the cost of replacing its assets is considerably higher than its market value. If the new management uses the assets appropriately, the market value will increase in the future.

Managers contend that diversification helps stabilize a firm’s earnings and thus benefits its owners as risk premium of the company's comes down. Stabilization of earnings is certainly beneficial to employees, suppliers, and customers; but its value is less certain from the standpoint of stockholders. Stockholders also can buy the stock of both firms? Many studies find that diversified firms are worth significantly less than the sum of their individual parts as top managements cannot provide adequate managerial expertise to diversified businesses.

Breakup Value
 Recently, takeover specialists have identified breakup value as  a basis for
valuation. A company’s breakup value, is the value of the individual parts of the firm if they are sold off separately. If this value is higher than the firm’s current market value, a takeover specialist could acquire the firm at or even above its current market value, sell it off in pieces, and earn a substantial profit. Such a breakup value is mainly appearing in diversified companies.

Types of Mergers

Mergers are classified into four types:
(1) horizontal,
(2) vertical,
(3) congeneric, and
(4) conglomerate.

A horizontal merger occurs when one firm combines with another in its same line of business.
An example of a vertical merger is a steel producer’s acquisition of one of its own suppliers, such
as an iron or coal mining firm. Congeneric means “allied in nature or action”; There is a relationship but not producers of the same product (horizontal) or firms in a producer-supplier relationship (vertical). A clothing retailer may acquire a food retailer.  A conglomerate merger occurs when unrelated enterprises combine.

Vertical and horizontal mergers generally provide the greatest synergistic operating benefits

Financial Analysis

The acquiring firm performs an analysis to value the target company based on its expected cash flows and cost of capital applicable and then determines whether the target can be bought at that value or, preferably, for less than the estimated value.

The target company also makes an analysis of its cash flows and makes a valuation of them and will accept the offer if the price exceeds either its value if it continued to operate independently or the price it could receive from some other bidder.

MBA Core Management Knowledge - One Year Revision Schedule

Management of Cash and Marketable Securities

Sophistication is increasing  in cash management by corporations. The trend has been toward reducing cash—the firm’s most liquid asset—to a minimum.  and the funds are invested in interest earning securities or in earning assets. This trend can be attributed to rising interest rates on securities, which make the opportunity cost of holding cash more expensive, to innovations in cash management, and to economies of scale in cash management as corporations grow larger.

A number of methods have come into existence in recent years to speed up this collection process and maximize available cash. These methods helps cash management in the following ways:
(1) speed the mailing time of payments from customers to the firm;
(2 ) reduce the time during which payments received by the firm remain uncollected funds; and
(3) speed the movement of funds to disbursement banks.

Multiple Collection Centers

 Instead of a single collection center located at the company headquarters, multiple collec-
tion centers are established. The purpose is to shorten the period between the time a customer mails in his payment and the time when the company has the use of the funds. Customers in a particular geographic area are instructed to remit their payments to a collection center in that area.  When
payments are received, they are deposited in the collection center’s local bank. Surplus funds are then transferred from these local bank accounts to a concentration bank or banks. A bank of concentration is one with which the company has a major account—usually a disbursement account.

Bank Collection of Checks from Post Offices

Another means of accelerating the flow of funds is a lock-box arrangement. The purpose
of a lock-box arrangement is to eliminate the time between the receipt of remittances by the company and their deposit in the bank. The company rents a local post office box and authorizes its bank in
each of these cities to pick up remittances in the box. Customers are billed with instructions to mail their remittance to the lock box. The bank picks up the mail several times a day and deposits the checks in the company’s account. This procedure frees the company from handling and depositing the checks. The main advantage of a lock-box system is that checks are deposited at banks sooner and become collected balances sooner than if they were processed by the company prior to deposit. No doubt, the bank will take an extra fee for the service. But the service is utilized only when it is profitable for the company to employ it.

Frequently, firms give special attention to the handling of large remittances so that they may be deposited in a bank as quickly as possible. This special handling may involve personal pickup of these checks or the use of airmail or special delivery.. The firm should exercise tight control over interbank transfers of cash and transfers between various units of the company, such as divisions or subsidiaries. Excessive funds may be tied up in various divisions of the firm.

Some companies maintain too many bank accounts, thereby creating unnecessary pockets of idle funds. With less number of accounts also similar service can be provided at a lesser cost to the company.

MBA Core Management Knowledge - One Year Revision Schedule

Management of Investment in Accounts Receivable

Management of Accounts Receivable

Accounts receivable is a current asset that appears due to the extension of open-account credit
by one firm to other firms and to individuals. Credit has to be extended to generate sales.
Therefore, accounts receivable are necessary investment, but require careful analysis. Receivables can be managed efficiently so that the level of investment in them is optimal.

Credit policy involves a tradeoff between the profits on sales that give rise to receivables on one hand and the cost of carrying these receivables plus bad-debt losses on the other. Credit policy determines
the amount of credit risk  accepted. In turn, the risk accepted or taken affects the slowness of receivables as well as the amount of bad-debt losses. Collection procedures also affect these factors. Thus, proper the credit granting and collection procedures of the firm determine the success of the firm’s overall credit management and collection policies.


The policy variables include the quality of the trade accounts accepted, the length of the credit period, the cash discount given, any special terms given, such as seasonal datings, and the collection program of the firm. Together, these elements largely determine the average collection period and the proportion of bad-debt losses.

Credit Standards

Credit policy can have a significant influence upon sales. If competitors extend credit liberally and if a firm does not, the policy may have a dampening effect upon the marketing effort. Trade credit is one of many factors that influence the demand for a firm’s product.  In theory, the firm can lower its quality standard for accounts accepted as long as the expected profitability of sales generated exceeds the added costs of the receivables. What are the costs of relaxing credit standards? The incremental cost comes from the increased probability of bad-debt losses. Also a slower average collection
period will occur.

To determine the profitability of a more liberal extension of credit, we must know the profitability of additional sales; the added demand for products arising from the relaxed credit standards; the increased slowness of the average collection period; and the required return on investment.

