FIN 300 Final Exam Study Guide PDF

FIN 300 – Final Exam Study Guide Financial Planning and Managing Growth (Chapter 19) · Retention ratio and Plowback ratio – Definitions and math similar to the problems we did in class. (Formulas 19.2 & 19.3) · External Funds Needed – Definition and math similar to the p...

FIN 300 – Final Exam Study Guide Financial Planning and Managing Growth (Chapter 19) · Retention ratio and Plowback ratio – Definitions and math similar to the problems we did in class. (Formulas 19.2 & 19.3) · External Funds Needed – Definition and math similar to the problems we did in class. (Formulas 19. Growth and External Funding The new investments are the projected capital expenditure, plus the increase in working capital necessary to sustain increases in sales Companies first resort to internally generated funds in the form of addition to retained earnings Once internally generated funds are exhausted, the firm looks to raise funds externally Model of External Funding Needed (EFN) A mathematical model of external funding needed shows that new investments are determined by the firm’s total assets and projected sales growth External funding needed External funding needed (EFN) is defined as the additional debt or equity a firm needs to issue so it can purchase additional assets to support an increase in sales - EFN is tied to new investments the management has deemed necessary to support the sales growth  · Percent change in sales (Formula 19.1), math here too. · Financial Planning – Definition. Financial Planning Identification of the kinds of projects a firm needs to undertake and the ways of financing them projects results in a financial plan The financial plan integrates the firm’s basic plans into a single planning document with a detailed budget Typically, the plan extends over 3 to 5 years, the planning horizon Concluding comments on financial planning The principal benefit of financial planning is that it establishes financial and operating goals for the firm an communicates them throughout the organization The financial plan also helps to align the actions of managers and their operating units with the firm’s strategic goals The plan acts as a catalyst to get everyone in the firm moving in the same direction To build support for the financial plan and energize people’s actions, top management should involve managers and other leaders in the firm at all levels in the planning process Investment and financial policy decisions Preparing a financial planning model requires top management to make investment and financial policy decisions, which impose constraints on the financial model’s outputs Important policy decisions include - Investment policy - Financial policy decisions Capital structure decisions Financial decision Payout decision  · Strategic Plan (Strategic Planning) – Definition. The strategic plan Strategic planning is the process by which management establishes the firm’s long-term goals - Describes the vision of the form - Documents the firm’s long-term goals, the strategies that management will use to achieve the goals, and the capabilities the firm needs to sustain its competitive position - The plan identifies Line of business the firm will compete in Capital expenditures Acquisitions and new lines of business Mergers, alliances, and divestitures · The Investment Plan, The Financing Plan, Cash Budget – Definitions. The planning documents Strategic plan - where is the company headed? Investment plan - what assets does management need to get there? Financing plan - How is the firm going to pay for the resources needed? Cash Budget - How is the firm going to pay its day-to-day bills? The investment plan Also known as the capital budget - Describes the firm’s outlay for plant and equipment - Determines the capital expenditures it will make - Can involve one-time investment or a routine investment that allows the firm to continue its operations - Investments, once made, are almost always impossible to reverse The financing plan Based on the list of necessary assets prepared in the capital budget, management now needs to decide how to fund them - External funding needed - Desired capital structure for the firm - Payout policy Cash budget An overall cash budget for the firm is generated based on all the divisional cash budgets and that of the corporate offices - Focuses on the firm’s cash inflows and outflows - Allows the firm to determine if any borrowing is necessary  - A poorly developed cah budget could lead to serious cash shortages · The Sales Forecast – What is it and why is it important? The sales forecast The most important input for a financial planning model - Sales forecast techniques come in quite an array - Usually generated from within the company - Large companies often hire consultants to help prepare sales forecasts under different scenarios - Since sales are often correlated to the regional or national economy, macroeconomic forecasts are incorporated into the model Sales forecasts for some time period For most financial planning models, the principal input variable is a forecast of the firm’s sales or sales growth rate The sales forecast is the key driver in financial models because so many items on the income statement and balance sheet vary with changes in the level of sales Sales forecasts are given for some time period, such as a quarter or a year, and are often expressed as a percent change in sales · Inputs into the financial Planning model. Building a financial planning model Inputs to the model - The current financial statements serve as the first major input and become the baseline to compare the projected financial statements - The sales forecast is prepared to compare the projected financial statements The financial planning model The financial planning model is a set of equations that generate projected financial statements - Management must specify key assumptions regarding how the income statement and the balance sheet accounts vary with sales - It might be reasonable to assume that these relations will hold for the projected income statement and balance sheet Outputs from the model: projected financial statement The outputs of the financial planning model p​​lanning model are a series of pro-forma financial statements and financial ratios based on these statements These pro-forma balance sheets may not be balanced  The difference between