Ch. 1 - An Introduction to Financial Management  2002, Prentice Hall, Inc.

Goal of the Firm 1) Profit Maximization? this goal ignores: a) TIMING of Returns (Time Value of Money - Ch. 5) b) UNCERTAINTY of Returns (Risk - Ch. 6)

Goal of the Firm 2) Shareholder Wealth Maximization? this is the same as: a) Maximizing Firm Value b) Maximizing Stock Price

Legal Forms of Business 1) Sole Proprietorship A business owned by a single individual. Owner maintains title to the firm’s assets. Owner has unlimited liability. 2) Partnership Similar to a sole proprietorship, except that there are two or more owners.

2a) General Partnership All partners have unlimited liability. 2b) Limited Partnership Consists of one or more general partners, who have unlimited liability, and One or more limited partners (investors) whose liability is limited to the amount of their investment in the business. Legal Forms of Business

3) Corporation A business entity that legally functions separate and apart from its owners. Owners’ liability is limited to the amount of their investment in the firm. Owners hold common stock certificates, and ownership can be transferred by selling the certificates. Legal Forms of Business

The Corporation and Financial Markets

Corporation

The Corporation and Financial Markets CorporationInvestors

The Corporation and Financial Markets Government CorporationInvestors

The Corporation and Financial Markets cash Government CorporationInvestors

The Corporation and Financial Markets cash Government securities CorporationInvestors

The Corporation and Financial Markets Government cash securities CorporationInvestors Secondary markets

The Corporation and Financial Markets cash Investors Secondary markets Government securities Cash flow Corporation

The Corporation and Financial Markets cash Investors Secondary markets Government securities Cash flow tax Corporation

The Corporation and Financial Markets cash Investors Secondary markets Government securities Cash flow reinvest tax Corporation

The Corporation and Financial Markets cash Investors Secondary markets Government securities Cash flow reinvest tax Corporation dividends, etc.

The Corporation and Financial Markets Primary Market

–Market in which new issues of a security are sold to initial buyers. The Corporation and Financial Markets

Primary Market –Market in which new issues of a security are sold to initial buyers. Secondary Market The Corporation and Financial Markets

Primary Market –Market in which new issues of a security are sold to initial buyers. Secondary Market –Market in which previously issued securities are traded. The Corporation and Financial Markets

Initial Public Offering (IPO) The Corporation and Financial Markets

Initial Public Offering (IPO) –The first time the firm’s stock is sold to the general public. The Corporation and Financial Markets

Initial Public Offering (IPO) –The first time the firm’s stock is sold to the general public. Seasoned New Issue The Corporation and Financial Markets

Initial Public Offering (IPO) –The first time the firm’s stock is sold to the general public. Seasoned New Issue –A new stock offering by a firm that already has stock that is traded in the secondary market. The Corporation and Financial Markets

Financial Management Axioms 1) Risk - return trade-off 2) Time value of money 3) Cash - not profits - is king 4) Incremental cash flows count 5) The curse of competitive markets 6) Efficient capital markets 7) The agency problem 8) Taxes bias business decisions 9) All risk is not equal 10) Ethical dilemmas are everywhere in finance

Problem 1 Financial management is the study of A.making decisions that create and maintain economic value or wealth. B.the process for generating of profits. C.the guidelines for the preparation of financial reports. D.the creation of money.

Problem 2 What is the appropriate goal of the firm? A.Maximization of shareholder wealth which means the maximization of the price of the existing common stock. B.Profit maximization. C.Maximize earnings per share. D.Maximize the firm's cash balance.

Problem 3 Maximizing shareholder wealth means maximizing the A.value of the firm's assets. B.amount of the firm's cash. C.value of the firm's investments. D.total market value of the firm's common stock.

Problem 4 There are three principal forms of business organization: the sole proprietorship, the partnership, and the corporation. An advantage of the corporation over the other legal forms of business organizations is: A.unlimited liability. B.nontransferability of ownership. C.ability of the corporation to raise large amounts of capital. D.double taxation of dividend income.

Problem 5 In a partnership, the major difference between limited partners and general partners is that general partners: A.have unlimited liability. B.are not liable for the actions of the other partners. C.incur liability restricted to the amount of capital invested in the partnership. D.may not participate in the management of the firm.

Problem 6 The "real" owners of the corporation are the: A. bondholders. B. managers. C. board of directors of the firm. D. common stockholders.

Problem 7 The ease of raising capital is the major reason for the popularity of the corporate form of business organization. Funds are raised in financial markets by selling securities-- stocks and bonds. A firm actually obtains funds when its securities are sold in the A.secondary market. B.primary market.

Problem 8 Although the goal of the firm is the maximization of shareholder wealth, the agency problem may interfere with the implementation of this goal. The agency problem results from: A.difficulties with the firm's insurance agency or broker. B.there is a separation of management and ownership of the firm that allows managers to make decisions that are not in line with the goal of maximization of shareholder wealth. C.pursuing the goal of maximization of shareholder wealth. D.agents of the firm overpowering the principals.

Ch. 2 - Understanding Financial Statements, Taxes, and Cash Flows , Prentice Hall, Inc.

SALES - EXPENSES = PROFIT Income Statement

SALES - EXPENSES = PROFIT Income Statement Revenue

Income Statement SALES - EXPENSES = PROFIT

Income Statement SALES - EXPENSES = PROFIT Cost of Goods Sold

Income Statement SALES - EXPENSES = PROFIT Cost of Goods Sold Operating Expenses

Income Statement SALES - EXPENSES = PROFIT Cost of Goods Sold Operating Expenses (marketing, administrative)

Income Statement SALES - EXPENSES = PROFIT Cost of Goods Sold Operating Expenses (marketing, administrative) Financing Costs

Income Statement SALES - EXPENSES = PROFIT Cost of Goods Sold Operating Expenses (marketing, administrative) Financing Costs Taxes

SALES - Cost of Goods Sold GROSS PROFIT - Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends - NET INCOME AVAILABLE TO COMMON STOCKHOLDERS Income Statement

Balance Sheet Total Assets = Outstanding Debt + Shareholders’ Equity

Balance Sheet

Assets

Balance Sheet Assets Liabilities (Debt) & Equity

Balance Sheet Assets Liabilities (Debt) & Equity Current Assets Cash Marketable Securities Accounts Receivable Inventories Prepaid Expenses Fixed Assets Machinery & Equipment Buildings and Land Other Assets Investments & patents Current Liabilities Accounts Payable Accrued Expenses Short-term notes Long-Term Liabilities Long-term notes Mortgages Equity Preferred Stock Common Stock (Par value) Paid in Capital Retained Earnings

Assets Current Assets:

Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year.

Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. –Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. –Cash, marketable securities, accounts receivable, inventories, prepaid expenses. Fixed Assets:

Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. –Cash, marketable securities, accounts receivable, inventories, prepaid expenses. Fixed Assets: machinery and equipment, buildings, and land.

Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. –Cash, marketable securities, accounts receivable, inventories, prepaid expenses. Fixed Assets: machinery and equipment, buildings, and land. Other Assets:

Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. –Cash, marketable securities, accounts receivable, inventories, prepaid expenses. Fixed Assets: machinery and equipment, buildings, and land. Other Assets: any asset that is not a current asset or fixed asset.

Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. –Cash, marketable securities, accounts receivable, inventories, prepaid expenses. Fixed Assets: machinery and equipment, buildings, and land. Other Assets: any asset that is not a current asset or fixed asset. –Intangible assets such as patents and copyrights.

Financing Debt Capital:

Financing Debt Capital: financing provided by a creditor.

Financing Debt Capital: financing provided by a creditor. Short-term debt:

Financing Debt Capital: financing provided by a creditor. Short-term debt: borrowed money that must be repaid within the next 12 months.

Financing Debt Capital: financing provided by a creditor. Short-term debt: borrowed money that must be repaid within the next 12 months. –Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes.

Financing Debt Capital: financing provided by a creditor. Short-term debt: borrowed money that must be repaid within the next 12 months. –Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes. Long-term debt:

Financing Debt Capital: financing provided by a creditor. Short-term debt: borrowed money that must be repaid within the next 12 months. –Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes. Long-term debt: loans from banks or other sources that lend money for longer than 12 months.

Financing Equity Capital:

Financing Equity Capital: shareholders’ investment in the firm.

Financing Equity Capital: shareholders’ investment in the firm. Preferred Stockholders:

Financing Equity Capital: shareholders’ investment in the firm. Preferred Stockholders: receive fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm.

Financing Equity Capital: shareholders’ investment in the firm. Preferred Stockholders: received fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm. Common Stockholders:

Financing Equity Capital: shareholders’ investment in the firm. Preferred Stockholders: received fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm. Common Stockholders: residual owners of a business. They receive whatever is left after creditors and preferred stockholders are paid.

Corporate Income Tax Rates Since 1993 Taxable Income Corporate Tax Rate $1 - $50,000 15% $50,001 - $75,000 25% $75,001 - $100,000 34% $100,001 - $335,000 39% $335,001 - $10,000,000 34% $10,000,001 - $15,000,000 35% $15,000,001 - $18,333,333 38% over $18,333,333 35%

Free Cash Flows Free cash flow: cash flow that is free and available to be distributed to the firm’s investors (both debt and equity investors)

Free Cash Flows Firm’s Operating Free cash flows = Firm’s Financing Free cash flows Cash flows generated through the firm’s operations and investments in assets = Cash flows paid to - or received by - the firm’s investors (creditors & stockholders)

Calculating Free Cash Flows: An Operating Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets

Calculating Free Cash Flows: An Operating Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets Operating income + depreciation - cash tax payments

Calculating Free Cash Flows: An Operating Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets [Change in current assets] - [change in non-interest bearing current liabilities]

Calculating Free Cash Flows: An Operating Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets Change in gross fixed assets, and any other assets that are on the balance sheet.

Calculating Free Cash Flows: A Financing Perspective Interest payments to creditors - change in debt principal - dividends paid to stockholders - change in stock = Financing Free Cash Flows

Tax Example:

Space Cow Computer has sales of $32 million, cost of goods sold at 60% of sales, cash operating expenses of $2.4 million, and $1.4 million in depreciation expense. The firm has $12 million in 9.5% bonds outstanding. The firm will pay $500,000 in dividends to its common stock holders. Calculate the firm’s tax liability.

Sales $32,000,000 Cost of Goods Sold (19,200,000) Operating Expenses (2,400,000) Depreciation Expense (1,400,000) EBIT or NOI 9,000,000 Interest Expense (1,140,000) Taxable Income 7,860,000

Income tax rate tax payment $50,000 x.15 = $ 7,500 $25,000 x.25 = 6,250 $25,000 x.34 = 8,500 $235,000 x.39 = 91,650 $7,525,000 x.34 = 2,558,500 Total Tax payment $2,672,400 short cut: $7,860,000 x.34 = $2,672,400

Problem 1 What financial statement measures the amount of profits generated by a firm over a given period of time? A.statement of cash flow. B.balance sheet. C.income statement or profit and loss statement. D.Operating Income Statement.

Problem 2 A major difference between the income statement and balance sheet is that the A.balance sheet includes sales, cost of goods sold, interest expense, income taxes, and net income. B.balance sheet indicates a firm's position over a period of time and the income statement indicates the firm's position at a specific point in time. C.income statement measures the amount of profits generated by the firm over a given period of time and the balance sheet provides a snapshot of the firm's financial position at a specific point in time. D.income statement includes assets, liabilities, and owners' equity and the balance sheet does not.