Suppose a firm’s product sells for $ 10 a unit, of which $7 represents variable costs before taxes, including credit department costs. Current annual sales are $2.4 million, represented entirely by credit sales, and the average total cost per unit at that volume is $9 before taxes. The firm is considering a more liberal extension of credit, which will result in a slowing in the average collection period from one to two months. This relaxation in credit standards is expected to produce a 25 per cent increase in sales, to $3 million annually.  With this percentage increase, the unit sales and total costs of the firm become:

Cost of Present sales  =  240,000 units X $9 = $2,160,000
Marginal cost of Additional sales =  60,000 units X $7 = 420,000
Total cost =  $2,580,000
The average cost per unit of sale at the new level of sales is

Assume that the firm’s required return on investment is 20 per cent before taxes.

Inasmuch as the profitability on additional sales, $180,000 (60,000 * $3), exceeds the required return on the additional investment in accounts receivable, $50,000, the firm is advised to relax its credit standards. An optimal credit policy would involve extending trade credit more liberally until the marginal profitability on additional sales equals the required return on the additional investment in receivables necessary to generate those sales.

MBA Core Management Knowledge - One Year Revision Schedule

Financial Management of Inventory


Inventory management usually is not the direct operating responsibility of the financial manager. But  the investment of funds in inventory is a very important aspect of financial management. The finance manager has to appraise the proposed investment in inventory like the appraisal he does for fixed capital assets. Consequently, the financial manager must be familiar with methods proposed in the theory to plan and control inventories. Planning of the inventory is based on minimising the costs associated with keeping inventory.

The inventory control or management methods described give  a means for determining an optimal level of inventory, and also to decide when to ordered and in what quantity. . These tools are necessary for
managing inventory efficiently and balancing the advantages of additional inventory against the cost of carrying this inventory. With the use of computers, great improvements in inventory control have been made
and are continuing to be made. Also there are manyu applications of operations research to inventory management.

New ideas to reduce inventory required normally occur with in the inventory management theory. But even finance theory sometimes may come out with principles related to optimizing inventory. When the innovation occurs in the finance field, finance managers have to take the responsibility of implementing it within their activity or within inventory management activity.

Inventories, like receivables, represent a significant portion of most firms’ assets, and, accordingly, require substantial investments. Inventories must be managed efficiently.

Inventories provide a very important link in the production and sale of a product. For a company engaged in manufacturing, a certain amount of inventory is absolutely necessary in the production distribution system. Toyota Production System came out of the efforts of managers identify and eliminate excess inventory which was thought at that time as essential.

 The obvious disadvantages of inventory are the total cost of holding the inventory, including storage and handling costs, and the required return on capital tied up in the investment in inventory. Inventories, like accounts receivable, should be increased as long as the resulting savings exceed the total cost of holding the added inventory. The balance finally reached depends upon the estimates of actual savings, the cost of carrying additional inventory, and the efficiency of inventory control.


Without inventory between production stages, each stage of production would be dependent upon the preceding stage’s finishing its operation on a unit of production. As a result, there probably would be delays and considerable idle time in certain stages of production.

According to traditional inventory theory,  the advantages of increased inventories, then, are several. The firm can effect economies of production and purchasing and can fill customer orders more quickly. In short, the firm is more flexible.

For a given level of inventory, the efficiency of inventory control affects the flexibility of the firm. Two essentially identical firms with the same amount of inventory may have significantly different degrees of
flexibility in operations due to differences in inventory control. Inefficient procedures may result in an unbalanced inventory —the firm may frequently be out of certain types of inventory, and overstock other
types, necessitating excessive investment. These inefficiencies ultimately have an adverse effect upon profits. Turning the situation around, differences in the efficiency of inventory control for a given level of flexibility
affect the level of investment required in inventories. The less efficient the inventory control, the greater the investment required. Similarly, excessive investment in inventories affects profits adversely.



The economic order quantity (EOQ) is an important concept in inventory management.

The optimal order quantity for a particular item of inventory, given its forecasted usage, ordering cost, and carrying cost is determined using mathematics. Ordering can mean either the purchase of the item or its production. Assume for the moment that the usage of a particular item of inventory is known with certainty. Moreover, assume that ordering costs per order, O, are constant regardless of the size of the order. In the purchase of raw materials or other items, these costs represent the clerical costs involved in placing an order as well as certain costs of receiving and checking the goods once they arrive.

For finished-goods inventories, ordering costs involve scheduling a production run. For in-transit inventories, ordering costs are likely to involve nothing more than record keeping. The total ordering cost for
a period is simply the number of orders for that period, times the cost per order. It is important to state at this point that Toyota reduced its ordering cost or set up cost and thereby reduced its economic order quantities.

Carrying costs per period, C, represent the cost of inventory storage, handling, and insurance, together with the required rate of return on the investment in inventory. These costs are assumed to be constant per unit
of inventory, per unit of time. Thus, the total carrying cost for a period is the average number of units of inventory for the period, times the carrying cost per unit. In addition, it is  assumed  that inventory orders are filled immediately, without delay.

If the usage of an inventory item is perfectly steady over a period of
time and there is no safety stock, average inventory (in units) can be expressed
as:  EOQ/2

The EOQ formula is  SQRT(2AS/I)

A = annual demand
S = ordering cost
I = inventory carrying cost per unit


In practice, the demand or usage of inventory generally is not known with certainty; usually it fluctuates during a given period of time. Typically, the demand for finished-goods inventory is subject to the fluctuation. . In addition to demand or usage, the lead time required to receive delivery of inventory once an order is placed is usually subject to some variation. Owing to these fluctuations, it is not feasible in most cases to allow expected inventory to fall to zero before a new order is expected to be received, as could be done when usage and lead time were known with certainty.

Most firms maintain some margin of safety, or safety stock; otherwise, they may at times be unable to satisfy the demand for an item of inventory. There are opportunity costs to being out of stock. In the case of
finished-goods inventory, the customer is likely to become irritated and may take his business elsewhere. In the case of raw-materials and intransit inventories, the cost of being out of stock is a delay in production.
While this opportunity cost is measured more easily than that associated with finished-goods inventory, a stockout of the latter has a cost; and the firm must recognize it.

. If we know the cost per unit of stockout, we can calculate the expected cost of stockouts and then compare this cost with the cost of carrying additional inventory.

Uncertainty o f Lead Time. Suppose that the lead time required for procurement, like demand or usage, is subject to a probability distribution. Based on this probability distribution can determine the optimal level of safety stock for the period.


