B4 Flashcards

8/8/2019 B4 Flashcards

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Value chain analysis Idea was first suggested by Michael Porter in 1985.It assesses how the perceived value of the customer grows along thechain of activities that the firm goes through to bring its product to themarketplace.

Two major categories of business value activities exist:

Primary activities Activities involved with the direct manufacture ofproducts, the delivery of the products through distribution channels, andthe support of the product that exists after the sale is made. (e.g.

handling the raw materials, the manufacturing process, taking productorders, advertising and servicing the product.)

Secondary activities Activities that are performed by the support staff ofan organization (e.g. accounting, finance, purchasing of supplies andmaterials).

Shanks and Govindarajans work in 1993 indicated that the firm itselfis a part of the overall value chain of the industry. In this view, thevalue starts with the suppliers who provide the raw material for theproduction process, continues with the firm and its strategic plan,continues further with the value created by the customers, and thenends with the disposal and recycling of the materials.

When firms must assess every part of the value chain to allow them toprovide their customers with maximum value, they must determine theparts of the value chain that will provide them with the largest amount ofcompetitive advantage. There are three major forms:

Internal cost analysis The sources of profit and costs of the internalactivities within the firm must be analyzed.

Internal differentiation analysis The firm may analyze its ability to createvalue through differentiation when the customer perceives that the firms

product is superior to those of its rivals.

Vertical linkage analysis See Index Card

Vertical linkage analysis It means understanding the activities ofthe suppliers and buyers of the product and determining where valuecan be created external to the firms operations.

The greatest competitive advantage stems from the informationobtained from this analysis because of the activities that create themost and least amount of value can be determined.

Steps in the Value Chain Analysis include:

1) Identify value chain activities (Value activities are generalthose processes that are involved with designing,preparing, manufacturing, and delivering a good orservice.)

2) Identify cost drivers associated with each activity.

3) Develop a competitive advantage by reducing cost oradding value.

- Costs leadership strategies will look at cost saving

opportunities.- Differentiation strategies will look at opportunitiesfor innovation.

The three framework strategies in a value chain analysis include:1) Industry structure analysis2) Core competencies analysis3) Segmentation analysis


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Industry structure analysis Michael Porters work in 1980 and1985 identified five forces that influence profitability for the firm,and thus, impact the competitive environment of a firm. Thesefive forces include:

1) Barriers to market entry2) Market competitiveness3) Existence of substitute products

4) Bargaining power of the customers5) Bargaining power of the suppliers

Core competencies analysis It provides answer to why one firm isable to create, attain, and sustain new types of competitiveadvantage and profits while another firm always seems to follow orwhy some firms are always able to come up with the bestinnovations while others attempt to copy them. It also attempts toreveal what it is within the firm that enables it to create advantage.

Core competencies are the glue that allows a firm to work as ateam and to transfer good ideas from one product or segment of abusiness to another.

A competency is deemed a core competency if it has the ability to:

1) Reduce the threat that competitors may copy theproduct,

2) Increase perceived customer value, and3) Provide leverage (i.e. Can a large amount of markets be

assessed?)

Segmentation analysis When vertical integration exists within afirm (it is involved in almost every aspect of the firms value chain,from supplying the raw materials to distributions to the ultimateconsumer) and when analysis of the industry structure and the corecompetencies varies among the activities in the value chain,segmentation analysis, which takes a look at the competitiveadvantages that exist in the various segments, is often helpful.

When various parts of the value chain exist in different parts of the world,this often poses problems of costs of transportation and lack of control

and communication, which can negatively impact the overall customervalue. Porter indicated four major factors that impact global competitiveadvantage (GCA):

1) Conditions of the factors of production If the nation has astrong set of production (e.g. skilled labor force), it will fare betterwith regard to GCA.

2) Conditions of domestic demand If the nations domesticdemand for the product is high, the nation will fare better withregard to GCA.