Problem 3 The taxable income for a corporation is based on A.Gross income less dividends. B.Gross income less the cost of producing the product. C.Gross income less tax-deductible expenses.

Problem 4 Free cash flow equals A.After-tax operating cash flows minus the change in net working capital. B.After-tax operating cash flow minus the change in fixed assets and other assets. C.After-tax operating cash flows minus the change in net working capital minus the D.change in fixed assets and other assets.

Problem 5 Free cash flows, from a financing perspective, are equal to the cash flows paid to or received from investors. Free cash flows from a financing perspective equal free cash flows from an operating perspective. Free cash flows from a financing perspective are calculated by what procedure? A.Interest received by the firm's creditors less the change in debt principal, less dividends paid to stockholders, less the change in stock. B.Interest received by the firm's creditors less the change in debt principal, less dividends paid to stockholders. C.Interest received by the firm's creditors less the change in debt principal, less the change in stock. D.Determining the operating cash flows and subtracting depreciation and amortization.

Problem 6 Which of the following statements about financial reporting requirements in different countries is correct? A.Most countries have similar guidelines for reporting financial performance. B.At this time, no international organization is working on trying to develop standardized international financial reporting guidelines. C.It is likely that international financial reporting standards will be developed soon and the problems associated with different guidelines will disappear. D.The U. S. accounting profession has rejected efforts toward international standards.

Comprehensive Tax Problem Carter B. Daltan sells microcomputers. During the past year the company’s sales were $3.5 million. The cost of its merchandise sold came to $2 million, and cash operating expenses were $500,000; depreciation expense was $100,000, and the firm paid $165,000 in interest on bank loans. Also, the corporation received $55,000 in dividend income but paid $25,000 in the form of dividends to its own common shareholders. Calculate the corporations tax liability. (Find Net Income & Addition to Retained Earnings)

Comprehensive Tax Problem Sales$3,500,000 COGS(2,000,000) Gross Profit1,500,000

Comprehensive Tax Problem Sales$3,500,000 COGS(2,000,000) Gross Profit1,500,000 Cash Operating Expense(500,000) Depreciation Expense(100,000) Operating Income$1,000,000

Comprehensive Tax Problem Sales$3,500,000 COGS(2,000,000) Gross Profit1,500,000 Cash Operating Expense(500,000) Depreciation Expense(100,000) Operating Income$900,000 Dividend Income$55,000 Less Exclusion(38,500)16,500 55,000 x 0.70 38,500 Dividend Exclusion

Comprehensive Tax Problem Sales$3,500,000 COGS(2,000,000) Gross Profit1,500,000 Cash Operating Expense(500,000) Depreciation Expense(100,000) Operating Income$ 900,000 Dividend Income$55,000 Less Exclusion(38,500)16,500 Interest Expense(165,000) Taxable Income$751,500

Comprehensive Tax Problem 751,500 x 0.34 255,510 Compute Taxes Marginal = Average for Taxable Income of $335,000-$10million Sales$3,500,000 COGS(2,000,000) Gross Profit1,500,000 Cash Operating Expense(500,000) Depreciation Expense(100,000) Operating Income$ 900,000 Dividend Income$55,000 Less Exclusion(38,500)16,500 Interest Expense(165,000) Taxable Income$751,500 Tax Liability(255,510)

Comprehensive Tax Problem Taxable IncomeTax Rate $0 - $50,00015%50,000x0.15=7,500 $50,001 - $75,00025%25,000x0.25=6,250 $75,001 - $10,000,00034%(751,600-75,000)x.34=230,010 over $10,000,00135% Surcharge (335,000-100,000)x0.05=11,750 $255,510 5% surcharge on income $100,000--335,000 Taxable Income $751,500 As long as income > $335,000 and less than $10 million Average=34%=Marginal Compute Tax Liability using Table

Comprehensive Tax Problem Add Tax-Free Portion of Dividends to Arrive at Net Income Sales$3,500,000 COGS(2,000,000) Gross Profit1,500,000 Cash Operating Expense(500,000) Depreciation Expense(100,000) Operating Income$ 900,000 Dividend Income$55,000 Less Exclusion(38,500)16,500 Interest Expense(165,000) Taxable Income$751,500 Tax Liability(255,510) Non-Taxable Dividend Income38,500 Net Income534,490

Comprehensive Tax Problem Sales$3,500,000 COGS(2,000,000) Gross Profit1,500,000 Cash Operating Expense(500,000) Depreciation Expense(100,000) Operating Income$ 900,000 Dividend Income$55,000 Less Exclusion(38,500)16,500 Interest Expense(165,000) Taxable Income$751,500 Tax Liability(255,510) Non-Taxable Dividend Income38,500 Net Income534,490 Dividends Paid$25,000 Addition to Retained Earnings$509,490 Subtract Dividends Paid from Net Income

Ch. 3 - Evaluating a Firm’s Financial Performance , Prentice Hall, Inc.

Financial Statement Analysis

Ratio Analysis Financial Ratios represent an attempt to standardize financial information in order to facilitate meaningful comparisons over time and between firms.

Ratio Analysis The business is a storehouse of resources (i.e. assets on the balance sheet) which it converts to profit through production and then sales (reported on the income statement)

Ratio Analysis Liquidity Ratios Operating Profitability Ratios Leverage Ratios Return on Equity Four Categories of Ratios

Financial Ratios Tools that help us determine the financial health of a company. We can compare a company’s financial ratios with its ratios in previous years (trend analysis). We can compare a company’s financial ratios with those of its industry.

Example: CyberDragon Corporation

CyberDragon’s Balance Sheet ($000) Assets:Liabilities & Equity: Cash$2,540Accounts payable 9,721 Marketable securities 1,800Notes payable 8,500 Accounts receivable18,320Accrued taxes payable 3,200 Inventories27,530Other current liabilities 4,102 Total current assets 50,190Total current liabilities 25,523 Plant and equipment43,100Long-term debt (bonds) 22,000 less accum deprec.11,400Total liabilities 47,523 Net plant & equip. 31,700Common stock ($10 par) 13,000 Total assets 81,890Paid in capital 10,000 Retained earnings 11,367 Total stockholders' equity 34,367 Total liabilities & equity 81,890

Sales (all credit)$112,760 Cost of Goods Sold (85,300) Gross Profit 27,460 Operating Expenses: Selling (6,540) General & Administrative (9,400) Total Operating Expenses (15,940) Earnings before interest and taxes (EBIT) 11,520 Interest charges: Interest on bank notes: (850) Interest on bonds: (2,310) Total Interest charges (3,160) Earnings before taxes (EBT) 8,360 Taxes (assume 40%) (3,344) Net Income 5,016 CyberDragon’s Income Statement

CyberDragon Other Information Dividends paid on common stock$2,800 Earnings retained in the firm 2,216 Shares outstanding (000) 1,300 Market price per share 20 Book value per share 26.44 Earnings per share 3.86 Dividends per share 2.15

1. Liquidity Ratios Do we have enough liquid assets to meet approaching obligations?

Ratio Analysis Liquidity Ratios Current Ratio = Current Assets Current Liabilities Is there a sufficient amount of current assets to pay off current liabilities? What is the cushion of safety?

What is CyberDragon’s Current Ratio?

50,190 25,523 = 1.97

What is CyberDragon’s Current Ratio? If the average current ratio for the industry is 2.4, is this good or not? 50,190 25,523 = 1.97

Ratio Analysis Liquidity Ratios Acid-Test Ratio = Current Assets - Inventory Current Liabilities What happens to the firm’s ability to repay current liabilities after the least liquid of the current assets is subtracted?

What is the firm’s Acid Test Ratio?

50,190 - 27,530 25,523 =.89

What is the firm’s Acid Test Ratio? Suppose the industry average is.92. What does this tell us? 50,190 - 27,530 25,523 =.89

Ratio Analysis Another approach to liquidity: Efficiency Ratios Average Collection Period = Accounts Receivable Daily Credit Sales How long does it take for the firm to collect its credit sales from customers?

What is the firm’s Average Collection Period?

18,320 112,760/365 = 59.3 days

What is the firm’s Average Collection Period? If the industry average is 47 days, what does this tell us? 18,320 112,760/365 = 59.3 days

Ratio Analysis Another approach to liquidity: Efficiency Ratios Accounts Receivable = Turnover Turnover ___ Sales______ Accounts Receivable

What is the firm’s Accounts Receivable Turnover?

112,760 18,320 = 6.16 times

What is the firm’s Accounts Receivable Turnover? CyberDragon turns their A/R over 6.16 times per year. The industry average is 8.2 times. Is this efficient? 112,760 18,320 = 6.16 times

Ratio Analysis Another approach to liquidity: Efficiency Ratios Inventory Turnover Ratio = Cost of Goods Sold Inventory Is the level of inventory appropriate given the firm’s sales?

What is the firm’s Inventory Turnover?

85,300 27,530 = 3.10 times

What is the firm’s Inventory Turnover? CyberDragon turns their inventory over 3.1 times per year. The industry average is 3.9 times. Is this efficient? 85,300 27,530 = 3.10 times

Low inventory turnover: The firm may have too much inventory, which is expensive because: Inventory takes up costly warehouse space. Some items may become spoiled or obsolete.

2. Operating Profitability Ratios Are profits sufficient relative to the assets being invested?

Ratio Analysis Operating Profitability Ratios Operating Income Return = On Investment On Investment EBIT_ Total Assets

What is the firm’s Operating Income Return on Investment (OIROI)?

11,520 81,890 = 14.07%

Slightly below the industry average of 15%. What is the firm’s Operating Income Return on Investment (OIROI)? 11,520 81,890 = 14.07%

Slightly below the industry average of 15%. The OIROI reflects product pricing and the firm’s ability to keep costs down. What is the firm’s Operating Income Return on Investment (OIROI)? 11,520 81,890 = 14.07%

Ratio Analysis Operating Profitability Ratios Operating Profit Margin = EBIT Sales

What is their Operating Profit Margin?

11,520 112,760 = 10.22%

What is their Operating Profit Margin? This is below the industry average of 12%. 11,520 112,760 = 10.22%

Ratio Analysis Operating Profitability Ratios Total Asset Turnover Ratio = Sales Total Assets How effective is the firm in using all assets to generate sales? OIROI = Operating Profit Margin x Total asset turnover

What is their Total Asset Turnover?

112,760 81,890 = 1.38 times

What is their Total Asset Turnover? The industry average is 1.82 times. The firm needs to figure out how to squeeze more sales dollars out of its assets. 112,760 81,890 = 1.38 times

Ratio Analysis Operating Profitability Ratios Fixed Asset Turnover Ratio = Sales Net Fixed Assets How effective is the firm in using its fixed assets in generating sales?

What is the firm’s Fixed Asset Turnover?

112,760 31,700 = 3.56 times

What is the firm’s Fixed Asset Turnover? If the industry average is 4.6 times, what does this tell us about CyberDragon? 112,760 31,700 = 3.56 times

3. Leverage Ratios (financing decisions) Measure the impact of using debt capital to finance assets. Firms use debt to lever (increase) returns on common equity.

How does Leverage work? Suppose we have an all equity- financed firm worth $100,000. Its earnings this year total $15,000. ROE = (ignore taxes for this example)

How does Leverage work? Suppose we have an all equity- financed firm worth $100,000. Its earnings this year total $15,000. ROE = = 15% 15,000 100,000

How does Leverage work? Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000. ROE =

How does Leverage work? Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000. ROE == 15,000 - 4,000 50,000

How does Leverage work? Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000. ROE == 22% 15,000 - 4,000 50,000

Ratio Analysis Leverage Ratios Balance Sheet Leverage Ratios measure the proportion of the firm’s assets financed with non-owner funds. Debt Ratio = Total Debt Total Assets What proportion of the firm’s assets are financed with debt?

What is CyberDragon’s Debt Ratio?

47,523 81,890 = 58%

What is CyberDragon’s Debt Ratio? If the industry average is 47%, what does this tell us? 47,523 81,890 = 58%

What is CyberDragon’s Debt Ratio? 47,523 81,890 = 58% If the industry average is 47%, what does this tell us? Can leverage make the firm more profitable? Can leverage make the firm riskier?

Ratio Analysis Leverage Ratios Coverage Ratios measure the firm’s ability to cover (pay) then finance charges associated with its use of financial leverage. Times Interest Earned Ratio = Operating Income Interest Expense What is the margin of safety in the ability to repay interest payments?

What is the firm’s Times Interest Earned Ratio?

11,520 3,160 = 3.65 times

What is the firm’s Times Interest Earned Ratio? The industry average is 6.7 times. This is further evidence that the firm uses more debt financing than average. 11,520 3,160 = 3.65 times

4. Return on Equity Are the earnings available to the firm’s owners (common equity investors) attractive when compared to the returns of owners of companies in the peer group?

Ratio Analysis The Return on Equity can be written: Return on Equity = Net Income Common Equity

What is CyberDragon’s Return on Equity (ROE)?

5,016 34,367 = 14.6%

What is CyberDragon’s Return on Equity (ROE)? The industry average is 17.54%. 5,016 34,367 = 14.6%

What is CyberDragon’s Return on Equity (ROE)? 5,016 34,367 = 14.6% The industry average is 17.54%. Is this what we would expect, given the firm’s leverage?

Conclusion: Even though CyberDragon has higher leverage than the industry average, they are much less efficient, and therefore, less profitable.

The DuPont Model Brings together: Profitability Efficiency Leverage

( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales TA CE Explain the Du Pont System xx = ROE.

The Du Pont system focuses on: Expense control (PM) Asset utilization (TATO) Debt utilization (EM) It shows how these factors combine to determine the ROE.

Net Profit Total Asset Debt Margin Turnover Ratio ROE = x / (1- ) The DuPont Model

Net Profit Total Asset Debt Margin Turnover Ratio Net Income Sales Total Debt Sales Total Assets Total Assets ROE = x / (1- ) = x /(1- ) The DuPont Model

Net Profit Total Asset Debt Margin Turnover Ratio Net Income Sales Total Debt Sales Total Assets Total Assets 5,016 112,760 47,523 112,760 81,890 81,890 ROE = x / (1- ) = x /(1- ) The DuPont Model

ROE = x / (1- ) = x /(1- ) = 14.6% Net Profit Total Asset Debt Margin Turnover Ratio Net Income Sales Total Debt Sales Total Assets Total Assets 5,016 112,760 47,523 112,760 81,890 81,890 The DuPont Model

Problem 1 Financial ratios help to identify some the financial strengths and weaknesses of a company. What are the two ways that the ratios provide for making meaningful comparisons of a firm's financial data? A.the current ratio and acid-test ratio. B.how long it takes to collect the firm's receivables and how long it takes to pay its accounts payables. C.the return on assets versus the return on equity. D.examining ratios across time to identify trends and comparing the firm's ratios with those of other firms.

Problem 2 Which of the following is not one of the questions that are used as a map in analyzing financial ratios? A.How liquid is the firm? B.Is management generating adequate operating profits on the firm's assets? C.How much should the firm invest in new equipment next year? D.How is the firm financing its assets? E.Are the owners (stockholders) receiving an adequate return on their investment?

Ch. 4: Financial Forecasting, Planning, and Budgeting , Prentice Hall, Inc.

Financial Forecasting 1) Project sales revenues and expenses.

90 91 92 93 94 95 96 97 99 00 Time Sales Sales Forecast  Forecast future sales based on past sales growth

90 91 92 93 94 95 96 97 99 00 Time Sales Fit Regression Line Sales Forecast  Forecast future sales based on past sales growth

90 91 92 93 94 95 96 97 99 00 Time Sales Growth Rate Sales Estimates for next 4 years Sales Forecast  Forecast future sales based on past sales growth  Also include the effects of any events which are expected to impact future sales (new products or economic conditions)

Sales Forecast  Forecast future sales based on past sales growth  Also include the effects of any events which are expected to impact future sales (new products or economic conditions)

90 91 92 93 94 95 96 97 99 00 Time Sales New Product Introduced Sales Forecast  Forecast future sales based on past sales growth  Also include the effects of any events which are expected to impact future sales (new products or economic conditions)

Financial Forecasting and Planning Project revenues and expenses over the planning period Estimate level of investment which is necessary to support future sales Determine financing needs throughout the planning period DFN Summary: Estimate long term funds needed when the firm is growing Determining Future Needs of the Firm

Impact of Sales Growth  Sales Growth imposes costs on the firm.

Impact of Sales Growth  Sales Growth imposes costs on the firm.  Will require additional resources –Current Assets: Inventory, A/R, Cash –Fixed Assets: Plant and Equipment

Types of Assets & Liabilities  Spontaneous –Automatically change as sales change lAccounts Receivable lAccounts Payable lInventories lRetained Earnings  Discretionary  Require a decison lFixed Assets lLong Term Debt

Percent of Sales Method Example Suppose this year’s sales will total $32 million. Next year, we forecast sales of $40 million. Net income should be 5% of sales. Dividends should be 50% of earnings.

This year % of $32m Assets Current Assets$8m25% Fixed Assets$16m50% Total Assets$24m Liab. and Equity Accounts Payable$4m12.5% Accrued Expenses$4m12.5% Notes Payable$1mn/a Long Term Debt$6mn/a Total Liabilities$15m Common Stock$7mn/a Retained Earnings$2m Equity$9m Total Liab. & Equity$24m

Next year % of $40m Assets Current Assets25% Fixed Assets50% Total Assets Liab. and Equity Accounts Payable12.5% Accrued Expenses12.5% Notes Payablen/a Long Term Debtn/a Total Liabilities Common Stockn/a Retained Earnings Equity Total Liab. & Equity

Next year % of $40m Assets Current Assets$10m25% Fixed Assets50% Total Assets Liab. and Equity Accounts Payable12.5% Accrued Expenses12.5% Notes Payablen/a Long Term Debtn/a Total Liabilities Common Stockn/a Retained Earnings Equity Total Liab. & Equity

Next year % of $40m Assets Current Assets$10m25% Fixed Assets$20m50% Total Assets Liab. and Equity Accounts Payable12.5% Accrued Expenses12.5% Notes Payablen/a Long Term Debtn/a Total Liabilities Common Stockn/a Retained Earnings Equity Total Liab. & Equity

Next year % of $40m Assets Current Assets$10m25% Fixed Assets$20m50% Total Assets$30m Liab. and Equity Accounts Payable12.5% Accrued Expenses12.5% Notes Payablen/a Long Term Debtn/a Total Liabilities Common Stockn/a Retained Earnings Equity Total Liab. & Equity

Next year % of $40m Assets Current Assets$10m25% Fixed Assets$20m50% Total Assets$30m Liab. and Equity Accounts Payable$5m12.5% Accrued Expenses12.5% Notes Payablen/a Long Term Debtn/a Total Liabilities Common Stockn/a Retained Earnings Equity Total Liab. & Equity

Next year % of $40m Assets Current Assets$10m25% Fixed Assets$20m50% Total Assets$30m Liab. and Equity Accounts Payable$5m12.5% Accrued Expenses$5m12.5% Notes Payablen/a Long Term Debtn/a Total Liabilities Common Stockn/a Retained Earnings Equity Total Liab. & Equity

Next year % of $40m Assets Current Assets$10m25% Fixed Assets$20m50% Total Assets$30m Liab. and Equity Accounts Payable$5m12.5% Accrued Expenses$5m12.5% Notes Payable$1mn/a Long Term Debtn/a Total Liabilities Common Stockn/a Retained Earnings Equity Total Liab. & Equity

Next year % of $40m Assets Current Assets$10m25% Fixed Assets$20m50% Total Assets$30m Liab. and Equity Accounts Payable$5m12.5% Accrued Expenses$5m12.5% Notes Payable$1mn/a Long Term Debt$6mn/a Total Liabilities Common Stockn/a Retained Earnings Equity Total Liab. & Equity

Next year % of $40m Assets Current Assets$10m25% Fixed Assets$20m50% Total Assets$30m Liab. and Equity Accounts Payable$5m12.5% Accrued Expenses$5m12.5% Notes Payable$1mn/a Long Term Debt$6mn/a Total Liabilities$17m Common Stockn/a Retained Earnings Equity Total Liab. & Equity

Next year % of $40m Assets Current Assets$10m25% Fixed Assets$20m50% Total Assets$30m Liab. and Equity Accounts Payable$5m12.5% Accrued Expenses$5m12.5% Notes Payable$1mn/a Long Term Debt$6mn/a Total Liabilities$17m Common Stock$7mn/a Retained Earnings Equity Total Liab. & Equity

Predicting Retained Earnings Next year’s projected retained earnings = last year’s $2 million, plus:

Predicting Retained Earnings Next year’s projected retained earnings = last year’s $2 million, plus: projected net income cash dividends sales sales net income x x ( 1 - ) x x ( 1 - )

Predicting Retained Earnings Next year’s projected retained earnings = last year’s $2 million, plus: projected net income cash dividends sales sales net income $40 million x.05 x(1 -.50) x x ( 1 - ) x x ( 1 - )

Predicting Retained Earnings Next year’s projected retained earnings = last year’s $2 million, plus: projected net income cash dividends sales sales net income $40 million x.05 x(1 -.50) = $2 million + $1 million = $3million x x ( 1 - ) x x ( 1 - )

Next year % of $40m Assets Current Assets$10m25% Fixed Assets$20m50% Total Assets$30m Liab. and Equity Accounts Payable$5m12.5% Accrued Expenses$5m12.5% Notes Payable$1mn/a Long Term Debt$6mn/a Total Liabilities$17m Common Stock$7mn/a Retained Earnings$3m Equity Total Liab. & Equity

Next year % of $40m Assets Current Assets$10m25% Fixed Assets$20m50% Total Assets$30m Liab. and Equity Accounts Payable$5m12.5% Accrued Expenses$5m12.5% Notes Payable$1mn/a Long Term Debt$6mn/a Total Liabilities$17m Common Stock$7mn/a Retained Earnings$3m Equity$10m Total Liab. & Equity

Next year % of $40m Assets Current Assets$10m25% Fixed Assets$20m50% Total Assets$30m Liab. and Equity Accounts Payable$5m12.5% Accrued Expenses$5m12.5% Notes Payable$1mn/a Long Term Debt$6mn/a Total Liabilities$17m Common Stock$7mn/a Retained Earnings$3m Equity$10m Total Liab. & Equity$27m

Next year % of $40m Assets Current Assets$10m25% Fixed Assets$20m50% Total Assets$30m Liab. and Equity Accounts Payable$5m12.5% Accrued Expenses$5m12.5% Notes Payable$1mn/a Long Term Debt$6mn/a Total Liabilities$17m Common Stock$7mn/a Retained Earnings$3m Equity$10m Total Liab. & Equity$27m How much Discretionary Financing will we Need?

Predicting Discretionary Financing Needs

Discretionary Financing Needed =

Predicting Discretionary Financing Needs Discretionary Financing Needed = projectedprojectedprojected total- total- owners’ assetsliabilities equity

Predicting Discretionary Financing Needs Discretionary Financing Needed = projectedprojectedprojected total- total- owners’ assetsliabilities equity $30 million - $17 million - $10 million

Predicting Discretionary Financing Needs Discretionary Financing Needed = projectedprojectedprojected total- total- owners’ assetsliabilities equity $30 million - $17 million - $10 million = $3 million in discretionary financing

Sustainable Rate of Growth

g* = ROE (1 - b) where

Sustainable Rate of Growth g* = ROE (1 - b) where b = dividend payout ratio (dividends / net income)

Sustainable Rate of Growth g* = ROE (1 - b) where b = dividend payout ratio (dividends / net income) ROE = return on equity (net income / common equity) or

Sustainable Rate of Growth g* = ROE (1 - b) where b = dividend payout ratio (dividends / net income) ROE = return on equity (net income / common equity) or net income sales assets sales assets common equity ROE = x x

Practice Problem: Percent of Sales method (also called the pro forma or constant ratio method) Symbolic Logic Corp has recently patented an advanced version of its original path-breaking technology and expects sales to grow from its present level of $5 million to $8 by the end of the coming year. The firm is currently operating 24 hours per day--management realizes it must expand to increase production beyond current levels. The firm’s net profit margin is 8 percent. Dividend payout is expected to be 62.5%. What amount of outside financing must be raised to enable SCL to meet future sales estimates? Current Balance Sheet Symbolic Logic Corporation Current Assets$2.5Accounts Payable$1.0 Net Fixed Assets3.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Assets Liabilities

Balance Sheet Symbolic Logic Corporation Current Assets$2.5Accounts Payable$1.0 Net Fixed Assets3.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Assets Liabilities Determine Sales Growth Step 1 Pro forma/constant ratio method

Balance Sheet Symbolic Logic Corporation Current Assets$2.5Accounts Payable$1.0 Net Fixed Assets3.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Assets Liabilities Determine Sales Growth $8-$5 $5 = 60% Step 1 Pro forma/constant ratio method

Balance Sheet Symbolic Logic Corporation Current Assets$2.5Accounts Payable$1.0 Net Fixed Assets3.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Assets Liabilities Pro forma/constant ratio method Determine Capacity Step 2

Balance Sheet Symbolic Logic Corporation Current Assets$2.5Accounts Payable$1.0 Net Fixed Assets3.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Assets Liabilities Determine Capacity Step 2 Full Capacity, therefore additional investment required in Fixed Assets to support sales. Pro forma/constant ratio method

Productive Capacity Need to determine how sales growth will affect the firm’s need for fixed assets. –Full Capacity--Fixed assets are being used to their full extent--cannot increase sales (production) without increasing fixed assets.

Productive Capacity Need to determine how sales growth will affect the firm’s need for fixed assets. –Full Capacity--Fixed assets are being used to their full extent--cannot increase sales (production) without increasing fixed assets. –Less Than Full Capacity--Able to increase production by employing some (or all) of the firm’s idle capacity, therefore no need to increase investment in fixed assets when sales increase.

Balance Sheet Symbolic Logic Corporation Assets Liabilities Percent of Sales Method Forecasted Level = Current Level of the asset category x (1+ %Sales Growth) Step 3 Current Assets$2.5Accounts Payable$1.0 Net Fixed Assets3.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Pro forma/constant ratio method

Balance Sheet Symbolic Logic Corporation Percent of Sales Method Forecasted Level = Current Level x (1+ %Sales Growth) Step 3 $2.5(1+.60) = $4.0 Current Assets$2.5 $4.0 Accounts Payable$1.0 Net Fixed Assets3.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Assets Current Projected Liabilities Current Projected Pro forma/constant ratio method

Balance Sheet Symbolic Logic Corporation Percent of Sales Method Forecasted Level = Current Level x (1+ %Sales Growth) Step 3 $2.5(1+.60) = $4.0 Current Assets$2.5 $4.0 Accounts Payable$1.0 Net Fixed Assets3.0 $4.8 Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Assets Current Projected Liabilities Current Projected $3.0(1+.60) = $4.8 Pro forma/constant ratio method

Balance Sheet Symbolic Logic Corporation Percent of Sales Method Forecasted Level = Current Level x (1+ %Sales Growth) Step 3 Current Assets$2.5 $4.0 Accounts Payable$1.0 Net Fixed Assets3.0 4.8 Accrued Expenses0.5 Total$5.5 $8.8 Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 +$3.30 Assets Current Projected Liabilities Current Projected Pro forma/constant ratio method

Determine Spontaneous Liab. Step 4 Spontaneous Liabilities will increase as a percent of sales.. Balance Sheet Symbolic Logic Corporation Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0 Net Fixed Assets3.04.8Accrued Expenses0.5 Total$5.5$8.8Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Pro forma/constant ratio method

Determine Spontaneous Liab. Step 4 Spontaneous Liabilities will increase as a percent of sales.. Balance Sheet Symbolic Logic Corporation $1.0(1+.60) = $1.60 Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0 $1.60 Net Fixed Assets3.04.8Accrued Expenses0.5 Total$5.5$8.8Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Pro forma/constant ratio method

Determine Spontaneous Liab. Step 4 Spontaneous Liabilities will increase as a percent of sales.. Balance Sheet Symbolic Logic Corporation $1.0(1+.60) = $1.60 Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0 $1.60 Net Fixed Assets3.04.8Accrued Expenses0.5.80 Total$5.5$8.8Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 $0.5(1+.60) = $0.80 Pro forma/constant ratio method

Determine Expected R.E. Sales in the next year will generate profits, some of which are available for reinvestment in the firm. Balance Sheet Symbolic Logic Corporation Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0 $1.60 Net Fixed Assets3.04.8Accrued Expenses0.5.80 Total$5.5$8.8Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Pro forma/constant ratio method

Determine Expected R.E. Step 5 Sales in the next year will generate profits, some of which are available for reinvestment in the firm. Balance Sheet Symbolic Logic Corporation Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0 $1.60 Net Fixed Assets3.04.8Accrued Expenses0.5.80 Total$5.5$8.8Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Addition to R.E = Net Income - Dividends Pro forma/constant ratio method

Determine Expected R.E. Step 5 Sales in the next year will generate profits, some of which are available for reinvestment in the firm. Balance Sheet Symbolic Logic Corporation Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0 $1.60 Net Fixed Assets3.04.8Accrued Expenses0.5.80 Total$5.5$8.8Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Addition to R.E = Net Income - Dividends Net Profit Margin x Projected Sales NI =.08 x 8 million Pro forma/constant ratio method

Determine Expected R.E. Step 5 Sales in the next year will generate profits, some of which are available for reinvestment in the firm. Balance Sheet Symbolic Logic Corporation Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0 $1.60 Net Fixed Assets3.04.8Accrued Expenses0.5.80 Total$5.5$8.8Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Addition to R.E = Net Income - Dividends Net Profit Margin x Projected Sales NI =.08 x 8 million Net Income x Dividend Payout Dividends = 640,000 x 0.625 Pro forma/constant ratio method

Determine Expected R.E. Step 5 Sales in the next year will generate profits, some of which are available for reinvestment in the firm. Balance Sheet Symbolic Logic Corporation Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0 $1.60 Net Fixed Assets3.04.8Accrued Expenses0.5.80 Total$5.5$8.8Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 +.24 =1.74 Common Equity$2.0 Total$5.5 Addition to R.E = Net Income - Dividends Net Profit Margin x Projected Sales NI =.08 x 8 million Net Income x Dividend Payout Dividends = 640,000 x 0.625 Pro forma/constant ratio method $640,000 - $400,000 = $240,000

Constant Liabilities. Step 6 Initially hold the other liabilities constant to see what discretionary funds are needed. Balance Sheet Symbolic Logic Corporation Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0 $1.60 Net Fixed Assets3.04.8Accrued Expenses0.5.80 Total$5.5$8.8Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings 1.5 +.24 =1.74 Common Equity$2.0 Total$5.5 Pro forma/constant ratio method

Constant Liabilities. Step 6 Initially hold the other liabilities constant to see what discretionary funds are needed. Balance Sheet Symbolic Logic Corporation Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0 $1.60 Net Fixed Assets3.04.8Accrued Expenses0.5.80 Total$5.5$8.8Notes Payable0.00.0 Current Liabilities$1.5 Long Term Debt$2.02.0 Common Stock0.5.5 Retained Earnings 1.5 +.24 =1.74 Common Equity$2.02.0 Total$5.56.64 Pro forma/constant ratio method

Determine DFN Step 7 DFN = Difference between projected assets and projected liabilities and owner’s equity. Balance Sheet Symbolic Logic Corporation Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0$1.6 Net Fixed Assets3.04.8Accrued Expenses0.50.8 Total$5.5$8.8Notes Payable0.00.0 Current Liabilities$1.5$2.4 Long Term Debt$2.02.0 Common Stock0.50.5 Retained Earnings1.5 +0.24 =1.74 Common Equity$2.0$2.24 Total$5.5$6.64 Pro forma/constant ratio method

DFN = $8.80 - 6.64 $2.16 Determine DFN Step 7 DFN = Difference between projected assets and projected liabilities and owner’s equity. Balance Sheet Symbolic Logic Corporation Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0$1.6 Net Fixed Assets3.04.8Accrued Expenses0.50.8 Total$5.5 $8.8 Notes Payable0.00.0 Current Liabilities$1.5$2.4 Long Term Debt$2.02.0 Common Stock0.50.5 Retained Earnings1.5 +0.24 =1.74 Common Equity$2.0$2.24 Total$5.5 $6.64 Pro forma/constant ratio method

DFN = $8.80 - 6.64 $2.16 Balance Sheet Symbolic Logic Corporation Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0$1.6 Net Fixed Assets3.04.8Accrued Expenses0.50.8 Total$5.5 $8.8 Notes Payable0.00.0 Current Liabilities$1.5$2.4 Long Term Debt$2.02.0 Common Stock0.50.5 Retained Earnings1.5 +0.24 =1.74 Common Equity$2.0$2.24 Total$5.5 $6.64 Raise 2.16 million Using: Notes Payable, and/or LT Debt, and/or Common Stock May want to keep financing mix from percents already used Find the financing mix using ratios – what % if from debt vs equity? Pro forma/constant ratio method

Balance Sheet Symbolic Logic Corporation Assets Current Projected Liabilities Current Projected Current Assets$2.5$4.0Accounts Payable$1.0$1.6 Net Fixed Assets3.04.8Accrued Expenses0.50.8 Total$5.5$8.8Notes Payable0.0 2.16 Current Liabilities$1.5$2.4 Long Term Debt$2.02.0 Common Stock0.50.5 Retained Earnings1.5 +0.24 =1.74 Common Equity$2.0$2.24 Total$5.5 8.8 Assume all new financing is from Notes Payable only What is the risk and cost of this source of financing? Pro forma/constant ratio method

DFN Formula DFN t +1 = Projected Change in Assets Projected Change in Liabilities Projected Change in Owner’s Equity ––

