CMA Accelerated Program MODULE 3. Financial Management and Management Accounting 1

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CMA Accelerated Program

MODULE 3

Financial Management and

Management Accounting 1

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Page 2 © CMA Ontario, 2011

FINANCIAL MANAGEMENT

1. Scope and Environment of Financial Management

Introduction

The financial manager is an intermediary between investors (the market) and the firm's need for financing. Financial managers typically make two major types of decisions: financing decisions relate to generating funds and managing the liabilities/equity side of the balance sheet while investing decisions are concerned with the allocation of funds and the asset side of the balance sheet. In large part, investing decisions are dealt with

through the capital budgeting model that will be addressed in Lesson 18 of this course. The major emphasis in this lesson, therefore, will be on financing decisions.

The financial manager must understand how wealth is created and measured. This requires an understanding of how financial assets are valued and how the value of productive assets are measured. Also required is a thorough understanding of the time value of money, uncertainty, taxation, and capital markets.

It is generally assumed that the overall goal of all financial management decisions is to maximize shareholder wealth. While at first this may seem to be relatively

straightforward, in reality the maximization of shareholder wealth is highly dependent on assumptions which are made regarding the timing, risk and expected value of future earnings. Finally, it must be noted that finance is a living discipline that is constantly undergoing refinement. There is much discussion on the part of financial experts regarding many of the theoretical issues discussed in this lesson. Although definitive answers to many questions may not be possible, the theories discussed will help illustrate the issues that financial managers must deal with and identify approaches for problem solving.

This lesson attempts to cover a fairly wide spectrum of material that would ordinarily cover 600 or so pages in a textbook. Consequently, the discussion is abridged and aimed at addressing the main concepts . Students wishing to develop a more in-depth

understanding of the topic are encouraged to refer to an introductory Corporate Finance textbook.

a. Objectives of Financial Management

As stated above, the objective of financial management is the maximization of

shareholder wealth. In order to measure shareholder wealth, we must be able to measure the size of future cash flows, when these cash flows are expected to be received and the

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amount of risk or uncertainty that is involved. Note that the emphasis is on cash flows not income flows; financial management is concerned with the long-term flow of resources and, therefore, need not restrict itself to accounting measures of income based on generally accepted accounting principles.

Essentially managers maximize shareholder wealth (and by definition, maximize firm value) by making the following three decisions:

1. The Investment Decision - investing in projects that yield a return greater than the minimum acceptable return,

2. The Financing Decision - choosing a financing mix that will maximize the value of the firm and that will match the assets being financed, and

3. The Dividend Decision - if there are not enough investments that meet the Investment Decision criteria, returning the cash to the shareholders.

b. The Canadian Financial System

The Canadian financial market is comprised of participants and conventions that govern the exchange of financial assets. The market functions to:

• expedite the allocation of funds from surplus units (those with excess funds) to deficit units (those that need more funds than they presently have),

• provide a system where exchanges of resources can be performed efficiently,

• increase the liquidity of non-monetary instruments,

• facilitate the implementation of monetary policy, and

• provide a means of placing a value on financial assets.

The term financial market is generally used to denote the total market for financial instruments. This market can then be subdivided into the primary and secondary markets. The primary market is the usual place where instruments are sold to provide funds for investments in plant and equipment. It is also where a firm selling a bond or share issue would offer its securities for sale. The primary market is comprised of both public offerings and private placements of securities. The secondary market deals with previously issued securities. The purchase or sale of existing shares on the Toronto Stock Exchange (TSE) is an example of trading in the secondary market. The importance of the secondary market cannot be stressed enough as it brings together buyers and sellers in an efficient setting. Without the secondary market, the liquidity of most financial

instruments would decline substantially; who, for example, would want to invest in 20-year bonds or buy shares in a corporation if they knew that they could not sell these securities when they needed cash resources?

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A second method of looking at the financial market is to classify investments based on the average length of time from initial investment to maturity. Generally, we think of the money market as encompassing short-term securities, such as treasury bills, commercial paper and certificates of deposit. Treasury bills (or T-bills), for example, are sold by the government through the Bank of Canada and are highly liquid (easily convertible to cash without significant loss). The terms capital market and bond market refer to instruments which are long-term in nature such as stock and bonds.

In order to facilitate the functions of the markets, various financial intermediaries exist to bring together borrowers and suppliers of funds. The major financial intermediaries or institutions in Canada include: banks and trust companies, insurance companies and pension funds, investment brokers, and financial cooperatives.

c. Agency Theory

There are basically two agency relationships that matter to corporate finance: the

relationship between managers and shareholders and the relationship between managers and creditors. We will limit our discussion in this section to the agency relationship between managers and shareholders. The agency relationship between managers and creditors will be discussed in Section 3 of these notes.

The basic assumption we make is that shareholders, by virtue of their capacity to hire and fire managers and to design their compensation packages, exercise control over the managers. In return, managers consider the maximization of shareholder wealth as their primary objective in making decisions, even if it conflicts with other objectives managers may have.

This assumption is subject to debate. Three major types of potential conflict can occur: 1. Managers may use corporate resources to provide themselves with 'perks' or to

embark upon expansions (empire-building) that are not in the shareholders' best interests.

2. Managers may have shorter time horizons than shareholders. For example, managers may make decisions that increase short-run profitability at the expense of maximizing firm.

3. Managers and shareholders may have a different evaluation of risk. There are several means available to reduce these potential conflicts:

- establish incentive compensation plans that are tied directly to shareholder interests (i.e. maximize firm value),

- establish a strong corporate governance model, - monitor managerial effort, and

- threat of takeover - firms whose share prices are below potential are much more likely to invite a takeover attempt. Takeovers usually result in the replacement of management.

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Page 6 © CMA Ontario, 2011 d. Market Efficiency and the Efficient Market Hypothesis

An efficient capital market is defined as one where prices reflect all available

information. Technically, in an efficient capital market, an investor purchasing a security will receive a normal return that is commensurate with the risky nature of that security and will not receive any abnormal returns.

What makes a market efficient is the level of competition between investors. If a stock is considered to be underpriced, informed investors will buy this stock putting upward pressure on the price until the price reaches an equilibrium where it is neither under- or over-priced.

The Efficient Market Hypothesis (EMH) states that it is impossible to obtain abnormal returns consistently with either fundamental or technical analysis.

• Fundamental analysis is the evaluation of a security's future price movement based upon sales, internal developments, industry trends, the general economy, and expected changes in each factor.

• Technical analysis is the evaluation of a security's future price based on the sales price and number of shares traded in a series of recent transactions. Technical analysis, when applied to the stock market, attempts to predict future share prices based on the movement of past share prices.

