CMA Review Reference Book

CMA Review Reference Book

Part 2

Strategic Financial Management

Section 2100‐2600

2021

Surgent CMA Review: Editor‐in‐Chief: Liz Kolar, CPA, CGMA Director of Accounting and License Preparatory Content: John Castonguay, PhD, CPA This book is written to provide accurate and authoritative information concerning the covered topics. It is not meant to take the place of professional advice. Content and software copyright © 2021, Surgent CPE, LLC. No part of this work may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval system, except as may be expressly permitted by the 1976 Copyright Act or in writing by the Publisher. Printed in the United States of America.

Table of Contents

Part 2

Strategic Financial Management

Section 2100 Financial Statement Analysis ................................................................. 1

Section 2200 Corporate Finance ............................................................................... 73

Section 2300 Decision Analysis ................................................................................ 237

Section 2400 Risk Management ............................................................................... 275

Section 2500 Investment Decisions ......................................................................... 281

Section 2600 Professional Ethics .............................................................................. 313

© 2021 Surgent CPE, LLC 1

Surgent CMA Review

Section 2100 Basic Financial Statement Analysis (20%)

2110 Basic Financial Statement Analysis

2110.01 Financial statement analysis highlights key historical relationships and trends. Financial statements can be prepared to show data as a comparison. Forms of that analysis are:

a. Horizontal Analysis: Horizontal (common base year) analysis compares similar data between periods either on an absolute or relative scale, e.g., cash increased $2,000,000 or 34% from last year to this year. Typically, the earlier year is the base figure upon which change is measured.

b. Vertical Analysis: Vertical (common size) analysis compares data from the same reporting period to a base figure; e.g. current assets are 20% of total assets as of the reporting date. Typically, the 100% base figure is revenue or total assets (or the equivalent). The following is an example of a common‐size income statement.

Income Statement

Common‐Sized Income Statement

Revenue 100,000 100% Cost of Sales 58,000 58% Gross Profit 42,000 42% SG&A Expenses 24,000 24% Operating Income 18,000 18% Interest and Taxes 8,000 8% Net Income 10,000 10%

The balance sheet can be prepared in a similar schedule. A time‐series

analysis can identify trends in the ratios that reveal important variations.

A comparison of the common‐size percentages can also be made with

other companies within the industry.

c. Growth Analysis: Companies set growth rates and then determine if they actually attain the growth estimate. There are different methods of setting growth; one common growth computation is growth of earnings per share (EPS). It is computed as follows:

Section 2100 – Basic Financial Statement Analysis

2 ©2021 Surgent CPE, LLC

EPS (end of year) – EPS (beginning of year)

EPS (beginning of year)

Other growth measures include changes in total revenues, dividends per

share, and total assets. These growth measures can then be compared to

company expectations and to other companies in the industry.

d. Ratio Analysis: Ratio analysis compares datum or data to related items, e.g. cost of goods sold (COGS) to inventory. When comparing data that covers a period of time to data as of a point in time (beginning or ending inventory), more meaningful results are possible if an average (beginning plus ending inventory divided by 2) of the point data is used.

1. User’s Objective: Users may have different needs and criteria in

analyzing financial ratios; accordingly, ratios can be characterized by

objective. There are liquidity ratios to assist short‐term creditors who

are interested in how well a firm meets its currently maturing

obligations. Activity ratios measure how effectively the assets of an

entity are employed. Profitability ratios are of particular interest to

investors (both long‐term creditors and equity investors) because

they indicate the magnitude of the return on investment. Long‐term

creditors and investors also look to leverage/coverage ratios to

measure the degree of protection afforded their investment.

2. Usefulness: By itself, any single ratio is not conclusive or even very

meaningful. Ratios become informative when compared to industry

standards (if accounting standards are uniform), prior years’

performance, budgets, or used in conjunction with other ratios.

Pitfalls in relying exclusively on ratio analyses include:

Since the statements are historical in nature, the comparisons

reflect past, not future relationships.

Ratios have not been standardized.

Accounting methods, e.g., LIFO versus FIFO can produce different

data and thus ratios.