DFN Formula DFN t +1 = Projected Change in Assets Projected Change in Liabilities Projected Change in Owner’s Equity –– Balance Sheet Symbolic Logic Corporation Current Assets$2.5$4.0Accounts Payable$1.0$1.60 Net Fixed Assets3.04.8Accrued Expenses0.50.80 Total$5.5$8.8Notes Payable0.00.00 Current Liabilities$1.5$2.40 Long Term Debt$2.02.00 Common Stock0.50.50 Retained Earnings1.5 +0.24 =1.74 Common Equity$2.0$2.24 Total$5.5$6.64 +$3.30 Assets Current Projected Liabilities Current Projected

DFN Formula DFN t +1 = Projected Change in Assets Projected Change in Liabilities Projected Change in Owner’s Equity –– Balance Sheet Symbolic Logic Corporation Current Assets$2.5$4.0Accounts Payable$1.0$1.60 Net Fixed Assets3.04.8Accrued Expenses0.50.80 Total$5.5$8.8Notes Payable0.00.00 Current Liabilities$1.5$2.40 Long Term Debt$2.02.00 Common Stock0.50.50 Retained Earnings1.5 +0.24 =1.74 Common Equity$2.0$2.24 Total$5.5$6.64 +$.90 Assets Current Projected Liabilities Current Projected

DFN Formula DFN t +1 = Projected Change in Assets Projected Change in Liabilities Projected Change in Owner’s Equity –– Balance Sheet Symbolic Logic Corporation Current Assets$2.5$4.0Accounts Payable$1.0$1.60 Net Fixed Assets3.04.8Accrued Expenses0.50.80 Total$5.5$8.8Notes Payable0.00.00 Current Liabilities$1.5$2.40 Long Term Debt$2.02.00 Common Stock0.50.50 Retained Earnings1.5 +0.24 =1.74 Common Equity$2.0$2.24 Total$5.5$6.64 +$.24 Assets Current Projected Liabilities Current Projected

DFN Formula DFN t +1 = Projected Change in Assets Projected Change in Liabilities Projected Change in Owner’s Equity –– DFN t +1 = assets t * sales t – –  sales t+1 liabilities t * sales t  sales t+1 NPM t+1 (1-b)sales t+1

DFN Formula DFN t +1 = Projected Change in Assets Projected Change in Liabilities Projected Change in Owner’s Equity –– DFN t +1 = assets t * sales t – –  sales t+1 liabilities t * sales t  sales t+1 NPM t+1 (1-b)sales t+1 Assets that change when sales change

DFN Formula DFN t +1 = Projected Change in Assets Projected Change in Liabilities Projected Change in Owner’s Equity –– DFN t +1 = assets t * sales t – –  sales t+1 liabilities t * sales t  sales t+1 NPM t+1 (1-b)sales t+1 Prior Year Sales

DFN Formula DFN t +1 = Projected Change in Assets Projected Change in Liabilities Projected Change in Owner’s Equity –– DFN t +1 = assets t * sales t – –  sales t+1 liabilities t * sales t  sales t+1 NPM t+1 (1-b)sales t+1 $ Change in Sales

DFN Formula DFN t +1 = Projected Change in Assets Projected Change in Liabilities Projected Change in Owner’s Equity –– DFN t +1 = assets t * sales t – –  sales t+1 liabilities t * sales t  sales t+1 NPM t+1 (1-b)sales t+1 Spontaneous Liabilities

DFN Formula DFN t +1 = Projected Change in Assets Projected Change in Liabilities Projected Change in Owner’s Equity –– DFN t +1 = assets t * sales t – –  sales t+1 liabilities t * sales t  sales t+1 NPM t+1 (1-b)sales t+1 Net Profit Margin

DFN Formula DFN t +1 = Projected Change in Assets Projected Change in Liabilities Projected Change in Owner’s Equity –– DFN t +1 = assets t * sales t – –  sales t+1 liabilities t * sales t  sales t+1 NPM t+1 (1-b)sales t+1 Dividend Payout Ratio

DFN Formula DFN t +1 = Projected Change in Assets Projected Change in Liabilities Projected Change in Owner’s Equity –– DFN t +1 = assets t * sales t – –  sales t+1 liabilities t * sales t  sales t+1 NPM t+1 (1-b)sales t+1 New Sales Level

Problem- Solve using Formula Balance Sheet Symbolic Logic Corporation Assets Liabilities Current Assets$2.5Accounts Payable$1.0 Net Fixed Assets3.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Assets Liabilities DFN t +1 = 5.5 5.0 3 million

Balance Sheet Symbolic Logic Corporation Current Assets$2.5Accounts Payable$1.0 Net Fixed Assets3.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Problem- Solve using Formula DFN t +1 = 5.5 5.0 – 3 million 1.5 5.0 3 million

Balance Sheet Symbolic Logic Corporation Current Assets$2.5Accounts Payable$1.0 Net Fixed Assets3.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Problem- Solve using Formula Assets Liabilities DFN t +1 = 5.5 5.0 – – 3 million 1.5 5.0 3 million 0.08(1-.625)8 million

Current Assets$2.5$4.0Accounts Payable$1.0$1.60 Net Fixed Assets3.04.8Accrued Expenses0.50.80 Total$5.5$8.8Notes Payable0.00.00 Current Liabilities$1.5$2.40 Long Term Debt$2.02.00 Common Stock0.50.50 Retained Earnings1.5 +0.24 =1.74 Common Equity$2.0$2.24 Total$5.5$6.64 Problem- Solve using Formula Balance Sheet Symbolic Logic Corporation Assets Liabilities = 3,300,000 - 900,000 - 240,000 = $2,160,000 DFN t +1 = 5.5 5.0 – – 3 million 1.5 5.0 3 million 0.08(1-.625)8 million

Current Assets$2.5$4.0Accounts Payable$1.0$1.60 Net Fixed Assets3.04.8Accrued Expenses0.50.80 Total$5.5$8.8Notes Payable0.00.00 Current Liabilities$1.5$2.40 Long Term Debt$2.02.00 Common Stock0.50.50 Retained Earnings1.5 +0.24 =1.74 Common Equity$2.0$2.24 Total$5.5$6.64 +$3.30 +$.24 +$.90 Problem- Solve using Formula Balance Sheet Symbolic Logic Corporation Assets Liabilities = 3,300,000 - 900,000 - 240,000 = $2,160,000 DFN t +1 = 5.5 5.0 – – 3 million 1.5 5.0 3 million 0.08(1-.625)8 million

Current Assets$2.5$4.0Accounts Payable$1.0$1.60 Net Fixed Assets3.03.0Accrued Expenses0.50.80 Total$5.5$7.0Notes Payable0.00.00 Current Liabilities$1.5$2.40 Long Term Debt$2.02.00 Common Stock0.50.50 Retained Earnings1.5 +0.24 =1.74 Common Equity$2.0$2.24 Total$5.5$6.64 Assume that current sales level of $5 represents only 30% of SLC’s capacity. New Information Problem- Solve using Formula Excess Capacity Balance Sheet Symbolic Logic Corporation Assets Liabilities

Current Assets$2.5Accounts Payable$1.0 Net Fixed Assets3.03.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Fixed Assets remain constant Problem- Solve using Formula Excess Capacity Balance Sheet Symbolic Logic Corporation Assets Liabilities

Current Assets$2.5Accounts Payable$1.0 Net Fixed Assets3.03.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Problem- Solve using Formula Excess Capacity DFN t +1 = 2.5 5.0 3 million Balance Sheet Symbolic Logic Corporation Assets Liabilities

– 3 million 1.5 5.0 3 million Current Assets$2.5Accounts Payable$1.0 Net Fixed Assets3.03.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total$5.5 Problem- Solve using Formula Excess Capacity DFN t +1 = 2.5 5.0 3 million Balance Sheet Symbolic Logic Corporation Assets Liabilities

+$.24 +$.90 Current Assets$2.5$4.0Accounts Payable$1.0$1.60 Net Fixed Assets3.03.0Accrued Expenses0.50.80 Total$5.5$7.0Notes Payable0.00.00 Current Liabilities$1.5$2.40 Long Term Debt$2.02.00 Common Stock0.50.50 Retained Earnings1.5 +0.24 =1.74 Common Equity$2.0$2.24 Total$5.5$6.64 +$1.50 Problem- Solve using Formula Excess Capacity = 1,500,000 - 900,000 - 240,000 = $360,000 DFN t +1 = – – 3 million 0.08(1-.625)8 million 2.5 5.0 1.5 5.0

Determinants of DFN Growth Rate of Sales Profit Margin Dividend Payout Capacity

Determinants of DFN Growth Rate of Sales nHigher growth rate, larger DFN Profit Margin nHigher PM, larger Retained Earnings, lower DFN Dividend Payout nHigher Dividend Payout, lower Retained Earnings, higher DFN Capacity nCloser to full capacity, the more fixed assets will need to change so higher DFN

Used to determine monthly needs and surpluses for cash during the planning period Examines timing of cash inflows and outflows i.e. when checks are written and when deposits are made. Payments to suppliers are typically made some time after shipment is received. Receipts from credit customers are received some time after sale is recorded. The Cash Budget

Problem Halsey Enterprises has projected its sales for the first four months of 1996 as follows: January$120,000March $140,000 February$260,000April$140,000 Halsey collects 30 percent of its sales in the month of sale, 50 percent in the month following the sale, and the remaining 20 percent two months following the sale. During November and December of 1995 Halsey’s sales were $130,000 and $125,000, respectively. Halsey purchases raw materials two months in advance of its sales equal to 75 percent of its final sales. The supplier is paid one month after delivery. In addition, Halsey pays $2,000 per month for rent and $12,000 each month for other expenditures. Taxes are due in March and amount to $10,000. As of December 31, 1995 the company’s cash balance was $28,000; a minimum balance of $25,000 must be maintained to meet bank’s line of credit agreement. Halsey can borrow short term from its bank at a cost of 1/2% per month. They have a policy to repay short term debt in any month its cash balance exceeds the minimum desired balance of $25,000. Prepare a cash budget for Halsey.