Under the EMH, the expected return of each security is equal to the return required by the marginal investor given the risk of the security. Moreover, the price equals its fair value as perceived by investors.

In actuality, certain information impacts stock prices more quickly than other information. As such, the EMH has three forms:

• Strong form efficiency. All public and private information is instantaneously reflected in securities' prices. Thus, insider trading is assumed not to result in abnormal returns.

• Semi-strong form efficiency. All publicly available data is reflected in security prices, but private or insider data is not immediately reflected. Accordingly, insider trading can result in abnormal returns. Most experts conjecture that it is reasonable to assume that the market is semi strong efficient.

• Weak form efficiency. Current securities prices reflect all recent past price

movement data, so technical analysis will not provide a basis for abnormal returns in securities trading.

Some implications of market efficiency:

• changing accounting policies that increase income will have no impact on share prices

• managers cannot time the issue of securities, (i.e. the market will always price the securities correctly).

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Page 7 © CMA Ontario, 2011 e. Interest Rates

An interest rate is a price, and like all prices it is determined by the laws of supply and demand (see Figure 1). Unfortunately, the market that determines interest rates is very complex, resulting in various theories regarding how interest rates are determined. Included in the list of complicating factors are inflationary forces and a host of risk factors, including maturity risk, default risk and foreign exchange risk.

Interest %

Supply of Money

Nominal Rate

Demand for Money Supply = Demand Amount of Money Available

Figure 1: Supply and Demand for Money and Interest Rates

Maturity risk refers to the duration of the investment. The longer that funds will be locked into the security, the greater is the risk that interest rates will change significantly over the life of the investment. Default risk measures the likelihood that the borrower may become unable to meet the terms of the investment agreement. Exchange rate risk deals with the chance that the realreturn will change due to fluctuations in the foreign exchange rate between two or more countries. As a general rule, one can describe the interest rate that will prevail in any situation as follows:

Nominal Rate ₌ real rate ₊_{expected rate} ₊_risk of Interest of interest of inflation premium

It is important to note two things at this point. First, the expected rate of inflation is built into the interest rate that is quoted on the market. If the real rate of interest is 4% and the Canadian government sells T-bills to yield a return of 9%, it is reasonable to assume that the expected rate of inflation must be in the neighborhood of 5% because the risk

premium is likely close to zero (there is little chance that the federal government will not pay the stated interest and principle at maturity). In fact, most financial analysts refer to the return on federal government T-bills as being the risk-free rate.

Secondly, the greater the risk that is associated with a particular investment, the greater will be the required rate of return. As an investor, we would desire a higher return from a

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speculative gold mining stock than from an investment in federal T-bills. This fact is one of the fundamental rules by which financial management decisions are governed.

The risk premium is generally comprised of the following:

• the default risk premium – the risk that the issuer of the security will default on either the interest payments or the repayment of principal. It is generally assumed that debt issued by governments has a default risk premium of zero,

• the maturity risk premium – the longer the maturity, the higher the risk, and • the liquidity risk premium – if the security can be sold promptly, then the liquidity

risk premium is very low or close to zero.

Note that for short term securities that are subject only to inflation risk, the relationship between real and nominal rates of return are governed by the Fisher effect:

(1 + i) = (1 + r)(1 + π)

where i = nominal (i.e. observed) interest rates r = real rate of return

π = expected inflation rate

The term structure of interest rates

An interest rate curve can be obtained by graphing the interest rates (y-axis) vs. the maturities (x-axis) for debt securities of similar risk. The curve obtained is called the term structure of interest rates. More often than not, interest rates increase with maturity (due to the maturity risk premium). There are much less frequent periods when the reverse is true and the term structure is downward sloping. It will be downward sloping when investors expect interest rates to go down.

The rationale for an upwards sloping yield curve is that, all else being equal, longer maturities are riskier. Much of this risk depends on inflation expectations, which are an important determinant of interest rates. This is the basis for the idea that the term structure should usually be upward-sloping.

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Page 9 © CMA Ontario, 2011 f. Measurement of Risk

In its simplest terms, risk is the chance that things won't turn out as expected; in other words, the return may be more or less than expected. The measurement of risk can be objectively or subjectively. In its subjective state, we see statements about organizations or individuals as being risk averse. As you have learned in previous courses, it is

generally assumed that all individuals are rational, that is they behave in such a manner as to maximize their satisfaction given income, market opportunities and individual

preferences. Note that we do not mean that those who are risk averse are not rational; it means only that those who are risk averse will behave in a manner consistent with that risk aversion.

Risk can also be measured objectively by determining the variance of the probability distribution of expected returns from a certain investment. The greater the variance, the greater is the degree of uncertainty in the return or, in other words, the greater the risk. For example, look carefully at the expected returns for stocks A and B in Figure 2. The risk associated with Stock A is obviously greater than that for Stock B.

Probability Probability

0 30 60 0 25 30 35

Expected Return % Expected Return %

Stock A Stock B

Figure 2: Expected Returns for Stocks A and B

If one were to calculate the standard deviation for Stock A and Stock B, one might arrive at figures of approximately 9% and 0.25% respectively (this assumes that the

probabilities are 25%, 50% and 25% respectively). The larger number indicates more diversity in the distribution of Stock A's expected returns and thus indicates higher risk. A "blue chip" stock such as Bell Canada would be an example of a low risk stock; stocks in an exploratory oil-drilling venture would represent a high-risk stock. Combining the notions of risk and return, we can conclude that investors considering investing in Stock A would demand a greater expected return in order to compensate for the greater risks involved.

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Page 10 © CMA Ontario, 2011 Quantitative Measures of Risk

The preferences of an investor in terms of the mean-variance theory can be expressed as follows:

Stock A is preferred to Stock B… If E(Ra) > E(Rb)

And σa < σb

Where …

E(Ra) and E(Rb) are the expected returns of stock A and B respectively

σa and σb are the standard deviations of stock A and B respectively.

g. Capital Asset Pricing Model

By combining securities or investments from different firms, the investor can reduce the total risk associated with various investments. This notion of risk reduction is commonly referred to as diversification. Financial models can be employed to determine the

expected return for a given group of securities (or portfolio) and the degree of risk associated with such an investment strategy. The expected portfolio return is simply the weighted average of the expected returns for the individual stocks. Similarly, the

portfolio risk for a two-security portfolio incorporates the risks of both securities and the degree of correlation between them. Correlation refers to the degree to which the

expected returns move together. If two securities increase and decrease in value together, they would be positively correlated; if they moved in opposite directions, they would be negatively correlated. Therefore, if an investor purchased one stock that went up when inflation rose and another which went down when inflation rose, the risk associated with holding the two stocks together would likely be less than that which would exist by holding either one individually.

