CH-5-8 Operating and Financial Leverage – Foundations of Financial Management : Chapter Notes

This Document Contains Chapters 5 to 8 Chapter 5 Operating and Financial Leverage Author's Overview Though the student has probably covered break-even analysis in other courses, the material in Chapter 5 offers an opportunity to more fully explore the financial effects of all forms of leverage on the firm. The contrast between aggressive and conservative approaches should be emphasized particularly through the useful technique of computing degrees of leverage. This chapter also serves as a good basis for much of the later discussion in the text on the cost of capital. The student begins to appreciate the positive benefits of debt, but also realizes that unlimited use of debt increases the financial risk of the firm and perhaps the cost of various other sources of financing. Learning Objectives 1. Calculate breakeven in units and in dollars. 2. Define leverage as a method to magnify earnings available to the firm’s common shareholders. 3. Define and calculate operating leverage and assess its opportunities and limitations. 4. Define and calculate financial leverage and assess its opportunities and limitations. 5. Calculate the indifference point between financing plans using EBIT/ EPS analysis. 6. Define and calculate combined leverage. Annotated Outline and Strategy I. Leverage: Fixed charge obligations may magnify the potential return to the firm. A. Operating leverage: Capital investments (recorded as assets) and the associated fixed costs (rent, amortization, property taxes, and executive salaries) reflecting operating leverage are tied to the business risks of the firm. B. Financial leverage: Capital structure with resulting interest costs from debt financing must be paid regardless of the level of sales or profits. C. The income statement can effectively illustrate where operating and financial leverage impact the firm’s performance. II. Break-Even Analysis and Operating Leverage A. Break-even analysis: A numerical and graphical technique used to determine at what point the firm will break even. 1. Break-even point: the unit sales where total revenue = total costs 2. Contribution margin (per unit): CM = P ─ VC (5-1; page 120) 3. Break-even point formula: (5-2; page 122) Perspective 5-1: The instructor can best establish factors related to break-even analysis by illustrating the operations of a highly leveraged firm versus a conservative one. The material is presented in Figure 5-1, Table 5-3, Figure 5-2, and Table 5-4. 4. It may be desirable to calculate the break-even point in sales dollars rather than in units. (See problems in text). Break-even sales may be calculated as follows: Where: TVC/ S = percentage relationship of total variable costs to sales. This is the contribution margin. B. Cash break-even analysis 1. Deducting non-cash fixed expenses such as amortization in the break-even analysis enables one to determine the break-even point on a cash basis. 2. Cash break-even point formula: (Page 126) 3. Although cash break-even analysis provides additional insight, the emphasis in the chapter is on the more traditional accounting-data related break-even analysis. C. Operating leverage: A reflection of the extent capital assets and fixed costs are utilized in the business firm. The employment of operating leverage causes operating profit to be more sensitive to changes in sales. 1. The use of operating leverage increases the potential return but it also increases potential losses. 2. The amount of leverage employed depends on anticipated economic conditions, nature of the business (cyclical or noncyclical), and the risk aversion of management. 3. The sensitivity of a firm's operating profit to a change in sales as a result of the employment of operating leverage is reflected in its degree of operating leverage. 4. Degree of operating leverage (DOL) is defined as the ratio of percentage change in operating income in response to percentage change in volume. (5-3; page 127) 5. The DOL may also be computed (focused on the income statement)using the formulation: (5-4; page 128) or: Where: EBIT = operating profit (earnings before interest and taxes) Q = quantity at which DOL is computed P = price per unit VC = variable cost per unit FC = fixed costs 6. DOL and other measures of leverage always apply to the starting point for the range used in the computation. PPT 16 of 29 Operating income or loss (Table 5-5) Perspective 5-2: DOL can easily be computed from the summary data on the leveraged and conservative firm. The summary data is presented in Table 5-5 and is drawn from previously mentioned Tables 5-3 and Table 5-4. 7. The normal assumption in doing break-even analysis is that a linear function exists for revenue and costs as volume changes. This is probably reasonable over a reasonable range. However, for more extreme levels of operations, there may be revenue weakness and cost overruns. Non-linearity may exist. PPT 17 of 29 Non-linear break-even analysis (Figure 5-3) III. Financial Leverage: A measure of the amount of debt used in the capital structure of the firm. A. Two firms may have the same operating income but greatly different net incomes due to the magnification effect of financial leverage. The higher the financial leverage the greater the profits or losses at high or low levels of operating profit, respectively. B. While operating leverage primarily pertains to the left-hand side of the balance sheet (assets and associated costs) and capital budgeting decisions, financial leverage deals with the right-hand side of the balance sheet (liabilities and net