At order point which is a stock level, an order is placed.

Order Point* = S(L) +  Safety Stock

where S is the usage, L is the lead time required to obtain additional inventory

Suggestions for Inventory Efficiency

When demand or usage of inventory is uncertain, the financial manager may try to effect policies that will reduce the average lead time required to receive inventory once an order is placed. The lower the
average lead time, the lower the safety stock needed and the lower the total investment in inventory, all other things held constant. The greater the opportunity cost of funds invested in inventory, the greater the
incentive to reduce this lead time. In the case of purchases, the purchasing department may try to find new vendors that promise quicker delivery or place pressure on existing vendors for faster delivery. In the
case of finished goods, the production department may be able to schedule production runs for faster delivery by producing a smaller run. In either case, there is a tradeoff between the added cost involved in reducing the lead time and the opportunity cost of funds tied up in inventory. This discussion serves to point out the importance of inventory management to the financial manager. The greater the efficiency with which
the firm manages its inventory, the lower the required investment in inventory, all other things held constant.

The modern inventory system is zero inventory system. It is also being called lean system (non stock system). To know how nonstock highly efficient systems were developed in Toyota read
Toyota Production System Industrial Engineering.

MBA Core Management Knowledge - One Year Revision Schedule

Working Capital Finance - USA

This article  introduces the five major forms of debt used to finance working capital. The purpose of this information is to provide insight into the different ways in which debt for working capital can be structured and prepare finance professonals  to choose and structure  debt best suited to a firm’s financial situation and needs.

Line of Credit

A line of credit is an open-ended loan with a borrowing limit that the business can draw against or repay at any time during the loan period. This arrangement allows a company flexibility to borrow funds when the need arises for the exact amount required. Interest is paid only on the amount borrowed, typically on a monthly basis. A line of credit can be either unsecured, if no specific collateral is pledged for repayment, or secured by specific assets such as accounts receivable or inventory.

The standard term for a line of credit is 1 year with renewal subject to the lender’s annual review and approval. Lenders usually require full repayment of the line of credit during the annual loan period
and prior to its renewal. This repayment is sometimes referred to as the annual cleanup.

Lenders require a fee for providing the line of credit, based on the line’s credit limit, which is paid whether or not the firm uses the line. This fee, usually in the range of 25 to 100 basis points, covers the bank’s costs for underwriting and setting up the loan account in the event that a firm does not use the line and the bank earns no interest income. A second cost is the requirement for a borrower to maintain a compensating balance account with the bank. Under this arrangement, a borrower must have a deposit account with a minimum balance equal to a percentage of the line of credit, perhaps 10% to 20%. If a firm normally maintains this
balance in its cash accounts, then no additional costs are imposed by this requirement. However, when a firm must increase its bank deposits to meet the compensating balance requirement, then it is incurring an additional cost. In effect, the compensating balance reduces the business’s net loan proceeds and increases its effective interest rate.

 Like most loans, the lending terms for a line of credit include financial covenants or minimal financial standards that the borrower must meet. Typical financial covenants include a minimum current ratio, a minimum net worth, and a maximum debt-to-equity ratio. The advantages of a line of credit is that it allows a company to minimize the principal borrowed and the resulting interest payments.

With full repayment required each year and annual extensions subject to lender approval, a line of credit cannot finance medium-term or long-term working capital investments.

Accounts Receivable Financing

Loans secured by accounts receivable are a common form of debt used to finance working capital.
Under accounts receivable debt, the maximum loan amount is tied to a percentage of the borrower’s accounts receivable.  The firm must use customer payments on these receivables to reduce the loan balance. The borrowing ratio depends on the credit quality of the firm’s customers and the age of the accounts receivable. A firm with financially strong customers should be able to obtain a loan equal to 80% of its accounts receivable. With weaker credit customers, the loan may be limited to 50% to 60% of accounts
receivable. Lenders may exclude receivables beyond a certain age (e.g., 60 or 90 days) in the base used to calculate the loan limit.

Since accounts receivable are pledged as collateral, when a firm does not repay the loan, the lender will collect the receivables directly from the customer and apply it to loan payments. The bank receives
a copy of all invoices along with an assignment that gives it the legal right to collect payment and apply it to the loan. In some accounts receivable loans, customers make payments directly to a bank-controlled account (a lock box).

Firms gain several benefits with accounts receivable financing arrangements. Borrowing capacity grows automatically as sales grow. This automatic matching of credit increases to sales growth provides a ready means to finance expanded sales, which is especially valuable to fast-growing firms. Accounts receivable financing allows small businesses with creditworthy customers to use the stronger credit of their customers to
help borrow funds.


Factoring entails the sale of accounts receivable to another firm, called the factor, who then collects payment from the customer. Through factoring, a business can shift the effort and costs of collection and the risk of nonpayment to a third party. In a factoring arrangement, a company and the factor work out a credit limit and average collection period for each customer. As the company makes new sales to a customer, it provides an invoice to the factor. The customer pays the factor directly, and the factor then pays the company based on the agreed upon average collection period, less a slight discount
that covers the factor’s collection costs and credit risk.

A factor may advance payment for a large share of the invoice, typically 70% to 80%, providing the
company with immediate cash flow from sales. In this case, the factor charges an interest rate on this advance and then deducts the advance amount from its final payment to the firm when an invoice is collected

Factoring saves the cost of establishing and administering its own collection system. Second, a factor can often collect accounts receivable at a lower cost than a small business, due to economies of scale, and transfer some of these savings to the company. Third, factoring is a form of collection insurance that provides an enterprise with more predictable cash flow from sales. On the other hand, factoring costs may be higher than a direct loan,.The business loses control over the collection  part of the customer relationship, which may affect overall customer relations, especially when the factor’s collection practices differ from those of the company.

Inventory Financing

Inventory financing is a secured loan with inventory as collateral.  Firms with an inventory of standardized goods with predictable prices, such as automobiles or appliances, will be more successful at securing
inventory financing than businesses with a large amount of work in process or highly seasonal or perishable goods. Loan amounts also vary with the quality of the inventory pledged as collateral, usually ranging from 50% to 80%. For most businesses, inventory loans yield loan proceeds at a lower share of pledged assets than accounts receivable financing. When inventory is a large share of a firm’s current assets, however, inventory financing has to be sought to finance working capital.