Financial analysts use a simple model known as the Capital Asset Pricing Model

(CAPM). This model (see Figure 3) shows clearly the relationship between the degree of portfolio risk, the expected return of the portfolio and the risk-free rate of return. The straight line shown on the graph is known as the Security Market Line (SML) and represents various combinations of security investments that will yield a given return for a given level of risk. If an investor acquires a set of investments that matches the

proportions of risk-free and risky investments available in the market, we would refer to this as a market portfolio. The expected return from this portfolio is called the market rate of return and is often approximated by the rate of return on a broad-based stock exchange index such as the Toronto Stock Exchange (TSE) 300. Investors may reduce their risk below that which is prevalent on the market by investing in less risky securities, but their returns will fall. Additional returns beyond the market return may be earned by acquiring a higher percentage of risky investments. The main application of the Capital

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Asset Pricing Model and portfolio theory to a financial manager is the portrayal of the relationship between risk and return and how diversification can reduce risk.

Return %

Security Market Line

Market Return

Risk-Free Rate

Market Risk Risk

Figure 3: Capital Asset Pricing Model and SML

The idea underlying the CAPM can also be extended to individual securities as they exhibit the same relationship between risk and return. Financial analysts are able to determine the risk associated with individual securities by determining the

nondiversifiable risk or beta of the security. Note here that some risk is eliminated by the formation of the portfolio (this is known as diversifiable risk ) and the remaining risk (nondiversifiable risk) captures the amount of risk remaining for the security in question. Beta is a measure of the volatility of the returns for a particular investment relative to the market portfolio. The beta of the market-based portfolio is 1.0. Securities which exhibit less volatility than the market have betas of less than 1.0 (for example, Bell Canada and Trans-Canada Pipelines); stocks which are more volatile have betas of greater than 1.0 (for example, Alcan). Furthermore, we can say that if a particular stock has a beta of 1.3 it will rise in value 30% faster than the market when the market rises and fall 30% faster than the market if the market falls. The determination of the beta for a particular security, therefore, can tell us a lot about the relationship between risk and return for that particular investment.

The capital asset pricing model can be quantified as follows: E(Re) = E(Rf) + β [E(Rm) - E(Rf)]

Where E(Re) = the expected return of a given common stock

E(Rf) = the expected return of a risk free security (usually a long- term government bond)

β = the beta of the common stock

E(Rm) = the expected return of the market (the TSE 300 is often used as a surrogate for the market return)

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The beta value of a firm's stock can generally be calculated by regressing the firm's returns against market returns.

2. Valuation

a. Time Value of Money

Many financial decisions involve the comparison of a cash outlay now with cash inflows into the future. Because one dollar received now is worth more than one dollar received in the future, future cash flows have to be discounted in order to compare them with today's dollars. This section goes over the mechanics of calculating discounted cash flows.

The format for solutions using a financial calculator used throughout this module and other Accelerated program modules is as follows:

N I/Y PV PMT FV

Enter 5 6 1000

Compute X In the above example, we are trying the calculate the present value of $1,000 to be received in 5 years from now at an interest rate of 6%.

If you are using the Texas Instruments BA II Plus, you need to do the following: - set the calculator to accept one payment per year as follows:

1 2ND N

You only need to do this once.

- clear the Time Value of Money memory as follows:

2ND FV

You should do this every time you do a time value of money calculation. - enter the numbers above in the TVM memory registers

- to solve, press CPT and the TVM register you are attempting to solve for, in this case PV

- the answer provided is -747.26. This means that if you were to invest $747.26 today (money out of pocket and therefore the negative sign) and invest it for 5 years at 6% compounded annually, the amount would grow to $1,000.

If you are using the Hewlett Packard 10BII, you need to do the following: - set the calculator to accept one payment per year as follows:

1 then Orange Button then PMT You only need to do this once.

- clear the Time Value of Money memory as follows:

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You should do this every time you do a time value of money calculation. - enter the numbers above in the TVM memory registers

- to solve, press the TVM register you are attempting to solve for, in this case PV - the answer provided is -747.26. This means that if you were to invest $747.26

today (money out of pocket and therefore the negative sign) and invest it for 5 years at 6% compounded annually, the amount would grow to $1,000.

Present Value of a Single Sum to be received in the future

Say we expect to receive $100,000 in 10 years from now. What is the present value of this sum using a discount rate of 7%, i.e. what is this sum of money worth today?

N I/Y PV PMT FV

Enter 10 7 100000

Compute X PV = -50,834.93

Present Value of an Annuity

Say we expect to receive $1,000 per year for 5 years (to be received at the end of each year). What is the present value of this stream of payments? Assume an interest rate of 8%.

N I/Y PV PMT FV

Enter 5 8 1000

Compute X PV = -3,992.71

Assume now that you expect to receive $10,000 per year for the next 10 years and a final payment of $100,000 at the end of the 10th year. Assuming an interest rate of 6%, the present value of these cash flows is $129,440:

N I/Y PV PMT FV

Enter 10 6 10000 100000

Compute X If you were to draw a timeline for the above, it would look as follows:

0 1 2 3 4 5 6 7 8 9 10

10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000

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So, unless you tell it otherwise, the financial calculator always assumes that the timing of the cash flows is at the end of the year.

Future Value of a single sum invested today

Assume you have $1,000 to invest today and want to invest it for 5 years. Assuming a discount rate of 6%, how much will you have accumulated at the end of 5 years.

N I/Y PV PMT FV

Enter 5 6 1000

Compute X FV = -1,338.23

Future Value of an Annuity

Assume now that you are willing to invest $1,000 per year for 5 years, but starting next year. How much will you have accumulated at the end of 5 years?

N I/Y PV PMT FV

Enter 5 6 1000

Compute X FV = -5,637.09

The difference between an annuity and annuity due

Annuities assume that cash flows occur at the end of the year whereas annuities due assume that cash flows are at the beginning of the year. Most financial calculators have the capabilities of dealing with annuities due I would recommend you not use these since the function must be cleared before doing simple annuities and often this is forgotten leading to countless errors.

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Page 15 © CMA Ontario, 2011 Uneven Cash Flows

Both the TI BA II Plus and the HP 10B allow you to enter cash flows that are uneven. For example, say you are offered an investment with the following cash inflows. You want to calculate the present value of these cash flows at a discount rate of 6%.

Time Cash Flow

1 $20,000 2 30,000 3 40,000 4 40,000 5 40,000 6 50,000 7 50,000 Using the TI BA Plus, you proceed as follows:

1. Press 2nd RESET ENTER to clear all registers

2. Press CF

3. The first register is for CF0 – the cash flow at time=0. Press 0 and ENTER. 4. Using the ↑ and ↓ keys, find the register for C01 (the first cash flow), enter

20000 and press ENTER.

