AFM373 Lecture Notes - Lecture 4: Cash Conversion Cycle, Iterated Function, Circular Reference

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lilacmouse857

3 Jul 2018

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM373

Professor

Neil Brisley

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Tire City

A basic approach to cases

Alternatives: short term debt vs long-term debt

Leasing warehouse is not really asked in this case

Criteria

We want to lower the risk presented to a bank so we get charged a lower interest rate.

In general, its easier to pay off long-term debt than short-term because you have more time to

pay off.

Also put ourselves in the bank's position because they are looking for less risk.

Analysis: financial health, calculate relevant ratios

Leverage ratios are good, there are a lot of debt capacity for the company which banks like to

lend to.

Working capital gap days (cash conversion cycle) = Days in A/R + days in Inventory - days in A/P

If sales growth hits the firm, if the days above stays constant, then we need a higher financing

need.

Projected income statements

If COGS grow at the same rate as sales, we are assuming COGS are all variable costs and

COGS/Sales stays constant as the last historical year.

Projected balance sheets

Current assets are driven by activities (so sales)

Current liabilities could be driven by activities too but by COGS and not sales. However, if

COGS/sales is constant then it doesn't matter which number we use.

We can also use days in A/P to figure out the AP balance.

Less inventory needs = less financing needs.

Circular reference is to use the iterative function where interest payable affects the plug for

debt requirement, and the plug for debt is required to calculate the interest payable

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Document Summary

Leasing warehouse is not really asked in this case. We want to lower the risk presented to a bank so we get charged a lower interest rate. In general, its easier to pay off long-term debt than short-term because you have more time to pay off. Also put ourselves in the bank"s position because they are looking for less risk. Leverage ratios are good, there are a lot of debt capacity for the company which banks like to lend to. Working capital gap days (cash conversion cycle) = days in a/r + days in inventory - days in a/p. If sales growth hits the firm, if the days above stays constant, then we need a higher financing need. If cogs grow at the same rate as sales, we are assuming cogs are all variable costs and. Cogs/sales stays constant as the last historical year. Current assets are driven by activities (so sales)

Related Questions

X_SUP

X_SUP Paddle board (X_SUP) company sells stand-up paddle boards(SUPs) & accessories. X_SUP had a great 2014 and anticipates abanner year in 2015. To prepare for 2015 the owners, asked you tocreate pro forma financial statements for 2015.

They would like 2 sets of pro-formas.

One that shows the company operating as it has been (theBusiness-As-Usual scenario),

The Second set that shows financing need if they could takesupplier 2% discounts. To take the discounts they would have to payAccounts Payable in 10 days, so the year-end A/P balance would be10-days of COGS. Inventory and COGS would be 2% lower than in thebusiness-as-usual scenario.

Assumption for Business-As-Usual Scenario

Sales from 2014 to 2015 increase by 25% COGS remain at 70% ofSales GA&S Expense increases to $145,000 Interest Expense willbe 8.5% of the year-end Bank Loan balance Depreciation Expense willbe $10,000 in 2015 X_SUP will purchase $30,000 of long-termdepreciable assets in 2015 Cash, Accounts Receivable, AccountsPayable and Inventory will be the same %-of-Sales in 2015 as theywere in 2014. Common Stock is unchanged. All profits (Net Income)are retained to finance future growth. Bank Loan is the plugfigure. If this is negative then Cash becomes the plug figure.

Assumption for 2% Discount-Pay in 10-daysScenario

Use the assumptions above for the Business-As-Usual scenarioexcept: COGS will be 98% of the BAU COGS because of the 2% supplierdiscount. Inventory and A/Payable must be adjusted for the 2%discount. Inventory will be based on the 2% discount. AccountsPayable will be 10-days of COGS at year-end (Use a 365-day year)Interest Expense will be 8.5% of the year-end Bank Loan balance.Bank Loan is the plug figure. If this is negative then Cash becomesthe plug figure.

Assignment:

Create the pro forma financial statements and highlight the loanneed.

X_SUP
Income Statement	2014Actual	2015 ProForma	2015 ProForma (10 -day AP)
Sales	550,000.00
COGS	385,000.00
Gross Margin	165,000.00
GA&S Expense	110,000.00
Interest Expense	7,300.00
Depreciation Expense	7,500.00
Taxable Income	40,200.00
Taxes (30%)	12,060.00
Net Income	28,140.00

Balance Sheet
Assets	2014Actual	2015 ProForma	2015 ProForma (10 -day AP)
Cash	5,500.00
A/Receivables	22,000.00
Inventory	167,500.00
Total Current Assets	195,000.00
Net Fixed Assets	80,000.00
Total Assets	275,000.00

Liabilities & Equity	2014
A/Payable	39,600.00
Bank Loan (8.5%)	86,000.00
Total Current Liabilities	125,600.00
Common Stock	40,000.00
Retained Earnings	109,400.00
Total Liabilities & Equity	275,000.00	343,750.00

redsea-lion883

Question 1

In a world with no frictions (taxes, etc.), value is created by how you finance a project.

