1. CMA Part 2 Financial Decision Making Study Unit 4: Managing Current Assets

2. SU 4.1 – Working Capital Concept Basic components of an organization’s working capital cash marketable securities accounts receivable inventory Working capital finance concerns the optimal level, mix, and use of current assets and the means used to acquire them, notably current liabilities. 2

3. SU 4.1 – Working Capital Objective 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. 3

4. SU 4.1 – Working Capital What is working capital and types of capital policies? 1.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. 4

5. SU 4.1 – Working Capital 2.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. 5

6. SU 4.1 – Working Capital Working Capital policies include: 1.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? 6

7. SU 4.1 – Working Capital 2.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 7

8. SU 4.1 – Working Capital 3.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. 8

9. SU 4.1 – 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 9

10. SU 4.1 – Working Capital Permanent and Temporary Working Capital – Def. – 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 10

11. SU 4.1 – 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 11

12. SU 4.1 – Practice 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. 12

13. SU 4.1 – Practice 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. 13

14. SU 4.1 – Practice 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. 14

15. SU 4.1 – Practice 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. 15

16. SU 4.1 – Practice 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. 16

17. SU 4.1 – Practice 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. 17

18. SU 4.1 – Practice 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. 18

19. SU 4.1 – Practice 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. 19

20. SU 4.2 – Cash Management  Read Gleim Success Tip on page 108 20

21. SU 4.2 – Cash Management Concept Cash management describes the collective activities by which a corporation administers and invests its cash. 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 21

22. SU 4.2 – Cash Management Cash Management Techniques 1. Managing the cash levels – What are the motives for holding cash? Transactional Precautionary Speculative 22

23. SU 4.2 – Cash Management – What is the firms optimal cash? 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 23

24. SU 4.2 – Cash Management Cash Management Techniques 2. Forecasting future cash flows – Cash Budget Projected receipts and activity Re-evaluated constantly Based on projected sales, credit terms, and estimated collection rates Cash payments based on budgeted purchases and total sales  Forecasting future cash flows (see examples on page 109-110, very typical test questions!) 24

25. SU 4.2 – Cash Management Cash Management Techniques 3. 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 25

26. SU 4.2 – 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. 26

27. SU 4.2 – 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. 27

28. SU 4.2 – Cash Management Lockbox benefit analysis Net Benefit from Lockbox = Reduction in Float Opportunity Cost + Reduction in Internal Processing Costs - Lockbox Processing Costs  See page 111 28

29. SU 4.2 – 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. 29

30. SU 4.2 – Cash Management Cash Management Techniques 4. 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. 1.Mail float 2.Processing float 3.Clearing float 30

31. SU 4.2 – Cash Management 1.Mail float – How and by which means can we slow down receipt of the check? 2.Processing float – How by which means can we slow down the processing of a pmt a)Draft b)PTD – Payable through draft 3.Clearing float - the time interval between when the check is deposited by the payee and when the firm’s account is debited 31

32. SU 4.2 - 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. 32

33. SU 4.2 - Answer 1 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. 33

34. SU 4.2 - 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. 34

35. SU 4.2 - Answer 2 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. 35

36. SU 4.2 - 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 36

37. SU 4.2 - Answer 3 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 37

38. SU 4.2 - 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 38

39. SU 4.2 - Answer 4 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. 39

40. SU 4.3 – 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. 40

41. SU 4.3 – Marketable Securities Management Definition – 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). 41

42. SU 4.3 – Marketable Securities Management Consideration in Marketable Securities 1.Safety 2.Marketability 3.Yield 4.Maturity 5.Taxability 42

43. SU 4.3 – 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. 43

44. SU 4.3 – 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. 44

45. SU 4.3 – 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. 45

46. SU 4.3 – 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. 46

47. SU 4.3 – 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. 47

48. SU 4.3 – Marketable Securities Management – CD’s 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. 48

49. SU 4.3 – Marketable Securities Management – Others Money-market mutual funds – invest in short-term, low-risk securities Short-term securities – by State and local governments 49

50. SU 4.3 – Marketable Securities Management Remember! Companies invest in marketable securities for three main reasons: 1.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 2.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) 3.Income generation. To earn interest on surplus cash for which the company has no immediate use 50

51. SU 4.3 – 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. 51

52. SU 4.3 – 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. 52

53. SU 4.3 – Question 2 Hendrix, Inc., is interested in purchasing a $100 U.S. Treasury bill and was presented with the following options: Due DateDiscount Rate Option 1180 days6% Option 2360 days3.5% Option 3120 days8% Option 4240 days4.5% If Hendrix wishes to buy the Treasury bill at the lowest purchasing price, which option should be chosen, assuming a 360-day year? A.Option 1. B.Option 2. C.Option 3. D.Option 4. 53