worth) and capital structure decisions. C. Financial leverage is beneficial only if the firm can employ the borrowed funds to earn a higher rate of return than the interest rate on the borrowed amount. The extent of a firm's use of financial leverage may be measured by computing its degree of financial leverage (DFL). The DFL is the ratio of the percentage change in net income (or earnings per share) in response to a percentage change in EBIT. Finance in Action: Leverage of 24 Times Equity Large profits in the banking industry are achieved with high debt to equity ratios of over 20 to 1. www.royalbank.com RY D. The DFL may also be computed utilizing the following formula: (5-5; page 126) or: (5-6; page 131) E. The DFL is associated with a specific level of EBIT and changes as EBIT changes. Perspective 5-3: The financial information for computing these measures is found in Table 5-5. The impact of financial leverage can also be viewed in Figure 5-4. PPT 20 of 29 Impact of financial plan on earnings per share (Table 5-6) PPT 22 of 29 Financing plans and earnings per share (Figure 5-4) F. The purpose of employing financial leverage is to increase return to the owners but its use also increases their risk. G. An indifference point, with respect to EPS impact, between two alternative financing plans can be calculated with the following formula: (5-7; Page 135) Where: EBIT* = operating income at the indifference point I = interest costs under plan A and B S = shares outstanding under plan A and B H. The use of financial leverage is not unlimited and will affect share value. 1. Interest rates that a firm must pay for debt financing rise as it becomes more highly leveraged. 2. As the risk to the shareholders increases with leverage, their required rate of return increases and share prices may decline. Finance in Action: Why Japanese Firms Tend to Be So Competitive Japanese firms must be competitive because of high operating and financial leverage. PPT 23 of 29 Financial leverage in selected industries (Figure 5-5) IV. Combined Leverage A. Combining operating and financial leverage provides maximum magnification of returns-it also magnifies the risk. Perspective 5-4: This is an excellent place to go directly to the income statement in Table 5-1 to illustrate what part of the income statement operating leverage controls and what part financial leverage controls and how the interaction provides combined leverage. The student should clearly see that operating income is the end result of operating leverage and the beginning factor for financial leverage (in the form of earnings before interest and taxes). These relationships are further enforced through Figure 5-6. PPT 25 of 29 Combining operating and financial leverage (Figure 5-6) B. The degree of combined leverage (DCL) is a measure of the effect on net income as a result of a change in sales. The DCL is computed similar to DOL or DFL (5-8; page 138) C. The DCL may also be found by multiplying DOL times DFL. DCL = DOL  DFL (5-9; page 138) D. The DCL may also be computed as follows: (5-10, page 139) or: PPT 26 of 29 Operating and financial leverage (Table 5-7) After the problems in Chapter 5, there are comprehensive review problems for Chapters 2 through 5. These problems cover ratio analysis, break-even analysis, operating and financial leverage, and an analysis of new funds required. Summary Listing of Suggested PowerPoint Slides PPT 7 of 29 Income statement (Table 5-1) PPT 11 of 29 Break-even chart: leveraged firm (Figure 5-1) PPT 10 of 29 Volume-cost-profit analysis: leveraged firm (Table 5-3) PPT 13 of 29 Break-even chart: conservative firm (Figure 5-2) PPT 12 of 29 Volume-cost-profit analysis: conservative firm (Table 5-4) PPT 16 of 29 Operating income or loss (Table 5-5) PPT 17 of 29 Non-linear break-even analysis (Figure 5-3) PPT 20 of 29 Impact of financial plan on earnings per share (Table 5-6) PPT 22 of 29 Financing plans and earnings per share (Figure 5-4) PPT 23 of 29 Financial leverage in selected industries (Figure 5-5) PPT 25 of 29 Combining operating and financial leverage (Figure 5-6) PPT 24 of 29 Operating and financial leverage (Table 5-7) PowerPoint Presentation The Chapter 5 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 29 frames. Chapter 6 Working Capital and the Financing Decision Author's Overview The chapter introduces the student to the topic of working capital management. The emphasis is on the build-up of current assets and how they can best be financed. McGraw-Hill illustrates that seasonal earning and sales go hand in hand. Companies in cyclical or seasonal industries have a more challenging job of managing their current assets. Such key topics as the impact of production on financing needs and the differences between temporary and permanent assets are considered. The cash flow cycle is discussed. Throughout the chapter, the instructor is operating within the framework of a risk-return tradeoff. Highly liquid assets minimize risk, but lower return; likewise, short-term borrowing is generally less expensive than long-term financing, but increases exposure to a tight money squeeze. The concept of hedging is introduced. Also, the relative costs and volatility of short and long-term financing are evaluated with an emphasis on the term structure of interest rates. The chapter provides the framework from which to move into the next two chapters, which cover the management of specific short-term assets and sources of short-term financing. Learning Objectives 1. Define working capital management. 2. Describe the effect asset growth has on working capital positions. 