2110.02 Purpose and Components of Financial Statements: A full set of financial statements will include each of the following:

Financial position (balance sheet) at the end of the period.

Earnings for the period (income statement).

Comprehensive income for the period.

Cash flows during the period.

Investments by and distributions to owners during the period.

Note that a statement of financial position does not purport to show the value of a business enterprise.

a. Financial Position – Balance Sheet: The balance sheet provides information concerning the nature of the firm’s financial resources, the claims of creditors against those resources, and the equity of the owners in the net resources of the firm. In order to provide useful information to users of the financial statements, the balance sheet is normally broken down into various classifications.

1. Current Assets: Cash and other assets that will be converted into

cash, sold, or consumed within one year or the operating cycle,

whichever is greater, are classified as current. Included are such

items as marketable securities, notes and accounts receivable and

inventories.

2. Long‐Term Investments: This category includes investments in

related companies, bonds which are not intended to be liquidated

within the operating cycle, funds accumulated to retire debt, and

the cash surrender value of life insurance.

3. Property, Plant and Equipment: Land, buildings, plant, fixtures,

furniture, leasehold improvements and the capitalized value of

certain leased assets are included along with various depreciation

contra accounts.

4. Intangible Assets: Patents, copyrights, trademarks and goodwill

are included.

5. Other Assets: This is for assets that do not fit into another

category such as deferred items and prepayments.



6. Current Liabilities: This category includes those obligations that

will be liquidated by the use of current assets or the creation of

other current liabilities within one year or the operating cycle,

whichever is greater.

7. Long‐Term Liabilities: These are liabilities that will be paid in

more than one year. Included are items such as debentures,

mortgages, and obligations under capital leases.

8. Stockholders’ Equity: This is the category that represents the

various ownership interests in the business. Common and

preferred stock, retained earnings and treasury shares are the

usual components.

b. Earnings for the Period (Income Statement): The income statement’s function is to report the results of operations for a given period of time. Presented in the statement are revenues and expenses from ongoing business activities and gains and losses in the ordinary course of business. These constitute “income from continuing operations.” A company may also experience discontinued operations, “extraordinary” items, and the need to report the cumulative effect of a change in accounting principle. These are presented separately after income from continuing operations. This is the “all‐inclusive” concept. Proponents of the “current operating performance” concept believe that only regular earnings from normal operations should be included in the income statement. They contend that other types of gains and losses (i.e. extraordinary items) should be taken directly to Retained Earnings as they do not reflect the regular earnings capacity of a company. APB No. 9 requires application of the “all‐inclusive” approach in practice.

c. Earnings Concept and Comprehensive Income: The concept of earnings set forth in SFAC 5 is similar to net income for a period in present practice; however, it excludes certain accounting adjustments of earlier periods that are recognized in the current period – cumulative effect of a change in accounting principles is the principal example from present practice. Comprehensive income is a broad measure of the effects of transactions and other events on an entity. It includes all changes in equity (net assets) during a period from transactions and other events and circumstances except those resulting from investments by owners and distributions to owners. It should be noted, therefore, that earnings and comprehensive income are not the same. Comprehensive income includes net income plus all the other non‐owner derived changes in equity that do not go through the income statement.



d. Cash Flows Statement: A statement of cash flows directly or indirectly reflects an entity’s cash receipts classified by major sources and its cash payments classified by major uses during a period, including cash flow information about its 1) operating, 2) financing, and 3) investing activities. The primary purpose of the statement of cash flows is to provide information about the entity’s cash receipts and cash disbursements during a period, i.e. the changes that occurred between reporting periods. Through such information, investors, creditors, and others may

Assess the enterprise’s ability to generate positive future net cash

flows.

Assess the enterprise’s ability to meet its obligations, its ability to pay

dividends, and its needs for external financing.

Assess the reasons for differences between net income and

associated cash receipts and payments.

Assess the effects on an enterprise’s financial position of both its cash

and non‐cash investing and financing transactions during the period.

e. Statement of Investments by and Distributions to Owners: This reflects an entity’s capital transactions during a period – the extent to which and in what ways the equity of the entity increased or decreased from transactions with owners as owners.