Lenders need to control the inventory pledged as collateral to ensure that it is not sold before their loan is repaid. Two primary methods are used to obtain this control: (1) warehouse storage; and (2) direct assignment by product serial or identification numbers.  Under one warehouse arrangement, pledged inventory is stored in a public warehouse and controlled by an independent party (the warehouse operator). A warehouse receipt is issued when the inventory is stored, and the goods are released only upon
the instructions of the receipt-holder. When the inventory is pledged, the lender has control of the receipt and can prevent release of the goods until the loan is repaid. A field warehouse, can also be established. Here, an independent public warehouse company assumes control over the pledged inventory at the
firm’s site.  Direct assignment by serial number is a simpler method to control inventory used for manufactured goods that are tagged with a unique serial number. The lender receives an assignment or trust
receipt for the pledged inventory that lists all serial numbers for the collateral. The company houses and controls its inventory and can arrange for product sales. However, a release of the assignment or return of the trust receipt is required before the collateral is delivered and ownership transferred to the buyer. This release occurs with partial or full loan repayment.

While inventory financing involves higher transaction and administrative costs than other loan instruments, it is an important financing tool for companies with large inventory assets.

Term Loan

Term loans can finance medium-term noncyclical working capital. A term loan is a form of medium-term debt in which principal is repaid over several years, typically in 3 to 7 years. Since lenders prefer not to bear interest rate risk, term loans usually have a floating interest rate set between the prime rate and prime plus 300 basis points, depending on the borrower’s credit risk.
Term loans have a fixed repayment schedule that can take several forms. Level principal payments over the loan term are most common. In this case, the company pays the same principal amount each month plus interest on the outstanding loan balance. A second option is a level loan payment in which the total payment amount is the same every month but the share allocated to interest and principle varies with each payment. Finally, some term loans are partially amortizing and have a balloon payment at maturity. Term loans can be either unsecured or secured; a business with a strong balance sheet and a good profit and cash flow history might obtain an unsecured term loan, but many small firms will be required to pledge assets. Moreover,
since loan repayment extends over several years, lenders include financial covenants in their loan agreements to guard against deterioration in the firm’s financial position over the loan term. Typical financial covenants
include minimum net worth, minimum net working capital (or current ratio), and maximum debt-to-equity ratios. Finally, lenders often require the borrower to maintain a compensating balance account equal to 10% to 20% of the loan amount.

To be rewritten once again.

MBA Core Management Knowledge - One Year Revision Schedule

November 26, 2014

Chapter 15. Working Capital Management

Chapter 15 -- Working Capital Management

. Working capital, net working capital, and net operating working capital
. Current asset investment and financing policies
. Cash conversion cycle
. Cash and marketable securities
. Inventories
. A/R and A/P (trade credit)
. Bank loans

. Working capital, net working capital, and net operating working capital

 Working capital refers to current assets

Net working capital = currents assets - current liabilities

Net operating working capital = current assets - (current liabilities - notes payable)

. Current assets investment and financing policies

Current assets investment policy: how much current assets a firm should have

 Relaxed current asset policy: carry a relatively large amount of current assets

 along with a liberal credit policy with a high level of A/R

 Restricted current asset policy: carry constrained amount of current assets along
with restricted credit policy

Moderate current asset policy: in between the relaxed and restricted policies

 Current asset financing policy: the way current assets are financed

Permanent assets vs. temporary assets

 Permanent assets: to be held for more than one year

 Temporary assets: to be held for less than one year

 Maturity matching approach: a policy that matches asset and liability maturities
and it is a moderate policy

 Aggressive approach: uses more short-term, non-spontaneous debt financing

 Conservative approach: uses more long-term debt and equity financing

Permanent assets should be financed by intermediate and long-term debt,
preferred stock, and common stock.

Temporary assets should be financed by notes and short-term loans.

. Cash conversion cycle

 (1) The cash conversion cycle (CCC)

 The average length of time funds are tied up in working capital or the length of
time between paying for working capital and collecting cash from the sale of the
working capital

(2) Inventory conversion period (days of sales in inventory, DSI)

The average time required to convert materials into finished goods and then sell

(3) Average collection period (ACP)

The average length of time required to convert the firm’s receivables into cash

(4) Payables deferral period (days of payable outstanding, DPO)

The average length of time between the purchase of materials and labor and
the payment of cash for them

The relationship is: DPO + CCC = DSI + ACP, or CCC = DSI + ACP - DPO

Minimizing working capital: speeding cash collection (reducing ACP), increasing
inventory turnovers (reducing DSI), and slowing down cash disbursement
(increasing DPO)

. Cash and marketable securities

 Refer to currency and demand deposits in addition to very safe and highly liquid
marketable securities that can be sold quickly at a predictable price and thus be
converted to bank deposits

. Inventories

 Include supplies, raw materials, work-in-process, and finished goods

. A/R and A/P (trade credit)

 A/R: funds due from customers

 Credit policy: a set of rules that includes credit period, discounts, credit standards,
and collection policy

 Credit terms: for example, 2/10, net 30 means that the firm allows a 2% price
discount if payment is received within 10 days of the purchase; if the discount is
not taken, the full payment is due in 30 days

 Credit score: a numerical score from 1 to 10 that indicates the likelihood that a
person or business will pay on time

 A/P (trade credit): debt arising from credit sales and recorded as an account
receivable by the seller and as an account payable by the buyer

 Trade credit may be free or it may be costly. For example, the terms 2/10, net 30 are offered when a firm makes the purchase on its credit card. Assuming 365 days per year,

 discount % 365

Nominal annual cost of trade credit = --------------------*-------------------------------

 100-discount % credit days-discount days

 2 365

 = ------------- * ------------- = 37.24%

 100 - 2 30 - 10

. Bank loans

 Promissory note: a document specifying the terms and conditions of a loan

 Line of credit: an agreement in which a bank agrees to lend up to a specified

 maximum amount of funds during a designated period

 Cost of bank loans:

 interest 1

 Annual Percentage Rate (APR) = -------------*-------

 principal time

Accrued wages and taxes

Commercial papers: unsecured, short-term promissory notes issued by large firms

MBA Core Management Knowledge - One Year Revision Schedule


Chapter 14. Dividend Policy

Chapter 14 -- Dividend Policy

. Dividend vs. retained earnings
. Dividend policy: three basic views
. The clientele effect
. The information content or signaling hypothesis
. Dividend policy in practice
. Dividend payment procedures
. Factors influencing dividend policy
. Stock repurchase, stock dividends and stock splits

. Dividend vs. retained earnings

 Dividend payout ratio vs. profit retention ratio: a review

 Higher dividends mean lower retained earnings, which means lower growth rate
and less capital gains

. Dividend policy: three basic views

 Dividend policy: to determine the optimal payout ratio to maximize the stock price

 View 1: dividend policy is irrelevant (Irrelevance Theory by MM 1961)

Assumptions: perfect capital markets with no taxes, no transaction costs, no
flotation costs, etc.