3. Identify working capital management considerations for permanent components, the impact of sales/ production schedules, and liquidity versus risk. 4. Identify the cash flow cycle of the firm. 5. Explain financing of assets in terms of hedging. 6. Describe the term structure of interest rates, explain the theories that suggest its shape, and assess how it can be of use to a financial manager. 7. Examine risk and profitability in determining the financing plan for current assets. Annotated Outline and Strategy I. Working Capital Management A. Working capital management entails arranging ST financing to facilitate investment in the firm’s current assets. B. Management of working capital is the financial manager's most time-consuming function. Finance in Action: Working Capital Is a Large Investment at Loblaw From the financial statements of a food distributor we note the dominance of working capital components in this operation. www.loblaw.com L C. Success in managing current assets in the short run is critical for the firm's long-run existence. D. Nature of asset growth 1. Changes in current assets may be temporary (seasonal) or ‘permanent.’ a. Current assets are expected to become cash in one operating cycle (self-liquidating). The level of the current assets may be ‘permanent’ or increasing. b. Businesses subject to cyclical sales may have temporary fluctuations in the level of current assets. PPT 7 of 39 The nature of asset growth (Figure 6-1) 2. Matching sales and production a. Both accounts receivable and inventory rise when sales increase as production increases. When sales rise faster than production, inventory declines and receivables rise. b. Level production (matching production and sales over an entire cycle) may cause large buildups in current assets when sales are slack. These buildups drop rapidly during peak demand periods since sales exceed the level production output. The following PowerPoint slides relate to the Yawakuzi example. PPT 12 of 39 Yawakuzi sales forecast (Table 6-1) PPT 13 of 39 Yawakuzi's production schedule and inventory (Table 6-2) PPT 14 of 39 Sales forecast, cash receipts and payments, and cash budget (Table 6-3) PPT 15 of 39 Total current assets, first year (Table 6-4) PPT 16 of 39 Cash budget & assets for second year with no growth in sales (Table 6-5) PPT 17 of 39 The nature of asset growth (Yawakuzi) (Figure 6 – 4) E. The cash flow cycle describes how funds move in and out of the firm and influences the firm’s liquidity. PPT 19 of 39 Cash conversion cycle (Figure 6-6) 1. Calculation of the cash conversion cycle is described as: Time in inventory + time for collection – time allowed for payables 2. This cycle can be described by the asset utilization formulas of chapter 3: Inventory holding period + average collection period – accounts payable period Finance in Action: Loblaw’s Cash Conversion Cycle Can Generate Cash Applying the formulas to Loblaw’s financial statements reveals at times a negative cash conversion cycle suggesting positive cash flow. www.loblaw.com II. Both seasonal and permanent increases in working capital must be financed. A. Ideally, temporary increases in current assets are financed by short-term funds and permanent current assets are financed with long-term sources. 1. Matching short-term funds with short-term assets allows the company to increase and decrease sources and uses of funds as the sales fluctuate. 2. Many firms, however, choose or are forced to use plans that do not match up financing with asset needs. 3. Financing a high percentage of short-term assets with long-term funds means the financial manager will have excess funds to invest at seasonal or cyclical troughs, in other words excess financing. PPT 23 & 24 of 39 Using long-term financing for part of short-term needs (Figure 6-9) and Using short-term financing for part of long-term needs (Figure 6-10) PPT 22 of 39 Matching long-term and short-term needs (Figure 6-8) 4. Financing permanent current assets and some long-term assets with short-term funds is quite risky because short-term funds will be permanently needed and thus cost is highly volatile and sources of short-term funds are not always available in tight credit markets. PPT 26 of 39 Decision tree and the financing decision (Figure 6-11) 5. Hedging is the matching of maturities of assets and liabilities to reduce risk. III. The term structure of interest rates indicates the relative cost of short and long-term financing and is important to the financing decision. A. The many possible sources of funds, with risk/ return considerations, are identified in figure 6-11. B. The relationship of interest rates at a specific point in time for securities of equal risk but different maturity dates is referred to as the term structure of interest rates. PPT 29 of 39 Yield curves showing term structure of interest rates (Figure 6-12) C. The term structure of interest rates is depicted by yield curves. D. There are three theories describing the shape of the yield curve. 1. Liquidity premium theory: the theory states that long-term rates should be higher than short-term rates because long-term securities are less liquid and more price sensitive. 2. Segmentation theory: the yield curve is ‘shaped’ by the relative demand for securities of various maturities. Some institutions such as commercial banks are primarily interested in short-term securities. Others such as insurance companies manifest a preference for much longer-term securities. 3. Expectations hypothesis: the expectations hypothesis says that long-term rates reflect the average of expected short-term rates over the time period that the long-term security is outstanding. E. Types of yield curves 1. Flat: short- and long-term rates are roughly equal. 