2111 Common Size Financial Statements

2111.01 Common size financial statements display each item as a percentage of some base item. Not all companies are the same size. A company has more cash, inventory, or revenue than another company. This makes it hard to compare the financial statements of the two companies. By using common size financial statements, companies can compare two companies and gather usable information.



2111.02 Common Size Balance Sheet: In a common sized balance sheet, each asset is displayed as a percentage of total assets, each liability as a percentage of total liabilities, and each equity item is a percentage of total equity. Example below:

Standard Balance Sheet

Common Size Balance Sheet

Assets

Cash 5,000 50%

Inventory 3,500 35%

Accounts Receivable 1,500 15%

Total Assets 10,000 100%

Liabilities

Accounts Payable 6,000 33%

Notes Payable 9,000 67%

Total Liabilities 15,000 100%

Equity

Common Stock 20,000 40%

Retained Earnings 30,000 60%

Total Equity 50,000 100%

2111.03 Common Size Income Statement: In a common sized balance sheet profit and loss is detailed as a percentage of total sales/revenue.

Standard Income Statement

Common Size Income Statement

Sales 50,000 100%

Cost of Goods Sold 20,000 40%

Gross Profit 30,000 60%

Taxes 6,600 13%

Net Income 23,400 47%



2112 Common Base Year Financial Statements

2112.01 Common base year financial statements are constructed by dividing the current year account value by the base year account value.

2112.02 Common base year balance sheet example.

Standard Balance Sheet

Common Base Year Balance Sheet

20X9 20X0

Assets

Cash 5,000 7,000 140%

Inventory 3,500 4,000 114%

Accounts Receivable 1,500 1,000 67%

Total Assets 10,000 12,000 120%

Liabilities

Accounts Payable 6,000 8,000 133%

Notes Payable 9,000 8,000 89%

Total Liabilities 15,000 16,000 107%

Equity

Common Stock 20,000 20,000 100%

Retained Earnings 30,000 32,000 107%

Total Equity 50,000 52,000 104%



2112.03 Common Size Income Statement: In a common sized balance sheet profit and loss is detailed as a percentage of total sales/revenue.

Standard Income Statement

Common Size Income Statement

20X9 20X0

Sales 50,000 60,000 120%

Cost of Goods Sold 20,000 45,000 225%

Gross Profit 30,000 15,000 50%

Taxes 6,600 3,150 49%

Net Income 23,400 11,850 51%

2120 Financial Ratios

2121 Liquidity

2121.01 Objectives: Short‐term liquidity ratios and other measures provide information about how well a firm is able to meet its currently maturing obligations.

a. Creditor and Management: This is of special interest to creditors, but also important for management to know in order for them to be able to avoid embarrassing last minute scrambles. Liquidity refers to the composition of current assets and liabilities, primarily assets. A higher proportion of cash or marketable securities is more liquid than a low proportion.

b. Short‐term Liquidity: Operating activity and cash flow ratios are analyzed as part of short‐term liquidity. Operating activity ratios measure how effectively and efficiently the firm is carrying out its business – making sales, collecting on sales, and managing inventory. Companies with slow turning inventory and slow paying customers are less liquid. Cash flow gives an indication of the liquidity of a company as does the speed with which noncash current assets convert to cash.



2121.02 Definitions

a. Current Assets: Cash and other assets that will be converted into cash, sold, or consumed within one year or the operating cycle, whichever is longer. Items are usually listed from highly liquid to less liquid. Increasing current assets are a use of short‐term funds for a business. Typical categories are:

Cash and cash equivalents

Marketable securities (trading and available‐for‐sale‐classifications at

fair value)

Notes and accounts receivable (at net realizable value)

Inventories

Prepaid expenses (at unexpired cost)

b. Current Liabilities: Current liabilities are defined as liabilities to be paid within one year or the operating cycle, whichever is longer. Items are usually presented in order of their liquidation dates and reported at the amount to be paid. Increasing current liabilities are a source of short‐term funds for a business. Typical categories are:

accounts payable arising from the acquisition of goods and services

other accrued liabilities, such as wages payable and interest payable

notes payable such as but not limited to commercial paper, short term bank credit loans, factoring

collections of amounts in advance (unearned or deferred revenues)

currently maturing portions of long‐term debt

c. Working Capital: Working capital is simply the difference between Current Assets and Current Liabilities. Creditors are especially interested in working capital as it is the source from which they will be paid.

