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CMA Part 2 Financial Decision Making

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1 CMA Part 2 Financial Decision Making
Study Unit 6: Managing Current Assets Patricia Burnett, CMA Ronald Schmidt, CMA, CFM Glenn Mizell, CMA

2 SU 6.1 – Working Capital The basic components of an organization’s working capital are cash, marketable securities, accounts receivable, and inventory. Working capital finance concerns the optimal level, mix, and use of current assets and the means used to acquire them, notably current liabilities.

3 SU 6.1 – Working Capital The objective is to minimize the cost of maintaining liquidity while minimizing the risk of insolvency. In this section we will be looking at working capital and the management of each of these components.

4 SU 6.1 – Working Capital What is working capital and types of capital policies? What all is included in working capital? Working capital (or current capital) generally refers to the funds a company holds in current (short-term) asset accounts, and includes cash, marketable securities, receivables, and inventories.

5 SU 6.1 – Working Capital What is “Net” working capital?
Net working capital provides a measure of immediate liquidity and indicates how much cash a firm has available to sustain and build its business, and refers specifically (from an accounting perspective ) to the difference between a firm’s current assets and its current liabilities. Depending on a firm’s level of current liabilities, the number may be positive or negative.

6 SU 6.1 – Working Capital Working Capital policies include:
Conservative = minimize risk = Higher current ratio & acid test ratio A conservative working capital management policy focuses on low-risk, low return working capital investment and financing. A conservative policy places a greater proportion of capital in liquid assets but at the sacrifice of some profitability. Conservative policy uses higher-cost capital but postpones the principal repayment of debt or avoids it entirely by using equity. With a conservative policy, current assets will be much greater than current liabilities. So if you did not “conserve” current assets what would you do with them?

7 SU 6.1 – Working Capital Aggressive = more (max) risk = Lower current ratio & acid test ratio An aggressive working capital management policy focuses on high profitability potential, despite the cost of high risk and low liquidity. Aggressive asset management results in capital being minimized in current assets versus long-term investments. Aggressive financing policies include higher levels of lower-cost short-term debt and less long-term capital investments. Although this lowers capital costs, it increases the risk of short-term liquidity problems. With an aggressive policy, current assets will be less than current liabilities. You ultimately accept a higher risk of short-term cash-flow problems

8 SU 6.1 – Working Capital Moderate = average risk =
A moderate (or matching) working capital management policy uses risk and return and financing strategies that match the maturity of the assets with the maturity of the financing. The hedging approach to financing involves matching maturities of debt with specific financing needs. A moderate policy seeks a balance between current assets and current liabilities.

9 SU 6.1 – Working Capital What is the optimal level of working capital?
Varies with industry! Contrast a grocery chain which has to rotate its inventory and probably has no receivables versus a manufacturer Consequently ratios are only meaningful in terms of norms and trends and relative its competitors or the industry it which it operates

10 SU 6.1 – Working Capital Permanent and Temporary Working Capital
The minimum level of current assets maintained by a firm (which could fluctuate with seasonality). It should increase as the company grows Permanent financed with long-term debt Why not short-term debt? Timing, incr. interest rates, uncertainty of loans

11 SU 6.1 – Working Capital Remember!
What is used to acquire working capital? Long-term vs. short-term sources What is the objective of having working capital? Minimize the cost of maintaining liquidity while guarding against the risk of insolvency

12 SU 6.1 – Working Capital Question 1
During the year, Mason Company’s current assets increased by $120,000, current liabilities decreased by $50,000, and net working capital A Increased by $70,000 B Did not change C Decreased by $170,000 D Increased by $170,000

13 SU 6.1 – Working Capital Question 1 Answer
Correct Answer: D Net working capital is the excess of current assets over current liabilities. An increase in current assets or a decrease in current liabilities increases working capital. Thus, net working capital increased by $170,000 ($120,000 + $50,000). Incorrect Answers: A: Both the increase in current assets and the decrease in current liabilities increase working capital. B: Net working capital did change. C: Net working capital increased.

14 SU 6.1 – Working Capital Question 2
Mason Company’s board of directors has determined 4 options to increase working capital next year. Option 1 is to increase current assets by $120 and decrease current liabilities by $50. Option 2 is to increase current assets by $180 and increase current liabilities by $30. Option 3 is to decrease current assets by $140 and increase current liabilities by $20. Option 4 is to decrease current assets by $100 and decrease current liabilities by $75. Which option should Mason choose to maximize net working capital? A Option 1 B Option 2 C Option 3 D Option 4

15 SU 6.1 – Working Capital Question 2 Answer
Correct Answer: A Net working capital is the excess of current assets over current liabilities. An increase in current assets or a decrease in current liabilities will increase net working capital. Option 1 maximizes Mason Company’s net working capital, increasing it by $170 ($120 + $50). Incorrect Answers: B: Option 2 increases net working capital by $150. C: Option 3 decreases net working capital by $160. D: Option 4 decreases net working capital by $25.

16 SU 6.1 – Working Capital Question 3
Starrs Company has current assets of $400,000 and current liabilities of $300,000. Starrs could increase its net working capital by the A Prepayment of $50,000 of next year’s rent. B Refinancing of $50,000 of short-term debt with long-term debt. C Acquisition of land valued at $50,000 through the issuance of common stock. D Purchase of $50,000 of trading securities for cash.

17 SU 6.1 – Working Capital Question 3 Answer
Correct Answer: B Net working capital is defined as the excess of current assets over current liabilities. Refinancing short-term debt with long-term debt decreases current liabilities with no effect on current assets, resulting in an increase in working capital. Incorrect Answers: A: A prepayment of expenses does not change current assets or current liabilities. Cash decreases by the same amount that prepaid rent increases. C: The acquisition of land (a noncurrent asset) for common stock (an equity interest) does not affect either current assets or current liabilities. D: The purchase of trading securities does not affect total current assets. Cash is replaced by trading securities, another current asset.

18 SU 6.1 – Working Capital Question 4
If a firm increases its cash balance by issuing additional shares of common stock, net working capital A Remains unchanged and the current ratio remains unchanged. B Increases and the current ratio remains unchanged. C Increases and the current ratio decreases. D Increases and the current ratio increases.

19 SU 6.1 – Working Capital Question 4 Answer
Correct Answer: D Net working capital is the excess of current assets over current liabilities. The current ratio equals current assets divided by current liabilities. Selling stock for cash increases current assets and stockholders’ equity, with no effect on current liabilities. The result is an increase in working capital and the current ratio. Incorrect Answers: A: Both working capital and the current ratio increase. B: Both working capital and the current ratio increase. C: Both working capital and the current ratio increase.

20 SU 6.1 – Additional questions from the test bank
 Since Marsh, Inc., is experiencing a sharp increase in sales activity and a steady increase in production, the management of Marsh has adopted an aggressive working capital policy. Therefore, the company’s current level of net working capital A. Would most likely be lower than under other business conditions in order that the company can maximize profits while minimizing working capital investment. B. Would most likely be higher than under other business conditions as the company’s profits are increasing. C. Would most likely be higher than under other business conditions so that there will be sufficient funds to replenish assets. D. Would most likely be the same as in any other type of business condition as business cycles tend to balance out over time.

21 SU 6.1 – Additional questions from the test bank
Answer (A) is correct.  When a firm has an aggressive working capital policy, management keeps the investment in working capital at a minimum. Thus, a growing company would want to invest its funds in capital goods and not in idle assets. This policy maximizes return on investment at the price of the risk of minimal liquidity

22 SU 6.1 – Additional questions from the test bank
During the year, Mason Company’s current assets increased by $120,000, current liabilities decreased by $50,000, and net working capital A. Decreased by $170,000. B. Increased by $170,000. C. Increased by $70,000. D. Did not change.

23 SU 6.1 – Additional questions from the test bank
Answer (B) is correct.  Net working capital is the excess of current assets over current liabilities. An increase in current assets or a decrease in current liabilities increases working capital. Thus, net working capital increased by $170,000 ($120,000 + $50,000).

24 SU 6.1 – Additional questions from the test bank
Starrs Company has current assets of $400,000 and current liabilities of $300,000. Starrs could increase its net working capital by the A. Prepayment of $50,000 of next year’s rent. B. Refinancing of $50,000 of short-term debt with long-term debt. C. Purchase of $50,000 of trading securities for cash. D. Acquisition of land valued at $50,000 through the issuance of common stock.

25 SU 6.1 – Additional questions from the test bank
Answer (B) is correct.  Net working capital is defined as the excess of current assets over current liabilities. Refinancing short-term debt with long-term debt decreases current liabilities with no effect on current assets, resulting in an increase in working capital.

26 SU 6.1 – Additional questions from the test bank
Q4. The Herb Salter Corporation is considering a plant expansion that will increase its sales and net income. The following data represent management’s estimate of the impact the proposal will have on the company: Current Proposed Cash $  120,000 $  140,000 Accounts payable 360,000 450,000 Accounts receivable 400,000 550,000 Inventory 420,000 Marketable securities 180,000 Mortgage payable (current) 160,000 310,000 Fixed assets 2,300,000 3,200,000 Net income The effect of the plant expansion on Salter’s net working capital will be a(n) A. Increase of $230,000. B. Decrease of $10,000. C. Increase of $10,000. D. Increase of $240,000

27 SU 6.1 – Additional questions from the test bank
Net working capital is defined as current assets minus current liabilities. Net working capital is calculated as follows: Current Proposed Cash $120,000 $140,000 Accounts receivable 400,000 550,000 Inventory 360,000 420,000 Marketable securities 180,000 Total current assets $1,060,000 $1,290,000 Accounts payable $360,000 $450,000 Mortgage payable -- current 160,000 310,000 Total current liabilities $ (520,000) $ (760,000) Working capital $   540,000 $   530,000 Net working capital decreases by $10,000 from the current $540,000 to $530,000 under the proposal.

28 SU 6.2 – Cash Management Read Gleim Success Tip on page 160

29 SU 6.2 – Cash Management Cash management describes the collective activities by which a corporation administers and invests its cash. The primary goal of cash management is to use cash as efficiently as possible and in a manner that is consistent with the firm’s strategic objectives and risk management profile. To maintain the firm’s optimal cash balance

30 SU 6.2 – Cash Management Managing the cash levels
What are the motives for holding cash? Transactional Precautionary Speculative

31 SU 6.2 – Cash Management What is the firms optimal cash?
Firms optional level of cash should be determined by a cost benefit analysis like EOQ Economic Order Quantity (EOQ) – As applied to cash (as opposed to inventory) Questions you will have answer How much cash Transaction cost Return on marketable securities

32 SU 6.2 – Cash Management Managing cash flows begins with the cash budget, which states receipts and payments. Cash receipts are based on projected sales, credit terms and estimated collection rates.

33 SU 6.2 – Cash Management Review examples
Forecasting future cash flows (see examples on page 161, very typical test questions!)

34 SU 6.2 – Cash Management Cash management techniques
1. Speeding up cash collections A collection system is the set of banking arrangements and processing procedures used to process customer payments and gather incoming cash. A firm’s collection system affects the timing of cash inflows. Firms generally attempt to speed up cash collections by reducing collection float. Collection float is the time interval between when the maker mails a check and when the funds are available for the receiving firm to use. Collection float has three components: 1. Mail float. The time between when a check is mailed and when it is received by the payee or a processing site 2. Processing float. The time between when the payee or processing site receives a check and when it is deposited at a financial institution 3. Availability float. The time interval between when the check is deposited and when the firm’s account is credited with the collected funds

35 SU 6.2 – Cash Management In attempting to reduce collection float, important considerations include the optimal number and location of collection points, whether to use a lockbox system or an electronic payment system, and how to manage the concentration banking system.

36 SU 6.2 – Cash Management Collections Points - The more collection points available, the shorter the collection float, especially if collection points are closer to customers or near Federal Reserve banks (for faster check-clearing purposes). Lockbox System - A lockbox system is an arrangement between a firm and a banking institution in which all deposits are received directly by the bank and immediately deposited into the firm’s account.

37 SU 6.2 – Cash Management See example question #7 on page 179
Lockbox Benefit Analysis Net Benefit from Lockbox = Reduction in Float Opportunity Cost + Reduction in Internal Processing Costs Lockbox Processing Costs See example question #7 on page 179

38 SU 6.2 – Cash Management An electronic payment system – Will facilitate a payment or a transfer in an electronic format. Because electronic systems bypass mail and manual processing, they can guarantee funds availability on the payment date. In the United States, two of the primary electronic payment methods are the automated clearing house system and Fedwire.

39 SU 6.2 – Cash Management Review examples
See examples of how to speed up cash flows (see example b. & c. page 162)

40 SU 6.2 – Cash Management Slowing cash Payments through a disbursement system A disbursement system is the set of banking arrangements, payment mechanisms, and processing procedures used to disburse funds to employees, vendors, suppliers, tax agencies, and other payees (e.g., shareholders and/or bondholders). A firm’s disbursement system affects the timing of cash outflows and disbursement float. Disbursement float is the time interval between when the maker mails a check and when funds are deducted from the maker’s account. Disbursement float has three components. Mail float Processing float Clearing float

41 SU 6.2 – Cash Management Mail float – How and by which means can we slow down receipt of the check? Processing float – How by which means can we slow down the processing of a payment Draft PTD – Payable through draft Clearing float - the time interval between when the check is deposited by the payee and when the firm’s account is debited

42 SU 6.2 – Cash Management Question 1
The economic order quantity (EOQ) formula can be adapted in order for a firm to determine the optimal split between cash and marketable securities. The EOQ model assumes all of the following except that A The cost of a transaction is independent of the dollar amount of the transaction. B Interest rates are constant over the short run. C There is an opportunity cost associated with holding cash, beginning with the first dollar. D Cash flow requirements are random.

43 SU 6.2 – Cash Management Question 1 Answer
Correct Answer: D The EOQ formula is a deterministic model that requires a known demand for inventory or, in this case, the amount of cash needed. Thus, the cash flow requirements cannot be random. The model also assumes a given carrying (interest) cost and a flat transaction cost for converting marketable securities to cash, regardless of the amount withdrawn. Incorrect Answers: A: Use of the EOQ model assumes that the cost of a transaction is independent of the dollar amount of the transaction. B: Use of the EOQ model assumes that interest rates are constant over the short run. C: Use of the EOQ model assumes that there is an opportunity cost associated with holding cash, beginning with the first dollar.