2. Normal: upward sloping; shorter maturities have lower required yields. 3. Inverted: downward sloping: short-term rates higher than long-term rates. F. Yield curves shift upward and downward in response to changes in anticipated inflation rates and other conditions of uncertainty. IV. A Decision Process A. The composition of a firm's financing of working capital is made within the risk-return framework. 1. Short-term financing is generally less costly but more risky than long-term financing. PPT 30 of 39 Long-term and short-term interest rates (Figure 6-13) 2. During tight money periods, short-term financing may be unavailable or very expensive. Short-term rates are more volatile. B. Applying probabilities of occurrence of various economic conditions, an expected value of alternative forms of financing may be computed and used as a decision basis. V. Shift in Asset Structure A. Risk versus return considerations also affects the composition of the left-hand side of the balance sheet. B. A firm may compensate for high risk on the financing side with high liquidity on the asset side or vice versa. C. Since the early 1960's, business firms have reduced their liquidity as a result of: 1. Profit-oriented financial management 2. Better utilization of cash balances, through electronic funds transfer VI. Toward an Optimum Policy A. An aggressive firm will borrow short term and carry high levels of inventory and longer-term receivables. Panel 1 of Table 6-11 represents the firm’s position. B. The conservative firm (panel 4) will maintain high liquidity and utilize more long-term financing. C. Moderate firms compensate for short-term financing with highly liquid assets (panel 2) or balance low liquidity with long-term financing (panel 3). PPT 37 of 39 Current asset liquidity and asset financing plan (Table 6-11) Summary Listing of Suggested PowerPoint Slides PPT 7 The nature of asset growth (Figure 6-1) PPT 9 Sales and earnings for McGraw-Hill Ryerson, 2000 - 2010 (Figure 6-2) PPT 10 Current assets at McGraw-Hill Ryerson, 2000 - 2010 (Figure 6-3) PPT 12 Yawakuzi sales forecast (Table 6-1) PPT 13 Yawakuzi production schedule and inventory (Table 6-2) PPT 14 Sales forecast, cash receipts and payments, and cash budget (Table 6-3) PPT 15 Total current assets, first year (Table 6-4) PPT 16 Cash budget and assets for second year with no growth in sales (Table 6-5) PPT 17 The nature of asset growth (Yawakuzi) (Figure 6 – 4) PPT 19 Expanded cash conversion cycle (Figure 6-6) PPT 22 Matching long-term and short-term needs (Figure 6-8) PPT 23 & 24 Using long-term financing for part of short-term needs (Figure 6-9) and Using short-term financing for part of long-term needs (Figure 6-10) PPT 26 Decision tree and financing decision (figure 6-11) PPT 29 Yield curves showing term structure of interest rates (Figure 6-12) PPT 30 Long-term and short-term interest rates (Figure 6-13) PPT 32 & 33 Alternative financing plans (Table 6-7) and Impact of financing plans on earnings (Table 6-8) PPT 34 & 35 Expected returns under different economic conditions (Table 6-9) and Expected returns for high risk firm (Table 6-10) PPT 37 Current asset liquidity and asset financing plan (Table 6-11) PowerPoint Presentation The Chapter 6 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 39 frames. Chapter 7 Current Asset Management Author's Overview The instructor should stress the profitability-liquidity trade-offs to be found in the current asset accounts. The student should think of the less liquid current assets as representing a competitive investment for capital. The four different topics for discussion in the chapter are all worthy of detailed coverage. The material on cash management has real contemporary importance and is usually of interest to the student who has struggled with his or her own cash management. The management of accounts receivable and inventories represents an excellent opportunity to cover decision-making tools that are an important part of financial management. Learning Objectives 1. Extend Chapter 6 concepts of liquidity and risk to current asset management, recognizing that a firm’s investment in current assets should achieve an adequate return for its liquidity and risk. 2. Examine cash management as the control of receipts and disbursements to minimize nonearning cash balances while providing liquidity and compare techniques to make cash management more efficient. 3. Define the various marketable securities available for investment by the firm and calculate the yield on these instruments. 4. Characterize accounts receivable as an investment resulting from the firm’s credit policies, outline the considerations in granting credit, and evaluate a credit decision that changes credit terms to stimulate sales. 5. Assess inventory as an investment and apply techniques to reduce the costs of this investment. Annotated Outline and Strategy I. Cost - Benefit Analysis (illustrated on page 197, PPT 17 of 41) A. Provides a framework to identify and evaluate all changes resulting from a decision. B. Considers explicit, implicit and opportunity costs. II. Cash Management A. Cash is a necessary but low earning asset. B. Financial managers attempt to minimize cash balances, while maintaining sufficient amounts of cash to meet obligations in a timely manner. Tie in to cash flow cycle of chapter 6 and forecasting of chapter 4. C. The three main reasons for holding cash are for: 1. Transactions 2. Compensating balances 3. Precautionary needs D. Temporarily, excess cash balances are transferred into interest-earning marketable securities. Finance in Action: Why are Firms Holding Such High Cash Balances? Firms are holding historically high cash balances. Why? III. Collections and Disbursements A. The financial manager attempts to get maximum use of minimum balances by speeding up inflows and slowing outflows. B. Playing the float: Using the difference in the cash balances shown on the bank's records and those shown on the firm's records. PPT 12 & 13 of 40 The use of float to provide funds (Table 7-1) and Playing the float (Table 7-2) C. Improving collections for increased efficiency. 