2121.03 Ratios, Computational Issues, and Analysis

a. Current Ratio: Measures short‐term solvency − the ability to meet current obligations. Generally higher is better, however the composition of current assets is also important. A quick rule of thumb is that a company should have a current ratio exceeding 2.0. However, many successful efficient companies run well at 1.0. Too high a ratio, say 3.0, may indicate inefficient use of capital. Creditors often look at the trend in the Current Ratio or compare it to other companies as gauges of liquidity.

Current Assets__

Current Liabilities



Example: A company has current assets of $400,000 and current

liabilities of $500,000. The company’s current ratio would be increased

by:

1. The purchase of $100,000 of inventory on account

2. The payment of $100,000 of accounts payable

3. The collection of $100,000 of accounts receivable

4. Refinancing a $100,000 long‐term loan with short‐term debt

Answer: The present current ratio is: 400,000 500,000

= 0.8

1. 500,000600,000

= 0.83

2. 300,000400,000

= 0.75

3. No change; current assets increase and decrease by the same amount4. 400,000

600,000 = 0.67

Example: The Solvent Corporation’s current ratio is 2.0 to 1 and its bond

indenture specifies the current ratio must remain above 1.5 to 1. If

current liabilities are 25 million, what is the maximum new short‐term

debt that can be taken out to finance inventory?

Answer: If Solvent’s current ratio is 2.0 and the current liabilities are $25

million, then current assets must be $50 million. The maximum increase

to both current assets and liabilities is:

50 𝑋25 𝑋

1.5, 𝑜𝑟 50 𝑋 1.5 25 𝑋 , 𝑜𝑟 0.5𝑋 12.5, 𝑜𝑓 𝑋 $25 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑚𝑎𝑥𝑖𝑚𝑢𝑚 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒

b. Acid‐Test (or Quick) Ratio: Measures short‐term liquidity, excluding inventory (which may be obsolete, difficult to sell, or slow in converting to cash), prepaid expense, and other non‐liquid current assets. This is a more conservative measure of the firm’s ability to pay short‐term obligations. It provides greater assurance to short‐term lenders about the company’s ability to repay them. A quick ratio of 1.0 is often considered average and adequate. A level trend of the quick ratio over time is often a meaningful indicator of good management.

Cash + Cash Equivalents + Receivables + Marketable Securities

Current Liabilities



Example: A company has a current ratio of 2 to 1 and a quick ratio (acid

test) of 1 to 1. A transaction that would change the company’s quick

ratio, but not its current ratio is:

a. The sale of short‐term marketable securities for cash that results

in a profit

b. The sale of inventory on account at cost

c. The collection of accounts receivable

d. The payment of accounts payable

Answer: b. Inventory is the only item mentioned that is in the current

ratio, but not the quick ratio. The increase in accounts receivable would

affect the quick ratio, but the sale of inventory would not. All other items

would affect both ratios in the same way.

c. Receivables Turnover: Indicates the efficiency of receivables collection and the quality of receivables. The higher the quality, the shorter the time between the sale and the collection of cash. Net credit Sales excludes cash sales and reflects all other sales during a year(period).

1. Calculation: Net Credit Sales_______

Average Trade Receivables (Net)

If no information is available about cash sales, then total sales are used as an estimate of credit sales. The average Trade Receivables is usually calculated as:

(Net A/R at the beginning of the period + Net A/R at the end of the period)/2

2. Comparison Problems: Because companies do not usually report cash

versus credit sales, turnover can be difficult to pin down precisely.

Inclusion of cash sales will artificially increase the turnover figure.