Your Answer

False. True.

Question 2

(5 points) The return on equity is equal to the return on assets of a project/firm.

Your Answer

Never true.

Always true.

Sometimes true.

Question 3

Suppose the expected returns on equity of two firms, Macrosoft and Microsoft, that operate in the same industry are 10.50% and 12.60%, respectively. What is the return on assets in this business if Macrosoft has no debt? (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

Answer: _____________________

Question 4

Suppose CAPM holds, and the beta of the equity of your company is 2.00. The expected market risk premium (the difference between the expected market return and the risk-free rate) is 4.5% and the risk-free rate is 3.00%. Suppose the debt-to-equity ratio of your company is 20% and the market believes that the beta of your debt is 0.20. What is return on assets of your business? (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

Answer: _____________________

Question 5

You are planning on opening a restaurant chain. You have projected yearly cash flows of $10 million starting next year (t = 1) with a growth rate of 1% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar restaurant businesses equity has an average beta of 1.20 and the average debt-to-value ratio in this industry is 25%. The risk-free rate is 3.25% and the expected market risk premium (the average difference between between the market return and the risk-free rate) is 4.50%. What is the value of the cash flows of your business?

Your Answer Score Explanation

Do not have enough information to calculate.

158730159.

130718954.

Question 6

You have just returned to your job after completing your MBA, generously funded by the CEO. A few days later, your CEO requests you to evaluate the following news release he will issue to analysts. "For years we have thought about our business strategy, without worrying about financing. Times have changed and we need to think about our cost of capital. Since (a) debt is always cheaper than equity; (b) we have decided to use debt to finance our next major projects." What is your assessment of this statement?

Your Answer

The statement is false.

The statement is true.

The statement is partly true/false.

Question 7

Two firms, Alpha, Inc., and Beta, Inc., are in the same business. Alpha, Inc., has debt that is viewed by the market as risk-less with a market value of $500 million. Beta, Inc., has no debt. Both firms are expected to generate cash flows of $100 million per year for the foreseeable future and the market value of the equity of Beta, Inc is $1 billion. Estimate the return on equity of Alpha, Inc. Assume there are no taxes, and the risk-free rate is 5%. (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

Answer: _____________________

Question 8

Mango, Inc. has had debt with market value of $1 million that has paid a 6% coupon and has had an expiration date that is far, far away. The expected annual earnings before interest and taxes for the firm are $2 million and the firm has not grown, nor does it have plans for any growth. The firm however has just raised more equity to retire all its debt. If the required rate of return to equity-holders (after the capital structure change) is now 20%, what is the market value of the firm? Assume there are no taxes. (Enter just the number without the $ sign or a comma; round to the nearest whole dollar.)

Answer: _____________________

Question 9

Suppose all investors are risk-averse and hold diversified portfolios. You are evaluating a new energy company that is going to use wind and will have two divisions: an electricity production unit and a Sales unit. [Transportation of the electricity will be outsourced.] Your CEO and you are arguing about whether projects that emerge in the two units should have the same cost of capital (WACC), or whether the discount rates should be different. If different, what should be the relative magnitudes of the discount rates, that is, which unit Production or Sales should have the higher discount rate. Assume the discount rates of the two units are labeled as P and S, for the production and Sales units, respectively. What do you think?

Your Answer

S>P.

P>S.

Same discount rates for both divisions/units (P=S).

Question 10

NorthSouth Airlines has been granted permission to fly passengers between major U.S. cities. The new company faces competition from four airlines that operate between the major cities. The betas of the equity of the four major competitors (A, B, C, D) are 2.25, 2.50, 2.75, and 3.00; and the debt-to-equity ratios of these four companies (in the same order: A, B, C, D) are 0.21, 0.42, 0.63, 0.83. Although these D/E ratios vary, all airline debt is rated the same. Suppose the yield on airline debt is 7%, the risk-free rate is 3% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 5%. What is the cost of capital (or discount rate) that you should use in valuing NorthSouth Airlines? (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

Answer: _____________________

skycricket77

Note:

This question has been answered totally from 1-8 questions in previuos requested, the only part ( need to answer ) I need to help me with that to have completed the calculations, provide a brief, two- to four-sentence rationale for how these calculations can be used in analyzing the financial position of a company and why they are important. Your rationale should explain what information the ratio provides to the reader and how the reader may use that information.

I will repeat tyoing the question for make it clearing .