The Cash Budget: Sales Collection of January Sales Nov Dec Jan Feb Mar Sales 130,000 125,000 120,000 260,000 140,000 36,000 120,000x.30

The Cash Budget: Sales Collection of January Sales Nov Dec Jan Feb Mar Sales 130,000 125,000 120,000 260,000 140,000 36,000 120,000x.30 60,000 120,000x.50

Collection of January Sales Nov Dec Jan Feb Mar Sales 130,000 125,000 120,000 260,000 140,000 36,000 120,000x.30 60,00024,000 120,000x.50 120,000x.20 The Cash Budget: Sales

Cash Budget Halsey Enterprises November December January FebruaryMarch Sales130,000125,000120,000260,000140,000 Collections: Month of Sale (30%)36,000 First Month (50%) 2nd Month (20%) Total Collections 120,000x.30 Determine January Collections The Cash Budget: Collections

Cash Budget Halsey Enterprises November December January FebruaryMarch Sales130,000125,000120,000260,000140,000 Collections: Month of Sale (30%)36,000 First Month (50%)62,500 2nd Month (20%) Total Collections 125,000x.50 Determine January Collections The Cash Budget: Collections

Problem-- Determine Collections Cash Budget Halsey Enterprises November December January FebruaryMarch Sales130,000125,000120,000260,000140,000 Collections: Month of Sale (30%)36,000 First Month (50%)62,500 2nd Month (20%)26,000 Total Collections 130,000x.20 Determine January Collections

Cash Budget Halsey Enterprises November December January FebruaryMarch Sales130,000125,000120,000260,000140,000 Collections: Month of Sale (30%)36,000 First Month (50%)62,500 2nd Month (20%)26,000 Total Collections124,500 Determine January Collections The Cash Budget: Collections

Cash Budget Halsey Enterprises November December January FebruaryMarch Sales130,000125,000120,000260,000140,000 Collections: Month of Sale (30%)36,00078,000 First Month (50%)62,500 2nd Month (20%)26,000 Total Collections124,500 260,000x.30 Determine February Collections The Cash Budget: Collections

Cash Budget Halsey Enterprises November December January FebruaryMarch Sales130,000125,000120,000260,000140,000 Collections: Month of Sale (30%)36,00078,000 First Month (50%)62,50060,000 2nd Month (20%)26,000 Total Collections124,500 120,000x.50 Determine February Collections The Cash Budget: Collections

Cash Budget Halsey Enterprises November December January FebruaryMarch Sales130,000125,000120,000260,000140,000 Collections: Month of Sale (30%)36,00078,000 First Month (50%)62,50060,000 2nd Month (20%)26,00025,000 Total Collections124,500 125,000x.20 Determine February Collections The Cash Budget: Collections

Cash Budget Halsey Enterprises November December January FebruaryMarch Sales130,000125,000120,000260,000140,000 Collections: Month of Sale (30%)36,00078,000 First Month (50%)62,50060,000 2nd Month (20%)26,00025,000 Total Collections124,500163,000 Determine February Collections The Cash Budget: Collections

Cash Budget Halsey Enterprises November December January FebruaryMarch Sales130,000125,000120,000260,000140,000 Collections: Month of Sale (30%)36,00078,00042,000 First Month (50%)62,50060,000 2nd Month (20%)26,00025,000 Total Collections124,500163,000 140,000x.30 Determine March Collections The Cash Budget: Collections

Cash Budget Halsey Enterprises November December January FebruaryMarch Sales130,000125,000120,000260,000140,000 Collections: Month of Sale (30%)36,00078,00042,000 First Month (50%)62,50060,000130,000 2nd Month (20%)26,00025,000 Total Collections124,500163,000 260,000x.50 Determine March Collections The Cash Budget: Collections

Cash Budget Halsey Enterprises November December January FebruaryMarch Sales130,000125,000120,000260,000140,000 Collections: Month of Sale (30%)36,00078,00042,000 First Month (50%)62,50060,000130,000 2nd Month (20%)26,00025,00024,000 Total Collections124,500163,000 120,000x.20 Determine March Collections The Cash Budget: Collections

Cash Budget Halsey Enterprises November December January FebruaryMarch Sales130,000125,000120,000260,000140,000 Collections: Month of Sale (30%)36,00078,00042,000 First Month (50%)62,50060,000130,000 2nd Month (20%)26,00025,00024,000 Total Collections124,500163,000196,000 The Cash Budget: Collections

Payments for January Purchases Nov Dec Jan Feb Mar Sales 130,000 125,000 120,000 260,000 140,000 90,000 75% of January Sales Purchased in November The Cash Budget: Payments

Payments for January Purchases Nov Dec Jan Feb Mar Sales 130,000 125,000 120,000 260,000 140,000 90,000 75% of January Sales Purchased in November, Paid for in December 90,000 The Cash Budget: Payments

Cash Budget Halsey Enterprises Sales130,000125,000120,000260,000140,000140,000 Purchases195,000 Payments195,000 November December January FebruaryMarch April 260,000x.75 Determine January Payments The Cash Budget: Materials Purchases

Cash Budget Halsey Enterprises Sales130,000125,000120,000260,000140,000140,000 Purchases195,000105,000 Payments195,000105,000 November December January FebruaryMarch April 140,000x.75 Determine February Payments The Cash Budget: Materials Purchases

Cash Budget Halsey Enterprises Sales130,000125,000120,000260,000140,000140,000 Purchases195,000105,000105,000 Payments195,000105,000105,000 November December January FebruaryMarch April 140,000x.75 Determine March Payments The Cash Budget: Materials Purchases

Cash Budget Halsey Enterprises Sales130,000125,000120,000260,000140,000140,000 Purchases195,000105,000105,000 Payments195,000105,000105,000 November December January FebruaryMarch April The Cash Budget: Materials Purchases

Cash Budget Halsey Enterprises Cash Collections 124,500163,000196,000 Material Payments195,000105,000105,000 January FebruaryMarch Summary of Previous Sheets The Cash Budget: Cash Inflows and Outflows

Cash Budget Halsey Enterprises Cash Collections 124,500163,000196,000 Material Payments195,000105,000105,000 Other Payments: Rent2,0002,0002,000 Other Expenses12,00012,00012,000 Tax Payments0010,000 January FebruaryMarch Remaining Cash Outflows The Cash Budget: Cash Inflows and Outflows

Cash Budget Halsey Enterprises Cash Collections 124,500163,000196,000 Material Payments195,000105,000105,000 Other Payments: Rent2,0002,0002,000 Other Expenses12,00012,00012,000 Tax Payments0010,000 Net Monthly Change(84,500)44,00067,000 January FebruaryMarch The Cash Budget: Cash Inflows and Outflows

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,000 Ending Cash (No Borrow) Needed (Borrowing) Loan Repayment Interest Cost Ending Cash Balance Cumulative Borrowing January FebruaryMarch The Cash Budget: Borrowing Needs

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,000 Ending Cash (No Borrow)(56,500) Needed (Borrowing) Loan Repayment Interest Cost Ending Cash Balance Cumulative Borrowing January FebruaryMarch The Cash Budget: Borrowing Needs

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,000 Ending Cash (No Borrow)(56,500) Needed (Borrowing) Loan Repayment Interest Cost Ending Cash Balance25,000 Cumulative Borrowing January FebruaryMarch Target Ending Balance The Cash Budget: Borrowing Needs

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,000 Ending Cash (No Borrow)(56,500) Needed (Borrowing)81,500 Loan Repayment Interest Cost Ending Cash Balance25,000 Cumulative Borrowing January FebruaryMarch The Cash Budget: Borrowing Needs Borrowing Needed to Cover Minimum Balance and Deficit 56,500 + 25,000

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,000 Ending Cash (No Borrow)(56,500) Needed (Borrowing)81,500 Loan Repayment0 Interest Cost0 Ending Cash Balance25,000 Cumulative Borrowing81,500 January FebruaryMarch The Cash Budget: Borrowing Needs

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,000 Ending Cash (No Borrow)(56,500)69,000 Needed (Borrowing)81,500 Loan Repayment0 Interest Cost0 Ending Cash Balance25,000 Cumulative Borrowing81,500 January FebruaryMarch The Cash Budget: Borrowing Needs

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,000 Ending Cash (No Borrow)(56,500)69,000 Needed (Borrowing)81,5000 Loan Repayment0 Interest Cost0 Ending Cash Balance25,00025,000 Cumulative Borrowing81,500 January FebruaryMarch Target Ending Balance The Cash Budget: Borrowing Needs

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,000 Ending Cash (No Borrow)(56,500)69,000 Needed (Borrowing)81,5000 Loan Repayment0 Interest Cost0408 Ending Cash Balance25,00025,000 Cumulative Borrowing81,500 January FebruaryMarch Interest Incurred on Prior Month Borrowing 81,500 x.005 The Cash Budget: Borrowing Needs

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,000 Ending Cash (No Borrow)(56,500)69,000 Needed (Borrowing)81,5000 Loan Repayment043,592 Interest Cost0408 Ending Cash Balance25,00025,000 Cumulative Borrowing81,500 January FebruaryMarch Amount that can be repaid from monthly surplus The Cash Budget: Borrowing Needs 69,000 - 408 - 25,000

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,000 Ending Cash (No Borrow)(56,500)69,000 Needed (Borrowing)81,5000 Loan Repayment043,592 Interest Cost0408 Ending Cash Balance25,00025,000 Cumulative Borrowing81,50037,908 January FebruaryMarch New Loan Balance 81,500 - 43,592 The Cash Budget: Borrowing Needs

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,00025,000 Ending Cash (No Borrow)(56,500)69,00092,000 Needed (Borrowing)81,5000 Loan Repayment043,592 Interest Cost0408 Ending Cash Balance25,00025,000 Cumulative Borrowing81,50037,908 January FebruaryMarch The Cash Budget: Borrowing Needs

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,00025,000 Ending Cash (No Borrow)(56,500)69,00092,000 Needed (Borrowing)81,50000 Loan Repayment043,592 Interest Cost0408190 Ending Cash Balance25,00025,000 Cumulative Borrowing81,50037,908 January FebruaryMarch Interest Incurred on Prior Month Borrowing 37,908 x.005 The Cash Budget: Borrowing Needs

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,00025,000 Ending Cash (No Borrow)(56,500)69,00092,000 Needed (Borrowing)81,50000 Loan Repayment043,59237,908 Interest Cost0408190 Ending Cash Balance25,00025,000 Cumulative Borrowing81,50037,908 January FebruaryMarch Repay Outstanding Loan Balance The Cash Budget: Borrowing Needs

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,00025,000 Ending Cash (No Borrow)(56,500)69,00092,000 Needed (Borrowing)81,50000 Loan Repayment043,59237,908 Interest Cost0408190 Ending Cash Balance25,00025,00053,902 Cumulative Borrowing81,50037,9080 January FebruaryMarch Ending Cash Balance $28,902 Surplus The Cash Budget: Borrowing Needs

Cash Budget Halsey Enterprises Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,00025,000 Ending Cash (No Borrow)(56,500)69,00092,000 Needed (Borrowing)81,50000 Loan Repayment043,59237,908 Interest Cost0408190 Ending Cash Balance25,00025,00053,902 Cumulative Borrowing81,50037,9080 January FebruaryMarch Halsey needs to raise $81,500 in short term debt in January, would probably take out a short term bank loan. In March has a 28,902 surplus, would probably invest in marketable securities at this point in time The Cash Budget: Borrowing Needs

Problem 1 Budgets perform three basic functions for a firm. Which of the following is not a function of the budgeting process? A.predicting future interest rates. B.providing an indication of the amount and timing of the firm's needs for future financing. C.providing the basis for taking corrective action. D.providing the basis for performance evaluation.

Problem 2 What are the sources of spontaneous financing? A.accrued expenses and accounts payable. B.mortgages and notes payable. C.common stock and long-term debt. D.paid-in capital and capital leases.

Problem 3 Which of the following statements best describe "lumpy assets"? A.Lumpy assets are those assets that irritate higher levels of management. B.Lumpy assets are those assets that cannot be disposed of without paying a very high sales commission. C.Gasoline is a good example of a lumpy asset because lumpy assets are usually associated with spontaneous sources of financing. D.Lumpy assets are those that must be purchased in large, nondivisible components, such as plant and equipment.

Problem 4 If a firm's forecasted ROE for the next year is 12 percent and the firm plans to pay out 40 percent of its net income as dividends, what is the firm's sustainable rate of growth? A.10.2%. B. 6.0%. C. 7.2%. D. 4.5%.

Problem 5 A firm's cash position would most likely be helped by: A.increasing inventories. B.establishing shorter credit terms for customers. C.reducing debt. D.increasing accounts receivable.

Problem 6 Which of the following items would NOT be included in the cash budget? A.depreciation charges B.sales. C.cash receipts D.interest on existing debt.