Additionally, bad debt reserves should be deducted from total AR to

arrive at net AR. Receivable turnover rates will vary widely across

industries and will also be affected by credit policies, aggressiveness

of collection efforts, and economic trends. If the ending A/R balance

is used instead of the average, the ratio gives a more current

snapshot of the current situation (assuming average daily sales

remains constant over the year). This may not be a good assumption

for a seasonal business, but in that case the ratio could provide better

insight into seasonal variations.

d. Average Collection Period (or Days Sales Outstanding): The average time in days that receivables are outstanding (date of sale to date of collection). Because this ratio is calculated by dividing 365 days by the



receivables turnover, its interpretation is inversely related to that of the receivables turnover ratio (discussed above)—the greater number of days outstanding, the greater the possibility of delinquencies becoming uncollectible. This ratio should ideally be less than the terms extended to customers. If you offer net 30 day terms and everybody pays exactly on time, the ratio should be 30 days. 365________

Receivables Turnover

e. Inventory Turnover: Measures how effectively the inventory portion of working capital is being used in terms of the number of times inventory is replaced every year. Calculations are similar to receivables insofar as wanting to measure turnover (higher is better) and length of turnover (shorter is better). High inventory turnover can mean high liquidity and/or good merchandising. It could also mean frequent stockouts and lost potential sales. Conversely, low turnover could mean obsolete merchandise or excessive inventory accumulation.

1. Calculation: Cost of Sales___

Average Inventory

The average inventory is usually calculated as:

(Inventory at the beginning of the period + Inventory at the end of the period)

2

2. Comparisons: To be meaningful, this ratio should be compared to the

standard for the particular industry. The inventory turnover is a

function of the technology of the industry as well as the operating

efficiency of the enterprise. For instance, it takes a certain number of

days for a farmer to raise chickens to a certain size, no matter what

else he does. Similarly, beer requires a certain amount of

fermentation time no matter what. Other factors are more

controllable.

3. Values to Use: Inventory accounts include raw materials, work‐in‐

progress, and finished goods. Analysis may be conducted on any

portion of or the total inventory, but is usually done on the total.

Inventory is valued at the lower of cost or market, not at the price for

which it will be sold. Sometimes the inventory turnover ratio is

calculated using sales instead of cost of goods sold in the numerator.

However, cost of sales is a better base for calculating turnover

because it eliminates any changes due solely to sales price changes.



Example: The following information is available for the years indicated:

20X1 20X2

Sales $1,400,000 $1,800,000

Inventory 190,000 210,000

Bad Debt Expense 12,000 10,000

Cost of Goods Sold 840,000 920,000

Calculate the inventory turnover for 20X2.

Select only the information actually needed.

920,000 =

920,000 = 4.6

(190,000 + 210,000)/2 200,000

Example: Earth Corporation has budgeted sales of $144,000 and costs of

sales of $90,000 during a year. It is earning 11% currently on its

investment in certificates of deposit. If Best can increase inventory

turnover from its present level of 9 times per year to 12 times per year,

how much can it save?

Answer: $275, calculated below

If inventory turnover is currently 9 times per year, then we can use the

inventory turnover ratio formula and the information about cost of sales

to calculate average inventory:

Cost of Sales = 9 → Average Inventory

Cost of Sales = $100,000 = $10,000

Average Inventory 9 9

If inventory turnover were 12 instead of 9 times per year, average

inventory would be:

Cost of Sales = $100,000 = $7,500

12 12

The average reduction in inventory would be: $10,000 ‐ $7,500 = $2,500 per year

At a rate of return of 11%, the savings would be: $2,500 × 11% = $275



f. Number of Days in Inventory (or Days Sales in Inventory): Measures the average length of time in days that merchandise is in inventory (the length of time necessary to sell an item of inventory). Because this ratio is calculated by dividing 365 days by the inventory turnover, its interpretation is inversely related to that of the inventory turnover ratio (discussed above).

365______

Inventory Turnover

g. Accounts Payables Turnover: Measures how many times per period accounts payable are paid. The turnover ratio is not used as frequently as the Days Purchases in Accounts Payable, discussed below.