3) Related and supporting industries If suppliers or materialinputs exist within the nation, it may help the nation fare better

with regard to GCA.4) Firm strategy, structure, and rivalry The practices of a

nation with respect to how companies are managed andorganized, along with the laws of the nation that regulate the

The SCOR Model assists a firm in mapping out its true supply chainand then configuring it to best fit the needs of the firm and consistsof four-key management processes. They are:

1) Plan Consists of developing a way to properly balanceaggregate demand and aggregate supply within the goals andobjectives of the firm and plan for the necessaryinfrastructure.

2) Source Procure the resources required to meet it and tomange the infrastructure that exists for the sources.

3) Make Includes all activities that turn the raw materials intofinished products that are produced to meet a planneddemand.

4) Deliver Includes all activities of getting the finished productinto the hand of the ultimate consumers to meet theirplanned demand.


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formation of companies and how intense the rivalry is withrespect to competing firms within the nation.

Integrated Enterprise Management will move away fromsimple consolidation of its operations to an internally-integrated

supply chain, which all work together with cross-functionalpurposes (rather than simply cross-functional communications)towards the main business issue of the cost of customer service.

It is essential that the people involved are able to work well as ateam and eliminate bias so that they are all aligned with the goalsof the firm. The firm will focus on the total cost of delivery, beingprofitable, and responding to customer needs.

Extended Supply Chain If integration of the supply chain moves

external to the firm, firms may see potential for increased profits byunifying the supply chain and forming mutual objectives. The needfor those involved to be able to work as a unified team without biasis even more essential, as this process strives to integrate the supplychains of many operations, not just those internally.

Benefits of implementing supply chain management include:

1) Reduced costs in inventory management2) Reduced costs in warehousing3) Optimization of the distribution network and facility

locations4) Enhanced revenues5) Improved service times6) Strategic shipment consolidation7) Reduced cost in packaging8) Improved delivery times9) Integration of suppliers10)Management of suppliers

General steps in implementing integrated supply chain management:

1) Assess the opportunities in the supply chain2) Develop a vision for ISCM3) Develop a strategy for ISCM4) Create an optimum organization structure for ISCM5) Establish an information and communication network for ISCM6) Translate the ISCM strategy into actions


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A firm must be able to manage its supply chain in way that isaligned with its business strategy, which is directed at serving theneeds of the consumers of the firms products.

The supply chain of a firm must be both responsive to thechanging needs of customers and allow the firm to do so in an

efficient manner. This is essentially the ability of the firm toincrease its market share and protect profits.

The five supply chain drivers are:

1) Production2) Inventory3) Location4) Transportation5) Information

Currency option hedges use the same principles as forward hedge

contracts and money market transactions. However, instead ofrequiring a commitment to a transaction, the currency optionhedge give the business the option of executing the optioncontract or purely settling its originally negotiated transactionwithout the benefit of the hedge, depending on which result ismost favorable.

A call option is an option to buy. It is used to mitigate thetransaction exposure associated with exchange rate risk forpayables.

Generally, if the option price is less than the exchange rate at thetime of settlement, the business will exercise its option. If the optionprice is more than the exchange rate at the time of settlement, thebusiness will allow the option to expire.

While premiums are used to compute any net savings associatedwith option transactions, they are a suck cost and are irrelevant tothe decision to exercise the options.

A put option is an option to sell. It is used to mitigate thetransaction exposure associated with exchange rate risk forreceivables.

Generally, if the option price is more than the exchange rate atthe time of settlement, the business will exercise its option. If theoption price is less than the exchange rate at the time ofsettlement, the business will allow the option to expire.

While premiums are used to compute any net savings associatedwith option transactions, they are a suck cost and are irrelevant to

the decision to exercise the options.

The nominal cost of hedging a foreign currency is the knownexchange rate for the currency times the underlying.

Example: Assume the cost of the Canadian dollar is $.75. Thenominal cost of hedging C$1,000,000 is known to be $750,000.

The nominal cost of hedging a foreign currency represents theexpected value of a transaction settlement given a range ofexchange rates and associated probabilities.