 Result: dividend policy doesn't matter; dividend policy does not affect a firm ‘s
value or its overall cost of capital

 View 2: high dividends increase stock price (Bird-in-the-hand theory 1979)

 Result: investors feel more secure to receive cash dividends than the income from
capital gains. Therefore, the higher the cash dividend, the better the stock

 View 3: low dividends increase stock price (Tax differential theory 1979)

 The tax rates on cash dividends were higher than the tax rates on long-term
capital gains before 2003. In addition, capital gains tax can be delayed until the
stocks are sold (time value of money) or can be avoid if stocks are passed to
beneficiaries provided the original owner passes away.

 Result: the lower the cash dividend, the better the stock

. The clientele effect

 Different dividend policies will attract different investors

. The information content or signaling hypothesis

 Information asymmetry: insiders and outsiders have different information

 Dividends reveal some inside information about firm's future profitability. By
increasing dividends, managers signal to the market that the firm will have enough
earnings to support future projects.

 Result: an increase in dividend is regarded as a good signal, which causes the stock

 price to go up.

. Dividend policy in practice

 Residual dividend model

 A model that states that the dividends to be paid should equal to the capital left over
after financing of profitable investments.


 Constant dividend payout ratio

 Stable dividend per share

 Low regular dividend plus extras when time is good

. Dividend payment procedure

 Declaration date

 Holder-of record date

 Ex-dividend date: two business days prior to the holder-of record date

 Payment date

 2 business   days

 Declaration Ex-div Record Payment

 Tax implications: if you buy the stock before Ex-dividend date, you will receive
dividend (but you pay a higher price); if you buy the stock after Ex-dividend date,
you will not receive dividend (but you pay a lower price).

. Factors influencing dividend policy


 Bond indenture

 Preferred stock restrictions

 Impairment of capital structure: dividends cannot exceed the balance sheet item R/E

 Availability of cash

 Penalty tax on improperly accumulated earnings

 Investment opportunities:

 Profitable investment opportunities

 Possibility of accelerating or delaying projects

 Alternative sources of capital:

 Cost of selling new stock

 Ability to substitute debt for equity

 Control of the company

 Effects of dividend policy on cost of equity

(1) Stockholders’ desire for current vs. future income
(2) The perceived riskiness of dividends vs. capital gains
(3) The tax advantage of capital gains
(4) The information (signaling) content

. Stock repurchase, stock dividend and stock splits

 Stock repurchase: transactions in which a firm buys back shares of its own stock


 Internal investment opportunity

 Decreasing the number of shares outstanding

 Changing capital structure

 Increase in EPS

 Changing the ownership

 Taking tax advantage

Stock dividend: a distribution of new shares to current stock holders based on a
pro rata basis. For example, a 20% stock dividend will give a shareholder with
100 shares additional 20 shares (usually in small percentages)

Stock splits: an action taken by a firm to increase the number of shares
outstanding. For example, a 2-for-1 stock split will give a shareholder with 100
shares additional 100 shares (usually for large percentages)

 After stock dividend or stock split, the number of shares outstanding increases,

 earnings per share, dividend per share, and stock price all decline

 Why stock dividends and/or stock splits?

 Conserve cash

 Optimal stock price range

 Positive signals

Higher total value

 Examples: APPLE is using stock buyback program to increase its stock price

MBA Core Management Knowledge - One Year Revision Schedule


Chapter 13. Capital Structure and Leverage

Chapter 13 -- Capital Structure and Leverage

. Capital structure
. Business risk vs. financial risk
. Break-even analysis
. Determining the optimal capital structure
. Capital structure theories

Firms can use equity and debt as sources of finance. Capital structure theory is concerned with the decision relating to their proportion.

. Capital structure

Capital: investor-supplied funds, such as long- and short-term loans, preferred
stock, common stock, and retained earnings

Capital structure: the mix of debt, preferred stock, and common equity that is used
by a firm to finance its assets

The optimal capital structure: the capital structure that maximizes the company’s
stock price (or minimizes the company’s overall cost of capital, WACC)

Capital structure changes over time

. Business risk vs. financial risk

 Business risk: the riskiness inherent in the firm’s operations if it uses no debt

It is measured by the variability of expected ROE (ROA)

Business risk depends on:


Demand variability

Sales price variability

Input cost variability

Ability to develop new products

Operating leverage

Foreign risk


 Operating leverage: the extent to which the fixed costs are used, the higher the

fixed costs, the higher the operating leverage, the higher the business risk

 Financial risk: the additional risk placed on stockholders as a result of the firm’s
decision to use debt

 Financial leverage: the extend to which fixed income securities are used

. Break-even analysis

 Variable costs: vary with the output

 Fixed costs: not vary with the output

 Notation: V: variable cost per unit

 Q: the number of units sold

 P: price

 F: fixed costs


 Break-even level of sales: QBE = ---------

 P - V

. Determining the optimal capital structure

WACC and capital structure change

WACC = wd(rd)(1-T) + wc(rs), assuming no preferred stock

 = (D/A)*(rd)*(1-T) + (E/A)*(rs)

where D/A is the debt-to-asset ratio (also called debt ratio) and E/A is the equity-
to-asset ratio (also called equity ratio) and D/A + E/A = 1

You are going to choose D/A or E/A to minimize WACC

Cost of debt increases with debt; cost of equity increases with debt; beta increases
with debt (since higher debt increases the risk of bankruptcy)

We observe , T, D/E ratio, therefore we can figure out . We then vary D/E to figure out at different capital structure. We apply CAPM to find the required rates of return and stock prices at different capital structure to find the optimal capital structure that maximizes the stock price (or minimizes the WACC) 

Note: EPS maximization is not the goal of a firm and usually the maximum EPS doesn’t occur at the same capital structure where the stock price is maximized or the WACC is minimized. 