Cost of Goods Sold (COGS)

Average Accounts Payable

h. Days Purchases in Accounts Payable: Measures how many days’ worth of inventory purchases are still unpaid. This gives some information about how well a company is paying its bills to its suppliers. Previous cautions about data quality in receivables and inventory apply here too.

365_________

Accounts Payable Turnover

In theory it would be preferable to segregate inventory purchases from all other payables, but this information is seldom given to outsiders. Therefore, COGS and A/P must be used as surrogates.

The two payables ratios are not used as frequently as the receivables and

inventory ratios, but they come into play when determining the

operating cycle, below.

i. Days Purchases in Accounts Payable: Measures how many days’ worth of inventory purchases are still unpaid. This gives some information about how well a company is paying its bills to its suppliers. Previous cautions about data quality in receivables and inventory apply here too.

j. Operating Cycle: The operating cycle represents the average number of days it takes to sell inventory and then collect on the sales. It is a key measure of an enterprise’s operating efficiency and financial health. A shorter operating cycle indicates a company is more efficient than either it was last year or than a competitor with equivalent products and markets. A longer cycle time indicates just the reverse. Not only are the absolute numbers important, but the trend over time is often more important. For instance, short‐term lenders will want to know how quickly they can expect to be paid back.

Average Collection Period + Number of Days in Inventory



Example: Given the following information, estimate the operating cycle. Accounts Receivable Turnover Ratio 3.65 Inventory Turnover Ratio 3.30

Answer: The answer is calculated below.

Average Collection Period = 365

= 365

= 100 days AR Turnover 3.65

Average days in Inventory = 365

= 365

= 110.6 days

Inventory Turnover 3.30

Operating Cycle = 110 + 110.6 = 210.6 days

k. Cash Flow Cycle: A related concept is the Cash Flow Cycle (or Cash‐to‐Cash or Cash‐on‐Cash cycle). This simply takes the Operating Cycle and deducts the days purchases in accounts payable. This gives recognition to the fact cash is not used to purchase inventory at the time it is acquired. However, the longer Operating Cycle is more frequently taught and used for analysis.

Example of Cash Flow Cycle: If the average age of inventory is 60 days,

the average age of accounts receivable is 40 days, and the average days

purchases in accounts payable is 35 days, the length of the cash flow

cycle is:

60 + 40 – 35 = 65 days

l. Cash Ratio (or Cash to Current Liabilities): Severe liquidity problems with receivables and inventories, or pledging of those assets, may require an even more conservative analysis of liquidity. The cash ratio includes only cash and current assets that are readily converted to cash (i.e., cash equivalents and marketable securities) in the numerator. Thus, it is more conservative than either the current ratio or the acid‐test (quick) ratio for measuring the company’s short‐term liquidity.

Cash + Cash Equivalents + Marketable Securities

Current Liabilities



m. Cash Flow Ratio: Measures the cash generated from operations compared to the current liabilities. This ratio looks at the flow of cash over the course of time rather than the static amount of cash on hand. Greater operating cash flow leads to a higher likelihood that sufficient cash will be generated to pay current obligations.

Cash Flow from Operations

Current Liabilities

n. Liquidity Index: A more comprehensive ratio for trend analysis and comparative analysis across companies is the liquidity index. It is measured in days and can be considered a weighted average conversion time for current assets.

Total Dollar‐Days in Current Assets

Current Assets

Example: An example is the easiest way to understand the liquidity index.

CA Component $ Amount × Days to Convert

to Cash = Dollar‐Days

Cash 25,000 0 0

Marketable Securities 5,000 2 10,000

Accounts Receivable 20,000 45a 900,000

Inventory 50,000 60b 3,000,000

Total Current Assets 100,000 3,910,000

a The days to convert A/R to cash is equal to the number of days it takes to collect A/R (i.e., the average collection period)

b The days in the operating cycle (i.e., the number of days to convert inventory to cash plus the number of days it takes to collect A/R)

Liquidity Index = Dollar‐Days

= 3,910,000

= 39.1 days Dollar Amount 100,000

This number is not necessarily meaningful in itself but it gains significance when compared to other periods or other entities. A higher or increasing liquidity index is a sign of less liquidity, while a lower or declining index indicates greater liquidity.