1. Decentralized collection centers speed collection of accounts receivable by reducing mailing time. 2. Lock-box system-customers mail payment to a post office box serviced by a local bank in their geographical area. Cheques are cleared locally and balances transferred by wire to a central location 3. Electronic transfer of funds-excess cash balances are transferred from collection points to a centralized location for use. The corporate treasurer can initiate this funds transfer. D. Remote disbursement to take advantage of slower mailing of cheques. E. The movement towards an electronic funds transfer, a system in which funds are moved between computer terminals without the use of a cheque. Additionally electronic data interchange (EDI) is growing rapidly as information and funds are bundled together for electronic transfer. The debit card has been well received. Perspective 7-1: The instructor may wish to use Figure 7-1 as an example of how funds are freed up. He or she can then apply a potential rate of return on these funds and relate that to the maximum cost that should be incurred. Cash management analysis is illustrated on page 197. PPT 17 of 40 PPT 16 of 40 Cash management network (Figure 7-1) F. International Cash Management 1. Multinational firms shift funds from country to country daily, maximizing returns and balancing foreign exchange risk. 2. The same techniques of cash management used domestically are utilized in the expanding international money markets but with additional risks. 3. Difference in time zones, banking systems, culture and other differences create a non-uniform system in some cases. 4. Over 9,000 financial institutional users, such as the International Stock Exchange in London, use SWIFT for standardized interbank electronic funds transfer, around the clock. IV. Marketable Securities A. Marketable securities normally represent temporary funds held in reserve and the maturity should be kept reasonably short to avoid interest rate risk. B. Many factors influence the choice of marketable securities: 1. Yield 2. Maturity (interest rate risk) 3. Minimum investment required 4. Safety 5. Marketability PPT 19 of 40 An examination of yield and maturity characteristics (Figure 7-2) C. Money market or short-term investments have several characteristics in common as identified on pages 199 - 200. Most often sold on a discount basis with yield calculated using formula: (7-1a; page 200) P = discounted price as % of maturity value d = number of days to maturity r = annualized yield An annualized effective yield calculation considering compounding is expressed by the formula: (7-1b; page 201) Perspective 7-2: The instructor can use Table 7-3 to highlight the attributes of the various securities and instruments, stressing the ever-changing nature of the market and competition between financial institutions. PPT 20 & 21 of 40 Hierarchy of money market instruments and rates (Table 7-3) and (Figure 7-3). D. There is a wide array of securities from which to choose. The base interest rate is the overnight or call money rate. Finance in Action: Treasury Bills, Not ABCP for Liquidity and Safety Treasury bill rates are compared in different countries www.bloomberg.com/markets/rates/index.html V. Management of Accounts Receivable A. Accounts receivable represent a substantial and growing investment in assets by a company. The primary reasons for the increases have been: 1. Increasing sales 2. Inflation 3. Extended credit terms during recessions B. Accounts receivable are an investment. PPT 24 of 40 Financing growth in accounts receivable (Figure 7-4) 1. Investment in accounts receivable should generate a return equal to or in excess of the return available on alternative investments. Perspective 7-3: Discuss a credit decision relating the sales function to the credit created by the new accounts. Stress that the emphasis should be on the rate of return! Finance in Action: Vendor Financing at RIM RIM’s use of vendor credit through accounts receivable and the significant impact on the balance sheet is highlighted. www.rim.com C. There are three primary variables for credit policy administration. 1. Credit standards a. The firm screens credit applicants on the basis of prior record of payment, financial stability, current net worth, and other factors. b. The four C’s of Credit are a useful framework: character (willingness to repay), capacity (ability to repay), capital, and conditions. c. Many sources of information serve as a basis for credit evaluation. i. D&B’s Reference and individualized reports ii. Industry credit reporting agencies (Equifax Canada) iii. Local credit bureaus iv. Sales reports and visits to the customer’s place of business v. Customer financial statements vi. Financial institutions vii. Other suppliers and industry contacts 2. Terms of trade a. Discounts b. Credit period 3. Collection policy: Some measures used to assess collection efficiency are: a. Average collection period b. Ratio of bad debts to sales c. Aging of accounts receivable D. An actual credit policy