. Capital structure theories 

 Assumptions: perfect capital markets with no taxes, homogeneous information, 

EBIT is not affected by using debt, and investors can borrow at the same rate as 

 Irrelevance theory (Modigliani and Miller 1958): capital structure doesn’t matter; the capital structure 

does not affect stock price or the overall cost of capital 

The effect of taxes (MM 1963): if corporate taxes are considered, stock price and overall cost of capital will be affected by the capital structure. The higher the debt, the lower the overall cost of capital, the higher the stock price. 

 The trade-off model: corporate taxes are considered and firms may fail.
Costs of financial distress include bankruptcy-related costs 

Benefits from tax shields 

The greater the use of debt, the larger the fixed interest charges, the greater the probability that a firm will go bankruptcy. At the same time, the greater the use of debt, the larger the tax shields. 

 VL = VU + PV(tax shields) - PV(financial distress and agency costs) 

 Implication of trade-off model: 

Higher-risk firms should borrow less 

Firms with tangible assets can borrow more 

Firms in higher tax bracket can borrow more 

 Signaling theory: asymmetric information means that investors and management 

have different information. Any change in capital structure reveals insider 

information. For example, a firm issues new stock to raise money is viewed as a 

negative signal which causes stock price to drop.

MBA Core Management Knowledge - One Year Revision Schedule


Chapter 12. Capital Budgeting and Risk Analysis of Projects

. Risk analysis in capital budgeting

 Adjusting the cost of capital for risk

 Project stand-alone risk: the risk of a project as if it were the firm’s only project

 Project’s within-firm risk: the amount of risk that a project contributes to the firm

Project’s market risk: the risk that a project contributes to the market, measured
by the project’s beta coefficient

 Pure play method to estimate a new project’s market risk

Identify firms producing only one product that is the same as your project is going
to produce and estimate betas for these firms; average these betas to proxy for
your project’s beta: use CAPM to estimate your project’s required rate of return

Methods to incorporate risk into capital budgeting

Risk-adjusted cost of capital: use the beta risk to estimate the required rate of  return for the project and use that rate as the discount rate to evaluate the project; the higher the risk, the higher the discount rate

. Optimal capital budget

 The annual investment in long-term assets that maximizes the firm’s value

 Capital rationing: the situation in which a firm can raise a specified, limited amount of capital regardless of how many good projects it has

 For example, a firm has $5 million of capital budget and has three good projects


Initial investment











 The firm should choose projects B and C to maximize firm’s value

MBA Core Management Knowledge - One Year Revision Schedule


Chapter 11. Capital Assets - Projects - Proposals Appraisal

Chapters 11. Capital Budgeting

. Capital budgeting
. Project classifications
. Capital budgeting techniques
. Cash flow estimation
. Risk analysis in capital budgeting
. Optimal capital budget

. Capital budgeting

 Strategic business plan: a long-run plan that outlines in broad terms the firm’s
basic strategy for the next 5 to 10 years

 Capital budgeting: the process of planning expenditures on assets with cash flows

 that are expected to extend beyond one year

. Project classifications

Replacement Projects:

Need to continue current operations

Need to reduce costs

Expansion Projects:

Need to expand existing products or markets

Need to expend into new products or markets

Others: safety/environmental projects, mergers

. Capital Assets - Projects Appraisal techniques

 (1) Net present value (NPV): present value of future net cash flows, discounted at  the cost of capital

 , where r is the cost of capital, CFt is the cash flow in time t ..

 (2) Internal rate of return (IRR): rate of return a project earns (a discount rate that forces a project’s NPV to equal zero)


 Problems associated with IRR:

 Multiple rates of return and unrealistic reinvestment rate assumption

 (3) Modified internal rate of return (MIRR): discount rate at which the present value of initial cost is equal to the present value of the terminal value

 (4) Payback period: the length of time (years) required for an investment’s cash flows to cover its cost

 (5) Discounted payback period: the length of time (years) required for an investment’s cash flows, discounted at the investment’s cost of capital to recover its cost

 Decision rule: if NPV > 0, accept the project; if NPV < 0, reject the project

 Independent vs. mutually exclusive projects

 Independent projects are projects with cash flows that are not affected by the acceptance or rejection of other projects

 Mutually exclusive projects are a set of projects where only one can be accepted

 In general, you should choose the project with the highest positive NPV

 If they are independent, you choose all projects with NPV  > 0

Decision rule: if IRR > r, accept the project; if IRR < r, reject the project

where r is the hurdle rate (the required rate of return for the project)

 Multiple IRRs: the situation where a project has two or more solutions (or IRRs)

 Reinvestment rate assumptions: NPV approach is based on the assumption that
cash flows can be reinvested at the project’s risk-adjusted WACC, where the IRR
approach is based on the assumption that cash flows can be reinvested at the
project’s IRR

(3) MIRR approach

(1) Compound each future cash inflow to the “terminal year”, using WACC

(2) Add all the future values to get “terminal value”

(3) Calculate I/YR to get MIRR

Decision rule: if MIRR > r, accept the project; if MIRR < r, reject the project

where r is the hurdle rate (the required rate of return for the project)

 NPV profile: a graph that shows the relationship between a project’s NPV and the firm’s cost of capital

  Crossover rate: the cost of capital at which the NPV profiles of two projects cross and thus, at which the projects’ NPVs are equal

  Ranking problem (conflict): NPV approach and IRR approach sometimes will
lead to different rankings for mutually exclusive projects

 If ranking problem occurs use NPV approach to make the final decision

 Main conditions to cause conflicts

 a. Timing of cash flows

 b. Scale of cash flows

 (4) Payback period approach

 Decision rule:

If payback < maximum payback, then accept the project

If payback > maximum payback, then reject the project


 Arbitrary maximum payback

 Ignores time value of money

 Ignores cash flows after maximum payback period

 (5) Discounted payback period approach

Step 1: discount future cash flows to the present at the cost of capital (round to the
nearest whole dollar)

Step 2: follow the steps similar to payback period approach

 Decision rule: similar to that of payback period


 Arbitrary maximum discounted payback period

 Ignores cash flows after maximum discounted payback period

. Cash flow estimation

 Guidelines when estimating cash flows:

 Use after tax cash flows

 Use increment cash flows

 Changes in net working capital should be considered

 Sunk costs should not be included

 Opportunity costs should be considered

 Externalities should be considered

 Ignore interest payments (separate financing decisions from investment decisions)

 FCF = [EBIT*(1 - T) + depreciation] – [capital expenditures + NOWK) .