54. SU 4.3 – 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 $97.00. C: Option 3 has a purchase price of $97.33. D: Option 4 has a purchase price of $97.00. 54

55. SU 4.3 – 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 55

56. SU 4.3 – 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. 56

57. SU 4.4 – Portfolio Management Efficient Portfolios – Investor wants to maximize return, minimize risk Highest return for given risk Least risk for given return – Considerations Amount of money to invest Securities in which to invest 57

58. SU 4.4 – Portfolio Management – Indifference Curve Steeper slope  more risk to investor Higher curve  greater level of investor utility  See Figure 4-1 on page 113 58

59. SU 4.4 – Portfolio Management – Invest in securities based on expected net cash flows and cash flow uncertainty Maturity matching Uncertain cash flows – marketability, market risk, transaction costs Certain cash flows – maturity date most important 59

60. SU 4.4 – Portfolio Management Hedging (securities, commodities, foreign currency) is offsetting commitments to minimize or avoid impact of adverse price movement – Derivative – offset price changes – Natural hedge – cancel each other out – Futures contract – buy or sell at future, fixed price 60

61. SU 4.4 – Portfolio Management Measures of Risk – Risk - the chance that the actual return will differ from the expected return – Expected rate of return - an average of possible outcomes weighted according to their probabilities – Standard deviation (variance) – measures the tightness distribution and riskiness of investment  See example page 114 61

62. SU 4.4 – Portfolio Management Security Risk vs. Portfolio Risk – Individual securities – Portfolio of securities Weighted average of returns on individual securities Risk is not an average of standard deviation of individual securities Diversification 62

63. SU 4.4 – Portfolio Management Correlation – Correlation coefficient measures the degree to which any two variables are related (1.0 to -1.0) Perfect positive correlation (1.0) – two variables move together – Nearly impossible Perfect negative correlation (-1.0) – two variables always move in the opposite direction – Risk, in theory, eliminated – Hedge risk in stocks Normal range is.50 to.70 63

64. SU 4.4 – Portfolio Management Covariance – Covariance measures mutual volatility Correlation coefficient of two securities can be combined with their standard deviations to arrive at their covariance  See example page 115 64

65. SU 4.4 – Portfolio Management Risk and Diversification – Specific risk is the risk associated with a specific investee’s operations: new products, patents, acquisitions, competitors’ activities, etc. Also called “diversifiable, unsystematic, residual, unique” Should, in principle, continue to decrease as the number of different securities held increases(20-30 securities) – Market risk is the risk of the stock market as a whole Also called “undiversifiable, systematic” 65

66. SU 4.4 – Portfolio Management Beta – Beta is a measure of sensitivity to the market Best measure of risk of individual security held in a diversified portfolio Beta of 1.0 – average risk stock with returns perfectly positively correlated with market Beta less than 1.0 – less volatile than market Beta over 1.0 – volatile security – Beta coefficient is slope of the regression line for returns of individual security (dependent) and overall market return (independent) – Beta of a portfolio is weighted average of betas of the individual securities 66

67. SU 4.4 – Portfolio Management Capital Asset Pricing Model (CAPM) – Used to measure contribution of risk of a security – Relates level of risk to average return available – Takes into consideration time value of money (risk free rate) and risk (risk premium and beta). – Practical problems Risk-free rate may be hard to estimate Single-period model  See Figure 4-2 on page 117  See example page 117 67

68. SU 4.4 – Portfolio Management Quantitative Risk Assessment Tools – Value at risk (VaR) is a technique that employs normal distribution (bell curve) to determine the maximum potential gain or loss within a certain period at a given level of confidence Highest point – most probable event with all other possible situations equally distributed Within 1.96 standard deviations from most probable event – potential gain can be calculated within 95% confidence Within 2.57 standard deviations from most probable event – potential gain can be calculated with 99% confidence – Cash flow at risk and earnings at risk – identical application  See Figure 4-3 on page 118 68

69. SU 4.4 – Question 1 69 The state of the economy has a strong effect on expected returns as shown below: State of the EconomyProbabilityStock Returns Recession.35-10% Stable.4010% Expansion.2530% What is the expected rate of return? A.8% B.10% C.15% D.30%