2122 Leverage

2122.01 Operating leverage

a. Business risk is built partially on the degree a company uses fixed costs in its operations. The higher the fixed costs, the greater the risk that the breakeven point will not be reached given a drop in sales. When fixed costs are high, a small drop in sales can result in a loss for the period. Operating leverage relates the percentage changes in EBIT to the percentage change in revenue. The greater the operating leverage, the greater the change in operating income will be given a particular change in sales. Therefore, a company with a high degree of operating leverage would have a large change in operating income for a relatively small change in sales.

b. The degree of operating leverage (DOL) is the percentage change in EBIT related to a given percentage change in revenue.

DOL = % change in net operating income

% change in sales =

Contribution margin Contribution margin – Fixed costs

A DOL of 2 means that the percentage change of EBIT will be twice the size of the percentage change in sales. If sales increase by 20%, then EBIT will increase by 40%; however, if sales decrease by 20%, then EBIT will decrease by 40%.

c. A firm can change the DOL by changing the proportion of fixed costs to variable costs. The larger the proportion of fixed costs, the higher the DOL and the higher the breakeven point. The higher the proportion of variable costs, the lower the DOL and the lower the breakeven point.

Also, notice that after the breakeven point is reached with a high DOL, the operating profit increases quickly; thus, the additional risk associated with high fixed costs also contains the possibility of higher profits in the event of a positive sales outcome. The following diagram shows how income can increase rapidly after reaching the breakeven point if high fixed costs and low variable costs are used in the production process.



The lower the fixed costs, the lower the DOL and breakeven point will be. Given the same sales as in the above diagram, a lower percentage of fixed cost will cause the breakeven point to be reached at an earlier sales level; however, the operating profit will increase slowly in relation to increased sales. The operating profit (loss) is the difference between the sales and total costs.

d. Illustration: Tally Company has the following information available regarding sales and costs from the last period:

What is the DOL?

Solution:

DOL = Contribution margin Contribution margin - Fixed costs

= 10,000 Units ($10.00 – $6.00) 10,000 Units ($10.00 – $6.00) – $20,000

= 2

2122.02 Financial leverage

a. Financial leverage refers to the extent to which debt and preferred stock (fixed income securities) are used in the capital structure. The larger the percentage of debt and preferred stock that is used for financing, the greater the risk that the company will not earn enough to cover the fixed interest and preferred dividend payments. The more leverage, the greater the risk, and the higher the cost of capital.

b. Degree of financial leverage (DFL) is the percentage change in earnings available to common stockholders related to a given percentage change in EBIT.

DFL = % change in net income % change in net operating income

= EBIT EBIT – Interest

When there is no debt financing used, the DFL will equal 1. When debt does exist, a change in EBIT will result in a greater proportional change in the earnings per share.

If the DFL were 2, then a 10% increase in EBIT would result in a 20% (10%

2) increase in earnings per share.

If the organization has preferred stock, the DFL equation is modified to:

DFL = EBIT

EBIT – Interest expense – Preferred dividends

1 – Tax rate

Sales in units 10,000 Selling price per unit $10.00 Variable costs per unit $6.00 Fixed costs for period $20,000



c. If a firm has no debt and begins to substitute debt for equity, at first the value of the firm will rise, reach a peak, and then begin to fall due to the increased risk of additional debt. This peak in maximized value is the target capital structure.

d. Illustration: Tally Company has the following information available about sales and costs from the last period:

Sales in units 10,000 Selling price per unit $10.00 Variable costs per unit $6.00 Fixed costs for period $20,000 Interest costs for period $15,000

What is the DFL?