decision. Text examples on pages 208 to 211. PPT 26 of 40 An actual credit decision VI. Inventory Management A. Inventory is the least liquid of current assets. B. Inventory is a significant investment for the firm. There is a relationship between the inventory holding period (chapter 3), COGS and inventory levels. C. A firm's level of inventory is largely determined by the cyclicality of sales and whether it follows a seasonal or level production schedule. The production decision is based on the trade-off of cost savings of level production versus the additional inventory carrying costs. D. Rapid price movements complicate the inventory level decision. One way of protecting an inventory position is by hedging with a futures/commodities contract. E. There are two basic costs associated with inventory: 1. Carrying costs: a. Interest on funds tied up in inventory b. Warehouse space costs c. Insurance d. Material handling expenses e. Risk of obsolescence (implicit cost) 2. Ordering and processing costs F. Carrying costs vary directly with average inventory levels. G. Total carrying costs increase as the order size increases. H. Total ordering costs decrease as the order size increases. (7-3; page 213) I. The first step toward achieving minimum inventory costs is determination of the optimal order quantity. This quantity may be derived by use of the economic order quantity formula: (7-2; page 213) PPT 30 of 40 Determining the optimum inventory level (Figure 7-5) Perspective 7-4: Combine the EOQ formula with Figure 7-5 to clearly illustrate the impact of selecting the optimum order size. J. Assumptions of the basic EOQ model: 1. Inventory usage is at a constant rate. 2. Order costs per order are constant. 3. Delivery time of orders is consistent and order arrives as inventory reaches zero. K. Minimum total inventory costs will result if the assumptions of the model are applicable and the firm's order size equals the economic ordering quantity. L. The EOQ model has also been applied to management of cash balances. The opportunity cost (lost interest on marketable securities) of having cash is analogous to the carrying costs of inventory. Likewise, the transactions cost of shifting in and out of marketable securities is very similar to inventory order costs. M. Stock outs and safety stock 1. A stock out occurs with missed sales because a firm is out of inventory items. 2. A firm may hold safety stock, inventory beyond the level determined by the EOQ model, to reduce the risk of losing sales. Safety stock hedges against stock outs caused by delayed deliveries, production delays, equipment breakdown, unexpected surges in sales, etc. 3. Safety stock will increase a firm’s average inventory and carrying costs. Average inventory = EOQ/ 2 + safety stock Carrying costs = average inventory units x carrying costs per unit 4. Ideally, the additional carrying costs from having safety stock is offset by eliminating lost profits on missed sales and/or maintenance of good customer relations. N. Just-in-Time Inventory Management 1. Just-in-time inventory management (JIT) seeks to minimize the level of inventory within a highly effective quality control program. 2. Suppliers are located near manufactures that are able to make orders in small lot sizes because of short delivery time. 3. The JIT process has enabled firms to reduce their number of suppliers, reduce ordering complexity, and enhance quality control. 4. JIT has resulted in various cost savings. a. Lower carrying costs. b. Lower investment in space and, therefore, lower costs of construction, utilities, and manpower. c. Lower clerical costs (computerized tracking systems). d. Lower defects and waste-related costs. Finance in Action: Just-in-Time for Money and Inventory Control JIT money transfer systems for global trade and RFID inventory control systems are discussed. Summary Listing of Suggested PowerPoint Slides PPT 12 & 13 The use of float to provide funds (Table 7 – 1) and Playing the float (Table 7 – 2) PPT 16 Cash management network (Figure 7 – 1) PPT 17 Cash management analysis PPT 19 An examination of yield and maturity characteristics (Figure 7 – 2) PPT 20 Hierarchy of money market instruments and rates (Table 7 – 3) PPT 21 Hierarchy of money market rates (Figure 7 – 3) PPT 24 Financing growth in accounts receivable (Figure 7 – 4) PPT 26 An actual credit decision PPT 30 Determining the optimum inventory level (Figure 7 – 5) PowerPoint Presentation The Chapter 7 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 40 frames. Chapter 8 Sources of Short-Term Financing Author's Overview The instructor has the opportunity to cover the various sources of short-term financing with an eye toward the borrower's size and the relative cost of doing business. Since banking is such a rapidly changing area, the instructor may wish to highlight some of the changes that are taking place. The student should also get some exposure to the various considerations in computing interest costs. The bank rate and its determination is of interest to students. Throughout the chapter, there are ample opportunities to indicate the advantages and drawbacks of trade credit, bank credit, commercial paper, foreign borrowing and collateralized borrowing arrangements. Finally a brief coverage of hedging and the financial futures market will allow the student to appreciate these markets as protective devices against volatile interest rates. Learning Objectives 1. Characterize trade credit as an important form of short term financing and calculate its cost to the firm if a discount is forgone. 