fi3300 corporation finance spring semester 2010 dr. isabel tkatch assistant professor of finance 1
TRANSCRIPT
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FI3300Corporation Finance
Spring Semester 2010
Dr. Isabel TkatchAssistant Professor of Finance
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Learning objectives☺ Discuss working capital management
☺ Identify the effect of seasonality on monthly cash flows
☺ Explain the purpose of long-term financial planning
☺ Use the percent of sales method to construct pro-forma financial statements
☺ Identify spontaneous assets and liabilities, internally generated funds and financing decision variables
☺ Compute ‘Outside (External) Funds Needed’
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Responsibilities of the Financial
Manager
1. Managing theworking capital
2. Estimating the seasonal fund
needs
3. Long-term financial planning: forecasting
long-term fund requirements
Financial Manager
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Working Capital on the Balance Sheet
ASSETS LIABILITIES and EQUITY
Current Assets:Cash
Net Accounts Receivable
Inventories
Current Liabilities:Notes Payable
Accounts Payable
Accrued Expenses
Current Portion of LT Debt
Net Fixed Assets Long-Term Debt
Equity
Total AssetsTotal Liabilities and Equity
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Net Working Capital (NWC)
Net Working Capital (NWC) represents the investment needed to maintain the cash, credit and inventory necessary for operations – varies over time
Net Working Capital (NWC) =
Current Assets - Current Liabilities
Efficient management of current assets and current liabilities reduces the investment in NWC
Related liquidity ratios:
Current assetsCurrent ratio =
Current liabilities
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Working Capital - Cash
1. Determining minimum cash requirements, maintaining the checking account and managing the cash balance
Related liquidity ratios:
Related financial statement:Statement of Cash Flows (operating activities)
Current assets - InventoriesQuick ratio =
Current liabilities
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Working Capital - Credit
2. Setting credit policy (for customers) and managing the collection of accounts receivable
Related activity ratios:
Book example 5.1-5.6 (page 135): Cost benefit analysis of a new credit policy
Account receivableAverage collection period = × 360
Annual credit sales
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Working Capital - Inventory
3. Establishing inventory target levels and managing inventory turnover
Related activity ratios:
InventoriesInventory conversion period = × 360
Cost of goods sold
Cost of goods soldInventory turnover ratio =
Inventories
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Working Capital – ST Debt
4. Establishing and maintaining banking relations to ensure access to short-term (ST) funds
☺ Short term funds offset effects on cash flow (CF) volatility:
☺Predictable / expected events: seasonality
☺Surprise / unexpected events: accidents
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Seasonality and Cash Budgets
☺Most firms experience seasonality in sales:
☺ Weather
☺ Holidays
☺Seasonality in sales leads to cash flow problems whenever
(cash balance + cash inflow) < cash outflow
☺Financial managers must plan in advance and secure funds to cover shortfalls
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Working Capital - Credit
5. Negotiating and monitoring trade credit terms and managing supplier relationships
Related activity ratios:
Account payablePayables period = × 360
Cost of goods sold
Discount percentEffective annual cost = × 360
Extra days if not take discount
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Working Capital - Interest
6. Monitoring and evaluating operating expenses, interest and taxes, and maintaining efficient payment patterns
Related debt utilization ratios:
Operating incomeTimes Interest Earned =
Interest expense
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Long-term financial planning
Why do we need long-term financial planning?To make sure that funds are available to support firm’s growth!
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Long-term financial planning
If the firms is not operating at full capacity find ways to use assets more efficiently
If the firm is operating at full capacity (maximum efficiency - no idle assets) increase investment in assets to support LT growth:
Current assets (cash, inventory, A/R ) Fixed assets (plant & equipment)
The financial manager must find additional funding sources to support assets growth and decide:
How much is needed? What sources of funding are available?
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Three sources of funds
1. “Spontaneous” liabilities:☺ Accounts payable☺ Accruals
2. Internally generated funds:☺ Addition to retained earnings
3. External funds (financing decision variables): ☺ Notes payable (credit line – short-term debt)☺ Long-term debt (issue new bonds, bank loan)☺ Common stock (issue new stock - equity)
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These liabilities usually increase as the firm buys more inventory and incurs additional expenses
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Pro-forma financial statements☺To determine if and how much
outside (external) funding is needed, financial managers construct pro-forma financial statements
☺We will use the percent of sales method to construct pro-forma financial statements
Textbook example: pages 142-147 (Coffy’s coffee Shop)
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Percent of sales method
Starting point: assume sales growth rate = g
Step 1:Each assets account on the balance sheet grows at the same rate as sales (g) Note: we assume that the growth rates of gross fixed assets, accumulated depreciation and net fixed assets are also g
Step 2:Each “spontaneous” liabilities account on the balance sheet grows at same rate as sales (g):
1. Accounts payable2. Accruals
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Percent of sales method
Step 3:
(3a) Compute the expected net income for the projected period
(3b) Find the addition to retained earnings:Addition to retained earnings =
net income – dividends
(3c) Use it to determine the retained earnings account on your pro-forma balance sheet: Retained earnings (t+1) =
retained earnings (t) + Addition to retained earnings
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Percent of sales method
Step 4:
Copy all the financing decision variables from the previous statement (BS):
1. Notes Payable
2. Long Term Debt
3. Common Stock
Result: Total Assets ≠ Total Liabilities & Equity
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Outside funds needed
Step 5: Holding the financing decision variables constant, calculate outside funds needed:
Outside Funds Needed (OFN)= Total Assets – Total Liabilities & Equity
Next Step: Determine financing sources1. Increase Notes Payable (ST debt)2. Borrow or issue new LT Debt3. Issue new stock (equity)
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Outside funds needed - Formula
An alternative way to calculate the OFN
Outside Funds Needed = + Change in Total Assets - Change in Spontaneous
Liabilities - Change in Retained Earnings
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Outside funds needed - Formula
Change in Total Assets =(total assets on current BS) x g
Change in Spontaneous Liabilities = (spontaneous liabilities on current BS) x g
Change in Retained Earnings = +[(1+ g) x sales on current IS] x (net profit margin)- planned dividend payment
Where g = sales growth rate
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Summary
Three main responsibilities of the financial manager:
☺Working capital management
☺Monthly cash budgeting
☺Long-term financial planning
☺Determine Outside Funds Needed (OFN) to support long term growth
☺Find funding sources