Problem 7 As of December 31, Harley-Davidson had a cash balance of $183.4 million. December sales were $215.9 million and are expected to be $200.0 million in January. Twenty-five percent of sales in any month are cash sales, and 75 percent of sales are collected during the following month. In January, Harley-Davidson is expected to have total cash disbursements of $110.0 million, and requires a minimum cash balance of $150 million. What are Harley-Davidson's cash receipts for January? A.$50.0 million. B.$161.9 million. C.$200.0 million. D.$211.9 million.

Problem 8 Using the information for Question 9, which is: As of December 31, Harley-Davidson had a cash balance of $183.4 million. December sales were $215.9 million and are expected to be $200.0 million in January. Twenty-five percent of sales in any month are cash sales, and 75 percent of sales are collected during the following month. In January, Harley- Davidson is expected to have total cash disbursements of $110.0 million, and requires a minimum cash balance of $150 million. A.What will Harley-Davidson's excess cash balance be at the end of January? B.excess cash balance of $40.4 million. C.excess cash balance of $41.9 million. D.excess cash balance of $33.4 million. E.excess cash balance of $150.0 million.

Problem 9 Harley-Davidson projects next year's sales, the year 2000, to be $3,000.0 million. Current sales, the year 1999, are at $2,600.0 million, with current assets of $1,000.0 million, and fixed assets of $1,162.0 million. The firm's net profit margin is 10.0 percent after taxes. Harley-Davidson forecasts that current assets will increase in direct proportion to the increase in sales, but fixed assets will increase by only$100.0 million. Currently, Harley-Davidson has $517.0 million in accounts payable, which vary directly with sales, $433.0 million in long-term debt, due in ten years, and common equity (including $1,162.0 million in retained earnings) totaling $1,212.0 million. Harley-Davidson plans to pay $350.0 million in common stock dividends next year. What is the amount of Discretionary Financing Needed by Harley-Davidson for the coming year? A. $2,192.0 million. B. $225.0 million. C. $2,417 million.

 1999, Prentice Hall, Inc. Chapter 5 The Time Value of Money

We know that receiving $1 today is worth more than $1 in the future. This is due to OPPORTUNITY COSTS. The opportunity cost of receiving $1 in the future is the interest we could have earned if we had received the $1 sooner. Today Future

? Today Future If we can measure the opportunity cost we can: Translate $1 today into its equivalent in the future (COMPOUNDING).

Translate $1 in the future into its equivalent today (DISCOUNTING). ? ? Today Future Today Future

Note: It’s easiest to use your financial functions on your calculator to solve time value problems. However, you will need a lot of practice to eliminate mistakes. Finance and Accounting Majors: It will be helpful later to take extra time now learning to use the formulas as well as the financial functions on your calculator!

Future Value

Future Value - single sums If you deposit $100 in an account earning 6%, how much would you have in the account after 1 year? 0 1 PV = FV =

Future Value - single sums If you deposit $100 in an account earning 6%, how much would you have in the account after 1 year? Calculator Solution: P/Y = 1I = 6 N = 1 PV = -100 FV = $106 0 1 0 1 PV = -100 FV =

Future Value - single sums If you deposit $100 in an account earning 6%, how much would you have in the account after 1 year? Calculator Solution: P/Y = 1I = 6 N = 1 PV = -100 FV = $106 0 1 0 1 PV = -100 FV = 106

Future Value - single sums If you deposit $100 in an account earning 6%, how much would you have in the account after 5 years? 0 5 0 5 PV = FV =

Future Value - single sums If you deposit $100 in an account earning 6%, how much would you have in the account after 5 years? Calculator Solution: P/Y = 1I = 6 N = 5 PV = -100 FV = $133.82 0 5 0 5 PV = -100 FV =

HP CALCULATORS èENTERING PAYMENTS PER YEAR qFIN qTVM qOTHER q1 qP/YR qEXIT

HP CALCULATORS èCLEARING OLD DATA qGOLD KEY qINPUT

HP CALCULATORS èPROBLEM INFORMATION q1 qN q6 qI%YR

FV Problem Info Continued q100 q+/- qPV qFV q106

TEXAS INSTRUMENTS BAII+ èCHANGING THE PAYMENTS PER YEAR q2ND qP/Y q1

Payment Frequency Continued qENTER q2ND qQUIT

TEXAS INSTRUMENTS BAII+ èCLEARING OLD DATA q2ND qQUIT q2ND qCLR TVM

TEXAS INSTRUMENTS BAII+ èPROBLEM INFORMATION q1 qN q6 qI/Y q100

FV PROBLEM INFO CONTINUED q+/- qPV qCPT qFV q106

Future Value - single sums If you deposit $100 in an account earning 6%, how much would you have in the account after 1 year? Mathematical Solution: FV = PV (FVIF i, n ) FV = 100 (FVIF.06, 1 ) (use FVIF table, or) FV = PV (1 + i) n FV = 100 (1.06) 1 = $106 0 1 0 1 PV = -100 FV = 106

Future Value - single sums If you deposit $100 in an account earning 6%, how much would you have in the account after 5 years? 0 5 0 5 PV = FV =

Future Value - single sums If you deposit $100 in an account earning 6%, how much would you have in the account after 5 years? Calculator Solution: P/Y = 1I = 6 N = 5 PV = -100 FV = 0 5 0 5 PV = -100 FV =

HP CALCULATORS èENTERING PAYMENTS PER YEAR qFIN qTVM qOTHER q1 qP/YR qEXIT

HP CALCULATORS èCLEARING OLD DATA qGOLD KEY qINPUT

HP CALCULATORS èPROBLEM INFORMATION q5 qN q6 qI%YR

FV Problem Info Continued q100 q+/- qPV qFV q133.82

TEXAS INSTRUMENTS BAII+ èCHANGING THE PAYMENTS PER YEAR q2ND qP/Y q1

Payment Frequency Continued qENTER q2ND qQUIT

TEXAS INSTRUMENTS BAII+ èCLEARING OLD DATA q2ND qQUIT q2ND qCLR TVM

TEXAS INSTRUMENTS BAII+ èPROBLEM INFORMATION q5 qN q6 qI/Y q100

FV PROBLEM INFO CONTINUED q+/- qPV qCPT qFV q133.82

Future Value - single sums If you deposit $100 in an account earning 6%, how much would you have in the account after 5 years? Calculator Solution: P/Y = 1I = 6 N = 5 PV = -100 FV = $133.82 0 5 0 5 PV = -100 FV = 133. 82

Future Value - single sums If you deposit $100 in an account earning 6% with quarterly compounding, how much would you have in the account after 5 years? 0 ? PV = FV =

Calculator Solution: P/Y = 1I = 6/4=1.5 N = 20 PV = -100 FV = 0 20 0 20 PV = -100 FV = Future Value - single sums If you deposit $100 in an account earning 6% with quarterly compounding, how much would you have in the account after 5 years?

Calculator Solution: P/Y = 1I = 1.5 N = 20 PV = -100 FV = $134.68 0 20 0 20 PV = -100 FV = 134. 68 Future Value - single sums If you deposit $100 in an account earning 6% with quarterly compounding, how much would you have in the account after 5 years?

Future Value - single sums If you deposit $100 in an account earning 6% with monthly compounding, how much would you have in the account after 5 years? 0 ? PV = FV =

Calculator Solution: P/Y = 1I = 6/12 N = 60 PV = -100 FV = $134.89 0 60 0 60 PV = -100 FV = Future Value - single sums If you deposit $100 in an account earning 6% with monthly compounding, how much would you have in the account after 5 years?

Calculator Solution: P/Y = 1I = 6/12 N = 60 PV = -100 FV = $134.89 0 60 0 60 PV = -100 FV = 134. 89 Future Value - single sums If you deposit $100 in an account earning 6% with monthly compounding, how much would you have in the account after 5 years?

Future Value - continuous compounding What is the FV of $1,000 earning 8% with continuous compounding, after 100 years? 0 ? PV = FV =

Mathematical Solution: FV = PV (e in ) FV = 1000 (e.08x100 ) = 1000 (e 8 ) FV = $2,980,957. 99 0 100 0 100 PV = -1000 FV = Future Value - continuous compounding What is the FV of $1,000 earning 8% with continuous compounding, after 100 years?

0 100 0 100 PV = -1000 FV = Future Value - continuous compounding What is the FV of $1,000 earning 8% with continuous compounding, after 100 years? $2.98m Mathematical Solution: Mathematical Solution: FV = PV (e in ) FV = PV (e in ) FV = 1000 (e.08x100 ) = 1000 (e 8 ) FV = 1000 (e.08x100 ) = 1000 (e 8 ) FV = $2,980,957. 99 FV = $2,980,957. 99

Present Value

Present Value - single sums If you will receive $100 one year from now, what is the PV of that $100 if your opportunity cost is 6%? 0 ? PV = FV =

Calculator Solution: P/Y = 1I = 6 N = 1 FV = 100 PV = -94.34 0 1 0 1 PV = FV = 100 Present Value - single sums If you will receive $100 one year from now, what is the PV of that $100 if your opportunity cost is 6%?

Calculator Solution: P/Y = 1I = 6 N = 1 FV = 100 PV = -94.34 0 1 0 1 PV = -94. 34 FV = 100 Present Value - single sums If you will receive $100 one year from now, what is the PV of that $100 if your opportunity cost is 6%?

Present Value - single sums If you will receive $100 5 years from now, what is the PV of that $100 if your opportunity cost is 6%? 0 ? PV = FV =

Calculator Solution: P/Y = 1I = 6 N = 5 FV = 100 PV = -74.73 0 5 0 5 PV = FV = 100 Present Value - single sums If you will receive $100 5 years from now, what is the PV of that $100 if your opportunity cost is 6%?

0 5 0 5 PV = FV = 100 Present Value - single sums If you will receive $100 5 years from now, what is the PV of that $100 if your opportunity cost is 6%? -74. 73 Calculator Solution: Calculator Solution: P/Y = 1I = 6 P/Y = 1I = 6 N = 5 FV = 100 N = 5 FV = 100 PV = -74.73 PV = -74.73

Present Value - single sums What is the PV of $1,000 to be received 15 years from now if your opportunity cost is 7%? 0 ? PV = FV =

Calculator Solution: P/Y = 1I = 7 N = 15 FV = 1,000 PV = -362.45 0 15 0 15 PV = FV = 1000 Present Value - single sums What is the PV of $1,000 to be received 15 years from now if your opportunity cost is 7%?

Calculator Solution: P/Y = 1I = 7 N = 15 FV = 1,000 PV = -362.45 0 15 0 15 PV = -362. 45 FV = 1000 Present Value - single sums What is the PV of $1,000 to be received 15 years from now if your opportunity cost is 7%?

Present Value - single sums If you sold land for $11,933 that you bought 5 years ago for $5,000, what is your annual rate of return? 0 ? PV = FV =

Calculator Solution: P/Y = 1N = 5 PV = -5,000 FV = 11,933 I = 19% 0 5 0 5 PV = -5,000 FV = 11,933 Present Value - single sums If you sold land for $11,933 that you bought 5 years ago for $5,000, what is your annual rate of return?