2. Describe bank loans as self-liquidating, as short-term and as having their interest rate tied to the prime rate. Also calculate interest rates under differing conditions. 3. Describe commercial paper as a short-term, unsecured promissory note of the firm. 4. Review borrowing in foreign markets as a cost-effective alternative for the firm. 5. Explain that offering accounts receivable and inventory as collateral may lower the interest costs on a loan. 6. Demonstrate the hedging of interest rates to reduce borrowing risk. Annotated Outline and Strategy I. Trade Credit PPT 7 of 23 Structure of corporate debt, 2011 (Figure 8-1) A. Usually the largest source of short-term financing B. A spontaneous source of financing that increases as sales expand or contract. For example, if the annual purchase of inventory items is $3,650,000, and present payables policy is 20 days, average accounts payable position is: $3,650,000 / 365 × 20 = $200,000 If policy is changed to 30 days, the accounts payable position is increased to $300,000, an increase on an average daily basis in sources of funding of $100,000. C. Credit period is set by terms of credit but firms may be able to "stretch" the payment period. D. Cash discount policy 1. Suppliers may provide a cash discount for early payment. A 3/15, net 60 policy allows a buyer to deduct 3% from the billed charges if payment is made within 15 days. If not, the purchaser is expected to pay by the 60th day. 2. Forgoing discounts can be very expensive. The cost of failing to take a discount is computed as follows: (8-1; page 228) d% = discount percentage f (date) = final payment period d (date) = discount period 3. Whether a firm should take a discount depends on the relative costs of alternative sources of financing. E. Net Credit Position 1. The relationship between a firm's level of accounts receivable and its accounts payable determines its net credit position. 2. If the firm's average receivables exceed average payables, it is a net provider of credit. If payables exceed receivables, the firm is a net user of trade credit. Finance in Action: CN Rail Maintains a Negative Trade Credit Position CN Rail’s working capital position is enhanced by relying on significant amounts of trade credit. www.cn.ca II. Bank Credit A. Banks prefer short-term, self-liquidating loans B. Bank loan terms and concepts 1. Prime rate: The interest rate charged the most credit-worthy borrowers. a. The prime rate serves as a base in determining the interest rate for various risk classes of borrowers. b. The prime rate of banks receives much attention from government officials in managing the economy. c. The prime rate has been more volatile in the last couple of decades than in previous decades. PPT 12 of 23 Prime interest rate movements (Figure 8-2) d. The London Interbank Offer Rate (LIBOR) is being used worldwide as a base lending rate on dollar loans. 2. Fees and compensating balances a. As a loan condition, a borrower may be required to maintain an average minimum account balance in the bank equal to a percentage of loans outstanding or a percentage of future commitments and/or pay a fee for services. b. Compensating balances raise the cost of a loan and compensate the bank for its services. c. If a compensating balance is required, the borrower must borrow more than the amount needed. Amount borrowed = amount needed / (1 – C) Where C = compensating balance in percent 3. Maturity provisions a. Most bank loans are short-term and mature within a year. b. In the last decade more banks have extended intermediate-term loans (one to seven years) that are paid in installments. 4. Costs of commercial bank financing a. The annual interest rate depends on the loan amount, interest paid, length of the loan, and method of repayment. Perspective 8-2: The instructor should review formulas 8-2 through 8-6 with the students. The discussion can include a comparison of the annual costs of a loan under varying assumptions. Many students have borrowed money for college expenses or auto loans so they can readily relate to the calculations. (Pages 233-235) The introduction on page 227 may assist for the overall concept of loan rates. C. Bank credit availability tends to cycle 1. Credit crunches seem to appear periodically. Witness 2007/08 and repeats! 2. The pattern of the credit crunch has been as follows: a. The Bank of Canada tightens the money supply to fight inflation or financial institutions overextend themselves (2008). b. Lendable funds shrink, interest rates rise. c. Business loan demand increases due to price-inflated inventories and receivables. d. Depositors withdraw savings from banks seeking higher return elsewhere, further reducing bank credit availability. 3. The Bank of Canada’s policy of attempting to influence the level of the Canadian dollar closely ties Canadian interest rates to United States economic developments. III. Commercial Paper A. Short-term, unsecured promissory notes issued to the public in minimum units of $50,000. Finance in Action: Bank Loan, Commercial Paper, Accounts Payable or Securitization of Receivables Accounts receivable and inventory positions are financed by a mix from various sources. www.canadiantire.com www.cn.ca www.bmo.com B. Issuers 1. Finance companies such as Household Finance Corporation that issue paper directly. Such issues are referred to as finance paper or direct paper. 