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The real cost of hedging payables is expressed in the followingformula:

RCH = NCH - NC

Terms are defined below:RCH - Real cost of hedging payablesNCH - Nominal cost of hedging payablesNC - Nominal cost of payables without hedging

Negative results indicate the business should enter into a hedgetransaction, while positive results indicate that the businessshould not hedge the transaction.

The real cost of hedging receivables is expressed in the followingformula:

RCH = NR - NRH

Terms are defined below:RCH - Real cost of hedging receivablesNR - Nominal domestic revenues received without hedgingNRH - Nominal domestic revenues received from hedging

Negative results indicate the business should enter into a hedgetransaction, while positive results indicate that the business shouldnot hedge the transaction.

Limitation of hedging are:

1) Uncertainty To avoid the potential of overhedging, thecompany should only hedge the minimum amount knownto be due or payable.

2) Continual short-term hedging Consistent short-termhedging can be ineffective over time because it mirrors thecurrent trends of the market.

Long-term forward contracts They deals with the same issuesas any other forwards contracts. Long-term forward contracts areset up to stabilize transaction exposure over long periods. Long-term purchase contracts may be hedged with long-term forwardcontracts.

Parallel Loan -Two firms may mitigate their transactionexposure to long-term exchange rate loss by exchanging orswapping their domestic currencies for a foreign currency andsimultaneously agreeing to re-exchange or repurchase theirdomestic currency at a later date.

Other techniques for transaction exposure mitigation (alternativehedging techniques) include:

1) Leading and lagging2) Cross-hedging Involves those transactions that cannot be

hedged. Hedging one instruments risk with a differentinstrument by taking a position is a related derivativescontract.

3) Currency diversification Simplest hedge for long-termtransactions. Diversify foreign currency holdings over time.


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Economic Exposure It is defined by the degree to which cashflows of the business can be impacted by fluctuations in exchangerates. The extent to which revenues and expenses aredenominated in different currencies could seriously impact theprofitability of an organization and represents economic exposure.

Economic exposure typically relate to organization-wide issues and canusually only be mitigated with organization-wide approaches with involverestructuring and adjustments to the business plan.

Restructuringa) Decrease in sales A company fearful of depreciating foreign

currency used by a foreign subsidiary may elect to reduce foreignsales to preserve cash flows.

b) Increase in expenses A company anticipating a depreciating

foreign currency may elect to increase reliance on those suppliers totake advantage of paying for raw materials or supplies with cheapercurrency.

Restructuring tends to be more difficult than ordinary hedges. Economicexposures to exchange rate fluctuations are viewed as more difficult tomanage than transaction exposures.

Very little can be done to mitigate the generalized risk ofoperating within a foreign economy and to changes in the political

climate. However, international companies can perform a countryrisk analysis to fully assess the degree of their exposure.

Unsatisfactory evaluation of country risk could either result indivestiture of foreign operations or avoidance of development offoreign operations in a particular country.

Country risk analysis for foreign economy considerations include:

1) Foreign demand Weakening demand may cause the foreigngovernment to implement tariffs or other regulatory

measures that reduce foreign penetration.2) Interest rates High interest rates indicate slower economic

growth and reduced demand. Low interest rates may beindicative of increased growth and demand.

3) Inflation Higher local inflation and reduced purchasingpower makes imported goods more expensive and reduceslocal demand for them.

4) Exchange rate Weak local currency reduces demand forimported goods. Strong local currency increases demand forimported goods.

Country risk analysis for political risk considerations include:

1) Bureaucracies and related inefficiencies or barrier to trade2) Corruption3) Host government attitude toward foreign firms4) Attitude of consumers toward foreign firms5) Inconvertibility of foreign currency6) War


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CAAT Auditors can use manual audit procedures, computer-assisted audit techniques (CAAT), or a combination of both.

