ADMS 3530 Lecture Notes - Lecture 12: Yle, Effective Interest Rate, Credit Risk

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mag0sea

13 Feb 2017

School

York University

Department

Administrative Studies

Course

ADMS 3530

Professor

King Lois

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Document Summary

U(cid:374)til (cid:374)o(cid:449) (cid:449)e used, (cid:862)capital(cid:863) to (cid:396)efe(cid:396) to sou(cid:396)(cid:272)es of long-term financing but it can also have other meanings: (cid:862)(cid:396)(cid:863) = (cid:272)ost of capital in npv equations; Wacc = weighted average cost of capital; In this unit total capital requirements of a firm include capital (funds) required for. Property, plant and equipment (fixed assets) and also for. Inventory build-up, or to bridge the gap between accounts receivables and actual collection of cash from a sale (current assets). How to finance these total capital requirements: long-term financing funds raised by the sale of equity , bonds or preferred shares or long-term loans, short-term financing bank loans, secured loans, accounts payable etc. The difference between the long-term financing raised and the total capital requirement determines whether the firm is a short-term borrower or lender. Matching maturities: financial managers attempt to match the maturities of their assets and liabilities.

Related Questions

Question 8

Which of the following is NOT one of the steps taken in the financial planning process?
Answer Forecast the funds that will be generated internally. If internal funds are insufficient to cover the required new investment, then identify sources from which the required external capital can be raised.
Monitor operations after implementing the plan to spot any deviations and then take corrective actions.
Determine the amount of capital that will be needed to support the plan.
Develop a set of forecasted financial statements under alternative versions of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios.
Consult with key competitors about the optimal set of prices to charge, i.e., the prices that will maximize profits for our firm and its competitors.
.2 points
Question 9

Which of the following statements is CORRECT?
Answer Since accounts payable and accrued liabilities must eventually be paid off, as these accounts increase, AFN as calculated by the AFN equation must also increase.
Suppose a firm is operating its fixed assets at below 100% of capacity, but it has no excess current assets. Based on the AFN equation, its AFN will be larger than if it had been operating with excess capacity in both fixed and current assets.
If a firm retains all of its earnings, then it cannot require any additional funds to support sales growth.
Additional funds needed (AFN) are typically raised using a combination of notes payable, long-term debt, and common stock. Such funds are non-spontaneous in the sense that they require explicit financing decisions to obtain them.
If a firm has a positive free cash flow, then it must have either a zero or a negative AFN.
.2 points
Question 10

Spontaneous funds are generally defined as follows:
Answer Assets required per dollar of sales.
A forecasting approach in which the forecasted percentage of sales for each item is held constant.
Funds that a firm must raise externally through short-term or long-term borrowing and/or by selling new common or preferred stock.
Funds that arise out of normal business operations from its suppliers, employees, and the government, and they include immediate increases in accounts payable, accrued wages, and accrued taxes.
The amount of cash raised in a given year minus the amount of cash needed to finance the additional capital expenditures and working capital needed to support the firm

Take a look at and read this article that discusses the cost of capital. What are your thoughts? Elaborate and Explain

Capital for a small business is simply money. It is the financing for the small business or the money used to operate and buy assets. Cost of capital is the cost of obtaining that money or financing for the small business. The cost of capital is also called the hurdle rate.

Should very small businesses even worry about their cost of capital? The answer to that is absolutely yes! Even very small businesses need money to operate and that money is going to cost something. Companies want that cost to be as low as possible.

What is Capital?

Capital is the money businesses use for financing their operations. The cost of capital is simply the rent, or interest rate, it costs the business to obtain financing. In order to understand cost of capital, you must first understand the concept of capital. Capital for very small businesses may just be the supplier credit they rely on. For larger businesses, capital may be the supplier credit and longer term debt or liabilities, which are the firm's liabilities.

If a company is public or takes on investors, then capital will also include equity capital or common stock. Other equity accounts will be retained earnings, paid-in capital, perhaps preferred stock.

Why is Capital Important?

In order to build new plants, buy new equipment, develop new products, and upgrade informationtechnology, businesses have to have money or capital. For every decision like this, a business owner or Chief Financial Officer (CFO) has to decide if the return on the investment is greater than the cost of capital or the cost of the money it takes to invest in the project.

Business owners do not usually invest in new projects unless the return on the capital they invest in these projects is greater than or at least equal to the cost of the capital they have to use to finance these projects. Cost of capital is the key to all business decisions.

What is the Cost of Capital?

A company's cost of capital is simply the cost of money the company uses for financing. If a company only uses current liabilities and long-term debt to finance its operations, then it uses debt and the cost of capital is usually the interest rate on that debt.

If a company is public and has investors, then cost of capital gets more complicated. If the company only uses funds provided by investors, then the cost of capital is the cost of equity. Usually, this type of company has debt but it also finances with equity financing or money that investors supply. In this case, the cost of capital is the cost of debt and the cost of equity.

The combination of debt and equity financing for a company is the company's capital structure.

What is Return on Capital?

Return on capital is the amount of profit you earn out of a business or project as compared to the amount of capital you invested. The key to cost of capital for a company is that a company's return on capital must always equal or exceed the cost of capital for any project in which the firm wants to invest. In other words, the company's investment rate of return (return on capital) must equal or exceed their financing rate of return (cost of capital) in order for the firm to be profitable.

What Composes the Cost of Capital

One component of the cost of capital is the cost of debt financing. For larger businesses, debt usually means large loans or bonds. For very small companies, the debt can mean trade credit. For either, the cost of debt is the interest rate the company pays on debt.