 EBIT*(1 - T) = net operating profit after tax = NOPAT

 NOWK = change in net operating working capital

Steps in estimating cash flows:

(1) Initial outlay

 (2) Differential (operating) cash flows over project’s life

 (3) Terminal cash flows

 (4) Time line and solve

MBA Core Management Knowledge - One Year Revision Schedule

Chapter 10. Cost of Equity and Debt Capital

Chapter 10. Cost of Capital

. Capital components
. Cost of debt
. Cost of preferred stock
. Cost of retained earnings
. Cost of new common stock
. Weighted average cost of capital (WACC)
. Adjusting the cost of capital for risk

Cost of capital has to be calculated by finance managers and they have to communicate it to operating managers so that they come out with project proposals having return higher than the cost of capital. To calculate cost of valuation formulas developed for bonds, equity, and preferred stock are used with current market prices of company's securities. The assumption being that company can sell securities in the market at the current prices. Generally, company may have to sell at a lesser price than the market and this figure is included in floatation cost. Floatation cost also includes advertisement, underwriting and brokerage charges.

. Capital components

 Debt: debt financing

 Preferred stock: preferred stock financing

 Equity: equity financing (internal vs. external)

Internal: retained earnings

External: new common stock

 Weighted average cost of capital (WACC)

. Cost of debt

 Recall the bond valuation formula

 Replace VB by the net price of the bond and solve for I/YR

I/YR = rd (cost of debt before tax)

 Net price = market price - flotation cost of bonds

If we ignore flotation costs which are generally small, we can just use the actual

market price to calculate rd

Cost of debt after tax = cost of debt before tax (1-T) = rd (1-T)

 Example: if a firm can issue a 10-year 8% coupon bond with a face value of
$1,000 to raise money. The firm pays interest semiannually. The net price for
each bond is $950. What is the cost of debt before tax? If the firm’s marginal tax
rate is 40%, what is the cost of debt after tax?

 Answer: PMT = -40, FV = -1,000, N = 20, PV = 950, solve for I/YR = 4.38%

 Cost of debt before tax = rd = 8.76%

 Cost of debt after tax = rd*(1-T) = 8.76*(1-0.4) = 5.26%

. Cost of preferred stock

 Recall the preferred stock valuation formula

 Replace Vp by the net price and solve for rp (cost of preferred stock)

 Net price = market price - flotation cost (for preferred stock)

 If we ignore flotation costs, we can just use the actual market price to calculate rp

. Cost of retained earnings

 CAPM approach

 DCF approach

 Bond yield plus risk premium approach

 rs = bond yield + risk premium

 When must a firm use external equity financing?

It depends on the capital structure policy of the company and amount retained from the earnings.


 Retained earning breakpoint = -----------------

 % of equity

 It is the dollar amount of capital beyond which new common stock must be issued

 For example, suppose the target capital structure for XYZ is 40% debt, 10%
preferred stock and 50% equity. If the firm’s net income is $5,000,000 and the
dividend payout ratio is 40% (i.e., the firm pays out $2,000,000 as cash dividend
and retains $3,000,000), then the retained earning breakpoint will be


 --------------- = $6,000,000,


which means that if XYZ needs to raise more than $6,000,000 it has to issue new

common stock

. Cost of new common stock

. Weighted average cost of capital (WACC)

Target capital structure: the percentages (weights) of debt, preferred stock, and

common equity that will maximize the firm’s stock price

 WACC = wd rd (1-T) + wp rp + wc (rs or re)

Comprehensive example 

A company's target capital structure is 20% debt, 20% preferred stock, and 60% common equity. Its bonds have a 12% coupon, paid semiannually, a current maturity of 20 years, and a net price of  
$960. The firm could sell, at par, $100 preferred stock that pays a $10 annual dividend, but flotation costs of 5% would be incurred. The company's  beta is 1.5, the risk-free rate in the economy is 4%, and the market return is 12%. The company is a constant growth firm (8%) which just paid a dividend of $2.00, sells for $27.00 per share. Flotation cost on new common stock is 6%, and the firm’s  marginal tax rate is 40%. 


a) Cost of debt before tax = 12.55% 

 Cost of debt after tax = 7.53% 

b) cost of preferred stock? 

Cost of P/S = 10.53% 

c) Cost of R/E using the CAPM approach? 

Cost of R/E = 16% 

d) Cost of R/E using the DCF approach? 

Cost of R/E = 16% 

e) WACC  till the company uses retained earnings 

Answer: WACC (R/E) = 13.21% 

f) WACC once it starts using new common stock financing 

Cost of N/C = 16.51% 

Chapter 9. Valuation of Common Stock and Preferred Stock

Chapter 9 -- Stock Valuation

. Characteristics of common stock
. Common stock valuation
. Valuing a corporation
. Preferred stock

Finance managers have to understand how their company stock will be valued by various people in the financial market or more specifically stock market.

. Characteristics of common stock

 Ownership in a corporation: control of the firm

 Claim on income: residual claim on income

 Claim on assets: residual claim on assets

Commonly used terms: voting rights, proxy, proxy fight, takeover, preemptive

right, classified stock, and limited liability

. Common stock valuation

Intrinsic value is a term used to denote the value arrived at by using a valuation method.

Market valuation refers to the stock price at which shares are traded on a day on the stock exchange.

Growth rate in dividends is an important input in valuation formulas.

Growth rate g: expected rate of growth in dividends

g = ROE * retention ratio

Retention ratio = 1 - dividend payout ratio

 The growth rate, g plays an important role in stock valuation

 The general dividend discount model: .