In either event, because the reliability of automated systems ishighly dependent on the adequacy of control design andexecution, it is critical that the auditor gains a thoroughunderstanding of the structure and usage of the computerizedcontrol system through inquiry and observation.

CAAT

Transaction tagging A technique the auditor uses to

electronically mark (or tag) specific transactions and to followthem through the clients system. It tests both the computerizedprocessing and the manual handling of the transactions.

Embedded audit modules (EAM) EAMs are sections of theapplication program code that collect transaction data for theauditor. They are most often built into an application program whenthe program is developed.

CAAT

Test Deck (Test Data) A technique that uses an applicationprogram to process a set of test data, the results of which arealready known. The clients system is used to process theauditors data off-line. An advantage of this technique is that livecomputer data is not affected in any way.

Integrated Test Facility A technique similar to the test dataapproach that the test data is commingled with live data. Theclients system is used to process the auditors data online. Thetest data must be separated from the live data before the reportsare created. Client personnel are not informed that the test isbeing run.

CAAT

Parallel Simulation A technique where the auditor reprocessessome or all of the clients live data using a copy of the clientssoftware controlled by the auditor and then compares the resultswith the clients files.

With controlled reprocessing:- The auditor observes the actual processing and comparesthe actual results to the expected results.- The auditor uses an archived copy of the program inquestion (generally the auditors control copy) to reprocesstransactions. The results are then compared to the resultsfrom the normal processing run.- Differences indicate that there have been changes to theprogram.


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CAAT Parallel Simulation cont.

Source code comparison programs Programs that comparetwo versions of software to determine if they match. This type ofsoftware can be used to look for unauthorized changes.

Types of software Programs to accomplish parallel processingcan be:

- Developed for the application- Bought as a packaged program or utility- Produced by a generalized audit software package

Generalized audit software packages (GASPs) - Allow theauditor to perform tests of controls and substantive tests directly onthe clients system. The auditor first defines the clients system tothe GASP and then specifies the tests and selections of data to bemade. The GASP generates the programs necessary to access thefiles and extract and analyze the data.

Tasks typically performed by GASPs include:

1) Examining transactions for control compliance2) Selecting items meeting specified criteria3) Recalculating amounts and totals4) Reconciling data from two separate files5) Performing statistical analysis on transactions

Advantages of using GASPs include:

1) GASPs allow the auditor to sample and test a much higherpercentage of transactions, which results in a more reliableaudit

2) GASPs require little technical knowledge3) After the initial use, GASPs can significantly reduce audit time

without sacrificing quality.


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Perfect Competition

- Many firms in the industry- Highly competitive- Size of firm relative to industry is small- No barriers to entry- All firms sell the same commodity product- Perfectly elastic (Firm sells as much, or as little, as it wants atthe given market price)

- Firm has control over quantity produced only; price is set bythe market, firm must accept the market price- Pricing strategy: Accepts market price; can only adjustproduction so that P=MR=MC- Long run profitability: Zero economic profit

Monopolistic Competition

- Many firms in the industry- Highly competitive- Size of firm relative to industry is small- Low barriers to entry- Firms sell slightly different products that are close substitutes- Highly elastic but downward sloping (Firm can adjust quantity ofproducts sold without affecting the price very much)

- Firm has control mostly over quantity produced; price is mostlyset by the market- Pricing strategy: Searches for best price to maximize profitsP>MR=MC in the short run- Long run profitability: Zero economic profit

Oligopoly

- Few firms in the industry- Moderately competitive- Size of firm relative to industry is large

- High barriers to entry (Difficult to enter industry because ofeconomies of scale)- Firms usually sell differentiated products- Inelastic (Firms face a kinked downward-sloping demandcurve)- Firm has control over both quantity produced and the pricecharged- Pricing strategy: Does not engage in price competitionP>MR=MC- Long run profitability: Positive economic profit

Monopoly

- Only one firm in the industry- No competition- Size of firm relative to industry is 100% of industry

- Barriers to entry: Insurmountable (No entry is possible)- One firm sells only one product- Inelastic (Firms faces the entire demand curve for the product,which slopes downward)- Firm has control over both price and quantity- Pricing strategy: Searches for optimum price P>MR=MC in theshort and long run- Long run profitability: Positive economic profit

General Partnership

- Can be formed by verbal or written agreement, or mereconduct- Unlimited personal liability for all partnership obligations- Owners manage directly or can agree to appoint managingpartner- Partners cannot transfer ownership interest withoutunanimous consent- Flow through taxation

Limited Partnership

- File Certificate of Limited Partnership with state- Liability of Owners

- General Partnership: Unlimited Personal Liability- Limited Partnership: Only investment is at risk

- Management- General Partners are exclusive managers- Limited Partners cannot manage

- Partners (whether general or limited) cannot transferownership interest

without unanimous consent- Flow through taxation (but limited partners have passive

loss restrictions)


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Corporation

- File Articles of Incorporation or Corporate Charter with state- Shareholders generally not personally liable beyond their

investment- Managed by Board of Directors, who appoint officers to run

day-to-dayoperations

- Shareholders are free to transfer ownership interest unlessthey agree

otherwise- Income taxed at corporate level and taxed again toshareholders whendividends are distributed

Subchapter S Corporation

- File Articles of Incorporation or Corporate Charter and File SElection

- Shareholders generally not personally liable beyond theirinvestment

- Managed by Board of Directors, who appoint officers to runday-to-day

operations- Shareholders are free to transfer ownership interest unless theyagree

Otherwise; but cant transfer to foreign or entity shareholders- Owners manage directly or can agree to appoint managingpartner

- Flow through taxation (but shareholders not managing havepassive loss

restrictions)


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Limited Liability Company (LLC)

- File Articles of Incorporation with state- Shareholders generally not personally liable beyond their

investment- Members manage directly or can agree to appoint a

manager- Absent agreement otherwise, members cannot transferownership interest without unanimous consent

- Flow through taxation (but members not managing havepassive lossrestrictions)

Limited Liability Partnership (LLP)

- File Statement of Qualification with state- Partners are generally not liable for partnership obligations,

unless caused bytheir own negligence

- Partners manage directly or can agree to appoint a managingpartner

- Partners cannot transfer ownership interest without unanimous

consent- Flow through taxation (but partners not managing havepassive loss

restrictions)


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Accounting Rate of Return (ARR) is the same as Return on Investment(ROI).

On the CPA Exam, if the information is given, use the averageinvestment in the denominator.

ARR = Increase in expected average annual net incomeNet initial investment

ARR is similar to the internal rate of return (IRR) in that both calculate arate-of-return percentage.

ARR Uses operating income after accrualsIRR Uses cash flows and time value of money

* The main difference is depreciation of the investment asset.

Advantages of ARR

- Simple and easy to use- Total project profitability is considered (unlike thepayback method)

Disadvantages of ARR- Ignores the time value of money

If income tax considerations are ignored, how is depreciationhandled by the following capital budgeting techniques?

Internal Rate of Return Accounting Rate of ReturnPayback

Excluded IncludedExcluded

The formula notation for the cost of retained earnings is the symbol kre.

A firm should earn at least as much on any earnings retained and reinvestedin the business as stockholders could have earned on alternativeinvestments of equivalent risk. This return is represented by the cost ofretained earnings, kre.

Three common methods of computing kre are:

1) Capital Asset Pricing Model (CAPM)2) Discounted Cash Flow (DCF)3) Bond Yield plus Risk Premium (BYRP)

The average of the three cost amounts could be used as the estimate of the

cost of retained earnings (kre) if there is sufficient consistency in the resultsof the three methods.


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CAPM Model

Assumptions:- Cost of retained earnings is equal to the risk-free rate plus a riskpremium.- Risk premium is equal to the risks associated with the entiremarket risk.- Risk premium is the product of systematic (non-diversifiable)risk.

kre = Risk-free Rate + Risk Premiumkre = krf + (bi x PMR)kre = krf + [bi x (km-krf)]

* Risk premium = the stocks beta coefficient (bi) times themarket risk premium (PMR)* Market risk premium (PMR) = the market rate (km) minus therisk-free rate (krf)

Discounted Cash Flow (DCF) Model

Assumptions:- Stocks are normally in equilibrium relative to risk and return.- The estimated expected rate of return will yield an estimatedrequired rate of return- The expected growth rate may be based on projections of pastgrowth rates, a retention growth model, or analysts forecasts.

kre = (D1/P0) + g

* Current market value or price of the outstanding common stock =P0* The dividend per share expected at the end of one year = D1* The constant rate of dividends = g

Bond-Yield-Plus-Risk-Premium Model

Assumptions:- Equity and debt security values are comparable before taxes.- Risks are associated with both the individual firm and the sate of theeconomy. Risk premiums depend on non-diversifiable risk.- Risk estimation can be derived by using a market analysts surveyapproach or by subtracting the yield on an average (A-rated) corporate LTbond from an estimate of the market rate.

kre = kdt + PMR

* Pre-tax cost of long-term debt = kdt* Market risk premium (PMR) = the market rate (km) minus the risk-freerate (krf)

The CAPM is the basic theory that links together risk and return forall assets. Risk of a firm (or investment in a firm) is a function of therisks that exist independent of the investment (the nondiversifiablerisk of the marketplace measured by a beta coefficient) and thefirms (or investment specific) diversifiable risk.

The riskiness of a stock is measured by its beta coefficient. Thebeta coefficient of a stock reflects its price volatility in relationshipto the overall market and is calculated by dividing the percentagechange in the price of an individual stock by the percentagechange in the price of the greater market.

A beta greater than 1 implies that the stock is more volatile (risky)than the market.

A beta less than 1 implies that the stock is less volatile (risky) thanthe market.

CAPM Model

By using the beta coefficient (b) to measure nondiversifiable risk, thecapital asset pricing model equation divides risk into two parts:

1) The risk-free rate of return (RF) and2) The risk premium ([RM RF] x b).

The (RM RF) potion of the risk premium is called the market riskpremium because it represents the premium an investor expects to

receive in return for taking the average amount of risk associatedwith holding the market portfolio of assets.


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CAPM Model

kre = Risk-free Rate + Risk Premium

kre = krf + (bi x PMR) RA = RF + ([RM RF] x b)kre = krf + [bi x (km-krf)]

The required return on an asset (RA) is an increasing function ofbeta (b). Assuming risk averse behavior:

- The higher the risk, the higher the required rate of return.- The lower the risk, the lower the required rate of return.

Note: Risk-free rate of return (RF) and risk premium ([RM RF] xb).

CAPM Model - When the capital asset pricing model (CAPM) isdepicted graphically, that graph is referred to as the security marketline. The SML is an upward sloping straight line that reflects therequired return in the marketplace for each level of nondiversifiablerisk (or beta).

Changes in the Security Market Line

The required returns of equity investors are not f ixed by contract and

fluctuate with changes in the market. Consequently, the SML does notremain stable over time. The position and slope of the SML are affectedby two major forces:

1) Inflationary expectations Because the risk-free rate (RF) is abasis component of all rates of return, any change in RF will bereflected in all required rates of return and will result in parallelshifts in the SML in direct response to the magnitude anddirection of the change.

2) Risk aversion Most investors are risk-averse, which means thatthey require increased returns for increased risk. The slope of theSML reflects the degree of risk aversion. The steeper the slope,the greater the degree of risk aversion, because a higher level ofreturn would be required for each level of risk as measured by thebeta.

In capital budgeting decisions, the discount rate used is the hurdlerate, which is the desired (minimum) rate of return that is set bymanagement to evaluate investments. This could be any ratedetermined by management.

If the project cash flows are more or less risky than is normal for thefirm, the discount rate may be adjusted to reflect managementsassessment of the risk associated with the project.


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WACC Company Cost of Capital

The company cost of capital (WACC) is often used by companiesto evaluate business decision when discount analysis is used.

The WACC is often referred to as the target rate. Use of the WACCensures that the firm is going to evaluate its investmentalternatives at the cost of obtaining investment funds. A companythat faces more risk than a firm of average risk will be expected to

have a higher company cost of capital than an average firm.

Different rates may be used to evaluate different projects.

Why companies use WACC (Company Cost of Capital)

1) Most projects are considered to be average risk in relation toother assets a company may have. The WACC is anappropriate discount rate to use in situations where the risk isdeemed to be average for the company.

2) Even if a project is not considered to be of average risk for acompany, the WACC can be used as a good starting point to

determine the discount the company cost of capital as theinitial starting point and adjust for risk from that point ratherthan attempting to calculate one from scratch.

In this case, the WACC is not a hurdle rate because it issimply being used as a benchmark to which adjustments willbe made.

Beta

Beta is used to define the relative level of risk in a project or

company where risk is equated to price volatility.

Beta is on the horizontal axis of the security market line and therequired return percentage is on the horizontal axis. (See graphon CAPM model flashcard.)

Betas can change over time.

The beta of the company of that of its industry can be used toestimate the risk likely associated with a project. The discountrate can then be inferred by using the SML.

Beta

The manager should look at the characteristics of the behavior of the

asset to estimate risk, even if the beta cannot be determined.

1) Operating leverage The amount of operating leverage (thecommitment of the company to fixed production charges) a companyhas will affect its beta. There is a higher beta when the ratio of fixedcots to project value increases.

2) Cyclical reaction of the company If the companysperformance (i.e. revenues, earnings, etc.) is dependent upon theperformance of the economy, a manager could assume that thecompany is a high-beta firm. The higher the ratio of the presentvalue of fixed costs to the present value of the project, the higher

the beta of the project.


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In any capital budgeting technique, cash flows must be estimated.Near term cash flows are easier and more reliably estimated thanlonger term cash flows. Capital projects carry higher risk ofinaccurate cash flow estimated due to their duration.

Most of the time, projects will use a single discount rate and onlyadjust separately for risk and time if the market risk or other riskchanges throughout the projects life.

The interest rate may be adjusted to compensate for this addedrisk related to the timing of the cash flows, however, this is onlydone if the beta of the project is not expected to be constant overthe life of the project.

If management looks at two alternative investments and determinesthat one of them appears more risky than the other (e.g., it hasgreater than expected estimated returns or is a type of investmentthat has not been purchased by the company before), managementmay decide to adjust the discount rate.

The adjustment in this case would be an increase in the rate tocompensate for the added risk contemplated by management.

When risks of different components of the projects cash flowsdiffer, it is acceptable to adjust the discount rates for eachseparate cash flow (a benefit of using the NPV approach) to a rate

that reflects the degree of risk associated with the respective cashflow.

The effect of increasing the discount rate in capital budgetingdecisions is to reduce the amount of present value for the future netcash flows. The higher the discount rate set by management, thehigher the risk management ahs assigned to the project.

When comparing two investment alternatives with the sameestimated net cash flow, the alternative with the higher risk will havea lower net present value that the investment with the lower risk.

Funding alternatives for investments in specific situations

A. Long term debt The funding of long-lived assets will

typically be done with long-term debt.

B. Short term loans and leases The funding ofequipment and vehicles will typically be made through the use ofshorter-term financing or leases.

C. Retained earnings Often used when acceptablefunding cannot be located, but only for those investments whosereturn duplicates the risk-adjusted rate of return of theorganization (possibly determined using the CAPM or the WACC).The return must duplicate or exceed the risk-adjusted rate ofreturn because this is demanded by the shareholders, who desireto maintain or increase shareholder wealth (i.e., they wish to

maintain the beta of the firm with respect to other firms in themarket.

Debt Financing

Debt financing is less costly than equity financing.

Debt involves default risk (i.e., the risk that borrowers may default,which will cause lenders to foreclose).

Debt financing involves surrendering some financing flexibility foremergencies. Long-term debt should not be used to the extent thatit exhausts reserve borrowing capacity and financing flexibility thatpermits the firm to issue new debt at favorable terms on shortnotice.


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Equity Financing

Equity financing is the most costly long-term financing alternative.

Conservative use of leverage may set a target capital structurethat uses so little long-term debt that the weighted average costof capital is not minimized and shareholder value is notmaximized.

Establishing and maintaining a minimum degree of control mayinfluence managements capital structure decisions. A targetcapital structure that includes more long-term debt financing thana truly optimal capital structure may be used if maintaining votingcontrol is an overriding issue.

Capital investment decisions are not made based on quantitative financialmeasure only. Various qualitative measures must be considered as well,many which assist in meeting the strategic objectives of the firm. Somemeasures include:

A. Shifts on the market supply and demandB. Technology changesC. Industry actionsD. Economic effectsE. Desire for public safety and the safety of employees

F. Regulatory requirementsG. Contractual requirementsH. Maintenance of market shareI. Social welfareJ. Public policyK. Environmental protection


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An annual profit plan consists of a master (or comprehensive)budget and a variety of supporting schedules.

A master budget is a comprehensive set of an organizationsbudget schedules and pro forma (projected) financial statements.Master budgets are generally comprised of operating budgets andfinancial budgets prepared in anticipation of achieving a singlelevel of sales volume for a specific period of time.

Operating budgets Comprised of sales budget and related costsand expenses anticipated in relation to achievement of thebudgeted level of sales.

Financial budgets Comprised of pro forma financial statements.

Sales budgets represent the anticipated sales of the organization inboth units and dollars. Sales budgets (particularly units) are thefoundation of the entire budget process. Inventory levels,purchases, and operating expenses are coordinated with sales levels.

Sales budgets are the first budgets prepared, and they drive thedevelopment of most other components of the master budget.

Sales budget units drive the number of units required by theproduction budget.

Sales budget dollars drive the anticipated cash and revenue figures.

Sales forecasts are derived from input received from numerousorganizational resources, including the opinions of sales staff, statisticalanalysis of correlation between sales and economic indicators, andopinions of line management.

Sales forecasts are developed after consideration of the following factors:1) Past patterns of sales2) Sales force estimates3) General economic conditions4) Competitors actions5) Changes in the firms prices6) Changes in product mix7) Results of market research studies8) Advertising and sales promotions plans

Sales budgets represent the sales forecast associated with plannedor anticipated conditions. They are based upon and selected fromsales forecasts. The sales forecast becomes the sale budget after

revision and after acceptance by management as an objective.

Production/inventory budgets are prepared for each product oreach department and anticipate the amount that will be produced,

stated in units. The production budget anticipates theaccumulation and coordination of resources necessary to sustainmanufacturing operations and fulfill budgeted sales goals.

It is comprised of the amounts spent for direct labor, directmaterials, and factory overhead.

The amount of the production budget is primarily defined by theamounts of inventory on hand and the planned inventory amountsnecessary to sustain sales.

Establishing required levels of production

Production/inventory budgets are prepared in a manner consistent

with the production and inventory levels anticipated by the salesbudget, with modifications for increases or decreases in inventorylevels.

Formula:Budgeted Sales

+ Desired ending inventory- Beginning inventory= Budgeted production


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The direct materials required to support the production budget aredefined by the direct materials usage budget and the directmaterials purchases budget.

Direct materials purchases budget Represents the dollar amountof purchases of direct material required to sustain productionrequirements.

Units of DM to be purchased for the period

x Cost per unit= Cost of direct materials to be purchased for the period

Direct materials usage budget Represents the number of unitsof direct materials required to sustain production requirementsalong with the related cost of those direct materials.


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B4 Flashcards

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