Another component of the cost of capital is the cost of equity financing if your company is a public company; in other words, if you have investors in your company who provide money in exchange for an ownership stake in the company.

There are several components of the cost of equity capital. First, there is the cost of retained earnings or the money that the company invests back into the company, instead of paying outdividends. Next, there is the cost of new common stock or stock that the company issues to raise money. Last, the company may even issue preferred stock to raise money.

For very small firms, the cost of capital may be much simpler. There are advantages and disadvantages to both debt and equity financing, including cost, that any business owner must consider before adding them to the capital structure of the company. Very small firms may just useshort term debt, in which case we have to establish a cost for this capital component.

The Company's Weighted Average Cost of Capital

Once the business owner understands the concepts of capital and cost of capital, the next step is to understand weighted average cost of capital. Each capital component is a certain percentage of the company's capital structure. In order to arrive at the true cost of capital for a business firm, the owner must multiply the percentage of the company's capital structure for each component by the cost of that component and sum them.

Summary of Cost of Capital

Before a company can engage in buying assets or obtaining financing for its operations, it must make some determination of its cost of capital -- what it really costs the firm for the money it has to have to for all its financing. That cost of financing must never exceed its return on capital. Here is a cost of capital video series that you may find helpful. It helps put the return on capital and cost of capital in real world terms for you.

1. Use the attached balance sheet and income statement to compute the required financial ratios for 2012. Use 360 for the number of days in a year. The computations for 2011 are already done for you.

Current ratio_________________________

Quick ratio__________________________

Inventor turnover____________________

Average Collection Period_____________

Total asset turnover__________________

Net profit margin____________________

Operating profit margin_______________

Times Interest Earned_________________

Debt/Net Worth Ratio_________________

Return on Equity ratio__________________

2. Using the computed financial ratios from question 1, compare Grounds Keeperâs performance from 2011 to 2012. Address what areas the company has improved and what areas it has not

A.)Liquidity

B.) Activity / turnover / efficiency

C.) Profitability

D.) Leverage / use of debt / solvency

3. If you were the CEO of Grounds Keeper, what area(s) would you concentrate on to improve the performance of the company?

4. Define the terms capital structure, cost of capital, and working capital. Focus on how they are different from each other and impact both profitability and risk.

5. Determine Grounds Keeperâs capital structure and working capital.

6. If Grounds Keeper has a required rate of return on its long-term debt of 9% (before taxes) and a required rate of return on its common stock, a tax rate of 40%, what is its weighted average cost of capital (WACC) for 2012? How could Grounds Keeper lower its WACC? (HINT: you will need to look at the balance sheet to determine the weight of debt to equity.

7. What are the advantages to Grounds Keeper in using money market instruments as financing? How does this related to financing net working capital?

8. Explain what Grounds Keeper should consider when deciding whether to issue stocks or bonds? Answer using at least 3 different characteristics comparing and contrasting stocks and bonds.

9. Define money market instruments; list at least one type of security that would be considered a money market instrument. What are the advantages to Grounds Keeper in using money market instruments as financing? What are the disadvantages?

	Grounds Keeper
	Consolidated Balance Sheets
	(Dollars in thousands)
	2012	2011
Assets
Current assets:
Cash and cash equivalents	78,240	44,395
Receivables	399,891	340,062
Inventories	844,737	736,677
Total current assets	1,322,868	1,121,133

Fixed assets, net	1,244,384	889,613
Other long-term assets	1,048,537	1,187,141
Total assets	3,615,789	3,197,887

Liabilities and Stockholdersâ Equity
Current liabilities:
Accounts payable	309,222	319,465
Accruals	201,017	145,240
Notes payable	9,748	6,669
Total current liabilities	519987	471374
Long-term debt	834574	814298
Total liabilities	1,354,561	1,285,672
Stockholdersâ equity:
Common stock, $0.10 par value:	15,268	15,447
Additional paid-in capital	1,464,560	1,499,616
Retained earnings	781400	397152
Total stockholdersâ equity	2,261,228	1,912,215
Total liabilities and stockholdersâ equity	3,615,789	3,197,887

Grounds Keeper

Consolidated Statements of Operations

(Dollars in thousands except per share data)

2012

2011

Net sales

3,889,426

2,642,390

Cost of sales

2,589,799

1,746,274

Gross profit

1,299,627

896,116

Selling and operating expenses

481,493

348,696

General and administrative expenses

219,010

187,016

Operating income

599,124

360,404

Interest expense

22,983

57,657

Income before income taxes

576,141

302,747

Income tax expense

212,641

101,699

Net Income

363,500

201,048

Basic income per share:

Average shares outstanding

154,933,948

146,214,860

Earnings per common share

2.35

1.38

Current Ratio	Current assets/ Current liabilities
Quick Ratio	Current assets â inventory/ Current liabilities
Inventory Turnover	Cost of goods sold/ Inventory
Receivables Turnover	Sales/ Accounts receivables
Average Collection Period	Receivables/ Sales per day
Fixed Asset Turnover	Sales/ Fixed assets
Total Asset Turnover	Sales/ Total Assets
Gross Profit Margin	Revenues - Cost of goods sold/ Sales
Operating Profit Margin	Earnings before interest and taxes/ Sales
Net Profit Margin	Net income/ Sales
Return on Total Assets	Net income/ Total assets
Debt/Net Worth Ratio	Total Debt/ Total Equity
Times-Interest-Earned	Operating Income/ Interest expense
Return on Equity	Net income/ Total equity

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ADMS 3530 Lecture Notes - Lecture 12: Yle, Effective Interest Rate, Credit Risk

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