The intrinsic value of a share is present value of all dividends expected from holding the share in the future.

Why one has to calculate intrinsic value?

 Rationale: estimate the intrinsic value for the stock and compare it with the
market price to determine if the stock in the market is over-priced or under-priced.

Underpriced shares can be bought with the expectation of higher than market return. Overpriced shares are sold by traders or speculators in the hope of buying them back at lower rates.

(1) Zero growth model (the dividend growth rate, g = 0)

I.V. =  D/r

D = dividend
r = rate of return required (can be calculated from the CAPM)

 (2) Constant growth model (the dividend growth rate, g = constant)

Common stock valuation: The expected rate of return can be estimated given the market

price for a constant growth stock

Expected return = expected dividend yield + expected capital gains yield


What would be the expected dividend yield and capital gains yield under the zero

growth model?

Expected capital gains yield, g = 0 (price will remain constant)

Expected dividend yield = D/P0

(3) Non-constant growth model: part of the firm’s cycle in which it grows much

faster for the first N years and gradually return to a constant growth rate

Apply the constant growth model at the end of year N and then discount all
expected future cash flows to the present

 Non-constant growth, gs Constant growth, gn

. Valuing a corporation

 It is similar to valuing a stock

 V = present value of expected future free cash flows

 FCF = EBIT*(1-T) + depreciation and amortization – (capital expenditures +in
net working capital)

 The discount rate should be the WACC (weighted average cost of capital)

. Preferred stock

 A hybrid security because it has both common stock and bond features

Claim on assets and income: has priority over common stocks but after bonds

Cumulative feature: all past unpaid dividends should be paid before any dividend
can be paid to common stock shareholders

Valuation of preferred stock

Intrinsic value = Vp = Dp / rp

MBA Core Management Knowledge - One Year Revision Schedule

November 25, 2014

Chapter 8. Risk and Rates of Return on Financial Assets

. Investment returns 
. Risk 
. Expected rate of return and standard deviation 
. Diversification 
. Beta coefficient - market risk 
. Return on a portfolio and portfolio beta 
. Relationship between risk and rates of return 

. Investment returns 

Dollar return vs. rate of return 

If you invested $1,000 and received $1,100 in return, then 

your dollar return = 1,100 - 1,000 = $100 and 

your rate of return = (1,100 - 1,000) / 1,000 = 10%  

. Risk 

 The chance that some unfavorable event will occur 

 Stand-alone risk vs. market risk 

 Stand-alone risk: risk of holding one asset measured by standard deviation and its systematic risk is measured by beta.

 Market risk: risk of holding a well-diversified portfolio is also measured by standard deviation and its systematic by beta 

. Expected rate of return and standard deviation 

 Probability distribution: a list of possible outcomes with a probability assigned to each outcome 

Expected rate of return: the rate of return expected to be realized 

 Variance and standard deviation: statistical measures of variability (risk) 

 Coefficient of variation (CV) = standard deviation / expected rate of return, 

 which measures the risk per unit of expected return 


 Using historical data to estimate average return and standard deviation 

 Stock returns: expected vs. realized 

 Expected return 

Use Excel to calculate mean and standard deviation with historical data 

 Risk premium: the difference between the expected/required rate of return on a 

 given security and that on a risk-free asset 

. Diversification 

 As you increase the number of securities in your portfolio, the portfolio total risk decreases  

 Total risk = firm’s specific risk + market risk 

 Total risk = diversifiable risk + nondiversifiable risk 

 Total risk = unsystematice risk + systematic risk 

. Beta coefficient - market risk 

 Sensitivity of an asset (or a portfolio) with respect to the market or the extent to which a given stock’s returns move up and down with the stock market 

 Plot historical returns for a firm along with the market returns (S&P 500 index, for example) and estimate the best-fit line. The estimated slope of the line is the estimated beta coefficient of the stock, or the market risk of the stock. 

Return on a portfolio and portfolio beta 

Expected return on a portfolio: the weighted average of the expected returns on the assets held in the portfolio 

For example, the expected rate of return on stock A is 10% and the expected rate 
of return on stock B is 14%. If you invest 40% of your money in stock A and 60% 
of your money in stock B to form your portfolio then the expected rate of return 
on your portfolio will be 12.4% = (0.4)*10% + (0.6)*14%* 

 Portfolio beta: weighted average of individual securities’ betas in the portfolio 

For example, if the beta for stock A is 0.8 and the beta for stock B is 1.2, with the 
weights given above, the beta for your portfolio is 1.04 = (0.4)*0.8 + (0.6)*1.2 

. Relationship between risk and rates of return 

Required rate of return: the minimum rate of return necessary to attract an investor to purchase or hold a security 

Market risk premium: the additional return over the risk-free rate needed to compensate investors for assuming an average amount (market) of risk 

For example, if the required rate of return on the market is 11% and the risk-free 
rate is 5% then the market risk premium will be 6% 

Risk premium for a stock: the additional return over the risk-free rate needed to compensate investors for assuming the risk of that stock 

For example, if the required rate of return on a stock is 15% and the risk-free rare 
is 5% then the risk premium for that stock will be 10% 

Capital Asset Pricing Model (CAPM) 

 Ri  =   Rf + Beta*Market Risk Premium

where Ri is the required rate of return on stock i; Rf is the risk-free rate; 

Security market line (SML): a line that shows the relationship between the required return of an asset and the market risk 

 Overvalued vs. undervalued securities 

 If the actual return lies above the SML, the security is undervalued 

 If the actual return lies below the SML, the security is overvalued 

 Example: a stock has a beta of 0.8 and an expected rate of return of 11%. The 
expected rate of return on the market is 12% and the risk-free rate is 4%. Should 
you buy the stock? 

 Answer: required rate of return for the stock (using CAPM) is 

 4% + (12% - 4%)*(0.8) = 10.4% < 11% (expected rate of return) 

 The stock is under-valued

 The impact of inflation: a parallel shift in SML 

 Change in risk aversion: the slope of SML gets steeper 

 Change in beta: changes the required rate of return 

The  CAPM is a single variable model and multivariable models are proposed by some researchers with the statement that they give better estimates of risk and risk premium and therefore better required return estimates.