70. SU 4.4 – Question 1 Answer 70 Correct Answer: A State of the EconomyPossible Rate of ReturnProbabilityWeighted Averages Recession(10)%x35%=(3.5)% Stable10%x40%=4.0% Expansion30%x25%=7.5% 8.0% Incorrect Answers B: 10% is a simple average of the returns C: 15% is the result from adding, not subtracting, the average for the recession rate D: 30% is the result from failing to weight the rates of return by their probabilities

71. SU 4.5 – Receivable Management Overview – A firm must balance default risk and sales maximization – A/R are carried for competitive and investment purposes Firms must offer credit to match competitors Customers can pay in the discount period, when due or beyond and pay interest 71

72. SU 4.5 – Receivable Management Factors influencing receivables: – Customer creditworthiness – Standard credit terms – Means for tracking A/R – Collection of past due accounts 72

73. SU 4.5 – Receivable Management Optimal credit policy balances: – Bad debt – from taking on riskier customers; default risk – Increasing sales – attracting new customers with more liberal credit terms 73

74. SU 4.5 – Receivable Management Default Risk – probability that customer won’t pay, and can be managed by: – Agreements like guarantees (i.e. personal or secondary) – Using credit scoring, much like individual credit scoring 74

75. SU 4.5 – Receivable Management Aging Accounts Receivables – The longer debt is outstanding the less likely it is likely to be collected. – Some industries have longer outstanding A/R (i.e. construction) – Aging statement provides estimate on “Net” A/R 75

76. SU 4.5 – Receivable Management Basic Receivables Terms – 2/10, net 30 = approx. 36% Example - $100 receivable paid in the 10 days from receipt of goods (in the discount period) $2 savings/$98 “net” payment by customer = 2.04% Diff. in payment periods = 20 days (30 days – 10 days) 20 days diff. / 360 days in a year = 18x 18x 2.04% = approx. 36.73% 76

77. SU 4.5 – Receivable Management Why would companies offer a 36+% discount for customers to pay early? Average collection period – Days sales outstanding. Number of days between sale and collection 77

78. SU 4.5 – Receivable Management Important is to understand the impact of changes to credit terms. – Cost < extra net revenue generated – Consider the opportunity cost of funds tied up in A/R – See example on page 121 (very common test question) 78

79. SU 4.5 – Receivable Management Factoring – Transfer (selling) of A/R to third party – Usually very high cost – With or without recourse; affects factoring cost – See example on the top of page 122 – Factoring is different from “pledging” (or using as collateral) for line of credit/loans 79

80. SU 4.5 – 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. 80

81. SU 4.5 – 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. 81

82. SU 4.5 – 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. 82

83. SU 4.5 – 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. 83

84. SU 4.5 – 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. 84

85. SU 4.5 – 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. 85

86. SU 4.5 – 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 86

87. SU 4.5 – 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. 87

88. SU 4.6 – 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. 88

89. SU 4.6 – Inventory Management Cost related to inventory includes: – Purchase costs – actual invoice amount – Carrying costs – storage, insurance, security, taxes, interest, obsolescence/spoilage/”shrinkage” – Ordering costs – Stockout costs – opportunity cost of missing a customer order (see example on page 123) 89

90. SU 4.6 – 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: 1.What to order (or make)? 2.When to order (or make)? 3.How much to order (or make)? 90

91. SU 4.6 – Inventory Management Reasons for carrying inventory include: – Hedging against supply uncertainty – Hedging against demand uncertainty – Ensuring that operations are not interrupted (ref. JIT) 91

92. SU 4.6 – Inventory Management Safety stock is held to protect against stock outs. – It also increases carrying costs – Involves balancing the variability of demand, lead time and level of risk company is willing to accept See figure 4-4 and following inventory “relationships” on page 123 92

93. SU 4.6 – 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. They are: 1.What do we have? 2.How much do we have? 3.Where is it? 93

94. SU 4.6 – Inventory Management Remember: – 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. 94

95. SU 4.6 – Inventory Management Just-in-Time and Kanban Systems – JIT – 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 = 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. 95

96. SU 4.6 – 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 96

97. SU 4.6 – Inventory Management Remember! Cost of Safety Stock = Expected stockout cost + Carrying Cost 97

98. SU 4.6 – 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

99. SU 4.6 – Inventory Management Determining the Order Quantity Square root of ((2x VC/purchase 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