assets and liabilities and owners’ equity, often referred to as the plug value, often represents the external funding needed Financial Planning Models Help management analyze proposed investment and financing alternatives Usually on computer spreadsheets, which reduce the drudgery of tracing investment, financing, and operating decisions through a company’s accounting system · Percent of Sales Model – Definition and math and its limitations. (Formula 19.1) A Simple Planning Model A very basic planning model is called the percent of sales model - The driving factor of this model is the expected sales growth rate - All or most of the input variables (i.e., the income statement and balance sheet elements) vary directly with sales · Pro Forma Financial Statements – Definition. The Income Statement Replacement Cost The pro-forma income statement is generated by recognizing all variable costs that change directly with sales Two key ratios are calculated - Dividend payout ratio The percentage of net income paid out as dividends - Retention (plowback) ratio The percentage of net income reinvested by the firm The Preliminary Pro Forma Balance Sheet To construct the preliminary pro forma balance sheet, we follow these steps: 1. Calculate the projected values for all the accounts that vary with sales, and enter these values into the preliminary pro forma balance sheet 2. Compute and enter the projected value of any other balance sheet accounts for which an end-of-period value can be forecast or otherwise determined 3. For all the accounts for which end-of-period values could not be forecast or otherwise determined, we enter the current year’s value 4. Typically, the balance sheet will not balance at this point. We thus compute the plug value, which balances the balance sheet The Final Pro Forma Balance Sheet Financial models do not make decisions. Firm’s management do that Financial models can only generate numbers given the inputs and assumptions Once constructed, financial models can help management evaluate strategic alternatives, assess their financial impact on the firm, and determine whether they are consistent with the firm’s financial policies Outputs from the Model: Projected Financial Statements The outputs of the financial planning model are a series of pro-forma financial statements and financial ratios based on these statements These pro-forma balance sheets may not be balanced The difference between assets and liabilities and owners’ equity, often referred to as the plug value, often represents the external funding needed Generating Pro Forma Statements It is assumed that the financial statement accounts vary directly with changes in sales With the given information, projected sales and projected costs are calculated, and thus the projected net income The projected values for the balance sheet accounts are also similarly calculated · Capital Expenditure – Definition and explanation. · Sophisticated Financial Planning Models and how they differ from the Percent of Sales Model – Explanation only, no math here. Financial Planning Models Help management analyze proposed investment and financing alternatives Usually on computer spreadsheets, which reduce the drudgery of tracing investment, financing, and operating decisions through a company’s accounting system The Planning Documents: Benefits Alignment and Support - Helps management establish financial and operating goals for the firm and communicate those goals - Helps align the actions of managers and their operating units with the firm’s strategic goals Improving Financial Planning Models There are several weaknesses in the previously described models - First, interest expense was not accounted for. This is difficult to do until all the financing options are finalized - Second, all working-capital accounts do not necessarily vary directly with sales, especially cash and inventory  - Third, how fixed assets are adjusted plays a significant role When a firm is not operating at full capacity, sales may be increased without adding any new fixed assets Fixed assets are added in large discrete amounts called lumpy assets; since it requires time to get new assets operational, they are added as the firm nears full capacity · Operating below or at full capacity – What it means. The Balance Sheet: Fixed Assets Fixed assets do not always vary directly with sales, only if the firm is operating at 100 percent capacity and fixed assets can be incrementally changed The ratio of total assets to net sales is called the capital intensity ratio, which tells us the amount of assets needed by the firm to generate $1 in sales The higher the ratio, the more capital the firm needs to generate sales—the more capital intensive the firm Firms that are highly capital intensive are riskier because a downturn can reduce sales sharply, but fixed costs do not change as rapidly Improving Financial Planning Models There are several weaknesses in the previously described models - First, interest expense was not accounted for. This is difficult to do until all the financing options are finalized - Second, all working-capital accounts do not necessarily vary directly with sales, especially cash and inventory - Third, how fixed assets are adjusted plays a significant role When a firm is not operating at full capacity, sales may be increased without adding any new fixed assets Fixed assets are added in large discrete amounts called lumpy assets; since it requires time to get new assets operational, they are added as the firm nears full capacity Chapter 13 Cost of Capital · Weighted Cost of Capital - Definition and MATH examples as done for homework and discussed in class (Monday 12/2 Estimating the Cost of Capital If we divide the costs of capital into debt and equity portions of the firm, then we can use the above to arrive at the weighted average cost of capital (WACC) for a firm with only debt and equity Using the WACC in Practice Limitations of WACC as a discount rate for evaluating projects - Financial theory tells us that the rate that should be used to discount these incremental cash flows is the rate that reflects their systematic risk - This means that the WACC is going to be the appropriate discount rate for evaluating project only when the project has cash flows with systematic risks that are exactly the same as those for the firm as a whole Limitations of WACC as a Discount