5. Using the ↑ and ↓ keys, find the register for C02, enter 30000 and press ENTER. 6. Using the ↑ and ↓ keys, find the register for C03, enter 40000 and press ENTER. 7. Because the $40,000 repeats three times, we want to make sure that the frequency

for this cash flow reflects this. To do this, using the ↑ and ↓ keys, find the

register for F03, enter 3 and press ENTER. (Note that the frequencies assigned to all cash flows is 1 by default so you only need to enter a frequency if it is other than 1.

8. Using the ↑ and ↓ keys, find the register for C04, enter 50000 and press ENTER. 9. Using the ↑ and ↓ keys, find the register for F04, enter 2 and press ENTER. 10. Press the NPV key. The calculator will ask for the interest rate. Press 6 and press

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11. Using the ↑ and ↓ keys, find the register for NPV= and press CPT. The calculator should give you a present value of $209,227.55.

Using the HP 10BII, you proceed as follows:

1. Clear all: Orange Button C ALL

2. Enter the cash flow at time = 0: 0 and press CFj 3. Enter the cash flow at t=1: 20,000 and press CFj 4. Enter the cash flow at t=2: 30,000 and press CFj 5. Enter the cash flow at t=3: 40,000 and press CFj

You now need to inform the calculator that this cash flow repeats three times:

Enter 3 Orange Button Nj

6. Enter the cash flow at t=6: 50,000 and press CFj

You now need to inform the calculator that this cash flow repeats twice:

Enter 2 Orange Button Nj

7. Enter 6 I/YR

8. Press Orange Button NPV

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Page 17 © CMA Ontario, 2011 Perpetuities and Growing Perpetuities

A perpetuity is an infinite annuity, i.e. a constant cash flow to be received at regular intervals forever.

Present value of a perpetuity =

PMT₁

r

Examples of perpetuities are preferred shares - they have no maturity and pay a fixed annual dividend. For example, if you were to purchase a preferred share that pays a constant dividend of $7.50 per year and you require a 12% rate of return, then the preferred share would have a value of $7.50 / 0.12 = $62.50.

A growing perpetuity is a constant cash flow growing at a constant rate at regular intervals forever. The present value of a growing perpetuity is equal to:

PMT₁

r−g

where PMT1 = next year's payment g = growth rate.

For example, a preferred share whose dividend is growing at a rate of 5%, and generates a returns of 10% and will pay a dividend of $10 next year should have a value of:

$10 / (.10 -.05) = $200

b. General Valuation Model

The value of any asset is the discounted value of its expected future cash flows:

V₀ = CF1 (1+r)+ CF₂ (1+r)2 +...+ CF_n (1+r)n

where V0 = Value of the asset at time 0 CF = cash flow at period 1, 2, …n r = discount rate

Three things should be noted with regards to this model: 1. only cash flows are relevant

2. past cash flows are irrelevant. It is the expected cash flows that determine the current value of an asset.

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3. the discount rate must reflect the asset's underlying risk - the higher the risk, the higher the expected rate of return.

c. Valuation of bonds

A bond is a long-term obligation for borrowed money. It is a promise to pay interest and to repay the principal on terms specified in a contract called the bond indenture.

A typical indenture will usually include the following provisions:

• the face value of the bond - the amount of money borrowed (usually in denominations of $1,000)

• the coupon - the amount of stated interest to be paid - usually semi-annually • the maturity - the end of the bond life

• a call provision - gives the issuer the right to redeem the bonds prior to their maturity by paying a call price.

A bond's market price will only be equal to its face value when market interest rates are equal to the coupon rate. If the bond pays a coupon rate that is less than the required market rate, the bond will sell at a discount (i.e. less than $1,000) since investors need to be compensated for the difference in interest rates. If the bond pays a coupon rate that is more than the required market rate, the bond will sell at a premium since investors are willing to pay more for a bond that pays higher than required interest. The required market rate is called yield to maturity.

This can be shown through the bond valuation formula:

Bond Price = P0 = Present Value of the Coupon Stream (Annuity or PMT) + Present Value of the Face Value (Future Value)

Example: suppose a bond has a coupon rate of 8.5%, a remaining maturity of 12 years, and a face value of $1,000. If the yield-to-maturity on this bond is 10%, what is the current price of this bond? The bond pays coupons semi-annually.

Coupon = $1,000 x 8.5% / 2 = $42.50

N I/Y PV PMT FV

Enter 24 5 42.50 1000

Compute X Bond Price = $896.51

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Page 19 © CMA Ontario, 2011 Computing the Yield to Maturity

Example: A bond paying a coupon of 9% with 10 years remaining to maturity sells for $1,223. What is the yield to maturity?

N I/Y PV PMT FV

Enter 20 -1223 45 1000

Compute X

Note that: (1) the present value is entered as a negative on the assumption that we would have to outlay $1,223 to purchase this bond and then receive the coupon payments and face values and (2) the coupon payment is calculated as: $1,000 x 9% / 2 = $45.

The yield-to-maturity provided by the calculator is 3% is for a six month . This converts to an annual yield of 3% x 2 = 6%.

Interest Rate Risk

Whenever the required return of a bond changes, the price of that bond also changes. This is referred to as interest rate risk: the inverse relationship between interest yields and bond prices. When yields increase, bond prices drop. When yields decrease, bond prices increase.

This sensitivity is dependent on two things:

1. time to maturity - the lower the time to maturity the lower the interest rate risk 2. coupon rate - the lower the coupon rate the greater the interest rate risk

For example - take two bonds with a face value of $1,000 with 10 years to maturity. The current yield to maturity is 8% - the only difference is the coupon rate:

Bond A, with a coupon rate of 12%, will sell for $1,271.81 (N = 20, i =4%, , PMT = $60, FV = $1,000)

Bond B with a coupon rate of of 6% will sell for $864.10 (N = 20, i =4%, , PMT = $30, FV = $1,000)

Now, assume that the YTM drops one percentage point to 7%, then the new price of Bond A will be $1,355.31 and Bond B will be $928.94.

The percentage increase in the price of Bond A is 6.6% and the percentage increase in the price of Bond B is 7.5%. Therefore, Bond B is riskier.

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Page 20 © CMA Ontario, 2011 d. Valuation of stocks

Using the general valuation model, the valuation of a stock is the present value of future dividends expected to be received over the time the stock is held plus the present value of the proceeds when the stock is sold:

P₀ = D1 (1+r)+ D₂ (1+r)2 +...+ D_n (1+r)n + P_n (1+r)n

where P0 = the price of a share today

Dn = dividend to be received at time n Pn = the price of a share at time n

r = rate of return required by common shareholders

Generally, however, we tend to conceptualize the value of a share as being the present value of all future dividends to be received in perpetuity:

P0 = D₁

r

If we assume a constant growth rate in dividends, the equation becomes:

P₀ = D1 r−g

where g is the dividend growth rate and r > g

This model is known as the dividend growth model (or the Gordon model). If we rework the above equation, we can solve for the required rate of return:

r=D1 P0

+g = Dividend Yield + Capital Gain Yield

Example 1: A stock currently paid a dividend of $4 which is not expected to change. If investors require a 12% rate of return, what is the selling price of the stock?

P0 = D1/r = $4 / .12 = $33.33

Example 2: Assume that PTH Co. just paid a cash dividend of $5.00 per share and that dividends are expected to grow at a rate of 8% per year forever. What is the current market value of a share of PTH Co. stock is the required rate of return is 12%?

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Page 21 © CMA Ontario, 2011 P₀ = D1 r−g= D₀(1+g) r−g = 5.00(1.08) .12−.08 = 5.40 .04 =$135.00

Example 3: The XYZ Company is planning excessive growth over the next three years and expects to pay the following dividends:

End of year Dividend

1 $2.00

2 3.00

3 4.50

After year 3, it is expected that the growth rate will stabilize at 6%. If investors require a 14% rate of return, what is the stock selling for today? What will it be selling for in a year from now? Show that the required return of 14% is the sum of the dividend yield and the capital gain yield, using year one data.

P₃= D4 r−g= D3(1+g) r−g = 4.50(1.06) .14−.06 =$59.625

To calculate Po, use the cash flow features of your calculator and discount at 14% (don’t forget to set the first cash flow as zero). The following are the cash flows:

T Cash Flow

1 $2.00 2 3.00

3 $4.50 + 59.625 =64.125

Your calculator should return a value of $47.35

If we calculate the expected price of the stock in one year from now (P1), we can see how investors receive their 14% return.

T Cash Flow

1 3.00

2 $4.50 + 59.625 =64.125

The value of P1 = $51.97

Dividend yield in year 1 =

D₁ P₀ =

2.00

47.35=4.2%

Capital Gain yield in year 1 =

P₁−P₀ P₀ =

51.97−47.35

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Dividend yield + Capital Gain Yield = 4.2% + 9.8% = 14% = expected rate of return (r)

e. Cost of Capital

The cost of capital or Weighted Average Cost of Capital (WACC) represents the cost of funds for the firm and is the rate which firms use as a discount rate in evaluating capital budgeting proposals. It is dependent on the capital structure of the firm and assumes that the risk associated with any particular investment will be close to the average risk of the firm.

As will be seen later in this lesson, there exists an optimal capital structure for every firm. This optimal capital structure is defined as the proportion of debt and equity that will maximize the value of the firm (and minimize its weighted average cost of capital). In this section, we will take the capital structure for granted.

In order to determine the WACC, we must first determine the cost of each source of financing. Beginning with debt, the cost of debt is equal to the after-tax cost of debt financing. This is because interest expense is a tax deductible expense. The two formulas are as follows:

After tax cost of debt = kd= k(1−t)

Where: k = interest rate, t = corporate tax rate

The cost of preferred shares is similar to that of debt except, of course, that preferred dividends are not deductible by the firm. The basic formula (derived from the present value of a perpetuity formula) is as follows:

Cost of preferred shares =

k_p = D P

Where: D = annual dividends paid, and P = the market value of one preferred share

The cost of equity capital is typically derived using either the Capital Asset Pricing Model (section 1g) or the Gordon Model (section 2d).

The weighted average cost of capital can then be determined by weighting each cost by its relative proportion in the total capital structure. Note that this figure represents the current marginal cost of new funds that can be raised. If no new funds are to be raised or the acquisition of incremental funds will not cause the current capital structure to change, the current weighted average cost of capital and the true marginal cost of capital will be the same.

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Page 23 © CMA Ontario, 2011 WACC= B Vkd+ P Vkp+ E Vke

Where: kd = cost of debt, kp = cost of preferred shares, ke = cost of equity,

B = market value of debt outstanding,

P = market value of preferred stock outstanding E = market value of common equity outstanding and V = B + P + E.

Example: Suppose a firm had a capital structure of $40,000 debt, $20,000 preferred and $40,000 in equity. Also assume that the interest rate on long-term bonds is 10% and that the tax rate is 40%. $100 preferred shares can be sold to yield 12% with issue-related costs of $4 per share. The current dividend on common shares is $4 per share. The current market price is $44 per share. The long-term growth in dividends is expected to be 10%. Following is the determination of the weighted average cost of capital:

Cost of Debt = kb = k (1 - T) = .10 x (1 - .4) = 6.0%

Cost of Preferred = kp = Dp / Pp = $12 / $96 = 12.5%

Cost of Common Shares = ke = (D1 / Pe) + g = ($4(1.1) / $44) +.10 = 20%

= $4.40/ $44 + .10 = 20%

The weighted average cost of capital is as follows: Weighted Average Cost of Capital

= (40 / 100 x 6%) + (20 / 100 x 12.5%) + (40 / 100 x 20%) = 2.4% + 2.5% + 8%

= 12.9% or 13%

The WACC of 13% would be the appropriate rate to use in the analysis of prospective capital budgeting projects. If the net present value of the project is positive, therefore, it will cover its financing costs, including a normal return for common shareholders. If the proposed investment represented a higher than normal degree of risk for the firm, it would be appropriate to employ a discount rate greater than 13%.

One final note on the capital structure. As mentioned earlier, the weights that should be used are based on the optimal capital structure of the firm. These weights (if known) should be used regardless of the actual capital structure. The reason for this is that presumably, the firm is moving towards this capital structure and that WACC is used to evaluate long-term capital projects.

Often, these optimal weights are not available. In this case, one can assume that the existing capital structure is the optimal structure. The issue before us now is whether to

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use market value or book value weights. If market values are known, they should be used. Book values should be used only if market values are not known.

To summarize, the best weights to use in the WACC Calculation are the following: 1. if the optimal capital structure is provided, then we use these weights; 2. if not, then if market values are provided for all of the elements, then market

value weights should be used. Note that the in this case, the market value of the common equity (E) is simply the number of common shares outstanding times the market value per share; or

3. if not, then we have to resort to book values. When using book values, the common equity (E) is calculated as common stock plus retained earnings. Example: The James Company has the following partial balance sheet as at December 31, 20x9:

Bonds Payable, face value $20,000,000, 20 years, semi-annual, coupon 8%, issued on January 2, 20x3 when the market interest rate

was 10% $17,120,000

Preferred shares, 6%, par value = $100, currently trading at $80,

100,000 shares issued and outstanding 10,000,000

Common stock, 1,200,000 shares issued and outstanding, currently trading at $37

18,000,000

Retained earnings 21,500,000

$66,520,374 Additional Information –

• the bonds are currently trading at a yield to maturity of 12% • the corporate tax rate is 35%

• the common stock’s most current dividend was $4.00 per share (annual) • financial analysts expect the firm to grow at a constant rate of 4%

Note that we are not given the optimal capital structure of the firm. Therefore we must calculate the WACC using market values.

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The present value of the bonds is $14,798,733 rounded to $14,800,000

N I/Y PV PMT FV Enter 26 6 800000 20000000 Compute X P = 100,000 shares x $80 = $8,000,000 Kp = $6 / 80 = 7.5% E = 1,200,000 shares x $37 = $44,400,000 Ke = D1/P0 + g = (($4.00 x 1.04)/37) + .04 = 15.24% WACC = (14,800/67,200)(12%)(0.65) + (8,000/67,200)(7.5%) + (44,400/67,200)(15.24%) = 12.7%

Note that if book value weights had been used, then B = $17,120,000, P = $10,000,000 and E = $39,500,000 ($18,000,000 + 21,500,000).

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3. Financial Planning and Dividend Policy Decisions

a. Financial Forecasting and Planning

This topic is covered in the Management Accounting Module (Budgeting).

b. Working Capital Management

This section of the lesson deals with the management of working capital. Working capital is made up of current assets and current liabilities and is commonly measured by reporting the absolute amount of working capital (current assets - current liabilities) or the current ratio (current assets/current liabilities). The degree of liquidity in every organization is usually dependent on the predictability of cash flows; firms with highly uncertain cash flows will likely have to hold more working capital than those which can accurately predict their cash inflows and outflows. Finally, because working capital is not free, efforts to reduce the level of working capital will, all else being equal, cause profits to increase.

c. Management of Cash and Marketable Securities

A certain amount of cash is necessary for the firm's operations to cover the normal deficiencies between payments and receipts of cash. Additional cash may be retained, at the discretion of the financial manager, to cover unexpected events and to provide a fund for speculative purposes (i.e. buying additional materials if it is expected that prices will rise dramatically in the near future). A financial manager must ensure that all needs for cash are met without incurring undue costs.

The most important tool in the management of cash is the cash budget (see Lesson 19 of this course). Here, the expectations regarding the inflows and outflows of cash are combined with minimum required balances to minimize borrowings of short-term funds and keep interest costs as low as possible.

When excess cash is available, it is the responsibility of the financial manager to invest these resources to earn a return. The duration of these investments is typically short-term, and in most cases such investments are in securities (such as T-bills) which are risk-free and easily convertible to cash (despite this fact, many firms do invest in short-term securities for which the level of risk approaches that of a market portfolio).

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There are three reasons to hold cash:

(1) for speculative reasons - there needs to be enough cash so that the firm does not pass up good opportunities,

(2) for precautionary purposes - to meet unspecified and unexpected contingencies that may arise, and

(3) for transaction purposes - the firm must have enough cash to be able to pay bills as they become due.

Generally, the firm will keep enough cash in the chequing account to meet its transaction obligations. Any cash held for speculative or precautionary purposes is usually invested in short-term securities such as Treasury Bills (or any relatively safe short-term security that is highly liquid). Alternatively, some firms do not keep any cash for speculative purposes but rather maintain borrowing capacity in order to meet these cash needs. Firms will differ significantly in terms of their needs:

• the greater the uncertainty about operating cash-flow needs, the greater the cash requirements for transaction and precautionary reasons

• the higher the seasonal factors affecting product demand, the greater the cash requirements for transaction and precautionary reasons

• firms that can borrow easily and at low cost are much less likely to keep large balances to cover unexpected events

• the speculative motive typically is not a big factor for firms that usually invest in long-term projects but may be a significant factor for firms faced with the

possibility of short-term profit making opportunities that have to be taken advantage of quickly

In cash management, firms should be more concerned with managing float than with managing the cash book balance. Float is the difference between book and bank balance and is caused by the outstanding cheques and deposits.

Disbursement float refers to cheques written but not yet cashed.

Collection float refers to cheques received but not deposited.

Net float is equal to disbursement float less collection float. If positive, then the available cash balance exceeds the book balance.

Float can also be broken down as follows:

Float = Mail float + Processing Float + Availability Float The time cheques are in

the mail.

The time taken between the cheque is received and deposited

The time taken between when the cheque is deposited and is cleared by the banking system.

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A firm with a positive net float can use it to its advantage and maintain a smaller cash balance than it would have in the absence of the float.

d. Management of Accounts Receivable

The management of accounts receivable is important to the overall success of the organization. The key to the management of accounts receivable is the careful

monitoring of the extension of credit terms. Selling on credit involves the risk of non-payment. More lenient credit terms may stimulate sales, but the firm will likely suffer losses if the accounts prove to be uncollectible. This is not to suggest that credit sales should not be made; the objective must be to earn a return which is commensurate with the risks undertaken. Various procedures may be employed to measure and monitor the credit worthiness of current and potential customers. In addition to operating an internal credit department, many firms employ the services of commercial credit rating agencies. The careful monitoring of the liquidity of new clients and clients with high volume accounts is especially important.

The main variables in the establishment of a credit policy are the length of the credit period, the quality of credit standards, the size of the cash discount offered for early payment, and collection procedures. There are no simple answers as towhat is best, as each depends on the situation facing the firm at any point in time. Lengthening the credit period for customers will usually stimulate sales (for example, "don't pay a cent for six months") and result in increased operating profits, but these receivables must be carried on the balance sheet at some cost (most analysts employ the interest rate on short-term bank loans as a surrogate measure of the opportunity cost in accounts receivables). The evaluation of whether or not to extend credit , and if extended, at what terms can be analyzed using the 6 C's of credit:

1. Capacity to pay: consider the size of the firm, the interest coverage ratio. 2. Capital: to what extent is the firm financed - the debt/equity ratio.

3. Collateral: nature of the assets offered for collateral.

4. General economic Conditions: the degree of linkages for the firm to economic cycles. Consider the degree of riskiness the firm's business is in.

5. Character of management - willingness to pay.

6. Communication : how well the potential customer communicates their true financial information to creditors.

Cash discounts for early payment benefit the firm by reducing accounts receivable sooner rather than later, but the cost is the reduction in the profit margin which the discount creates.

A firm offering a cash discount of 2/10, n/30 (2% discount if payment is received within 10 days, otherwise the whole amount has to be received within 30 days) is faced with an

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interest cost of 44.6%. For example, take an order for $100. The buyer can pay $98 in 10 days or $100 in 30 days. If the buyer chooses to pay in 30 days, the buyer is effectively borrowing $98 for a period of 20 days and repaying $100. The effective annual interest on this borrowing can be calculated as follows:

EAR = (1+ Cash Discount / (Price – Cash Discount)) 365 / Extra Days - 1

Extra days is the number of extra days to make payment, in this case 20 days.

1+ 2 100−2 ⎛ ⎝ ⎜ ⎜ ⎞ ⎠ ⎟ ⎟ 365 20 −1=

(

1.020408

)

18.25 −1= 44.6%

Most firms have established procedures for dealing with overdue accounts receivable. Reminder notices are sent to all overdue accounts at periodic intervals with increasing pressure to make a full or partial payment. If no satisfaction is reached on this informal basis, the firm may consider taking legal action or turning the account over to a collection agency.

e. Management of Inventory

Inventories often represent a significant portion of the total current assets in many organizations, and determining the right amount of inventory to hold is difficult at the best of times. In a retail setting, carrying inventory in excess of current needs provides a safety measure which prevents customer dissatisfaction from stockouts; in the

manufacturing arena, excess inventories allow the firm to smooth out production runs and reduce setup costs. There are, however, costs associated with the holding of inventories, including handling and storage costs, the risk of obsolescence, spoilage and the

opportunity cost of funds used to finance their acquisition.

Various inventory planning models can be employed to aid in determining the right amount of inventory to hold. Most firms track the level of inventory against sales activity by monitoring the number of days of inventory on hand or the inventory turnover ratio. One of the earliest quantitative models is called the Economic Order Quantity (EOQ) model. In the end, however, it is important to remember that the adoption of a Just-In-Time (JIT) approach to inventory management can significantly reduce the funds tied up in inventories and the total cost of acquiring, holding and using inventory. The EOQ model can be helpful in inventory planning, but should not be relied upon as the sole management tool.

When we cannot accurately schedule demand for a product or material, then we have to carry inventories. For example, most retailers cannot predict when specific goods will be sold. The firm must therefore maintain sufficient inventories to cover the normal

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between the costs of holding inventory and the incremental cost of placing additional orders to acquire inventory. Let's now examine the data requirements and the factors we need to consider when choosing an inventory policy.

Assume that our firm plans to produce 50,000 units of product next year. Production will be erratic and on short notice. Each unit requires 2 kg. of a particular material, so we anticipate needing 100,000 kg. of this material. Our objective now is to determine when to buy the materials. Two extreme solutions are available: (1) buy all the materials at the beginning of the year and store them until they are needed, or (2) buy each day's

requirements as needed. The first approach will minimize the costs to acquire the materials (costs to type purchase orders, delivery charges, and so forth) but may involve some significant costs to store the inventory (handling costs, spoilage, insurance, property taxes, and so on). At the other extreme, the second approach will minimize storage costs but at the expense of increasing acquisition costs. Our objective is to try to minimize the sum of these two costs.

Assume that management has arbitrarily chosen to order 2,500 kg. of material each time it places an order. First, let's look at what our annual inventory ordering and storage costs will be. If it costs $10 to place an order, then the total costs to place orders will be $10 multiplied by the number of orders placed. Since we assumed that we would need 100,000 kg. of inventory during the year, we will have to place 40 orders if we order 2,500 units at a time:

number of orders = annual demand / order size = 100,000 - 2,500 = 40

Thus our total costs to place orders will be $400 (40 orders x $10/order).

Assuming further that it costs $2.50 per year to store a kg. in inventory, let's now calculate our annual storage costs. To do so, we need to know the average number of units that will be held in inventory over the year. We will simplify our estimate of the average number of units in inventory by assuming that demand for these materials is uniform. That is, we use exactly the same number of units every day. If demand follows this pattern, then we can time the ordering of new units so that they arrive at precisely the moment we run out of stock. This, in turn, means that the largest number of units that we will ever have on hand is 2,500. That is, at the moment a new order arrives we will have 2,500 units in inventory. The smallest number of units that we will ever have is zero, which will occur just before a new order arrives. With uniform demand, we also know that precisely halfway through the time period between orders 1,250 units will remain in inventory. At a cost of $1.50 per unit per year, our annual storage cost will be $3,125 (1,250 average inventory x $2.50 carrying costs per kg. per year).

Thus our total ordering and storage costs will be the sum of the ordering storage costs, or $400 + 3,125 = $3,525. That is, our arbitrary decision to order 2,500 units each time we place an order should result in total ordering and storage costs of $3,525 per year.

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Our objective in inventory management and purchasing policy is to try to minimize this total cost. We can do so by finding the optimal number of units we should buy every time we place an order. This optimal order size is known as the economic order quantity. Let's define the following terms:

D = demand in units for a specified time period (usually one year) P = costs incurred per order

C = carrying cost of one unit of stock for a specified time period (usually one year)

The economic order quantity formula is:

2DP

C

Continuing with our example, the optimal order size would be:

2(100,000)(10)

2.50 =894

Thus, we should order 894 kg. at a time. This would result in a total of 112 order per year. The total ordering and carrying costs would be:

Ordering costs: 112 orders x $10 $1,120

Carrying costs: 894/2 x $2.50 1,118

$2,238 (note that the ordering costs and carrying costs should be the same, the differences above are due to rounding)

Inventory Order Point

Once the economic order quantity has been determined, management must decide when to place the order; i.e., the order point must be established. If the lead time and the inventory usage rate are known, determination of the order point is very simple. Lead time is the period between the placement of an order and the receipt of the materials. Inventory usage rate is the quantity of materials used in production over a period of time. The order point should be where the inventory level reaches the number of units that would be consumed during the lead time.

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Since it is almost impossible to estimate lead time and average usage rate with certainty, many companies prefer to carry a safety stock (or additional inventory) as a cushion against possible stockouts. In such a case, the order point is computed by adding the safety stock to the estimated usage during the lead time. A safety-stock calculation should arrive at a figure which properly balances the risk of a stockout against the additional carrying costs incurred by the extra inventory. One method is to determine safety stock on the basis of experience or traditional rules of thumb. Although this method is less involved, it does not ensure that the optimum amount will be chosen.

Another method of calculating safety stock is to provide for the extreme boundaries of lead time and usage variance. Estimates are made for the longest possible time for delivery and the greatest possible usage rate. Safety stock is the number of additional units needed above the order point if the lead time and usage rate should increase to their estimated maximums.

f. Sources of financing

The basic sources of external financing for a firm are short-term and long-term. In addition, financing is provided by the basic business activity of the organization. Short-term sources of financing include accounts payable and secured/unsecured bank loans. Typically, the cost of borrowing short-term funds is greater than long-term funds, but they provide more flexibility than long-term securities. The firm may acquire additional short-term funds when needed and repay them with relative ease when excess cash resources are available. As a general rule, most financial managers think about matching their use of short-term sources of financing with their level of short-term assets. For example, if accounts receivable levels were to rise during the month of December and then fall in January, one would expect the firm to cover any shortfall in cash resources by borrowing money from a bank rather than trying to float new common shares.

Long-term sources of financing typically include preferred and common stock and various forms of debt instruments such as mortgages and bonds. In most firms, these financial instruments are tied to the existence of long-term assets such as plant, building and equipment. The expectation on the part of the firm and potential investors is that the firmwill need additional financing over an extended period of time. Typically, the cost of long-term sources is less than short-term sources, but issuing such instruments can be expensive and time consuming; furthermore, a failed issue (one which does not sell well on the market) can be even more expensive and damaging to a firm's reputation.

There also exists several additional sources of financing which are intermediate in term, such as leases and intermediate-term bank loans, which may be employed to further match the firm's year-to-year financial requirements and required resources. The

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financial accounting part of this course covers the basic bookkeeping issues with respect to leases.

Operating leases are for relatively short periods of time and because the lessor bears the risk of obsolescence, the annual payments are usually higher than for financial leases that cover a substantial portion of the useful life of the asset. What is important to remember from a financial management perspective is that leasing allows the firm to acquire theuse of an asset without investing large sums of cash to physically own it.

g. Management of Current Liabilities and Bank Loans

Trade credit is more flexible than other means of short-term financing in the sense that firms do not have to negotiate a loan agreement, pledge collateral and adhere to a rigid repayment schedule. Also, the consequences of delaying trade credit is much less onerous than those resulting from failure to repay a bank loan on schedule. Trade credit also has no cost to the firm, unless cash discounts are involved (see section d) in which case there is a generally high cost to the firm of not taking these discounts.

Trade credit is particularly valuable to small firms who may have difficulty in obtaining credit elsewhere.

The main source of short-term financing is the line of credit. Normally, these have a fixed maximum and allow firms to draw to meet unanticipated and seasonal working capital needs. Interest rates on line of credits tend to be tied to the bank's prime rate. Lines of credit provide firms with funds that are accessible as needed and no interest cost is payable on unused funds.

h. Leasing

This topic will be covered as part of the Capital Budgeting segment of the Management Accounting module.

i. Venture Capital Financing

Venture capital financing is usually provided to private firms by investors in exchange for a share of the ownership of the firm. Generally, this form of financing is sought out when all alternatives have been exhausted. Consequently, venture capital financing is generally obtained by small and usually risky businesses.

The proportion of a firm that ends up with venture capitalists will usually depend on two factors:

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1. the amount of venture capital financing: the venture capitalist will demand a proportion at least equal to a fair proportion of the firm value.

2. alternative sources of financing: the bargaining position of the firm vis-à-vis venture capitalists is enforced if alternative sources of financing are available. Generally, venture capitalists expect (1) high returns commensurate with the risk taken and (2) expect to cash out in a relatively short-period of time (5-10 years), usually when the firm is taken public.

j. Financial Management of Small and Medium-Sized Businesses

Small to medium-sized business do not have ready access to capital markets and therefore are restricted to the following sources of financing:

1. financing provided by shareholders 2. financing provided by internal growth 3. trade credit financing

4. short-term financing provided by financial institutions 5. long-term financing provided by financial institutions, and 6. venture capital financing.

Financing obtained through financial institutions is facilitated by the 6 C's of credit (see section d) and for small and medium sized business, it is vitally important that firms: • get to know their banker - a banker will have an easier time supporting the firm in

cases of doubt when the banker has an established relationship with the firm, and • be transparent and timely in its financial reporting - it is in the best interests of the

firm to produce more information than the bank requests and do so in a timely fashion. If the banker is well appraised of the financial situation (in good and bad times) of the firm, it will be easier to support the firm.

k. Long-term Financing Debt Financing

Advantages and disadvantages of debt The advantages of debt are as follows:

1. Tax deductibility: interest payments are deductible, dividend payments are not 2. Discipline of debt: Harvard University's Michael Jensen believes that managers

that have substantial free cash flows (cash flows remaining after all financial obligations have been paid off) and little or no debt have such a large cushion against mistakes that they have little incentive to be efficient. In this sense, borrowing creates commitment to make interest and principal repayments and

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instills a certain discipline in managers. This obviously presumes that there is a separation between management and shareholders.

The disadvantages of debt are:

1. Bankruptcy costs: the probability of bankruptcy is a function of the size of operating cash flows relative to the size of cash flows on debt obligations and the variance of operating cash flows. Costs of bankruptcy can be direct or indirect. Direct costs include legal and administrative costs of liquidating the company and the present value effects of delays in paying out the cash flows to the various stakeholders. Indirect cash flows include the perception on the part of customers that the firm is in financial trouble (who wants to buy a product from a company on the verge of failure), stricter terms demanded by suppliers and the difficulties of raising fresh capital.

2. Agency costs: an agency relationship develops between the bondholders (or any holders of long-term debt) and shareholder interests. There are basically two types of agency problems: (1) investment decisions: the tendency of stockholders (managers) to take on riskier projects than bondholders expect them to and (2) financing decisions: once money has been borrowed, shifting to a strategy of high leverage and default risk leaving the lenders worst off. Covenants and protective puts are usually given to bond holders to protect them from these agency

problems. Covenants are limitations placed on the company with regards to minimum ratios, dividend payouts, debt issue, etc… Protective puts allow bondholders to return the bonds before maturity under a series of conditions. If bondholders believe there is a significant chance that stockholder action might make them worse off, they build this expectation into bond prices by demanding higher rates. This translates in higher borrowing costs to the company. Direct agency costs include direct costs of monitoring.

3. Loss of flexibility: this refers to the capacity of firms to meet any unforeseen contingencies that may arise (recessions, sales downturns) and take advantage of unanticipated opportunities using funds they have on hand and any debt capacity that may have been nurtured. One of the reasons firms do not use their debt capacity is to keep it for a rainy day. Firms that borrow to capacity lose this flexibility.

Characteristics of long-term debt

General bond terminology has been covered in Lesson 3.

The issue of long-term debt is usually characterized by an indenture. This is the contract between the bondholders and the company that specified detailed provisions of a debt

CMA Accelerated Program MODULE 3. Financial Management and Management Accounting 1