Present Value - single sums Suppose you placed $100 in an account that pays 9.6% interest, compounded monthly. How long will it take for your account to grow to $500? 0 PV = FV =

Calculator Solution: P/Y = 1FV = 500 I = 9.6/12PV = -100 N = 202 months Present Value - single sums Suppose you placed $100 in an account that pays 9.6% interest, compounded monthly. How long will it take for your account to grow to $500? 0 ? 0 ? PV = -100 FV = 500

Hints for single sum problems –In every single sum future value and present value problem, there are 4 variables: –FV, PV, i, and n –When doing problems, you will be given 3 of these variables and asked to solve for the 4th variable. –Keeping this in mind makes “time value” problems much easier!

Compounding and Discounting Cash Flow Streams 01 234 The Time Value of Money

Annuity: a sequence of equal cash flows, occurring at the end of each period. Annuities

Annuity: a sequence of equal cash flows, occurring at the end of each period. 01 234 Annuities

Examples of Annuities If you buy a bond, you will receive equal coupon interest payments over the life of the bond. If you borrow money to buy a house or a car, you will pay a stream of equal payments.

Future Value - annuity If you invest $1,000 at the end of the next 3 years, at 8%, how much would you have after 3 years? 0 1 2 3

BOTH CALCULATORS 4Need to set payments 4Remember to clear out old data 4Diagram the problem

Calculator Solution: P/Y = 1I = 8N = 3 PMT = -1,000 FV = $3,246.40 Future Value - annuity If you invest $1,000 at the end of the next 3 years, at 8%, how much would you have after 3 years? 0 1 2 3 10001000 1000 10001000 1000

HP CALCULATORS qOTHER q1 qP/YR qEXIT q3 qN q 1000 q +/- q PMT q I%/YR q 8 q FV

BAII+ CALCULATORS q2ND qP/YR q1 q2ND qQUIT q1000 q+/- qPMT q 3 q N q 8 q I% q CPT q FV

Present Value - annuity What is the PV of $1,000 at the end of each of the next 3 years, if the opportunity cost is 8%? 0 1 2 3

Calculator Solution: P/Y = 1I = 8N = 3 PMT = -1,000 PV = $2,577.10 0 1 2 3 10001000 1000 10001000 1000 Present Value - annuity What is the PV of $1,000 at the end of each of the next 3 years, if the opportunity cost is 8%?

Other Cash Flow Patterns Perpetuities Ordinary versus Annuity Due Uneven Cash Flows

Perpetual Income Streams Suppose you will receive a fixed payment every period (month, year, etc.) forever. This is an example of a perpetuity. You can think of a perpetuity as an annuity that goes on forever.

Present Value of a Perpetuity When we find the PV of an annuity, we think of the following relationship:

PV = PMT (PVIFA i, n ) PV = PMT (PVIFA i, n ) Present Value of a Perpetuity When we find the PV of an annuity, we think of the following relationship:

Mathematically, (PVIFA i, n ) =

Mathematically, (PVIFA i, n ) = 1 - 1 (1 + i) n i

Mathematically, (PVIFA i, n ) = We said that a perpetuity is an annuity where n = infinity. What happens to this formula when n gets very, very large? 1 - 1 (1 + i) n i

When n gets very large,

this becomes zero. 1 - 1 (1 + i) n i

1 - 1 (1 + i) n i 1 i 1 i When n gets very large, this becomes zero. this becomes zero. So we’re left with PVIFA =

Present Value of a Perpetuity So, to find the PV of a Perpetuity:

PMT i PV = Present Value of a Perpetuity So, to find the PV of a Perpetuity

What should you be willing to pay in order to receive $10,000 annually forever, if you require 8% per year on the investment?

PMTi PV = = $10,000.08 = $125,000

Is the cash flow at the beginning or end of the period? Ordinary Annuity –Cash flow occurs at the end of the period, year, month, quarter –Use the “End” Mode on your calculator Annuity Due –Occurs at the beginning of the time period –Use the begin mode

HP CALCULATORS qFin qTVM qOTHER qEND qEXIT

BAII+ q2ND qBGN (Above the Payment Key) q2ND qSET (ABOVE ENTER KEY) Then you toggle back and forth between begin or end mode. Always check your calculator and the problem information

Problem Information Find the Future Value and Present Value of $1,000 for 3 years at 8% if the cash flows occur at the end of each year Compare the future and present value of the annuity numbers with those you get when the cash flow is at the beginning of the year Try to answer the question: Why are the numbers different depending on when the cash flow occurs?

Using an interest rate of 8%, we find that: The Future Value (at 3) is $3,246.40. The Present Value (at 0) is $2,577.10. 0 1 2 3 10001000 1000 10001000 1000 Earlier Example: Ordinary Annuity

Same 3-year time line, Same 3 $1000 cash flows, but The cash flows occur at the beginning of each year, rather than at the end of each year. This is an “annuity due.” 0 1 2 3 1000 1000 1000 1000 1000 1000 What about this annuity?

Future Value - annuity due If you invest $1,000 at the beginning of each of the next 3 years at 8%, how much would you have at the end of year 3? 0 1 2 3

Calculator Solution: Mode = BEGIN P/Y = 1I = 8 N = 3 PMT = -1,000 FV = $3,506.11 0 1 2 3 -1000 -1000 -1000 -1000 -1000 -1000 Future Value - annuity due If you invest $1,000 at the beginning of each of the next 3 years at 8%, how much would you have at the end of year 3?

0 1 2 3 -1000 -1000 -1000 -1000 -1000 -1000 Future Value - annuity due If you invest $1,000 at the beginning of each of the next 3 years at 8%, how much would you have at the end of year 3? Calculator Solution: Mode = BEGIN P/Y = 1I = 8 N = 3 PMT = -1,000 FV = $3,506.11

Present Value - annuity due What is the PV of $1,000 at the beginning of each of the next 3 years, if your opportunity cost is 8%? 0 1 2 3

Calculator Solution: Mode = BEGIN P/Y = 1I = 8 N = 3 PMT = 1,000 PV = $2,783.26 0 1 2 3 1000 1000 1000 1000 1000 1000 Present Value - annuity due What is the PV of $1,000 at the beginning of each of the next 3 years, if your opportunity cost is 8%?

01 234 -10,000 2,000 4,000 6,000 7,000 Uneven Cash Flows Is this an annuity? How do we find the PV of a cash flow stream when all of the cash flows are different? (Use a 10% discount rate).

01 234 -10,000 2,000 4,000 6,000 7,000 How do we discount uneven cash flows?

01 234 -10,000 2,000 4,000 6,000 7,000 Uneven Cash Flows

If the interest rate does not change you can use your cash flow menu on your calculator If the interest rate changes, you need to discount each one individually 01 234 -10,000 2,000 4,000 6,000 7,000 Uneven Cash Flows

period CF PV (CF) 0-10,000 -10,000.00 1 2,000 1,818.18 2 4,000 3,305.79 3 6,000 4,507.89 4 7,000 4,781.09 PV of Cash Flow Stream: $ 4,412.95 01 234 -10,000 2,000 4,000 6,000 7,000

Cash Flow Menu Calculators let you solve for the present value of an uneven cash flow stream Often used to find Net Present Value or the present value of a project’s cash flows Using a new menu on your calculator

HP 19BII CASH FLOW MENU 4This is a separate menu “CFLO” or cash flow 4Solution below indicates the keystrokes and display 4Clear out old data in CFLO menu -- gold key, input 4Answer “yes” to clear the list?

HP 19BII CASH FLOW MENU HERE IS THE DISPLAY IN THE CALCULATOR: INITIAL FLOW= INIT= NOW YOU NEED TO ENTER DATA. This would be a cash flow at the start of year 1 similar to the cost of a machine.

Entering Data: HP CFLO -10,000 q+/- qINPUT FLOW (1)= #TIMES=

Entering Data: HP CFLO cont. q2,000 qINPUT q1 qINPUT q4,000 qINPUT q1 qINPUT q 6,000 q INPUT q 1 q INPUT q 7,000 q INPUT q 1 q INPUT qCALC q10 qI% qNPV q4,412.94

 BAII+ CASH FLOW MENU qCF q2ND qCLEAR WORK q10,000 q+/- qENTER q  q 2,000 q ENTER q  q 1 q ENTER q 4,000 q ENTER q  q 1 q6,000 qENTER q  q1 qENTER q7,000 qENTER q  q1

BAll+ CASH FLOW CONT. Need to access the NPV portion of the worksheet qNPV I= q10 qENTER q  qCPT NPV =4,412.94

Example Cash flows from an investment are expected to be $40,000 per year at the end of years 4, 5, 6, 7, and 8. If you require a 20% rate of return, what is the PV of these cash flows?

Example012345678 0 0 0 0 40 40 40 40 40 0 0 0 0 40 40 40 40 40 Cash flows from an investment are expected to be $40,000 per year at the end of years 4, 5, 6, 7, and 8. If you require a 20% rate of return, what is the PV of these cash flows?

This type of cash flow sequence is often called a “deferred annuity.” 012345678 0 0 0 0 40 40 40 40 40 0 0 0 0 40 40 40 40 40

The PV of the cash flow stream is $69,226. 012345678 0 0 0 0 40 40 40 40 40 0 0 0 0 40 40 40 40 40

Example After graduation, you plan to invest $400 per month in the stock market. If you earn 12% per year on your stocks, how much will you have accumulated when you retire in 30 years?

Retirement Example After graduation, you plan to invest $400 per month in the stock market. If you earn 12% per year on your stocks, how much will you have accumulated when you retire in 30 years? 01 23... 360 400 400 400 400

01 23... 360 400 400 400 400

Using your calculator, P/YR = 1 N = 360 PMT = -400 I%YR = 12/12=1 FV = $1,397,985.65 01 23... 360 400 400 400 400

If you borrow $100,000 at 7% fixed interest for 30 years in order to buy a house, what will be your monthly house payment? House Payment Example

If you borrow $100,000 at 7% fixed interest for 30 years in order to buy a house, what will be your monthly house payment?

01 23... 360 ? ? ? ?

Using your calculator, P/YR = 1 N = 360 I%YR = 7/12 PV = $100,000 PMT = -$665.30 01 23... 360 ? ? ? ? ? ? ? ?

Team Assignment Upon retirement, your goal is to spend 5 years traveling around the world. To travel in style will require $250,000 per year at the beginning of each year. If you plan to retire in 30 years, what are the equal monthly payments necessary to achieve this goal? The funds in your retirement account will compound at 10% annually.

How much do we need to have by the end of year 30 to finance the trip? PV 30 = PMT (PVIFA.10, 5 ) (1.10) = = 250,000 (3.7908) (1.10) = = $1,042,470 272829303132333435 250 250 250 250 250 250 250 250 250 250

Using your calculator, Mode = BEGIN PMT = -$250,000 N = 5 I%YR = 10 P/YR = 1 PV = $1,042,466 272829303132333435 250 250 250 250 250 250 250 250 250 250

Now, assuming 10% annual compounding, what monthly payments will be required for you to have $1,042,466 at the end of year 30? 272829303132333435 250 250 250 250 250 250 250 250 250 2501,042,466

 Using your calculator, Mode = END N = 360 I%YR = 10/12 P/YR = 1 FV = $1,042,466 PMT = -$461.17 272829303132333435 250 250 250 250 250 250 250 250 250 2501,042,466

So, you would have to place $461.17 in your retirement account, which earns 10% annually, at the end of each of the next 360 months to finance the 5-year world tour.

Ch. 1 - An Introduction to Financial Management  2002, Prentice Hall, Inc.

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Ch. 1 - An Introduction to Financial Management  2002, Prentice Hall, Inc.

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