100. SU 4.6 – Inventory Management See examples on pages 124 and 125 100

101. SU 4.6 – 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

102. SU 4.6 – Question 1 Answer 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

103. SU 4.6 – 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

104. SU 4.6 – 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

105. SU 4.6 – Question 3 The following information regarding inventory policy was assembled by the JRJ Corporation. The company uses a 50-week year in all calculations. Sales10,000 units per year Order quantity2,000 units Safety stock1,300 units Lead time4 weeks The reorder point is A.3,300 units. B.2,100 units. C.1,300 units. D.800 units. 105

106. SU 4.6 – 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

107. CMA Part 2 Financial Decision Making Study Unit 5: Corporate Restructuring and International Finance by Ronald Schmidt, CMA, CFM

108. SU 5.1 – Mergers and Acquisitions (M&As) and Bankruptcy 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. 108

109. SU 5.1 – Mergers and Acquisitions (M&As) and Bankruptcy – 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. 109

110. SU 5.1 – Mergers and Acquisitions (M&As) and Bankruptcy – Merger 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 110

111. SU 5.1 – Mergers and Acquisitions (M&As) and Bankruptcy 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 111

112. SU 5.1 – Mergers and Acquisitions (M&As) and Bankruptcy – 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. 112

113. SU 5.1 – Mergers and Acquisitions (M&As) and Bankruptcy – What are some of the motivations of M&As? Increased salaries, prestige, benefits of market domination Replacing inefficient management Optimizing capital structure – Deterrents include: Terminations, loss of management power 113

114. SU 5.1 – Mergers and Acquisitions (M&As) and Bankruptcy Opposition to Combinations – Greenmail – Staggered Directors – Golden Parachutes – Fair Price Provisions – Going Private and LBOs – Poison Pill – Flip-over Rights – Flip-in Rights – Issuing Stock – Reverse Tender – ESOP – White Knight Merger – Crown Jewel Transfer – Legal Actions 114

115. SU 5.1 – Mergers and Acquisitions (M&As) and Bankruptcy Other Restructurings – Spin-offs – Divestures – Liquidation of assets – Equity carve-out 115

116. SU 5.1 – Mergers and Acquisitions (M&As) and Bankruptcy Bankruptcy – Conditions – debt exceeds assets or illiquid – Sign include – financial distress like past due payments, plant closings – May be voluntary or involuntary – Primary are 7 and 11, know which is which 116

117. SU 5.1 – 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? AThe surviving company is one of the two combining companies. BThe surviving company is neither of the two combining companies. CAn investor-investee relationship is established. DA parent-subsidiary relationship is established. 117

118. SU 5.1 – 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. 118

119. SU 5.1 – Question 2 The acquisition of a retail shoe store by a shoe manufacturer is an example of AVertical integration. BA conglomerate. CMarket extension. DHorizontal integration. 119

120. SU 5.1 – 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. 120

121. SU 5.1 – 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 ASpin-off. BStock split. CScrip dividend. DReverse split. 121

122. SU 5.1 – 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. 122

123. Remember 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. 2005 Bankruptcy Reform Act as amended in 2008. 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. 123

124. SU 5.1 – Mergers and Acquisitions (M&As) and Bankruptcy continued – 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 124

125. SU 5.1 – Mergers and Acquisitions (M&As) and Bankruptcy (continued) 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. 125

126. SU 5.1 – Mergers and Acquisitions (M&As) and Bankruptcy (continued) – 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. 126

127. SU 5.1 – Question 1 Which of the following is indicative of insolvency? APayments to creditors are late. BThe market value of the firm’s stock has declined substantially. COperating cash flows of the firm cannot meet current obligations. DDividends are not declared because of inadequate retained earnings. 127

128. SU 5.1 – 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. 128

129. SU 5.1 – 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. BA 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. 129

130. SU 5.1 – 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. 130

131. SU 5.1 – 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 AYes B No C Yes DNo 131

132. SU 5.1 – 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. 132

133. SU 5.1 – Question 4 A discharge in bankruptcy under Chapter 7 (liquidation) may be obtained by a(n) IndividualCorporationPartnership AYes BNoYes C No D Yes 133

134. SU 5.1 – 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. 134

135. SU 5.2 – Foreign 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 135

136. SU 5.2 – Foreign 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 136

137. SU 5.2 – Foreign 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) 137

138. SU 5.2 – Foreign 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 RateDays in forward period – Cross rate is used when two currencies are not stated in terms of each other 138

139. SU 5.2 – Foreign Exchange Rates – Systems and Calculations Exchange Rates and Purchasing Power – Understand if a currency has appreciated or depreciated  Understand graph on page 283 139

140. SU 5.2 – 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$50 140

141. SU 5.2 – 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. 141

142. SU 5.2 – 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 AAppreciated by 5.56%. BDepreciated by 5.56%. CAppreciated by 5.88%. DDepreciated by 5.88%. 142

143. SU 5.2 – 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]. 143

144. SU 5.2 – Question 3 Exchange rates are determined by AEach industrial country’s government. BThe International Monetary Fund. CSupply and demand in the foreign currency market. DExporters and importers of manufactured goods. 144

145. SU 5.2 – 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. 145

146. SU 5.2 – 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? A9.20% B5.60% C4.00% D0.95% 146

147. SU 5.2 – 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. 147

148. SU 5.3 – Factors Affecting Rates and Risk Mitigation Techniques Factors Affecting Exchange Rates – Trade-related factors Relative inflation rates Relative income levels Government intervention – Financial factors Relative interest rates Ease of capital flow 148

149. SU 5.3 – Factors Affecting Rates and Risk Mitigation Techniques 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 149

150. SU 5.3– Factors Affecting Rates and Risk Mitigation Techniques 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 288 150

151. SU 5.3– Factors Affecting Rates and Risk Mitigation Techniques 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 151

152. SU 5.3– Factors Affecting Rates and Risk Mitigation Techniques Risks of Exchange Rate Fluctuation  See table on page 290 152

153. SU 5.4 – Effects of Foreign Exchange Fluctuations Functional currency – currency of the primary economic environment in which the entity operates Foreign currency – any other currency Foreign currency transactions – fixed currency other than functional currency (buy or sell on credit, borrow or lend, party to derivative, acquisition or disposal of assets, settlement of liability fixed in foreign currency) 153

154. SU 5.4 – Effects of Foreign Exchange Fluctuations Cross-Border Transactions Recorded at spot rate in effect at transaction date Transactions gains/losses – Recorded at balance sheet date and receivable settlement date (inc. in net income) – Receivable or payable  See example on page 158 154

155. SU 5.4 – Effects of Foreign Exchange Fluctuations Exchange Rate Exposure Transactions recorded in firm’s domestic currency – Could be settled in another currency – Fixed exchange rates - no measurement issue – Not fixed exchange rates - possible gain/loss At settlement date Translation gain/loss calculated whenever financial statements are prepared during the payment deferral period 155

156. SU 5.4 – Effects of Foreign Exchange Fluctuations Two-Transaction Perspective In accordance with GAAP – First transaction – purchase/sale – Second transaction – future acquisition of foreign currency Importer/Exporter assumes exchange rate risk because they are not settling immediately 156

157. SU 5.4 – Effects of Foreign Exchange Fluctuations Effects of Exchange Rate Fluctuations Transaction that will be settled in a foreign currency Sale Purchase Results in a Foreign-Denominated Receivable Payable Foreign Currency Appreciates Transaction gain Transaction loss Foreign Currency Depreciates Transaction loss Transaction gain 157

158. SU 5.4 – Effects of Foreign Exchange Fluctuations Remeasurement Necessary when currency of accounting records differs from functional currency Attempts to make the financial statement items look like underlying transactions previously recorded in functional currency – Balance sheet items Historical cost - remeasured at historical rate Carried at current/future value – remeasured using current rate on reporting date Net gain/loss recognized as component of income from continuing operations 158

159. SU 5.4 – Effects of Foreign Exchange Fluctuations Translation Necessary when functional currency differs from reporting currency – Assets and liabilities - restated using reporting date exchange rates – Stockholders equity items - restated at historical rates – Revenues, expenses, gains – restates using historical rates in effect at the time they were recognized (or weighted average rate) Gain/loss – other comprehensive income  See example page 159 159

160. SU 5.4 – Question 1 160

161. SU 5.5 – 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 161

162. SU 5.5 – Question 1 All of the following are concerns that are unique to foreign investments AExchange rate changes. BPurchasing power parity. CChanges in interest rates. DExpropriation. 162

163. SU 5.5 – 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. 163

164. SU 5.5 – Question 2 Which of the following is a benefit to the home country of international diversification by multinational companies? AA better international monetary system. BJobs may be lost to foreign subsidiaries. CUnions may be weakened. DReduced flexibility of operation in a foreign political system. 164

165. SU 5.5 – Question 2 Answer Correct Answer: A A better international monetary system, because of greater participation by many users, is a benefit of international diversification. 165

166. SU 5.5 – 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 ALetters of credit. BBanker’s acceptances. CAmerican depository receipts. DGlobal depository receipts. 166

167. SU 5.5 – Question 3 Answer Correct Answer: C American depository receipts (ADRs) are ownership rights in foreign corporations. 167