44 SU 6.2 – Cash Management Question 2
What is the benefit for a firm with daily cash receipts of $15,000 to be able to speed up collections by 2 days, assuming an 8% annual return on short-term investments and no cost to the company to speed up collections? A $2,400 daily benefit B $2,400 annual benefit C $15,000 annual benefit D $30,000 annual benefit

45 SU 6.2 – Cash Management Question 2 Answer
Correct Answer: B Speeding up collections by 2 days will raise the firm’s average cash balance by $30,000. At 8% interest, the benefit will be $2,400 annually [($15,000 × 2 days) × .08]. Incorrect Answers: A: This figure is the annual, not the daily, benefit. C: This figure is the amount of daily cash receipts. D: This figure is the reduction in receivables.

46 SU 6.2 – Cash Management Question 3
DLF is a retail mail order firm that currently uses a central collection system that requires all checks to be sent to its Boston headquarters. An average of 6 days is required for mailed checks to be received, 3 days for DLF to process them, and 2 days for the checks to clear through its bank. A proposed lockbox system would reduce the mailing and processing time to 2 days and the check clearing time to 1 day. DLF has an average daily collection of $150,000. If DLF adopts the lockbox system, its average cash balance will increase by A $1,200,000 B $750,000 C $600,000 D $450,000

47 SU 6.2 – Cash Management Question 3 Answer
Correct Answer: A Checks are currently tied up for 11 days (6 for mailing, 3 for processing, and 2 for clearing). If that period were reduced to 3 days, DLF’s cash balance would increase by $1,200,000 ($150,000 per day × 8 days). Incorrect Answers: B: The decrease is 8 days, not 5. C: The amount of $600,000 represents only a 4-day savings. D: The lockbox system will result in an additional 8 days of savings, not 3

48 SU 6.2 – Cash Management Question 4
A firm has daily cash receipts of $300,000. A commercial bank has offered to reduce the collection time by 2 days. The bank requires a monthly fee of $3,000 for providing this service. If the money market rates will average 11% during the year, the annual pretax income (loss) from using the service is A $(30,000) B $30,000 C $66,000 D $63,000

49 SU 6.2 – Cash Management Question 4 Answer
Correct Answer: B The additional annual income (loss) from using the bank’s proposed service is the excess (deficit) of interest earned on the early deposits over (under) the cost of the service. If the plan is adopted, the firm’s average cash balance will increase by $600,000 ($300,000 × 2 days). Benefit (loss) = Interest earned – Cost ($600,000 × 11%) – ($3,000 × 12 months) $66,000 – $36,000 $30,000 Incorrect Answers:  A: This figure results from subtracting the interest earned from the cost.  C: This figure results from failing to subtract the $36,000 cost of the service.  D: This figure results from subtracting the service charge for only a single month.

50 SU 6.1 – Additional questions from the test bank
Assume that each day a company writes and receives checks totaling $10,000. If it takes 5 days for the checks to clear and be deducted from the company’s account, and only 4 days for the deposits to clear, what is the float? A. $10,000 B. $0 C. $10,000 D. $50,000

51 SU 6.1 – Additional questions from the test bank
Answer (C) is correct.  The float period is the time between when a check is written and when it clears the payor’s checking account. Check float results in an interest-free loan to the payor because of the delay between payment by check and its deduction from the bank account. If checks written require 1 more day to clear than checks received, the net float equals 1 day’s receipts. The company will have free use of the money for 1 day. In this case, the amount is $10,000.

52 Essays

53 Exam topics Part 2 – Financial Decision Making
4 hours, 100 multiple-choice questions and two 30-minute essay scenarios Financial statement analysis (25%) Corporate finance (25%) Decision analysis and risk management (25%) Investment decisions (20%) Professional ethics (5%)  

54 Essays This section provides a great opportunity to earn partial credit Be sure to show your work and assumptions Expect 3-6 questions for each essay scenario You can scroll between questions and scenarios within the essay section of the exam Helps to determine how much time you will need for responses

55 Essay Exam Strategies Pay close attention to verbs
E.g., if it says compare or contrast, don’t define something Read the entire question to understand all requirements You may have more than one requirement, for example: “Define abc and interpret its applicability to xyz.” Grammar and writing skills Focus is on use of standard English, organization and clarity Graders are looking for effective writing skills

56 Essay Exam Strategies Be brief and to the point
It’s ok to use bullet points Do not leave a questions blank If short on time, at least write an outline of your main points Graders are looking to give you points, not take them away Make it as easy as possible for graders to give you points!  

57 Essay Exam Information
Type your responses into a text box Similar to MS Word, but with more simple functionality Effective January 2013, the spreadsheet tool is no longer being used on the CMA exam Be sure to use all of the time available to you

58 IMA Essay Webinar Highlights
Here are highlights from webinar. Roughly 75% of points come from multiple choice, essay only accounts for 25% of points. There are two essay questions for each section of the CMA exam. Each question will have 3-6 parts that must be answered. Be sure you skim all essay parts before begin answering. This will help you survey how much time to spend on each question from the beginning. Some will be easy, just asking for a definition. Some will require calculations. Show all your work. Even if your answer is wrong, showing your work will give you partial credit. Be sure to answer the question correctly. If the question asks you to compare or contrast something, don't define it. That is not what they are looking for.

59 IMA Essay Webinar Highlights
Graders have a grading rubic for essay portion. This is shows the graders only to give points for correct answers. They don't deduct for wrong answers. In most cases there is more than one correct answer. Once you get the maximum points for this part, the grader moves on. You don't get more points for embellishing. Don't embellish. Be direct. Be simple. Use bullet points. Show your work, including calculations. Use proper grammar and English. Then move on to the next question. Practice answering essays online. This will get you used to how to type calculations and make bullet points. Use ALL the time you have on your essay questions, even if you pull time from your multiple choice section. The more you study, the better you will do. It is as simple as that.

60 SU 6.3 – Marketable Securities Management
Corporations need cash to meet their ongoing financial obligations. Although some amount of cash reserves is prudent, holding an excessive level involves several costs. Holding too much cash idle in bank accounts not only incurs maintenance costs but also results in a loss of potential interest income. That is why companies hold a short-term investment portfolio of interest-earning marketable securities.

61 SU 6.3 – Marketable Securities Management
Marketable securities are investments that mature in a year or less. They generally are classified as short-term investments (although balance sheet accounting differentiates securities with original maturities of three months or less as cash equivalents and those maturing in a year or less as short-term investments).

62 SU 6.3 – Marketable Securities Management
Consideration in Marketable Securities Safety Marketability Yield Maturity Taxability

63 SU 6.3 – Marketable Securities Management
Types of Marketable Securities U.S. Treasury obligations T-bills - do not bear interest; sold at a discount and mature to face value in one year or less. T-notes - bear interest semiannually; mature within one to ten years. T-bonds - similar to T-notes but have maturities longer than ten years; generally not purchased for a short-term portfolio except when the bond is close to maturity.

64 SU 6.3 – Marketable Securities Management
Repos Purchase of a security from another party, usually a bank or security dealer who agrees to buy it back at a specified date for a fixed price. Commonly involve U.S. Treasury securities as the underlying security to be repurchased at a rate slightly less than the U.S. Treasury securities offer. Varying maturity, starting with overnight repurchase agreements. Generally considered a relatively safe investment (because of the government underlier). Often transferred to a third party to ensure that securities are available for sale if the issuer defaults.

65 SU 6.3 – Marketable Securities Management
Federal agency securities Interest-bearing securities usually offered and redeemed at face value. Generally not backed by the full faith and credit of the U.S. government but still considered relatively safe investments and free of default risk. Typically smaller issues than treasury securities; not quite as marketable but still highly liquid. Limited tax exposure; many are exempt from state/local income taxes but not state franchise taxes.

66 SU 6.3 – Marketable Securities Management
Bankers’ acceptances Essentially time drafts that result from commercial trade financing; frequently involve international transactions. Involve a letter of credit “accepted” by a bank; typically implies the BA is backed by that bank. Varying maturities and denominations. Liquidity is provided by an active secondary market of dealers.

67 SU 6.3 – Marketable Securities Management
Commercial paper Unsecured short-term loan issued by a corporation. Negotiable instrument but typically held to maturity because of a weak secondary market; typically higher yield than similar securities because of its low marketability. Maturity ranges from 1 to 270 days. May be interest bearing or discounted; usually are discounted. Generally rated by credit rating agencies (e.g., Moody’s or Standard & Poor’s) to help investors assess risk.

68 SU 6.3 – Marketable Securities Management
CDs Interest-bearing deposits issued by banks or saving and loan institutions that can be traded in money markets; generally sold at face value in denominations of $1 million. Most mature between one and three months; some can be for several years. Offer fixed and variable interest rates. Not guaranteed by the Federal Deposit Insurance Corporation if in excess of $100,000; therefore, issuing bank should be investigated carefully. Highly marketable if issued by a large, established bank.

69 SU 6.3 – Marketable Securities Management
Others Money-market mutual funds – invest in short-term, low-risk securities Short-term securities – by State and local governments

70 SU 6.3 – Marketable Securities Management
Remember! Companies invest in marketable securities for three main reasons: Reserve liquidity. To provide a source of near cash (or instant cash) and cover any working capital imbalances resulting from insufficient cash inflows or unforeseen cash needs Controllable outflows. To earn interest on funds that are being held for predictable downstream cash outflows (such as interest payments, taxes, dividends, or insurance policies) Income generation. To earn interest on surplus cash for which the company has no immediate use

71 SU 6.3 – Marketable Securities Management Question 1
Which one of the following is not a characteristic of a negotiable certificate of deposit? Negotiable certificates of deposit A Have a secondary market for investors. B Are regulated by the Federal Reserve System. C Are usually sold in denominations of a minimum of $100,000. D Have yields considerably greater than bankers’ acceptances and commercial paper.

72 SU 6.3 – Marketable Securities Management Question 1 Answer
Correct Answer: D A certificate of deposit (CD) is a form of savings deposit that cannot be withdrawn before maturity without incurring a high penalty. A negotiable CD can be traded. CDs usually have a fairly high rate of return compared with other savings instruments because they are for fixed, usually long-term periods. However, their yield is less than that of commercial paper and bankers’ acceptances because they are less risky. Incorrect Answers:  A: Negotiable CDs do have a secondary market (i.e., they are negotiable).  B: Negotiable CDs are regulated.  C: Negotiable CDs are typically issued in a denomination of $100,000.

73 SU 6.3 – Marketable Securities Management Question 2
Hendrix, Inc., is interested in purchasing a $100 U.S. Treasury bill and was presented with the following options: Due Date Discount Rate Option 1 180 days 6% Option 2 360 days 3.5% Option 3 120 days 8% Option 4 240 days 4.5% If Hendrix wishes to buy the Treasury bill at the lowest purchasing price, which option should be chosen, assuming a 360-day year? A B C D

74 SU 6.3 – Marketable Securities Management Question 2 Answer
Correct Answer: B To determine the amount of interest the lender will earn, the 3.5% discount rate is multiplied by the face amount of the Treasury bill. The interest on this Treasury bill is $3.50 ($100 × 3.5% × 1 year). Thus, the purchase price is $96.50 ($100 – $3.5). Incorrect Answers:  A: Option 1 has a purchase price of $  C: Option 3 has a purchase price of $  D: Option 4 has a purchase price of $97.00.

75 SU 6.3 – Marketable Securities Management Question 3
Assuming a 360-day year, the current price of a $100 U.S. Treasury bill due in 180 days on a 6% discount basis is A $97.00 B $94.00 C $100.00 D $93.00

76 SU 6.3 – Marketable Securities Management Question 3 Answer
Correct Answer: A The 6% discount rate is multiplied times the face amount of the Treasury bill to determine the amount of interest the lender will earn. The interest on this Treasury bill is $3 ($100 × 6% × .5 year). Thus, the purchase price is $97 ($100 – $3). Incorrect Answers:  B: The interest is for 180 days, not a full year.  C: The purchase price will always be less than the face value when the Treasury bill is sold at a discount.  D: The interest rate is 6% per year. The question is based on 180 days or half a year.

77 SU 6.4 – Receivable Management
Overview Carried for competitive and investment purposes A firm must balance default risk and sales maximization Interest on late payments is considered revenue Function of sales, finance and accounting

78 SU 6.4 – Receivable Management
Factor influencing level of receibables Procedure for evaluating customer creditworthiness Formulas for standard credit terms The system for tracking accounts receivable and billing customers Procedures for following up on past due accounts

79 SU 6.4 – Receivable Management
Firms must balance default risk and sales maximization A good analytical tool is the aging statement Cash conversion cycle = cash to cash

80 SU 6.4 – Receivable Management
Receivable terms Credit terms- 2/10, net 30 Credit terms do not include volume discounts Average collection period = the number of days between the sale and collection of that sale

81 SU 6.4 – Receivable Management
Assessing impact of a credit term change See example on page 166 and 167

82 SU 6.4 – Receivable Management Question 1
A change in credit policy has caused an increase in sales, an increase in discounts taken, a reduction in the investment in accounts receivable, and a reduction in the number of doubtful accounts. Based upon this information, we know that A Net profit has increased. B The average collection period has decreased. C Gross profit has declined. D The size of the discount offered has decreased.

83 SU 6.4 – Receivable Management Question 1 Answer
Correct Answer: B An increase in discounts taken accompanied by declines in receivables balances and doubtful accounts all indicate that collections on the increased sales have been accelerated. Accordingly, the average collection period must have declined. The average collection period is a ratio calculated by dividing the number of days in a year (365) by the receivable turnover. Thus, the higher the turnover, the shorter the average collection period. The turnover increases when either sales (the numerator) increase or receivables (the denominator) decrease. Accomplishing both higher sales and a lower receivables increases the turnover and results in a shorter collection period. Incorrect Answers: A: No statement can be made with respect to profits without knowing costs. C: No statement can be made with respect to profits without knowing costs. D: The discount may have been increased, which has led to quicker payments.

84 SU 6.4 – Receivable Management Question 2
A change in credit policy has caused an increase in sales, an increase in discounts taken, a decrease in the amount of bad debts, and a decrease in the investment in accounts receivable. Based upon this information, the company’s A Average collection period has decreased. B Percentage discount offered has decreased. C Accounts receivable turnover has decreased. D Working capital has increased.

85 SU 6.4 – Receivable Management Question 2 Answer
Correct Answer: A An increase in discounts taken accompanied by declines in receivables balances and doubtful accounts all indicate that collections on the increased sales have been accelerated. Accordingly, the average collection period must have declined. The average collection period is a ratio calculated by dividing the number of days in a year (365) by the receivable turnover. Thus, the higher the turnover, the shorter the average collection period. The turnover increases when either sales (the numerator) increase, or receivables (the denominator) decrease. Accomplishing both higher sales and a lower receivables increases the turnover and results in a shorter collection period. Incorrect Answers:  B: A decrease in the percentage discount offered provides no incentive for early payment.  C: Accounts receivable turnover (sales ÷ average receivables) has increased.  D: No information is given relative to working capital elements other than receivables. Both receivables and cash are elements of working capital, so an acceleration of customer payments will have no effect on working capital.

86 SU 6.4 – Receivable Management Question 3
Clauson, Inc., grants credit terms of 1/15, net 30 and projects gross sales for next year of $2,000,000. The credit manager estimates that 40% of their customers pay on the discount date, 40% on the net due date, and 20% pay 15 days after the net due date. Assuming uniform sales and a 360-day year, what is the projected days’ sales outstanding (rounded to the nearest whole day)? A 20 days B 24 days C 27 days D 30 days

87 SU 6.4 – Receivable Management Question 3 Answer
Correct Answer: C The days’ sales outstanding can be determined by weighting the collection period for each group of receivables by its collection percentage. Hence, the projected days’ sales outstanding equal 27 days [(15 days × 40%) + (30 days × 40%) + (45 days × 20%)]. Incorrect Answers: A: Average receivables are outstanding for much more than 20 days. B: Twenty-four days assumes 40% of receivables are collected after 15 days and 60% after 30 days. D: More receivables are collected on the 15th day than on the 45th day; thus, the average must be less than 30 days.

88 SU 6.4 – Receivable Management Question 4
A firm averages $4,000 in sales per day and is paid, on an average, within 30 days of the sale. After they receive their invoice, 55% of the customers pay by check, while the remaining 45% pay by credit card. Approximately how much would the company show in accounts receivable on its balance sheet on any given date? A $4,000 B $48,000 C $54,000 D $120,000

89 SU 6.4 – Receivable Management Question 4 Answer
Correct Answer: D The average balance of receivables is $120,000 ($4,000 × 30 days). Whether customers pay by credit card or check, collection requires 30 days. Incorrect Answers: A: The amount of $4,000 is only 1 day’s sales. B: Invoices are outstanding for 30 days, not 12 days. C: The amount of $54,000 is based on the 45% of collections via credit card.

90 SU 6.5 – Inventory Management
Overview Understanding inventory management requires an understanding of these basic inventory control terms: Stock – All the goods a company stores and represents a supply that is kept for future use. Inventory – List of all the items held in stock. An item is a single type of product kept in stock or one entry in the inventory. A unit is the standard size or quantity of a stock item.

91 SU 6.5 – Inventory Management
Inventory management refers to the process of determining and maintaining the required level of inventory that will ensure that customer orders are properly filled on time. Inventory management requires that the organization answer three additional questions. They are: What to order (or make)? When to order (or make)? How much to order (or make)?

92 SU 6.5 – Inventory Management
Reasons for carrying inventory include Hedging against supply uncertainty Hedging against demand uncertainty Ensuring that operations are not interrupted (ref. JIT)

93 SU 6.5 – Inventory Management
Inventory control (or stock control) refers to the collective activities and procedures that ensure that the right amount of each item is held in stock. Inventory control requires that the organization be able to answer three questions. What do we have? How much do we have? Where is it?

94 SU 6.5 – Inventory Management
Inventory costs Purchase cost – actual invoice amounts Carrying cost included Storage Insurance Security Inventory taxes Depreciation or rent Interest Obsolescence and/or spoilage Opportunity cost

95 SU 6.5 – Inventory Management
Inventory costs Ordering costs include the marginal costs of placing a purchase or production order. They are the marginal cost of computer time to prepare orders and the cost of the supplies used to generate an order. Fixed costs of ordering, such as salaries, are irrelevant. Stockout costs are the opportunity cost of missing a customer order, which could include expediting a special shipment. See example on page 168

96 SU 6.5 – Inventory Management
Inventory Replenishment Models With Certainty Average daily demand X Lead time in days Without Certainty Average daily demand X Lead time in days) + Safety Stock Cost of Safety Stock = Expected stockout cost + Carrying Cost See example on page 170

97 SU 6.5 – Inventory Management
Economic order quantity (EOQ) – Represents the optimum order size—the quantity of a regularly ordered item to be purchased at a point in time that results in minimum total cost (i.e., the sum of ordering costs and carrying costs).

98 SU 6.5 – Inventory Management
Determining the Order Quantity Square root of 2 x fixed cost per purchase order X periodic demand in units periodic carrying cost Assumptions of EOQ Demand is uniform Order (setup) costs and carrying costs are constant No quantity discounts are allowed Sales are perfectly predictable Deliveries are always on time

99 SU 6.5 – Inventory Management
Just-in-Time and Kanban Systems The underlying objective of JIT systems is to minimize all waste in manufacturing operations by meeting production targets with the minimum amount of materials, equipment, operators, and so on. This is accomplished by completing all operations just at the time they are needed. It ultimately considers inventory as a nonvalue-adding activity Kanban is the simple manual method of control used in conjunction with JIT to ensure that all materials actually do arrive just as they are needed.

100 SU 6.5 – Inventory Management Question 1
The optimal level of inventory is affected by all of the following except the A Usage rate of inventory per time period. B Cost per unit of inventory. C Current level of inventory. D Cost of placing an order for merchandise

101 SU 6.5 – Inventory Management Question 1
Correct Answer: C The optimal level of inventory is affected by the factors in the economic order quantity (EOQ) model and delivery or production lead times. These factors are the annual demand for inventory, the carrying cost, which includes the interest on funds invested in inventory, the usage rate, and the cost of placing an order or making a production run. The current level of inventory has nothing to do with the optimal inventory level. Incorrect Answers:  A: The usage rate of inventory is a factor in determining how much inventory to carry.  B: The cost of inventory affects carrying costs and a firm wants to minimize its inventory carrying costs.  D: The cost of placing an order affects how often orders are placed. A firm wants to minimize its ordering costs.

102 SU 6.5 – Inventory Management Question 2
A major supplier has offered Alpha Corporation a year-end special purchase whereby Alpha could purchase 180,000 cases of sport drink at $10 per case. Alpha normally orders 30,000 cases per month at $12 per case. Alpha’s cost of capital is 9%. In calculating the overall opportunity cost of this offer, the cost of carrying the increased inventory would be A $32,400 B $40,500 C $64,800 D $81,000

103 SU 6.5 – Inventory Management Question 2 Answer
Correct Answer: A If Alpha makes the special purchase of 6 months of inventory (180,000 cases ÷ 30,000 cases per month), the average inventory for the 6-month period will be $900,000 [(180,000 × $10) ÷ 2]. If the special purchase is not made, the average inventory for the same period will be the average monthly inventory of $180,000 [(30,000 × $12) ÷ 2]. Accordingly, the incremental average inventory is $720,000 ($900,000 – $180,000), and the interest cost of the incremental 6-month investment is $32,400 [($720,000 × 9%) ÷ 2]. Incorrect Answers:  B: The amount of $40,500 is the result of assuming an incremental average inventory of $900,000.  C: The interest cost for 12 months is $64,800.  D: The amount of $81,000 is the result of assuming an incremental average inventory of $900,000 and a 12-month period.

104 SU 6.5 – Inventory Management Question 3
The following information regarding inventory policy was assembled by the JRJ Corporation. The company uses a 50-week year in all calculations. Sales 10,000 units per year Order quantity 2,000 units Safety stock 1,300 units Lead time 4 weeks The reorder point is A 3,300 units. B 2,100 units. C 1,300 units. D 800 units.

105 SU 6.5 – Inventory Management Question 3 Answer
Correct Answer: B The reorder point is the inventory level at which an order should be placed. It can be quantified using the following equation: Reorder point = (Average weekly demand × Lead time) + Safety stock [(10,000 units ÷ 50 weeks) × 4 weeks] + 1,300 units 800 units + 1,300 units 2,100 units

106 SU 6.6 – Short-term Financing
Sources Spontaneous Forms of Financing Trade credit Accrued expenses Commercial banks, and Market-based instruments Cost of not taking a discount - see example page 172 Continued

107 SU 6.6 – Short-term Financing
Short-term bank loans In addition to trade credit sources Increased risk May not renew Contractual restrictions Prime interest rate – best customers only Simple interest loans – Interest paid at the end of the term; state is same as nominal Effective Interest Rate on a Loan Net interest expense Usable funds

108 SU 6.6 – Short-term Financing
Discounted Loans Amount needed (1.0 – Stated rate) Loans with compensating balances – increases effective interest rate Lines of Credit with Commitment Fees

109 SU 6.6 – Short-term Financing
Market-based Instruments Secured Financing Factoring Receivables Other forms – Chattel mortgages such as equipment Maturity Matching

110 SU 6.6 – Short-term Financing Question 1
If a retailer’s terms of trade are 3/10, net 45 with a particular supplier, what is the cost on an annual basis of not taking the discount? Assume a 360-day year. A 24.00% B 37.11% C 36.00% D 31.81%

111 SU 6.6 – Short-term Financing Question 1 Answer
Correct Answer: D If the gross amount of the invoice is $1,000, the buyer will pay $970 [$1,000 × (1.0 – .03)] if (s)he takes the discount. If (s)he does not, (s)he will pay $30 for the use of $970 for up to an additional 35 days. The percentage cost of not taking the discount is the annualized interest rate, that is, the $30 cost divided by the $970 effectively borrowed for 35 days, multiplied by the number of 35-day periods in a 360-day year. Thus, the cost of forgoing the discount is 31.81% [($30 ÷ $970) × (360 ÷ 35)]. The annualized cost of not taking a discount is calculated with this formula: Cost of not taking discount = [3% ÷ (100% – 3%)] × [360 days ÷ (45 days – 10 days)] (3% ÷ 97%) × (360 days ÷ 35 days) 3.0928% × 10.29 31.81%

112 SU 6.6 – Short-term Financing Question 2
Corbin, Inc., can issue 3-month commercial paper with a face value of $1,000,000 for $980,000. Transaction costs will be $1,200. The effective annualized percentage cost of the financing, based on a 360-day year, will be A 8.16% B 8.66% C 8.00% D 2.00%

113 SU 6.6 – Short-term Financing Question 2 Answer
Correct Answer: B The total cost to the company will be $21,200 ($20,000 discount + $1,200 transaction cost), and the net amount available will be $978,800. The annualized amount of the costs is $84,800 (4 × $21,200). Accordingly, the annual interest cost will be 8.66% ($84,800 ÷ $978,800). Incorrect Answers:  A: This percentage is calculated without including transaction costs.  C: This percentage is calculated without including transaction costs as part of the total costs to the firm. It also assumes that the full $1,000,000 is available for use to the firm.  D: This percentage is calculated by dividing the discount for 3 months by the face value.

114 SU 6.6 – Short-term Financing Question 3
Hagar Company’s bank requires a compensating balance of 20% on a $100,000 loan. If the stated interest on the loan is 7%, what is the effective cost of the loan? A 5.83% B 7.00% C 8.40% D 8.75%

115 SU 6.6 – Short-term Financing Question 3 Answer
Correct Answer: D The effective interest rate on a loan with a compensating balance can be calculated as follows: Effective rate = Stated rate ÷ (1.0 – Compensating balance %) 7% ÷ (100% – 20%) 7% ÷ 80% 8.75% Note that the amount of the loan is not needed to calculate the effective rate.

116 CMA Part 2 Financial Decision Making
Study Unit 7: Raising Capital, Corporate Restructuring, and International Finance Ronald Schmidt, CMA, CFM

117 SU 7.1 – Financial Markets and Security Offerings
Financial or Capital Markets - The discussion of capital markets covers primary and secondary markets, the role of investment banks, market efficiency, insider trading, the role of credit rating agencies, and the role of the SEC.

118 SU 7.1 – Financial Markets and Security Offerings
Benefits of Financial Markets Facilitate the transfer of funds from those that need to invest to those that need to borrow. Financial markets are not particular places but rather the totality of supply and demand for securities. Transfer of funds maybe: Directly or indirectly (through intermediate entities) Why indirect (allocative efficiency)? Aggregate view of Financial Markets - Demand/Supply of Securities Can you list some of the securities included?

119 SU 7.1 – Financial Markets and Security Offerings
Money Markets vs. Capital Markets Money Markets Trade debt securities with maturities of less that 1 year Dealer driven Low default risk Includes Government bills, notes and bonds, Fed. Agency securities, Commercial paper, CDs, Eurodollar CDs, and Bankers’ acceptances Capital Markets trade long-term debt and equities, ex. NYSE

120 SU 7.1 – Financial Markets and Security Offerings
Primary Markets and Secondary Markets The migration of a company from private to public ownership often occurs when a private company finds that it needs access to additional funds. The primary market and the secondary market are terms referring to where securities are created and where they are traded among investors. By definition, the primary market is the market in which investors have the first opportunity to buy a newly issued security. The initial offering of stock to investors is in the primary market. The issuer receives the proceeds of sale in a primary market.

121 SU 7.1 – Financial Markets and Security Offerings
Primary Markets and Secondary Markets Subsequent trading is in the secondary market, i.e. NYSE, AMEX, OTC. By definition, the secondary market is a market in which an investor purchases an asset from another investor rather than an issuing corporation. This is the defining characteristic of the secondary market—investors trade among themselves. They buy and sell previously issued securities from other investors without the involvement of the issuing companies. Over-the-counter (OTC) market is a dealer market which conducts in trading securities not traded on the stock exchange, incl. Bonds of U.S. companies Federal, State and local government bonds Most Corp. bonds are traded on the OTC

122 SU 7.1 – Financial Markets and Security Offerings
Financial Intermediaries are specialized firms that help create and exchange the instruments of financial markets. Obtain funds from savers, issues its own securities, and uses the money to purchase an enterprise’s securities, i.e. issues savings account or CD. Examples include: Commercial Banks Life Insurance companies Private pension funds

123 SU 7.1 – Financial Markets and Security Offerings
Efficient Markets Hypothesis – States that current stock prices immediately and fully reflect all relevant information, consequently the theory is that it is impossible to obtain abnormal returns consistently with either fundamental or technical analysis. The U.S. security markets are relatively efficient. The markets quickly reflect information relevant to the value of a security. The idea of market efficiency is called the “efficient market hypothesis (theory).” The hypothesis has three forms: Strong form - The strong form of the theory states that all information (public or private) is incorporated in a security price. Therefore, it is not possible for insiders to earn abnormal profits.

124 SU 7.1 – Financial Markets and Security Offerings
The semistrong form states that all publicly available information (no private information) is incorporated in a security price. Therefore, abnormal returns from insider trading are possible. Weak form - The weak form of the theory says that security prices reflect all recent price movements only. Therefore, technical analysis will not provide a basis for abnormal returns. Empirical data have refuted the strong from of the efficient markets hypothesis but not the weak and semistrong forms.

125 SU 7.1 – Financial Markets and Security Offerings
Role of the Credit Rating Agencies Standard & Poor’s, Moody’s, and Fitch are the three largest bond credit rating agencies. The purpose of the agencies is to assign a rating to each debt security based on creditworthiness of the company or government issuing the security, which then is used to determine the market rate of interest on the debt security. When the market rate of a debt security is higher than its stated rate, the security will sell at a discount. When the market rate equals a debt security’s stated rate, it will sell at par (face) value. When the market rate is lower than the stated rate, the security will sell at a premium.

126 SU 7.1 – Financial Markets and Security Offerings
Role of Investment Banks and Underwriters Investment banks are financial institutions that assist companies and governments in issuing securities, for the purpose of raising capital. The services of an investment bank include providing advice, selling securities, and underwriting. An underwriter bears some or all of the risks of selling and holding the securities in exchange for a premium. Underwriters may form an underwriting syndicate, which is a group of financial institutions that join together to sell new securities and, possibly, offer to buy the unsold shares. Sometimes, especially with securities that have a higher risk such as unseasoned offerings, an underwriter signs a best efforts agreement that requires him or her to use all efforts to sell as much of an issue as possible to the public, but the underwriter does not take responsibility for unsold shares.

127 SU 7.1 – Financial Markets and Security Offerings
Role of Investment Banks and Underwriters A choice must be made as to whether to have the securities underwritten or sold through the best effort of the investment banker. Best effort provides no guarantee. Investment Banker receives a commission for selling using best effort. Underwritten deal provides a guarantee, and the Investment Banker agrees to purchase the entire issue. Review the process on pages 259 and 260

128 SU 7.1 – Financial Markets and Security Offerings
Flotation costs - include direct costs (such as underwriting fee, filing fees, legal fees, and taxes) and indirect costs (such as management time working on the new issue). Flotation costs are deducted from the selling price of the stocks and bonds to determine net proceeds. The issuer incurs indirect costs because of management time devoted to the issue. Tends to be greater for common stock than for preferred stock and for stocks than for bonds.

129 SU 7.1 – Financial Markets and Security Offerings
IPOs - A firm’s first issuance of securities to the public is an initial public offering Process is called “going public” Later issues are subsequent offerings Advantages and disadvantages of going public Steps involved in going public – see pages 261 – 262 Registration process Prefiling Waiting Post-effective Continued

130 SU 7.1 – Financial Markets and Security Offerings
IPOs – A firm’s first issuance of securities to the public is an initial public offering Prospectus – must be furnished to any interested investor, and is to supply sufficient facts for the investor to make an informed decision. Shelf registrations – filed for securities that the company reasonably expects to sell within 2 years, but are put “on the shelf” until most opportune time to offer. Public issues may be sold through a cash offer or rights offer Cash offer is most common and as described previously Rights offer gives rights to existing shareholders to purchase before offered to public.

131 SU 7.1 – Financial Markets and Security Offerings
Rule 506 – Private placement exemption from registration for transactions by an issuer. Sold without registered public offering, usually a small number of private investors.

132 SU 7.1 – Financial Markets and Security Offerings Question 1
Which of the following economic functions is provided by the securities markets? A A marketplace in which inefficient and expensive investment transactions take place. B Unstable security prices because of frequent price changes. C A small number of transactions. D Facilitation of the issuance and purchase of new securities.

133 SU 7.1 – Financial Markets and Security Offerings Question 1 Answer
Correct Answer: D Securities markets facilitate investment by providing a marketplace for investors to conduct inexpensive transactions efficiently. Thus, investors are assured that they will have a place to buy and sell securities. Securities markets can handle continuous transactions that are based on the values and judgments of investors. Securities markets increase liquidity of securities by providing a marketplace. Thus, prices are relatively stable due to smaller price changes. Securities markets also facilitate the issuance and purchase of new securities

134 SU 7.1 – Financial Markets and Security Offerings Question 2
Which of the following is not true about financial markets? A Financial markets are the total supply and demand for securities. B Financial markets facilitate borrowing and lending of financial assets and obligations. C In perfectly competitive markets, financial intermediaries act as price setters to clear the market. D Financial markets change over time, causing people to adjust their pattern of consumption.

135 SU 7.1 – Financial Markets and Security Offerings Question 2 Answer
Correct Answer: C Financial markets bring entities that have funds to invest together with entities that have financing needs. They facilitate the transfer of assets and obligations. Due to this activity, financial markets cause people to adjust their consumption patterns. Financial intermediaries increase the efficiency of financial markets through better allocation of financial resources, not by clearing the market.

136 SU 7.1 – Financial Markets and Security Offerings Question 3
In capital markets, the primary market is concerned with the provision of new funds for capital investments through A New issues of bond and stock securities. B Exchanges of existing bond and stock securities. C The sale of forward or future commodities contracts. D New issues of bond and stock securities and exchanges of existing bond and stock securities.

137 SU 7.1 – Financial Markets and Security Offerings Question 3 Answer
Correct Answer: A The primary market is the market for new stocks and bonds. In this market, wherein investment money flows directly to the issuer, securities are initially sold by investment bankers who purchase them from issuers and sell them through an underwriting group. Later transactions occur on securities exchanges or other markets.

138 SU 7.2 – Dividend Policy and Share Repurchase
The discussion of dividend policy covers the types of dividends, stock splits, dividend policy, and the dividend payout process. Dividends - With common stock, there is no guarantee that an investor will make money. Common stock market value per share is the current trading price of the stock. A dividend (or payout) represents a share in profits. Corporations are not required to pay dividends unless declared by the board of directors. Payments vary based on earnings and how much the board decides to pay out. Corporations usually pay cash dividends quarterly, but they may also pay dividends in kind or in the form of stock.

139 SU 7.2 – Dividend Policy and Share Repurchase
“To distribute or not to distribute”? High dividend rate means a slower rate of growth. Basic dividend policies: Passive residual Stable dollar Constant dividend payout ratio Small regular plus extras

140 SU 7.2 – Dividend Policy and Share Repurchase
Passive residual policy reinvests earnings as long as there are opportunities whose returns exceed the company’s required rate of return. Any residual is returned to the shareholders. Stable dollar policy pays a regular constant dividend as long as the corporation has the ability to do so. There is evidence that most corporations and shareholders prefer the predictability of stable dividends.

141 SU 7.2 – Dividend Policy and Share Repurchase
Many corporations pay a regular small quarterly dividend plus year-end extras in high-earnings years. Large companies, such as U.S. Steel and DuPont, oft en have followed this policy

142 SU 7.2 – Dividend Policy and Share Repurchase
The issue in dividend policy is how much the corporation should return to the shareholders versus how much should be reinvested in the business. The policy is determined by the board of directors, which generally meets quarterly to declare and approve a quarterly dividend or to approve the decision not to pay a dividend.

143 SU 7.2 – Dividend Policy and Share Repurchase
The determinants of dividend policy are: Shareholder preferences. Dividend versus corporation growth. Liquidity. Short-run cash position. Solvency. The corporation cannot declare a dividend if insolvent Borrowing capacity. If low, the corporation may wish to reinvest earnings rather than issue dividends. Earnings stability. Stable earnings correlate with regular, stable dividends. Growth opportunities. If high, the corporation may wish to reinvest earnings rather than issue dividends.

144 SU 7.2 – Dividend Policy and Share Repurchase
The determinants of dividend policy are: Inflation. If high, the corporation may need the earnings to reinvest. Capital impairment restrictions. Legal capital or appropriations (reservations) of retained earnings. Restrictive covenants. From term loans, bond indentures, or leasing agreements. Taxes. Dividends are ordinary income to the recipient whereas stock appreciations are treated as capital gains.

145 SU 7.2 – Dividend Policy and Share Repurchase
Dividend “dates” Date of declaration Date of distribution Ex-dividend date Types of Dividends A cash dividend is paid in the form of cash, usually a check. Cash dividends typically are taxable. Dividends in kind involve a dividend paid in assets other than cash. In the past, Wrigley Chewing Gum paid dividends in gum. A stock dividend is paid as additional shares of stock (rather than cash).

146 SU 7.2 – Dividend Policy and Share Repurchase
Types of Dividends Stock dividends allow a corporation to conserve cash for investment purposes while still rewarding investors. When a corporation issues a stock dividend, there typically are no tax consequences until shareholders sell their shares. Liquidating dividends are dividends that exceed the corporation’s retained earnings. They are not taxable.

147 SU 7.2 – Dividend Policy and Share Repurchase
Stock dividends vs. stock splits Stock splits involve the issuance of new stock shares to replace the existing shares. A two-for-one stock split, for example, involves replacing each existing share with two new shares. The two-for-one split doubles authorized, issued, treasury, and outstanding shares and cuts the par or stated value of the stock in half. Corporations typically split stocks to lower the price of a stock, make the price more appealing, and stimulate trading. The rationale is that when the price of the stock is high, individual investors may be reluctant to buy shares either because the shares cost so much or because of concern that the stock price has peaked in value. Stocks can be split in various increments: two for one, three for one, three for two, and so on. In a two-for-one split, a stockholder with 100 shares would turn in the 100 shares and receive 200 new shares.

148 SU 7.2 – Dividend Policy and Share Repurchase
DRPs or DRIPS - At the option of the investor, some companies provide a dividend reinvestment plan in which the investor does not receive the dividend as cash. Instead, the dividend is used to purchase new shares of the company stock, which allows the investor to have immediate reinvestment of earnings and lowered transaction costs and the company to maintain value and thereby increase stock price. Repurchase - Corporations often repurchase their own stock shares. Repurchased shares may be retired and returned to authorized shares or held in the corporation’s treasury as treasury stock. Shares normally are retired when a corporation is attempting to go private by eliminating non-management shareholders and taking the corporation’s stock off the exchange on which it had been trading. Continued

149 SU 7.2 – Dividend Policy and Share Repurchase
Corporations hold repurchased shares (treasury stock) for use in the future. Potential uses of the shares are listed next. Stock ownership plans, such as employee stock ownership plans Employee retirement plans Mergers and acquisitions Stock options and warrants A corporation may purchase its own shares in order to control the share price, especially when management believes the market price is unreasonably low.

150 SU 7.2 – Dividend Policy and Share Repurchase
Insider Trading Laws - the purchase or sale of any security by an individual who Has access to material, nonpublic information Has not disclosed it before trading Has a fiduciary obligation to the issuer Include: Officers Directors Consultants Lawyers Engineers Auditors bankers, etc.

151 SU 7.2 – Dividend Policy and Share Repurchase
Leases Firms usually use leases to get use of an asset without having to show it on the balance sheet as an asset and the corresponding liability. If the firm were to purchase the asset, it might have to use cash, thus converting short-term assets into long-term assets and worsening short-term liquidity ratio. Purchasing the asset on credit would increase the firm’s accounts payable, again worsening its short-term liquidity ratios. If the firm were to use long-term financing to purchase, it would worsen the debt to equity or other solvency ratios. To avoid any of these adverse consequences on the balance sheet, firms sometimes lease the asset. Generally accepted accounting principles require that a determination be made on whether the lease is an operating lease or a capital lease. When the lease meets one of the four conditions established for capital leases, the lease payments are accounted for as a long-term liability.

152 SU 7.2 – Dividend Policy and Share Repurchase
Leases Sometimes firms are able to structure a lease so as not to meet any of the four conditions. It can then classify the lease as an operating lease. With an operating lease, the firm is able to obtain the use of the asset without having to record its obligation to pay, thus obtaining off-balance sheet financing.

153 SU 7.2 – Dividend Policy and Share Repurchase Question 1
Brady Corporation has 6,000 shares of 5% cumulative, $100 par value preferred stock outstanding and 200,000 shares of common stock outstanding. Brady’s board of directors last declared dividends for the year ended May 31, Year 1, and there were no dividends in arrears. For the year ended May 31, Year 3, Brady had net income of $1,750,000. The board of directors is declaring a dividend for common shareholders equivalent to 20% of net income. The total amount of dividends to be paid by Brady at May 31, Year 3, is A $350,000 B $380,000 C $206,000 D $410,000

154 SU 7.2 – Dividend Policy and Share Repurchase Question 1 Answer
Correct Answer: D If a company has cumulative preferred stock, all preferred dividends for the current and any unpaid prior years must be paid before any dividends can be paid on common stock. The total preferred dividends that must be paid equal $60,000 (6,000 shares × $100 par × 5% × 2 years), and the common dividend is $350,000 ($1,750,000 × 20%), for a total of $410,000.

155 SU 7.2 – Dividend Policy and Share Repurchase Question 2
If a company uses the residual dividend policy, it will pay A A fixed cash dividend each quarter and use the residual as retained earnings. B A fixed stock dividend each quarter and retain all earnings as a residual. C All earnings as dividends each year. D Dividends only if earnings exceed the amount needed to support an optimal capital budget.

156 SU 7.2 – Dividend Policy and Share Repurchase Question 2 Answer
Correct Answer: D Under the residual theory of dividends, the amount (residual) of earnings paid as dividends depends on the available investment opportunities and the debt-equity ratio at which cost of capital is minimized. The rational investor should prefer reinvestment of retained earnings when the return exceeds what the investor could earn on investments of equal risk. However, the firm may prefer to pay dividends when investment opportunities are poor and the use of internal equity financing would move the firm away from its ideal capital structure.

157 SU 7.2 – Dividend Policy and Share Repurchase Question 3
The residual theory of dividends argues that dividends A Are necessary to maintain the market price of the common stock. B Are irrelevant. C Can be forgone unless there is an excess demand for cash dividends. D Can be paid if there is income remaining after funding all attractive investment opportunities.

158 SU 7.2 – Dividend Policy and Share Repurchase Question 3 Answer
Correct Answer: D The residual theory of dividends holds that the amount (residual) of earnings paid as dividends depends on the available investment opportunities and the debt-equity ratio at which cost of capital is minimized. The rational investor should prefer reinvestment of retained earnings when the return exceeds what the investor could earn on investments of equal risk. However, the firm may prefer to pay dividends when investment opportunities are poor and the use of internal equity financing would move the firm away from its ideal capital structure.

159 SU 7.3 – Mergers and Acquisitions
Businesses often grow by acquiring, or combining with, other business. Often the acquisition is a merger. A merger (acquisition) is a combination of two or more companies where all but one legally ceases to exist. The survivor continues under its existing name. For example, Company A purchases Company B and Company C. Company A continues with Company B and Company C subsumed. A merger can be financed through combinations of cash, borrowings, or stocks. Continued

160 SU 7.3 – Mergers and Acquisitions
Mergers may be horizontal (same industry), vertical (with suppliers or customers), congeneric (combination of firms with related products or services), or conglomerate (companies not in the same industry and not having a buyer–seller relationship). A consolidation is a combination that creates an entirely new company from the merged ones. For example, Company A, Company B, and Company C merge to form Company D. A leveraged buyout (LBO) is a merger that occurs when a buyer of a company borrows a major portion of the purchase price using the purchased assets as collateral for the borrowings. Continued

161 SU 7.3 – Mergers and Acquisitions
Advantages and disadvantages - Mergers and acquisitions are entered into for various reasons. A company may enter into a merger and acquisition for these reasons, among others: To obtain another company’s assets, skills, or technology To achieve economies of scale To obtain resources To obtain customers To grow faster than internally possible To diversify To be able to use net operating loss carry-forwards

162 SU 7.3 – Mergers and Acquisitions
These benefits are called “synergies.” Synergy, as a financial term, means that the corporation after the merger is worth more on the stock market than the sum of the individual unmerged corporations. In other words, shareholder wealth has increased. Three major techniques are used to value mergers: Discounted cash flow Adjusted book value Comparative price/earnings (P/E) ratio method

163 SU 7.3 – Mergers and Acquisitions
Acquisition is the purchase of all another firm’s assets or a controlling interest in its stock Advantages and disadvantages Voluntary vs. involuntary acquisitions Going private entails the purchase of the publicly owned stock of a corporation by a small group of private investors, usually including senior managers. The stock will ultimately be delisted.

164 SU 7.3 – Mergers and Acquisitions
Opposition to Combinations Greenmail Staggered Directors Golden Parachutes Fair Price Provisions Flip-in Rights Going Private and LBOs Issuing Stock Poison Pill Reverse Tender Flip-over Rights ESOP White Knight Merger Crown Jewel Transfer Legal Actions

165 SU 7.3 – Mergers and Acquisitions
Other Restructurings Spin-offs Divestures Liquidation of assets Equity carve-out

166 SU 7.3 – Mergers and Acquisitions Question 1
A business combination may be legally structured as a merger, a consolidation, or an acquisition. Which of the following describes a business combination that is legally structured as a merger? A The surviving company is one of the two combining companies. B The surviving company is neither of the two combining companies. C An investor-investee relationship is established. D A parent-subsidiary relationship is established.

167 SU 7.3 – Mergers and Acquisitions Question 1 Answer
Correct Answer: A In a business combination legally structured as a merger, the assets and liabilities of one of the combining companies are transferred to the books of the other combining company (the surviving company). The surviving company continues to exist as a separate legal entity. The non-surviving company ceases to exist as a separate entity. Its stock is canceled, and its books are closed.

168 SU 7.3 – Mergers and Acquisitions Question 2
The acquisition of a retail shoe store by a shoe manufacturer is an example of A Vertical integration. B A conglomerate. C Market extension. D Horizontal integration.

169 SU 7.3 – Mergers and Acquisitions Question 2 Answer
Correct Answer: A The acquisition of a shoe retailer by a shoe manufacturer is an example of vertical integration. Vertical integration is typified by a merger or acquisition involving companies that are in the same industry but at different levels in the supply chain. In other words, one of the companies supplies inputs for the other.

170 SU 7.3 – Mergers and Acquisitions Question 3
A corporation issued a property dividend to its shareholders. The dividend was distributed in the form of 100% of the common stock of a subsidiary. This is known as a A Spin-off. B Stock split. C Scrip dividend. D Reverse split.

171 SU 7.3 – Mergers and Acquisitions Question 3 Answer
Correct Answer: A A spin-off creates a new, separate entity. It is accomplished by distributing a property dividend in the form of stock of another corporation to shareholders, who then become shareholders of both corporations.

172 SU 7.4 – Bankruptcy An organization is technically insolvent when it is unable to meet current obligations even though the value of its assets exceeds its liabilities. It is legally insolvent when its liabilities exceed the value of its assets. It is bankrupt when it files a bankruptcy petition in accordance with the U.S Bankruptcy Reform Act as amended in A bankruptcy may be a corporate reorganization fi led under Chapter 11 of the act or a formal bankruptcy (liquidation) under Chapter 7 of the act.

173 SU 7.4 – Bankruptcy Conditions for Bankruptcy
Remember it is Insolvency/Bankruptcy – Debts exceed assets Illiquid - cash flows are insufficient to meet maturing obligations Early warning signs include late payments, plant closings, negative earnings, layoffs, falling stock prices, dividend policy changes Remedies include combining with another entity, selling assets, cost reductions, debt issue, debt restructuring Bankruptcy declaration is voluntary or involuntary (through debtor petition)

174 SU 7.4 – Bankruptcy Chapter 7 - liquidation per the Bankruptcy Reform Act of 1978 Involuntary > 12 Creditors - Three or more creditors with claims at least $11,625 < 12 Creditors - One claim of at least $11,625 All creditor collection activities must cease Absolutely priority rule – Claim with higher priority is first satisfied before any lower priority Priority Claims according: Claims for administrative expenses and expenses in preserving the estate Claims to tradespeople Wages due workers Claims for unpaid contributors to employee benefit plans Unsecured claims for customer deposit Taxes due, unfunded pensions…..common shareholders

175 SU 7.4 – Bankruptcy The order of priority for unsecured creditors is described next. First-priority creditors are paid in a specific order: Expenses for the administration of the bankruptcy Business expenses incurred after the petition has been fi led but before the trustee has been appointed Unpaid wages for services performed during the three months prior to the bankruptcy fi ling and not to exceed $2,000 per employee Unpaid contributions to employee benefit plans not to exceed $2,000 per employee Customer layaway deposits not to exceed $900 per customer Taxes owed to federal, state, and local governments General and unsecured creditors are paid next. If any monies remain, preferred shareholders receive their liquidation values. Common shareholders receive any monies remaining on a pro rata basis.

176 SU 7.4 – Bankruptcy Chapter 11 “reorganization” - allows distressed business enterprises to restructure its finances. Continuation of business Process of negotiations for the adjustment and discharge of debts Partnerships, corporations and any person may be an eligible debtor Plans may include: Change in management Filed by debtor or creditor To be effective a certain number of creditors have to accept the plan Once the court has ordered relief, a committee of unsecured creditors is appointed by the court. Remember - The court must approve the reorganization plan, and may convert the case to a Chapter 7 liquidation if it is in the best interests of the creditors.

177 SU 7.4 – Bankruptcy Question 1
Which of the following is indicative of insolvency? A Payments to creditors are late. B The market value of the firm’s stock has declined substantially. C Operating cash flows of the firm cannot meet current obligations. D Dividends are not declared because of inadequate retained earnings.

178 SU 7.4 – Bankruptcy Question 1 Answer
Correct Answer: C A firm is insolvent when its debts exceed its assets (stock-based insolvency) or when its cash flows are inadequate to meet maturing obligations (flow-based insolvency). Incorrect Answers: A: Late payments are an early signal of potential insolvency. B: A declining share price is an early signal of potential insolvency. D: Elimination of dividends is an early signal of potential insolvency.

179 SU 7.4 – Bankruptcy Question 2
A plan of reorganization formulated under Chapter 11 must be submitted to the creditors for acceptance and to the court for confirmation. Which of the following is correct? A The effect of confirmation is to make the plan binding on all parties and to grant the debtor a discharge from claims not protected by the plan. B A plan cannot be confirmed if any impaired class of claims or interests rejects it. C If no class of claims or interests accepts a plan, the court may nevertheless confirm it if the plan is in the best interests of the creditors. D A class that is not impaired is presumed to accept, but more than half of the claims in a class by amount must accept if the class is impaired.

180 SU 7.4 – Bankruptcy Question 2 Answer
Correct Answer: A Confirmation is the court’s approval of the plan after notice and a hearing. Confirmation makes the plan binding on the creditors, equity security holders, and debtor, whether or not they accepted the plan. It also operates as a discharge of unprotected debts, except for those claims previously denied discharge in a Chapter 7 case, and vests the estate property in the debtor. Confirmation is contingent upon the plan’s feasibility, the good faith in which it was proposed, and the provision for cash payment of certain allowed claims, such as administration expenses. Incorrect Answers: B: An impaired class may be required to accept a plan over its objection if the court finds that the plan is “fair and equitable,” for instance, if no junior claim or interest receives anything. C: At least one class of claims (not ownership interests) must accept. D: A class of claims accepts if approval is given by more than half the allowed claims, provided they represent at least two-thirds of the claims by amount. A class of interests (shareholders) accepts if approval is given by two-thirds in amount of the allowed interests.

181 SU 7.4 – Bankruptcy Question 3
Which of the following, if any, may be commenced by the filing of a voluntary or an involuntary petition in a bankruptcy court? Chapter 7 Liquidation Chapter 11 Reorganization A Yes B No C D

182 SU 7.4 – Bankruptcy Question 3 Answer
Correct Answer: A In a Chapter 7 liquidation or in a Chapter 11 reorganization, a voluntary or an involuntary petition is filed in the federal bankruptcy court. An involuntary petition must be joined by three or more creditors with unsecured claims of at least $14,425 if the debtor has 12 or more creditors. If there are fewer than 12, one creditor with a claim of at least $14,425 may file. Incorrect Answers: B: Both liquidation and reorganization may be commenced by either a voluntary or an involuntary petition. C: Both liquidation and reorganization may be commenced by either a voluntary or an involuntary petition. D: Both liquidation and reorganization may be commenced by either a voluntary or an involuntary petition.

183 SU 7.4 – Bankruptcy Question 4
A discharge in bankruptcy under Chapter 7 (liquidation) may be obtained by a(n) Individual Corporation Partnership A Yes B No C D

184 SU 7.4 – Bankruptcy Question 4 Answer
Correct Answer: C Individual debtors may receive a discharge under Chapter 7 from most debts that remain unpaid after distribution of the debtor’s estate. However, corporations and partnerships are merely liquidated. They are not eligible for a Chapter 7 discharge. Incorrect Answers: A: Individuals but not corporations and partnerships may receive a discharge. B: Individuals but not corporations and partnerships may receive a discharge. D: Individuals but not corporations and partnerships may receive a discharge.

185 SU 7.5 – Currency Exchange Rates – Systems and Calculations
Foreign Currency Markets are needed due to transactions with foreign entities Trade increases = demand for that countries currency increases Currencies must be easily convertible at some prevailing rate Four systems for exchange rates: Fixed Rate Freely floating rates Managed floating rates Pegged rates

186 SU 7.5 – Currency Exchange Rates – Systems and Calculations
Fixed Exchange Rates vs. Freely Floating Rate Systems “Fixed is fixed or almost fixed” Governments help to maintain exchange rates Very predictable and minimizes uncertainty re. exchange rate loses (gains) Governments can manipulate (like China has been accused of doing so) Freely floating helps correct disequilibrium's in the balance of payments

187 SU 7.5 – Currency Exchange Rates – Systems and Calculations
Managed Float Exchange Rate Systems Government allows market forces to determine exchange rates until they move to far, in which case they intervene Pegged Exchange Rate Systems One country fixes the rate of exchange for its currency with respect to another country’s currency (or basket of several currencies)

188 SU 7.5 – Currency Exchange Rates – Systems and Calculations
Exchange Rate Basics Spot rate = exchange rate today Forward rate = some definite date in the future Domestic currency forward rate is greater than its spot rate, it is trading at a forward premium Opposite would be a forward discount See Forward premium/discount calculation on page 282 Forward Rate – Spot Rate X Days in year Spot Rate Days in forward period Cross rate is used when two currencies are not stated in terms of each other

189 SU 7.5 – Currency Exchange Rates – Systems and Calculations
Exchange Rates and Purchasing Power Understand if a currency has appreciated or depreciated Understand graph on page 283

190 SU 7.5 – Currency Exchange Rates – Systems and Calculations Question 1
If a U.S. firm can buy £20,000 for $100,000, the rate of exchange for the pound is A $.20 B $5 C $20 D $50

191 SU 7.5 – Currency Exchange Rates – Systems and Calculations Question 1 Answer
Correct Answer: B Dividing $100,000 by £20,000 produces an exchange rate of $5 to the pound. Incorrect Answers: A: The amount of $.20 is the exchange rate for the dollar, not the pound. C: The exchange rate is $5 to the pound. D: The exchange rate is $5 to the pound.

192 SU 7.5 – Currency Exchange Rates – Systems and Calculations Question 2
Assume the spot rate of the Canadian dollar is $.90. If the spot rate one year from now is $.85, the Canadian dollar will have A Appreciated by 5.56%. B Depreciated by 5.56%. C Appreciated by 5.88%. D Depreciated by 5.88%.

193 SU 7.5 – Currency Exchange Rates – Systems and Calculations Question 2 Answer
Correct Answer: B After a year’s time, a single Canadian dollar now fetches fewer U.S. dollars, indicating a loss of purchasing power (depreciation). The spread is 5.56% [($.90 – $.85) ÷ $.90].

194 SU 7.5 – Currency Exchange Rates – Systems and Calculations Question 3
Exchange rates are determined by A Each industrial country’s government. B The International Monetary Fund. C Supply and demand in the foreign currency market. D Exporters and importers of manufactured goods.

195 SU 7.5 – Currency Exchange Rates – Systems and Calculations Question 3 Answer
Correct Answer: C Although currencies can be supported by various means for short periods, the primary determinant of exchange rates is the supply of and demand for the various currencies. Under current international agreements, exchange rates are allowed to “float.” During periods of extreme fluctuations, however, governments and control banks may intervene to maintain stability in the market. Incorrect Answers: A: Governments have only temporary influence, if any, on the setting of exchange rates. B: The International Monetary Fund has only temporary influence, if any, on the setting of exchange rates. D: Exporters and importers have only temporary influence, if any, on the setting of exchange rates.

196 SU 7.5 – Currency Exchange Rates – Systems and Calculations Question 4
A U.S. company took out a 12-month, 4% loan of £10,000 when the spot rate was $2 to £1. At the end of the loan term, the spot rate was $2.10 to £1. What was the company’s effective rate on this loan? A 9.20% B 5.60% C 4.00% D 0.95%

197 SU 7.5 – Currency Exchange Rates – Systems and Calculations Question 4 Answer
Correct Answer: A The effective interest rate on a loan denominated in a foreign currency is affected by changes in the exchange rates during the time the loan is outstanding. First, the amount borrowed is stated in terms of the borrowing party’s domestic currency [£10,000 × ($2.00 per £1) = $20,000]. The maturity amount of the loan in the foreign currency is then calculated (£10,000 × 1.04 = £10,400). This amount is then converted to the domestic currency at the spot rate in effect on the maturity date [£10,400 × ($2.10 per £1) = $21,840]. The difference in the amounts at the two dates is determined ($21,840 – $20,000 = $1,840), and this amount is divided by the face amount of the loan ($1,840 ÷ $20,000 = 9.2%). Incorrect Answers: B: This percentage results from reversing the conversion rates for the two currencies. C: This percentage is the stated rate of the loan. D: This percentage results from reversing the spot rates for the foreign currency.

198 SU 7.6 – Currency Exchange Rates
Factors Affecting Exchange Rates Trade-related factors Relative inflation rates Relative income levels Government intervention Financial factors Relative interest rates Ease of capital flow

199 SU 7.6 – Currency Exchange Rates Trade-related Factors
Relative Inflation Rates Inflation increases = domestic currency value goes up = falling purchasing power = investors sell currency = shift to the left of supply curve = lower prices. Relative income levels US income increases = greater demand of foreign goods = greater demand for that currency = shifting demand curve to the right. Government Intervention Complicated

200 SU 7.6 – Currency Exchange Rates Financial Factors
Relative interest rates Domestic country interest rate goes up = greater demand for that currency = right shift of demand curve = leftward shift of supply curve = higher price. Ease of capital flow High interest rates and reduced restrictions of capital flow = higher demand (shift of demand curve to the right) = higher prices. See flow chart on page 288

201 SU 7.6 – Currency Exchange Rates
Calculating Simultaneous Effects on Exchange rates Differential Interest Rates Differential Inflation Rates International Fisher Effect Theory Exchange Rates Fluctuations over Time Long-term Purchasing power parity Medium-term Short-term

202 SU 7.6 – Currency Exchange Rates
Risks of Exchange Rate Fluctuation See table on page 290

203 SU 7.7 – International Trade
Direct Foreign Investment Advantages Lower taxes in the foreign nation Annual depreciation allowances for the amount invested Access to foreign capital sources Disadvantages Exchange-rate risk Sovereignty Foreign capital laws Multinational Corporations

204 SU 7.7 – International Trade Question 1
All of the following are concerns that are unique to foreign investments A Exchange rate changes. B Purchasing power parity. C Changes in interest rates. D Expropriation.

205 SU 7.7 – International Trade Question 1 Answer
Correct Answer: C Interest rates are an aspect of doing business within any modern economy. They are not unique to foreign investment.

206 SU 7.7 – International Trade Question 2
Which of the following is a benefit to the home country of international diversification by multinational companies? A A better international monetary system. B Jobs may be lost to foreign subsidiaries. C Unions may be weakened. D Reduced flexibility of operation in a foreign political system.

207 SU 7.7 – International Trade Question 2 Answer
Correct Answer: A A better international monetary system, because of greater participation by many users, is a benefit of international diversification.

208 SU 7.7 – International Trade Question 3
For an American investor who wants to avoid legal restrictions on investing in equity securities of foreign companies, the most frequent means of making indirect investments is through the purchase of A Letters of credit. B Banker’s acceptances. C American depository receipts. D Global depository receipts.

209 SU 7.7 – International Trade Question 3 Answer
Correct Answer: C American depository receipts (ADRs) are ownership rights in foreign corporations.

210 CMA Part 2 Financial Decision Making
Study Unit 8: CVP Analysis and Marginal Analysis Ronald Schmidt, CMA, CFM Jim Clemons, CMA

211 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory
CVP = Break-even analysis Allows us to analyze the relationship between revenue and fixed and variable expenses It allows us to study the effects of changes in assumptions about cost behavior and the relevant ranges (in which those assumption are valid) may affect the relationships among revenues, variable costs, and fixed costs at various production levels Cost-volume-profit analysis is a tool to predict how changes in costs and sales levels affect income; conventional CVP analysis requires that all costs must be classified as either fixed or variable with respect to production or sales volume before CVP analysis can be used. It considers the effects of: Sales volume Sales price Product mixes What else……?

212 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory
CVP analysis is done with what assumptions? Cost and revenue relationships are predictable Unit selling prices are constant Changes in inventory are insignificant Fixed costs remain constant over relevant range (see slide 5 & 6) Total variable cost change proportional with volume (see slide 7 & 8) Continued

213 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory
The revenue (sales) mix is constant All costs are either fixed or variable (long-term all costs are considered as variable) Volume is the sole revenue driver and cost driver The breakeven point is directly related to costs and inversely related to the budgeted margin of safety and the contribution margin Time value of money is ignored

214 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory
Fixed Costs Total fixed cost remains unchanged in amount when volume of activity varies from period to period within a relevant range. The fixed cost per unit of output decreases as volume increases (and vice versa). When production volume and cost are graphed, units of product are usually plotted on the Horizontal axis and dollars of cost are plotted on the vertical axis. Fixed cost is represented by a horizontal line with no slope (cost remains constant at all levels of volume within the relevant range). Intersection point of line on cost (vertical) axis is at fixed cost amount. Likely that amount of fixed cost will change when outside of relevant range.

215 SU- 8.1 – Cost-Volume-Profit (CVP) Analysis – Theory Fixed Costs
Cost per call declines as activity increases. Number of Local Calls Monthly Basic Telephone Bill per Local Call Monthly Basic Telephone Bill Number of Local Calls Total fixed costs remain constant as activity increases. We begin our study of cost behavior with fixed costs. Your basic land-line telephone has a monthly connect charge that remains constant regardless of the number of local calls that you might make. The monthly charge that is independent of call activity is a fixed cost. Fixed costs per unit decline as activity increases. Dividing your monthly connect fee by more local calls reduces the cost per call by spreading the fixed amount over a higher number of calls. For example, if your monthly connect charge is $20 and you make 40 local calls in a month, your cost per local call is $ If you make 100 local calls in a month, your cost per local call is $0.20.

216 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory
Variable Costs Total variable cost changes in proportion to changes in volume of activity. Variable cost per unit remains constant but the total amount of variable cost changes with the level of production. When production volume and cost are graphed Variable cost is represented by a straight line starting at the zero cost level. The straight line is upward (positive) sloping. The line rises as volume increases.

217 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory
Cost per Minute Minutes Talked Cost per Minute is constant as activity increases. Total Costs Minutes Talked Total variable costs increase as activity increases. Total variable costs increase as activity increases. For most people, the total land-line long distance telephone bill is based on the number of minutes talked. As such, there’s a direct relationship between the number of minutes talked and your total bill. The cost per minute talked on your land-line is normally constant. For example, your service may charge five cents per minute. Talking more or less minutes will not change the per minute charge, so on a per unit basis, variable costs remain unchanged.

218 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory
Mixed Costs Include both fixed and variable cost components. When volume and cost are graphed, Mixed cost is represented by a straight line with an upward (positive) slope. Start of line is at fixed cost point (or amount of total cost when volume is zero) on cost (vertical) axis. As activity level increases, mixed cost line increases at an amount equal to the variable cost per unit. Mixed costs are often separated into fixed and variable components when included in a CVP analysis.

219 Total Cost in 1,000’s of Dollars
Scatter Diagrams P 1 Draw a line through the plotted data points so that about equal numbers of points fall above and below the line. * Total Cost in 1,000’s of Dollars 10 20 Activity, 1,000’s of Units Produced Estimated fixed cost = 10,000 We begin by plotting the data points on our graph. The vertical axis is cost and the horizontal axis is activity. Next, we draw a straight line through the data points with about an equal number of observations above and below the line. We continue the line past the observed points until it intersects with the vertical axis. In this case, the intercept is the fixed cost, which is estimated to be $10,000.

220 Total Cost in 1,000’s of Dollars
Scatter Diagrams P 1 Unit Variable Cost = Slope = Δ in cost Δ in units * Total Cost in 1,000’s of Dollars 10 20 Activity, 1,000’s of Units Produced Vertical distance is the change in cost. Horizontal distance is the change in activity. Next, we determine the slope of the line. The slope of the line is the change in cost divided by the change in activity. The slope, the amount of change in cost for a one unit change in activity, is the variable cost per unit of activity.

221 High-Low Method The following is not in this Study Unit, but it is important to know and be able to calculate.

222 The High-Low Method The following relationships between units produced and total cost are observed: Using these two levels of activity, compute: the variable cost per unit. the total fixed cost. Now let’s look at the high-low method. In our example, we’re going to look at the relationship between units produced and total production costs. During the year, the company reports units produced and total costs on a monthly basis. First we should locate the month with the highest level of production and the corresponding total costs. Next, we identify the month with the lowest level of production and the corresponding total costs for that month. The month with the high level of units produced shows 67,500 units and with corresponding costs of $29,000, and the month with the low level of units produced shows 17,500 units with corresponding costs of $20,500. We will use this information to compute the variable cost per unit and the total monthly fixed cost.

223 Total cost = $17,525 + $0.17 per unit produced
High-Low Method Variable cost per unit is determined as follows: Fixed costs are determined as follows: The high-low method is a way to estimate the cost equation by graphically connecting the two cost amounts at the highest and lowest unit volumes. In our case, the lowest number of units is 17,500, and the highest is 67,500. The costs corresponding to these unit volumes are $20,500 and $29,000, respectively. The variable cost per unit is determined as the change in cost divided by the change in units based on the data from the high and low unit volumes. This results in a slope, or variable cost per unit, of 17 cents. To estimate the fixed cost for the high-low method, we use the knowledge that total cost equals fixed cost plus variable cost per unit times the number of units. Then we pick either the high or low point to determine the fixed cost. The cost equation used to estimate costs at different units is $17,525 plus 17 cents per unit. A deficiency of the high-low method is that it ignores all cost points except the highest and lowest. The result is less precision because the high-low method uses the most extreme points rather than the more usual conditions likely to recur. Total cost = $17, $0.17 per unit produced

224 Contribution Margin and its Measures
Contribution margin is the amount by which revenue exceeds the variable costs of producing the revenue. Total contribution margin is $60,000 and the contribution margin per unit sold is $30. In manufacturing companies, volume of activity usually refers to the number of units produced. We then classify a cost as either fixed or variable, depending on whether total cost changes as the number of units produced changes. Once we separate costs by behavior, we can then compute a product’s contribution margin. We’re going to concentrate exclusively on the contribution format income statement for our break-even analysis. Contribution margin is the amount remaining after we deduct all our variable expenses from sales revenue. In this example, contribution margin can be expressed as a total amount, $60,000, or as an amount per unit, $30. Each unit sold contributes $30 toward covering Rydell’s fixed costs and providing for profits.

225 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory
Breakeven point is the level of output where total revenues equals total expenses; the point at which all fixed costs have been covered and operating income is zero. What is the break-even point and where is it on a graph on the next page?

226 CVP Graph Break-Even Point

227 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory
BEP = output level at which Total Rev = Total Exp It is also the point at which all fixed cost have been covered and operating income is zero Revenue $100,000 Var. Cost $ 80,000 Gross Margin $ 20,000 Fixed Cost $ 20,000 Oper. Income $

228 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory
Other terms and definitions Margin of safety is the excess of “budgeted” sales over BE Sales Mixed costs (See slide 11) are costs that have both a fixed and variable component. For example, the cost of operating an automobile includes some fixed costs that do not change with the number of miles driven (e.g., operating license, insurance, parking, some of the depreciation, etc.) Other costs vary with the number of miles driven (e.g., gasoline, oil changes, tire wear, etc.). Revenue or sales mix is the composition of total revenues in terms of various products Sensitivity analysis (See slide 12) examines the effect on the outcome of not achieving the original forecast or of changing an assumption. Since many decisions must be made due to uncertainty, probabilities can be assigned to different outcomes (“what-if”).

229 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory
Mixed costs contain a fixed portion that is incurred even when the facility is unused, and a variable portion that increases with usage. Utilities typically behave in this manner. Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) Total Utility Cost Total mixed cost Mixed costs have both a fixed and variable component. For example, utility bills often contain fixed and variable cost components. The fixed portion of the utility bill is constant regardless of kilowatt hours consumed. This cost represents the minimum cost that is incurred to have the service ready and available for use. The variable portion of the bill varies in direct proportion to the consumption of kilowatt hours. Here we see a graph with utility cost on the vertical axis and kilowatt hours on the horizontal axis. Notice that the fixed monthly charge is the same at all levels of kilowatt usage, even the zero level of usage. The variable cost, which rises as more kilowatt hours are used, is added to the fixed cost to obtain the total mixed cost.

230 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory

231 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory
Unit Contribution Margin (UCM) is an important term used with break-even point or break-even analysis is contribution margin. In equation format it is defined as follows: Contribution Margin = Revenues – Variable Expenses The contribution margin for one unit of product or one unit of service is defined as: Contribution Margin per Unit = Revenues per Unit (Sales price) – Variable Expenses per Unit Expressed in either percentage of the selling price (contribution margin ratio) or dollar amount Slope of total cost curve plotted so that volume is on the x-axis and dollar value is on the y-axis

232 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory
Break-even point in units Fixed costs UCM Break-even point in dollars CMR

233 Contribution Margin Ratio
Contribution margin per unit Sales price per unit = $30 per unit $100 per unit Contribution margin ratio = % The contribution margin ratio is equal to the unit contribution margin divided by the unit sales price. In this example, the contribution margin ratio is 30 percent, resulting from dividing the $30 per unit contribution margin by the $100 unit sales price. =

234 Computing the Break-Even Point
How much contribution margin must Rydell Company have to cover its fixed costs (break-even)? Answer: $24,000 How many units must Rydell sell to cover its fixed costs (break-even)? Contribution margin goes to cover our fixed costs. If all our fixed costs are covered, Rydell will operate in the profit area. If we fail to cover our fixed expenses, we will operate in the loss area. How much contribution must Rydell have to cover its fixed costs? Fixed costs are $24,000, so Rydell must generate $24,000 in contribution margin to cover its fixed costs. When contribution margin is exactly $24,000, Rydell’s sales are at break-even as its income will be zero. Rydell Company is earning $36,000 of income by selling 2,000 units. The break-even point will obviously occur at a sales volume less than 2,000 units. If each unit contributes $30 to covering fixed costs, can you compute the number of units that must be sold to cover the $24,000 in fixed costs and allow the company to break-even? We compute the break-even sales volume in units by dividing fixed costs of $24,000 by the unit contribution margin of $30. The resulting break-even sales in units is 800. Answer: $24,000 ÷ $30 per unit = 800 units

235 SU 8.1 – Cost-Volume-Profit (CVP) Analysis – Theory Question 1
Cost-volume-profit (CVP) analysis is a key factor in many decisions, including choice of product lines, pricing of products, marketing strategy, and use of productive facilities. A calculation used in a CVP analysis is the breakeven point. Once the breakeven point has been reached, operating income will increase by the A Gross margin per unit for each additional unit sold. B Contribution margin per unit for each additional unit sold. C Fixed costs per unit for each additional unit sold. D Variable costs per unit for each additional unit sold.

236 SU 8.1 – Cost-Volume-Profit (CVP) Analysis – Theory Question 1 Answer
Correct Answer: B At the breakeven point, total revenue equals total fixed costs plus the variable costs incurred at that level of production. Beyond the breakeven point, each unit sale will increase operating income by the unit contribution margin (unit sales price – unit variable cost) because fixed cost will already have been recovered. Incorrect Answers: A: The gross margin equals sales price minus cost of goods sold, including fixed cost. C: All fixed costs have been covered at the breakeven point. D: Operating income will increase by the unit contribution margin, not the unit variable cost.

237 SU 8.1 – Cost-Volume-Profit (CVP) Analysis – Theory Question 2
One of the major assumptions limiting the reliability of breakeven analysis is that A Efficiency and productivity will continually increase. B Total variable costs will remain unchanged over the relevant range. C Total fixed costs will remain unchanged over the relevant range. D The cost of production factors varies with changes in technology.

238 SU 8.1 – Cost-Volume-Profit (CVP) Analysis – Theory Question 2 Answer
Correct Answer: C One of the inherent simplifying assumptions used in CVP analysis is that fixed costs remain constant over the relevant range of activity. Incorrect Answers: A: Breakeven analysis assumes no changes in efficiency and productivity. B: Total variable costs, by definition, change across the relevant range. D: The cost of production factors is assumed to be stable; this is what is meant by relevant range.

239 SU 8.1 – Cost-Volume-Profit (CVP) Analysis – Theory Question 3
The margin of safety is a key concept of CVP analysis. The margin of safety is the A Contribution margin rate. B Difference between budgeted contribution margin and breakeven contribution margin. C Difference between budgeted sales and breakeven sales. D Difference between the breakeven point in sales and cash flow breakeven.

240 SU 8.1 – Cost-Volume-Profit (CVP) Analysis – Theory Question 3 Answer
Correct Answer: C The margin of safety measures the amount by which sales may decline before losses occur. It is the excess of budgeted or actual sales over sales at the BEP. Incorrect Answers: A: The contribution margin rate is computed by dividing contribution margin by sales. The contribution margin equals sales minus total variable costs. B: The margin of safety is expressed in revenue or units, not contribution margin. D: Cash flow is not relevant.

241 SU 8.1 – Cost-Volume-Profit (CVP) Analysis – Theory Question 4
The breakeven point in units increases when unit costs A Increase and sales price remains unchanged. B Decrease and sales price remains unchanged. C Remain unchanged and sales price increases. D Decrease and sales price increases.

242 SU 8.1 – Cost-Volume-Profit (CVP) Analysis – Theory Question 4 Answer
Correct Answer: A The breakeven point in units is calculated by dividing total fixed costs by the unit contribution margin. If selling price is constant and costs increase, the unit contribution margin will decline, resulting in an increase of the breakeven point. Incorrect Answers: B: A decrease in costs will cause the unit contribution margin to increase, lowering the breakeven point. C: An increase in the selling price will increase the unit contribution margin, resulting in a lower breakeven point. D: Both a cost decrease and a sales price increase will increase the unit contribution margin, resulting in a lower breakeven point.

243 Remember Computing the Break-Even Point
We have just seen one of the basic CVP relationships – the break-even computation. Break-even point in units = Fixed costs Contribution margin per unit Unit sales price less unit variable cost ($30 in previous example) The results of the previous question can be expressed in equation form as seen on your screen. The break-even point in units is equal to total fixed costs divided by the unit contribution margin. Rydell’s fixed costs are $24,000 per month. Rydell breaks even for the month when it sells 800 footballs ($24,000 ÷ $30 per unit), using the formula on your screen.

244 Remember Computing the Break-Even Point
The break-even formula may also be expressed in sales dollars. Break-even point in dollars = Fixed costs Contribution margin ratio Unit contribution margin Unit sales price The break-even point in sales dollars is equal to total fixed costs divided by the contribution margin ratio. The contribution margin ratio is equal to the unit contribution margin divided by the unit sales price. In the earlier example, the contribution margin ratio is 30 percent, resulting from dividing the $30 per unit contribution margin by the $100 unit sales price. You might want to refer back to the example to verify these numbers. The contribution margin ratio tells us that 30 cents of each sales dollar contributes to covering fixed costs and providing for income.

245 SU 8.1 – Cost-Volume-Profit (CVP) Analysis – Theory
Review: What is the difference between gross margin and contribution margin Effect of an increase in CM Effects on BEP by changes in CM

246 SU 8.2 – CVP Analysis – Basic Calculations
CVP Applications Target Operating Income Multiple products Choice of products Degree of Operating Leverage (DOL) Problems 8, 9, 10, 12 & 13 starting on page 255

247 SU 8.2 – CVP Analysis – Basic Calculations Question 1
Which of the following would decrease unit a contribution margin the most? A A 15% decrease in selling price. B A 15% increase in variable expenses. C A 15% decrease in variable expenses. D A 15% decrease in fixed expenses.

248 SU 8.2 – CVP Analysis – Basic Calculations Question 1 Answer
Correct Answer: A Unit contribution margin (UCM) equals unit selling price minus unit variable costs. It can be decreased by either lowering the price or raising the variable costs. As long as UCM is positive, a given percentage change in selling price must have a greater effect than an equal but opposite percentage change in variable cost. The example below demonstrates this point. Continued

249 SU 8.2 – CVP Analysis – Basic Calculations Question 1 Answer
Original: UCM = SP – UVC = $100 – $50 = $50 Lower Selling Price: = (SP × .85) – UVC = $85 – $50 = $35 Higher Variable Cost: = SP – (UVC × 1.15) = $100 – $57.50 = $42.50 Since $35 < $42.50, the lower selling price has the greater effect.

250 SU 8.2 – CVP Analysis – Basic Calculations Question 2
The breakeven point in units sold for Tierson Corporation is 44,000. If fixed costs for Tierson are equal to $880,000 annually and variable costs are $10 per unit, what is the contribution margin per unit for Tierson Corporation? A $0.05 B $20.00 C $44.00 D $88.00

251 SU 8.2 – CVP Analysis – Basic Calculations Question 2 Answer
Correct Answer: B The breakeven point in units is equal to the fixed costs divided by the contribution margin per unit. Thus, the UCM is $20.00 ($880,000 ÷ 44,000 units).

252 SU 8.2 – CVP Analysis – Basic Calculations Question 3
A manufacturer contemplates a change in technology that would reduce fixed costs from $800,000 to $700,000. However, the ratio of variable costs to sales will increase from 68% to 80%. What will happen to breakeven level of revenues? A Decrease by $301, B Decrease by $500,000. C Decrease by $1,812,500. D Increase by $1,000,000.

253 SU 8.2 – CVP Analysis – Basic Calculations Question 3 Answer
Correct Answer: D The original breakeven level was: Breakeven point = Fixed costs ÷ Contribution margin ratio = $800,000 ÷ (1.0 – .68) = $2,500,000 The new level is: Breakeven point = Fixed costs ÷ Contribution margin ratio = $700,000 ÷ (1.0 – .80) = $3,500,000 Thus, there is an increase of $1,000,000 ($3,500,000 – $2,500,000).

254 SU 8.3 – CVP Analysis – Target Income Calculations
Target Operating Income Fixed costs + Target operating income UCM Target Net Income Fixed costs + Target net income / (1.0 – tax rate) Problem 15, 16 and 18 on page 257

255 Computing Sales (Dollars) for a Target Net Income
To convert target net income to before-tax income, use the following formula: Target net income Before-tax income = 1 - tax rate Our previous formulas allowed us to solve for sales necessary to earn a target pretax income. Pretax income which has two components, net income (after tax) and the income taxes paid on the pretax income. If our target income is stated as after-tax net income, we can convert to pretax income by dividing the target after-tax net income by one minus the tax rate. Let’s work an example to see how income taxes affect cost-volume-profit problems.

256 SU 8.3 – CVP Analysis – Target Income Calculations Question 1
The data below pertain to the forecasts of XYZ Company for the upcoming year. Total Cost Unit Cost Sales (40,000 units) $1,000,000 $25 Raw materials 160,000 4 Direct labor 280,000 7 Factory overhead: Variable 80,000 2 Fixed 360,000 Selling and general expenses: 120,000 3 225,000 Continued

257 SU 8.3 – CVP Analysis – Target Income Calculations Question 1
How many units does XYZ Company need to produce and sell to make a before-tax profit of 10% of sales? A. 65,000 units. B. 36,562 units. C. 90,000 units. D. 25,000 units.

258 SU 8.3 – CVP Analysis – Target Income Calculations Question 1 Answer
Correct Answer: C Revenue minus variable and fixed expenses equals net income. If X equals unit sales, revenue equals $25X, total variable expenses equal $16X ($4 + $7 + $2 + $3), total fixed expenses equal $585,000 ($360,000 + $225,000), and net income equals 10% of revenue. Hence, X equals 90,000 units. $25X - $16X -$585,000 = $25X × 10% 6.5X $585,000 X 90,000 units

259 SU 8.3 – CVP Analysis – Target Income Calculations Question 2
The data below pertain to the forecasts of XYZ Company for the upcoming year. Total Cost Unit Cost Sales (40,000 units) $1,000,000 $25 Raw materials 160,000 4 Direct labor 280,000 7 Factory overhead: Variable 80,000 2 Fixed 360,000 Selling and general expenses: 120,000 3 225,000 Continued

260 SU 8.3 – CVP Analysis – Target Income Calculations Question 2
Assuming that XYZ Company sells 80,000 units, what is the maximum that can be paid for an advertising campaign while still breaking even? A. $135,000 B. $1,015,000 C. $535,000 D. $695,000

261 SU 8.3 – CVP Analysis – Target Income Calculations Question 2 Answer
Correct Answer: A The company will break even when net income equals zero. Net income is equal to revenue minus variable expenses and fixed expenses, including advertising. Thus, if X equals advertising cost, the equation is 80,000)($25) – (80,000)($16) – $585,000 – X = $2,000,000 – $1,280,000 – $585,000 – X X $135,000

262 SU 8.3 – CVP Analysis – Target Income Calculations Question 3
For one of its divisions, Buona Fortuna Company has fixed costs of $300,000 and a variable-cost percentage equal to 60% of its $10 per unit selling price. It would like to earn a pre-tax income of $90,000 per year from the division. How many units will Buona Fortuna have to sell to earn a pre-tax income of $90,000 per year? A 65,000 units. B 75,000 units. C 77,250 units. D 97,500 units.

263 SU 8.3 – CVP Analysis – Target Income Calculations Question 3 Answer
Correct Answer: D Buona Fortuna’s unit contribution margin is $4 ($10 unit price – $6 unit variable cost). By treating desired profit as an additional fixed cost, the target unit sales can be calculated as follows: Target unit sales = (Fixed costs + Target operating income) ÷ UCM = ($300,000 + $90,000) ÷ $4 = 97,500

264 Computing a Multiproduct Break-Even Point
The CVP formulas can be modified for use when a company sells more than one product. The unit contribution margin is replaced with the contribution margin for a composite unit. A composite unit is composed of specific numbers of each product in proportion to the product sales mix. Sales mix is the ratio of the volumes of the various products. To this point, we’ve assumed that a company sells a single product. We can extend the cost-volume-profit relationships to cover multiproduct companies. Instead of unit contribution margin for one unit, we will have a composite unit contribution for all units. The composite unit contribution margin is dependent on the sales mix of the products sold.

265 SU 8.4 – CVP Analysis – Multi-Product Calculations
Multiple Products (or Services) S = FC + VC = Calculated Weighted Average Contribution Margin See example page 243

266 SU 8.4 – CVP Analysis – Multi-Product Calculations
Choice of Product decisions – When resources are limited companies have to choose which products to produce A breakeven analysis of the point where the same operating income or loss will result See example page 244

267 SU 8.4 – CVP Analysis – Multi-Product Calculations
Special Orders (usually lower price than std.) The assumption are that idle capacity is sufficient to manufacture extra units of a special order.

268 SU 8.4 – CVP Analysis – Multi-Product Calculations Question 1
Moorehead Manufacturing Company produces two products for which the data presented to the right have been tabulated. Fixed manufacturing cost is applied at a rate of $1.00 per machine hour. The sales manager has had a $160,000 increase in the budget allotment for advertising and wants to apply the money to the most profitable product. The products are not substitutes for one another in the eyes of the company’s customers. Per Unit XY-7 BD-4 Selling price $4.00 $3.00 Variable manufacturing cost 2.00 1.50 Fixed manufacturing cost .75 .20 Variable selling cost 1.00 Continued

269 SU 8.4 – CVP Analysis – Multi-Product Calculations Question 1
Suppose Moorehead has only 100,000 machine hours that can be made available to produce additional units of XY-7 and BD-4. If the potential increase in sales units for either product resulting from advertising is far in excess of this production capacity, which product should be advertised and what is the estimated increase in contribution margin earned? A Product XY-7 should be produced, yielding a contribution margin of $75,000. B Product XY-7 should be produced, yielding a contribution margin of $133,333. C Product BD-4 should be produced, yielding a contribution margin of $187,500. D Product BD-4 should be produced, yielding a contribution margin of $250,000.

270 SU 8.4 – CVP Analysis – Multi-Product Calculations Question 1 Answer
Correct Answer: D The machine hours are a scarce resource that must be allocated to the product(s) in a proportion that maximizes the total CM. Given that potential additional sales of either product are in excess of production capacity, only the product with the greater CM per unit of scarce resource should be produced. XY-7 requires .75 hours; BD-4 requires .2 hours of machine time (given fixed manufacturing cost applied at $1 per machine hour of $.75 for XY-7 and $.20 for BD-4). XY-7 has a CM of $1.33 per machine hour ($1 UCM ÷ .75 hours), and BD-4 has a CM of $2.50 per machine hour ($.50 ÷ .2 hours). Thus, only BD-4 should be produced, yielding a CM of $250,000 (100,000 × $2.50). The key to the analysis is CM per unit of scarce resource. Incorrect Answers: A: Product XY-7 actually has a CM of $133,333, which is lower than the $250,000 CM for product BD-4. B: Product BD-4 has a higher CM at $250,000. C: Product BD-4 has a CM of $250,000.

271 SU 8.4 – CVP Analysis – Multi-Product Calculations Question 2
Product A accounts for 75% of a company’s total sales revenue and has a variable cost equal to 60% of its selling price. Product B accounts for 25% of total sales revenue and has a variable cost equal to 85% of its selling price. What is the breakeven point given fixed costs of $150,000? A $375,000 B $444,444 C $500,000 D $545,455

272 SU 8.4 – CVP Analysis – Multi-Product Calculations Question 2 Answer
Correct Answer: B Using the relationship: sales = total variable costs + total fixed costs, the combined breakeven point can be calculated as follows: S = 0.75S(0.60) S(0.85) + $150,000 0.45S S + $150,000 S – S $150,000 0.3375S $444,444 Incorrect Answers:  A: This amount is based on the contribution margin of Product A only rather than a weighted average.  C: This amount is based on half of the required sales at B’s contribution margin.  D: This amount is based on an unweighted average of the two contribution margins.

273 SU 8.4 – CVP Analysis – Multi-Product Calculations Question 3
Von Stutgatt International’s breakeven point is 8,000 racing bicycles and 12,000 5-speed bicycles. If the selling price and variable costs are $570 and $200 for a racer, and $180 and $90 for a 5-speed respectively, what is the weighted-average contribution margin? A $100 B $145 C $179 D $202

274 SU 8.4 – CVP Analysis – Multi-Product Calculations Question 3 Answer
Correct Answer: D Contribution margin equals selling price minus variable costs. The product contribution margins are: Racer: $570 – $200 = $370 5-Speed: $180 – $90 $90 The sales mix is: 8,000 ÷ (8, ,000) 40% 12,000 ÷ (8, ,000) 60% Multiply the CM by the sales mix for each product, and add the results. Weighted-average CM = ($370 × 40%) + ($90 × 60%) = $148 + $54 = $202

275 SU 8.4 – CVP Analysis – Multi-Product Calculations Question 3 Answer
Incorrect Answers: A: The sales mix dictates how much of the total CM will come from sales of each product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the UCM for racers must be added to 60% of the UCM for 5-speeds to get the weighted-average CM. B: The sales mix dictates how much of the total CM will come from sales of each product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the UCM for racers must be added to 60% of the UCM for 5-speeds to get the weighted-average CM. C: The sales mix dictates how much of the total CM will come from sales of each product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the UCM for racers must be added to 60% of the UCM for 5-speeds to get the weighted-average CM.

276 SU 8.4 – CVP Analysis – Multi-Product Calculations Question 4
Catfur Company has fixed costs of $300,000. It produces two products, X and Y. Product X has a variable cost percentage equal to 60% of its $10 per unit selling price. Product Y has a variable cost percentage equal to 70% of its $30 selling price. For the past several years, sales of Product X have averaged 66% of the sales of Product Y. That ratio is not expected to change. What is Catfur’s breakeven point in dollars? A $300,000 B $750,000 C $857,142 D $942,857

277 SU 8.4 – CVP Analysis – Multi-Product Calculations Question 4 Answer
Correct Answer: D A helpful approach in a multiproduct situation is to make calculations based on the composite unit, i.e., 2 units of Product X and 3 units of Product Y (a 66% ratio). The selling price of this composite unit is $110 [(2 × $10) + (3 × $30)]. The UCM of the composite unit is $35 {[2 × ($10 – $6)] + [3 × ($30 – $21)]}. Consequently, the breakeven point in composite units is 8, ($300,000 FC ÷ $35 UCM), and the breakeven point in sales dollars is $942,857 (8, × $110). Incorrect Answers: A: This amount equals the fixed costs. B: This amount assumes a 40% contribution margin ratio. C: This amount assumes a 35% contribution margin ratio.

278 SU 8.5 – Marginal Analysis Accounting Costs vs. Economic Costs
Accounting Costs = The total amount of money or goods expended in an endeavor. It is money paid out at some time in the past and recorded in journal entries and ledgers. The economic cost of a decision depends on both the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen. Economic cost differs from accounting cost because it includes opportunity cost. As an example, consider the economic cost of attending college. The accounting cost of attending college includes tuition, room and board, books, food, and other incidental expenditures while there. The opportunity cost of college also includes the salary or wage that otherwise could be earning during the period. So for the two to four years an individual spends in school, the opportunity cost includes the money that one could have been making at the best possible job. The economic cost of college is the accounting cost plus the opportunity cost. Thus, if attending college has a direct cost of $20,000 dollars a year for four years, and the lost wages from not working during that period equals $25,000 dollars a year, then the total economic cost of going to college would be $180,000 dollars ($20,000 x 4 years + the interest of $20,000 for 4 years + $25,000 x 4 years).

279 SU 8.5 – Marginal Analysis Explicit vs. Implicit Costs
Implicit cost, also called an imputed cost, implied cost, or notional cost, is the opportunity cost equal to what a firm must give up in order to use factors which it neither purchases nor hires. An explicit cost is a direct payment made to others in the course of running a business, such as wage, rent and materials.

280 SU 8.5 – Marginal Analysis Accounting vs. Economic Profit
See Tutorial at Accounting Profit = book income exceeds book expenses Economic Profit = includes Accounting Profit + Implicit costs

281 SU 8.5 – Marginal Analysis Marginal Revenue and Marginal Cost
Marginal Revenue is the additional or incremental revenue of one additional unit of output. See page 321 See that Marginal Revenue is $540 between generating 4 vs. 5 units of output. Marginal Cost is the additional or incremental cost incurred of one additional unit of output. Note that while cost decrease over some range they will at some point begin to increase due to the process becoming lest efficient. Profit Maximization is where MR = MC See page 246

282 SU 8.5 – Marginal Analysis Short-Run Cost Relationship – See graph on page 323 Other considerations/applications of CVP Make-or-Buy Capacity Constraints and Product Mix Disinvestments Sell-or-Process further

283 SU 8.6 – Short-Run Profit Maximization
Pure Competition is a market structure in which a very large number of firms sell a standardized product into which entry is very easy in which the individual seller has no control over the product price and in which there is no non-price competition; a market characterized by a very large number of buyers and sellers. Examples : Agricultural products such as potatoes and wheat

284 SU 8.6 – Short-Run Profit Maximization
A Monopoly is a market structure in which one firm sells a unique product into which entry is blocked in which the single firm has considerable control over product price and in which non-price competition may or may not be found. Examples / Importance 1. Public utilities: gas, electric, water, cable TV, and local telephone service companies, are often pure monopolies. 2. First Data Resources (Western Union), Wham-O (Frisbees), and the DeBeers diamond syndicate are examples of "near" monopolies. (See Last Word.) 3. Manufacturing monopolies are virtually nonexistent in nationwide U.S. manufacturing industries. 4. Professional sports leagues grant team monopolies to cities. 5. Monopolies may be geographic. A small town may have only one airline, bank, etc.

285 SU 8.6 – Short-Run Profit Maximization
Monopolistic Competition is a market structure in which many firms sell a differentiated product into which entry is relatively easy in which the firm has some control over its product price and in which there is considerable non-price competition. Examples are grocery stores and gas stations

286 SU 8.6 – Short-Run Profit Maximization
Oligopoly is a market structure in which a few firms sell either a standardized or differentiated product into which entry is difficult in which the firm has limited control over product price because of mutual interdependence (except when there is collusion among firms) and in which there is typically non-price competition.

287 SU 8.6 – Short-Run Profit Maximization
Law of Demand states that all other things remaining unchanged, people demand (buy) more of any good / service if the price of that good / service falls and demand (buy) less if the price increases. Usually represented by a negatively-sloped demand curve which slows that the quantity demanded (quantity of a particular good people intending to buy) declines as price rises and increases as price rises.

288 SU 8.6 – Short-Run Profit Maximization
Elasticity of demand measures how responsive a products demand is to changes in its price level. When we have inelastic demand, a consumer will pay almost any price for the good. Elastic demand therefore means that demand for the product will vary when its price changes. Generally goods which have elastic demand tend to have many substitutes, so if the price of one good increases too much I will substitute out towards a similar good which is cheaper.

289 SU 8.6 – Short-Run Profit Maximization
Calculating Price elasticity of demand Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. There are a number of factors that can determine the price elasticity of demand for a good or service. For example, the demand for luxury items tend to be more elastic than the demand for necessities. For items that are essential, you tend to be less responsive to changes in price. An example of this would be the demand for diamonds tends to be more price elastic than the demand for electricity. Price elasticity of demand is also affected how large a percentage of your total income an item is. We tend to be more elastic in regards to price changes for items that make up a larger percentage of our incomes. For example, if the price of a pack of gum goes up by 10%, I probably wouldn't even notice. On the other hand, if the price of a car I'm considering purchasing goes up by 10%, I would definitely notice and I would probably reconsider the purchase.

290 SU 8.6 – Short-Run Profit Maximization
A third factor that influences the price elasticity of demand is the time frame allowed for response. We tend to be more responsive to changes in price in the long run than in the short run. For example, if the price of gas were to go up overnight to $10/gallon I would still have to put gas in my car tomorrow morning because I have to go to work and I have to go to school. But if the price of gas were to stay at $10/gallon for a year, then I have more options. I could move closer to work, start carpooling, or trade in my car for a hybrid with better gas mileage so that I don't have to buy as much gas. So in the long run, demand tends to be more elastic than in the short run.

291 SU 8.6 – Short-Run Profit Maximization Price Elasticity Example
Antoinette has a beauty salon. She services 100 customers per day. Her usual fee is $50. She wants to expand her business. If she lowers her price (gives everyone a coupon for $10 off), she expects to get an extra 10 customers per day. Calculate the price elasticity of demand. Did she make the correct decision?

292 SU 8.6 – Short-Run Profit Maximization Price Elasticity Example Answer
Percentage change in quantity demanded = 10% (100 customers increased to 110 customers) Percentage change in price = -20% ($50 reduced to $40) A/B = 10%/-20% = The price elasticity of demand for this service is -0.5, and a price elasticity of demand less than 1 means that a good is inelastic, meaning that quantity demanded is relatively unresponsive to a change in price. So you could argue that she made the wrong decision, as the price decrease did not greatly affect demand. She might have been better choosing another strategy, such as better advertising or her services. You could also argue that she is reducing the price by 20% in return for a 10% increase in volume.

293 SU 8.6 – Short-Run Profit Maximization Price Elasticity Defined
A product with elasticity of 1.2 has elastic demand. What this means is that for every 1% rise in the price, demand will fall by 1.2% (similarly, a 1% fall in the price will lead to a 1.2% rise in demand). The rule is: Elasticity > 1 : elastic (% change in demand is greater than % change in price e.g. luxury goods such as cars etc.) Elasticity < 1 : inelastic (% change in demand is less than % change in price e.g. essential goods such as food) Elasticity = 1 : unitary elastic (% change in demand is equal to the % change in price) Basically a firm producing an inelastic good can increase revenue by raising the price, as the fall in demand is more than offset by the increased revenue on the remaining demand.

294 SU 8.6 – Short-Run Profit Maximization Price Elasticity Defined
Infinite or perfectly elastic - If it were “perfectly” elastic, demand would be infinite at all prices less than $3. A perfectly elastic demand graph is a vertical line. And, when the price is at $3, you can not tell from the graph what the demand is since the line is vertical. The demand could be at any value. Perfectly price inelastic - means that the quantity demanded will not change when price changes. Vertical demand curve Also, perfectly price elastic means if price changes, quantity demanded changes totally, Horizontal Demand Curve

295 Essays

296 Exam topics Part 1 – Financial Planning, Performance and Control
4 hours, 100 multiple-choice questions and two 30-minute essay scenarios Planning, budgeting, and forecasting (30%) Performance measurement (25%) Cost management (25%) Internal controls (15%) Professional ethics (5%) Part 2 – Financial Decision Making Financial statement analysis (25%) Corporate finance (25%) Decision analysis and risk management (25%) Investment decisions (20%) Professional ethics (5%)  

297 Essays This section provides a great opportunity to earn partial credit Be sure to show your work and assumptions Expect 3-6 questions for each essay scenario You can scroll between questions and scenarios within the essay section of the exam Helps to determine how much time you will need for responses

298 Essay Exam Strategies Pay close attention to verbs
E.g., if it says compare or contrast, don’t define something Read the entire question to understand all requirements You may have more than one requirement, for example: “Define abc and interpret its applicability to xyz.” Grammar and writing skills Focus is on use of standard English, organization and clarity Graders are looking for effective writing skills

299 Essay Exam Strategies Be brief and to the point
It’s ok to use bullet points Do not leave a questions blank If short on time, at least write an outline of your main points Graders are looking to give you points, not take them away Make it as easy as possible for graders to give you points!  

300 Essay Exam Information
Type your responses into a text box Similar to MS Word, but with more simple functionality Effective January 2013, the spreadsheet tool is no longer being used on the CMA exam Be sure to use all of the time available to you

301 IMA Essay Webinar Highlights
Here are highlights from webinar. Roughly 75% of points come from multiple choice, essay only accounts for 25% of points. There are two essay questions for each section of the CMA exam. Each question will have 3-6 parts that must be answered. Be sure you skim all essay parts before begin answering. This will help you survey how much time to spend on each question from the beginning. Some will be easy, just asking for a definition. Some will require calculations. Show all your work. Even if your answer is wrong, showing your work will give you partial credit. Be sure to answer the question correctly. If the question asks you to compare or contrast something, don't define it. That is not what they are looking for.

302 IMA Essay Webinar Highlights
There is a sample grading rubic for essay portion enclosed in slide presentation. This is interesting because this shows that the graders only give points for correct answers. They don't deduct for wrong answers. Notice on rubic for the second sample essay (slide 38), there are multiple points that could be earned for each question, but the total points for each question is less than the sum for all the possible answers. This means that there is more than one correct answer. Once you get the maximum points for this part, the grader moves on. You don't get more points for embellishing. Don't embellish. Be direct. Be simple. Use bullet points. Show your work, including calculations. Use proper grammar and English. Then move on to the next question. Practice answering essays online. This will get you used to how to type calculations and make bullet points. Use ALL the time you have on your essay questions, even if you pull time from your multiple choice section. The more you study, the better you will do. It is as simple as that.


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