Analysis of Financial Statements

Balance Sheets

EXHIBITS: INPUT DATA (XYZ)

Table 1 Balance Sheets

Assets	2013E	2012	2011
cash	$ 85,632	$7,282	$57,600
Acount Receivable	878,000	632,160	351,200
Inventories	1,716,480	1,287,360	715,200
Total current assets	$2,680,112	$1,926,802	$ 1,124,000
Gross fixed assets	1,197,160	1,202,950	491,000
Less: accumulated depreciation	380,120	263,160	146,200
Net fixed assets	$ 817,040	$ 939,790	$ 344,800
Total assets	$3,497,152	$2,866,592	$ 1,468,800


Liabilities and equity
Accounts payable	$ 436,800	$ 524,160	$ 145,600
Notes payable	300,000	636,808	200,000
Accruals	408,000	489,600	136,000
Total current liabilities	$1,144,800	$1,650,568	$ 481,600
Long term bonds	400,000	723,432	323,432
Total debt	$1,544,800	$2,374,000	$ 805,032
Common stock (100,000 shares)	1,721,176	460,000	460,000
Retained earnings	231,176	32,592	203,768
Total common equity	$1,952,352	$ 492,592	$ 663,768
Total liabilities and equity	$3,497,152	$2,866,592	$ 1,468,800

Analysis of Financial Statements

Income Statements

Table 2

Income Statements

	2013E	2012	2011
Sales	$7,035,600	$6,034,000	$ 3,432,000
Cost of goods sold	5,875,992	5,528,000	2,864,000
Other expenses	550,000	519,988	358,672
Total operating exp. excl. depreciation and amortization	$6,425,992	$6,047,988	$ 3,222,672
EBITDA	$ 609,608	$(13,988)	$ 209,328
Depreciation and amortization	116,960	116,960	18,900
Earnings before interest and taxes (EBIT)	$492,648	$(130,948)	$190,428
Interest expense	70,008	136,012	43,828
Earnings before taxes (EBT)	$ 422,640	$ (266,960)	$ 146,600
Taxes (40%)	169,056	(106,784)	58,640
Net Income	$ 253,584	$ (160,176)	$ 87,960
Earnings per share (EPS)	$ 1.014	$ (1.602)	$ 0.880
Dividends per share (DPS)	$ 0.220	$ 0.110	$ 0.220
Book value per share (BVPS)	$ 7.809	$ 4.926	$ 6.638
Stock price	$ 12.17	$ 2.25	$ 8.50
Shares outstanding	250,000	100,000	100,000
Tax rate	40.00%	40.00%	40.00%
Lease payments	$ 40,000	$ 40,000	$ 40,000
Sinking fund payments	0	0	0

Analysis of Financial Statements

Ratio Analysis

	2013E	2012	2011	Industry Average
Current ratio	*	1.2	2.3	2.7
Quick ratio	*	0.4	0.8	1.0
Inventory turnover	*	4.7	4.8	6.1
Days sales outstanding (DSO)	*	38.2	37.4	32.0
Fixed assets turnover	*	6.4	10.0	7.0
Total assets turnover	*	2.1	2.3	2.6
Debt-to- assets ratio	*	82.8%	54.8%	50.0%
Times interest earned (TIE)	*	-1.0	4.3	6.2
Operating margin	*	-2.2%	5.6%	7.3%
Profit margin	*	-2.7%	2.6%	3.5%
Basic earning power (BEP)	*	-4.6%	13.0%	19.1%
Return on assets(ROA)	*	-5.6%	6.0%	9.1%
Return on equity (ROE)	*	-32.5%	13.3%	18.2%
Price/earnings (P/E)	*	-1.4	9.7	14.2
Market/book (M/B)	*	0.5	1.3	2.4
Book value per share (BVPS)	*	$4.93	$6.64	n.a.

Requiremnts:

1. Calculate XYZâs 2013 current and quick ratios based on the projected balance sheet and income statement data.

2. Calculate the 2013 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover.

3. Calculate the 2013 debt-to-assets and times-interest-earned ratios.

4. Calculate the 2013 operating margin, profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE).

5. Calculate the 2013 price/earnings ratio, and market/book ratio.

6. Use the extended DuPont equation to provide a summary and overview of XYZâs financial condition as projected for 2013.

7. Use the following simplified 2013 balance sheet to show, in general terms, how an improvement in the DSO would tend to affect the stock price. For example, if the company could improve its collection procedures and thereby lower its DSO from 45.6 days to the 32-day industry average without affecting sales, how would that change âripple throughâ the financial statements (shown in thousands below) and influence the stock price?

Accounts receivable $878 Debt $1,545

Other current assets 1,802

Net fixed assets 817 Equity 1,952

Total assets $3,497 Liabilities plus equity $3,497

First, we need to calculate XYZâs daily sales.

Daily sales = Sales / 365

Daily sales = $7,035,600 / 365

Daily sales = $19,275.62

Target A/R = Daily sales Ã Target DSO

Target A/R = $19,276 Ã 32

Target A/R = $616,820

Freed-up cash = old A/R â new A/R

Freed-up cash = $878,000 â $616,820

Freed-up cash = $261,180

Note : All questions from 1-8 has been answered, but the only part I need help with to write the analysis or to provide a brief, two- to four-sentence rationale for how these calculations can be used in analyzing the financial position of a company and why they are important.

AFM373 Lecture Notes - Lecture 4: Cash Conversion Cycle, Iterated Function, Circular Reference

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