Rate for Evaluating Projects When a single rate, such as the WACC, is used to discount cash flows for projects with varying levels of risk, the discount rate will be too low in some cases and too high in others - When the discount rate is too low, the firm runs the risk of accepting a negative NP project – estimated NPV will be positive even though the true NPV is negative - When the discount rate is too high, the firm runs the risk of rejecting a positive NPV project – estimated NPV will be negative even though the true NPV is positive Conditions for using the WACC The key point is it is only appropriate to use a firm’s WACC to discount the cash flows for a project if the following conditions hold: - Condition 1: a firm’s WACC should be used to evaluate the cash flows for a new project only if the level of systematic risk for that project is the same as that of the portfolio of projects that currently comprise the firm - Condition 2: a firm’s WACC should be used to evaluate a project only if that project uses the same financing mix – the same proportions of debt, preferred shares, and common shares – used to finance the firm as a whole  Alternatives to Using WACC for Evaluating Projects If the discount rate for a project cannot be estimated directly, a financial analyst might try to find a public firm that is in a business that is similar to the project - This public company would be what financial analysts call a pure-play comparable because it is exactly like the project - This approach is generally not feasible due to the difficulty of finding a public firm that is only in the business represented by the project Financial managers sometimes classify projects into categories based on their systematic risks - They then specify a discount rate that is to be used to discount the cash flows for all projects within each category What Is Weighted Average Cost of Capital (WACC)? Weighted average cost of capital (WACC) represents a company's average after-tax cost of capital from all sources, including common stock, preferred stock, bonds, and other forms of debt. As such, WACC is the average rate that a company expects to pay to finance its business. WACC is a common way to determine required rate of return (RRR) because it expresses, in a single number, the return that bondholders and shareholders demand to provide the company with capital. A company's WACC is likely to be higher if its stock is relatively volatile or if its debt is seen as risky, because investors will want greater returns to compensate them. Weighted average cost of capital (WACC) represents a company's cost of capital, with each category of capital (debt and equity) proportionately weighted. WACC can be calculated by multiplying the cost of each capital source by its relevant weight in terms of market value, then adding the results together to determine the total. WACC is commonly used as a hurdle rate against which companies and investors can gauge the desirability of a given project or acquisition. WACC can be used as the discount rate for estimating the net present value of a project or acquisition. To investors, WACC is an important tool in assessing a company's potential for profitability. In most cases, a lower WACC indicates a healthy business that's able to attract money from investors at a lower cost. By contrast, a higher WACC usually coincides with businesses that are seen as riskier and need to compensate investors with higher returns. WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight and then adding those results together. E/V represents the proportion of equity-based financing, while D/V represents the proportion of debt-based financing. Cost of equity (Re in the formula) can be a bit tricky to calculate because share capital does not technically have an explicit value. When companies reimburse bondholders, the amount they pay has a predetermined interest rate. On the other hand, equity has no concrete price that the company must pay. As a result, companies have to estimate the cost of equity—in other words, the rate of return that investors demand based on the expected volatility of the stock. Determining cost of debt (Rd in the formula), on the other hand, is a more straightforward process. This is often done by averaging the yield to maturity for a company's outstanding debts. This method is easier if you're looking at a publicly traded company that has to report its debt obligations. Companies use various means to obtain the capital they need, which can include issuing bonds (debt) and shares of stock (equity). Capital structure refers to how they mix the two. · Understand that interest on debt is deductible as an expense and lowers taxes, whereas dividend payments on stock are not deductible as an expense and therefore do not lower taxes.  · When estimating the cost of debt for a firm, what are we are primarily interested in? The Cost of Debt Analysts often must rely on observed security prices to estimate the required rate We are particularly interested in the cost of the firm’s long- term debt Long-term debt refers to debt borrowing set to mature in more than one year Debt with a maturity of more than one year can typically be viewed as permanent debt because firms often borrow the money to pay off this debt when it matures Key Concepts for Estimating the Cost of Debt Interest rate (or historical interest rate determined when the debt was issued) that the firm is paying on its outstanding debt does not necessarily reflect its current cost of debt Current cost of long-term debt is the appropriate cost of debt for WACC calculations - WACC is the opportunity cost of capital for the firm’s investors as of today Use yield to maturity (YTM) for cost of debt, adjusting for the tax deductibility of interest on debt Estimating the Cost of Debt for a Firm The current cost of debt for a publicly traded bond is derived from its yield to maturity calculation - Consider compounding periods, the effective annual interest rate (EAR), and the cost of issuing the bond (float costs) For private debt, a firm can ask their bank and ask what rate the bank would charge if they decided to refinance the debt today To estimate the firm’s overall cost of debt when it has several debt issues outstanding, we must first estimate the costs of the individual debt issues then calculate a weighted average of these costs Unused equations: