AFM373 Lecture Notes - Lecture 7: Asset Turnover, Capital Structure, Cash Flow

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lilacmouse857

28 Jun 2018

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM373

Professor

Neil Brisley

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Business risks comes from operations (left

side of the balance sheet)

Financial risks = choices of how I finance,

D/E, capital structure (right side of the

balance sheet)

Each division needs an appropriate

allocation of capital and use WACC

to determined NPV of projects.

That’s why you need separate WACC

for each division to determine which

projects are profitable. WACC

determines how much funding the

division will get.

•

Midland centrally raising debt and equity

and re

financing its divisions.

Massive competition in R&M,

so lower prices to compete.

○

R&M is getting their raw

materials (oil) from E&P

(digging for oil)

○

E&P's high margin is due to

low cost of digging oil from

the ground and selling it at the

oil price while R&M's low

margin is due to high cost of

buying the actual oil from E&P

○

You can see that E&P has a high

margin and R&M has a low margin

(R&M has massive sales but tiny

margin)

•

Asset turnover (sales/asset) is low

because they have a higher asset

because they need to find land and

extract oil. In R&M, asset turnover is

high because of their lower asset

(just maintaining what they have to

do the job)

•

E&P is better at securing a loan

because they have higher cash flow

and more assets used for collateral.

•

For exhibit 3, we can calculate some

margins ratio, asset turnover ratio to

compare the different divisions.

Petrochem is in between the two, got

medium margins and asset turnovers

Midland Energy

January 29, 2018 2:30 PM

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WACC will be used to determine projects to take in each division and

Performance evaluation of individual projects and learn if the WACC is

•

Accurate

Performance evaluation of the managers that's estimating the WACC

•

Whether or not to purchase stocks with the whole firm WACC

EVA is not a good measure, they are seeing if you are to make positive on return on

capital that you are giving.

•

Measured over a particular period, but cannot look forward.

•

Logic for EVA is if NOPAT

rWACC x investment positive, then it could be a good investment

Investors and the market set the WACC.

What's effecting the cost of capital of all firms together

interest rates (rf on treasury bonds)

What's effecting firm specific cost of capital

cost of debt and equity (business/financing risks)

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Document Summary

Business risks comes from operations (left side of the balance sheet) Financial risks = choices of how i finance, D/e, capital structure (right side of the balance sheet) Midland centrally raising debt and equity and re-financing its divisions. Each division needs an appropriate allocation of capital and use wacc to determined npv of projects. That"s why you need separate wacc for each division to determine which projects are profitable. Wacc determines how much funding the division will get. Massive competition in r&m, so lower prices to compete. R&m is getting their raw materials (oil) from e&p (digging for oil) E&p"s high margin is due to low cost of digging oil from the ground and selling it at the oil price while r&m"s low margin is due to high cost of buying the actual oil from e&p. For exhibit 3, we can calculate some margins ratio, asset turnover ratio to compare the different divisions.

Related Questions

An important point is that we are estimating the cost of long-term capital that the firm raises through investors. The firm also has a source of capital implicit in its operations, and that is spontaneous credit. This credit comes about in the normal operations of business as the firm orders materials, and incurs wages payable and taxes payable. We want to exclude from our capital analysis all spontaneous sources of operating capital and only include investor capital, including retained earnings. Looking at the right side of our balance sheet, we will exclude the current liabilities of accounts payable, wages payable, taxes payable, and accruals. We will include both the current portion of long-term debt that is reflected in current liabilities and notes payable. We will include all investor long-term liabilities, and all equity, external and internal. This provides our value of investor-supplied capital. As you discuss your points, I invite you provide examples to illustrate your points.

SUMMARY:

A123 Systems, founded in 2001, is a company built on green energy storage technology, using proprietary NanophosphateÂ® technology to produce lithium-ion batteries for use in portable tools, electric cars, and electric grids. The companyâs main competitive advantages lie in its access to proprietary technology licensing from MIT, production facilities located in or close to potentially vast markets (the U.S. and China), joint venture agreements, partnerships and alliances with main players in the automotive market, and access to lucrative government grants and loans in the U.S.

The companyâs short ten-year history exemplifies both the benefits and risks inherent in nascent industries. Strategically, A123 must balance overhead, production, and development costs against revenues received within an undeveloped market. While government incentives abound within this newly emerging industry, the company must align strategy and operations with the realization that these incentives will not always be available to subsidize its operations. In addition, A123 will have to make important decisions with respect to utilizing and diversifying the application of specialized advanced technology in order to minimize or forestall many of the risks it may face in the future.

The leading green energy storage company, A123 Systems, had to balance overhead, production, and development costs against revenues received within an undeveloped market.

The three challenges facing A123 are:

(1) Depleting cash reserves: Until revenues begin to pick up significantly and meet the growth the company expects, capital needs will continue to put a

strain on the company, as we have seen in their short history an increase in

costs as accompanied by negative cash flows.

(2) Product-centric approach: A123 focuses its entire strategic philosophy and rests its livelihood on the fortunes of its product as opposed to

taking a wider view of how it can meet its customersâ energy requirements through more than just batteries. Having such a narrowly defined scope is a

dangerous path, especially since it could take potentially only one advance in battery or fuel cell technology to render its products obsolete.

(3) Order timing and overseas competition: Owing to the fact that the long anticipated electric car market has yet to fully arrive, it is difficult for A123 to

accurately time future demands. This makes it nearly impossible for A123 to efficiently and effectively manage inventories and production and has left them

with large, expensive inventories on hand and with little current demand. Considering the fact that countries like Korea and China are producing

comparable battery solutions at a lower cost, the traction they have within the industry may be in jeopardy

QUESTION:

How should A123 Systems diversify its business strategy to minimize the risks caused by the potential market development and government policy change regarding subsidies? Please name the relevant business strategies used to address each of the three issues above in your answer.

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