2. Industrial or utility firms that issue paper indirectly through dealers. This type of issue is called dealer paper. C. There has been very rapid growth in the commercial paper market in the last few decades. Many major corporations in Canada that are issuers. Securitized paper has become increasingly significant. PPT 17 of 23 Corporate short-term paper outstanding (Figure 8-3) D. Traditionally, commercial paper has been a paper certificate issued to the lender to signify the lender's claim to be repaid. There is a growing trend among companies that sell and buy commercial paper to handle the transaction electronically. Actual paper certificates are not created. Documentation of the transactions is provided by computerized book-entry transactions and transfers of money are accomplished by wiring cash between lenders and commercial paper issuers. E. Advantages 1. Commercial paper may be issued at below the prime rate at chartered banks. PPT 18 of 23 Comparison of commercial paper rate to bank prime rate (Figure 8-4) 2. No compensating balances are required, though lines of credit are necessary. 3. Prestige F. The primary limitation is the increased risk of the commercial paper market as demonstrated when Confederation Life, Olympia and York or Coven tree Capital defaulted. IV. Bankers Acceptances A. Short term promissory notes to finance goods in transit, particularly foreign related trade with payment guaranteed by a bank. V. Foreign Borrowing A. The Eurocurrency market is an increasing source of funds for Canadian firms. B. These loans are usually short to intermediate term in maturity. C. Borrowing in foreign currencies subjects the borrower to foreign exchange risk. VI. The Use of Collateral in Short-Term Financing A. The lending institution may require collateral to be pledged when granting a loan. Lines of credit may be secured or unsecured. B. Lenders lend on the basis of the cash-flow capacity of the borrower. Collateral is an additional but secondary consideration. C. Accounts receivable financing. 1. Pledging accounts receivable as collateral a. Convenient means of financing. Receivables levels are rising as the need for financing is increasing. b. May be relatively expensive and preclude use of alternative financing sources. c. Lender screens accounts and loans a percentage (60% – 75%) of the acceptable amount. d. Lender has full recourse against borrower. e. The interest rate, which is usually in excess of the prime rate, is based on the frequently changing loan balance outstanding. 2. Factoring Receivables a. Receivables are sold, usually without recourse, to a factoring firm. b. A factor provides a credit-screening function by accepting or rejecting accounts. c. Factoring costs. i. Commission of 1% – 3% of factored invoices ii. Interest on advances Finance in Action: Liquid Assets as Collateral – It Goes Down Well All sorts of assets are being used as collateral for short and intermediate credit. A chain of pubs in England ‘securitizing’ its suds, David Bowie his royalties or Sears its credit card receipts. 3. Asset-backed securities a. Public offerings of securities backed by receivables as collateral, is employed as a means of short-term financing. These have included mortgages, car loans and credit card receivables. Credit ratings often are better than the issuing firm (Sears, for example). b. Several problems must be resolved: i. Image: Historically, firms that sold receivables were considered to be in financial trouble. ii. Computer upgrading to service securities. iii. Probability of losses on default of underlying securities VII. Inventory Financing A. The collateral value of inventory is based on several factors. 1. Marketability a. Raw materials and finished goods are more marketable than goods-in-process inventories. b. Standardized products or widely traded commodities qualify for higher percentage loans. 2. Price Stability 3. Perishability 4. Physical Control a. Blanket inventory liens: Lender has general claim against inventory of borrower. No physical control. b. Trust receipts: Also known as floor planning; the borrower holds specifically identified inventory and proceeds from sale in trust for the lender. c. Warehousing: Goods are physically identified, segregated, and stored under the direction of an independent warehousing company. Inventory is released only upon presentation of warehouse receipt controlled by the lender. i. Public warehouse: facility on the premises of the warehousing firm. ii. Field warehouse: independently controlled facility on the premises of borrower. B. Inventory financing and the associated control methods are standard procedures in many industries. VIII. Hedging to Reduce Borrowing Risk A. Firms that continually borrow to finance operations are exposed to the risk of interest rate changes. Perspective 8-3: Hedging, and the use of derivative products, is always a hot topic in finance. Although at this point the student may lack the background to appreciate an in depth discussion, the general concept of hedging can be explained through the use of the example in the text. B. Hedging activities in the financial futures market reduce the risk of interest rate changes. Finance in Action: Montreal Exchange Opts for Futures The Montreal Futures Exchange (m-x.ca) specializes in derivatives in competition with the Chicago Mercantile Exchange. Stock trading takes place on the Toronto Stock Exchange (TMX). Summary Listing of Suggested PowerPoint Slides PPT 7 Structure of corporate debt, 2003 (Figure 8-1) PPT 12 Prime interest rate movements (Figure 8-2) PPT 17 Corporate short-term paper outstanding (Figure 8-3) PPT 18 Comparison of commercial paper rate to bank prime rate (Figure 8-4) PowerPoint Presentation The Chapter 8 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 23 frames. Instructor Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen, Doug Short, Michael Perretta 9780071320566, 9781259268892, 9781259261015