Solution: DFL = EBIT EBIT – Interest expense

=

10,000 Units ($10.00 – $6.00) – $20,000 [10,000 Units ($10.00 – $6.00) – $20,000] – $15,000

= 4

2122.03 Total leverage (degree of combined leverage)

a. If a company used both high degrees of operating and financial leverage, only small changes in sales will result in large fluctuations in EPS. This can be shown in equation form:

Degree of total leverage = % change in net income

% change in sales = DOL DFL

b. This ratio can be used to predict the effect of a change in sales on income and ultimately the earnings available to common stockholders.

c. This ratio is determined by the relationship between operating and financial leverage. For example, if risk is lowered by reducing the degree of operating leverage, then the firm would be in a better position to increase the use of debt, thus increasing the financial leverage.

d. The financial statement effects of DOL and DFL can be shown by using the income statement format:

Previous

Percentage Increase

Resulting Change

DTL of 8

DOL of 2

Sales $100,000 10% $110,000

Variable costs 60,000 66,000

Fixed costs 20,000 20,000

EBIT 20,000 20% 24,000

DFL of 4

Fixed financing costs 15,000 15,000

EBT 5,000 9,000

Taxes (40%) 2,000 3,600

Net income $ 3,000 80% $ 5,400



Please note that the results were based on the assumptions that the cost relationships remain unchanged (fixed and variable) as well as the firm’s capital structure, including the amount of the fixed financing payments. As the relationships change, the DOL, DFL, and DTL would also change.

e. Illustration: Tally Company has the following information available about sales and costs from the last period:

Sales in units 10,000 Selling price per unit $10.00 Variable costs per unit $6.00 Fixed costs for period $20,000 Interest costs for period $15,000

What is the DTL?

Solution: DTL = DOL DFL

= 10,000 ($10 – $6) 10,000 ($10 – $6) – $20,000

10,000 ($10 – $6) – $20,000 10,000 ($10 – $6) – $20,000 – $15,000

= 2 4 = 8

2123 Activity

2123.01 Activity ratios measure how effectively the assets of an entity are employed. Coverage of Activity Ratios is included in Section 2121.

2124 Profitability

2124.01 Profitability (asset utilization) is the measure of success in terms of income defined in a variety of ways over a period of time. In analyzing profitability, earnings are compared to a base such as sales, productive assets, or equity. Increased profitability provides the potential for increased dividend payments as well as from stock appreciation. Increased profitability also provides greater security for debt holders.

2124.02 Gross margin

a. The gross margin ratio compares the gross margin (gross profit) generated by the net sales revenue. In other words, what percentage of the sales dollars were used to cover the cost of goods sold? The remaining amount is left to cover the general and administrative expenses as well as to provide a profit. This is also known as the gross profit ratio.

Gross margin in ratio = Gross margin Net sales revenue



b. This ratio is generally more useful to management than to creditors or investors since the data necessary to analyze why changes occurred in the ratio are only available internally. Changes are caused by one of the following elements or a combination of the following items.

(1) Increase/decrease in unit sales price

(2) Increase/decrease in cost per unit

c. Calculation using data from the Sample Company for 20X2:

Gross margin in ratio = Gross margin Net sales revenue

= $400,000 $1,000,000

= 40%

2124.03 Profit margin

a. The profit margin ratio calculates the percentage of each dollar of sales that is recognized as net income. In other words, it measures the efficiency of earnings as compared to sales. It indicates how well management has controlled expenses in relationship to revenues earned. This ratio is an excellent way to compare the profits of companies of varying sizes. This is also known as the return on sales ratio.

Profit margin ratio = Net income Net sales

b. In alternative definitions, the numerator for this ratio can take a variety of forms—operating income, net income, income available to stockholders, or income from recurring operations.

c. The use of accrual income includes estimates and items over which management has little or no control.

d. Calculation using data from the Sample Company for 20X2:

Profit margin ratio = Net income Net sales

= $75,000 $1,000,000

= 7.5%



2124.04 Asset turnover

a. The asset turnover ratio indicates how many dollars of sales were created by each dollar of total assets. It helps to determine whether the available assets were used efficiently to create sales. One goal of management is to generate the highest possible amount of sales per dollar of invested capital. Note that different industries tend to have different reasonable ranges for this ratio.

Asset turnover = Net sales revenue Average total assets

b. As in all turnover ratios, a high asset turnover is a desirable outcome since it results from an effective use of available assets; however, it is not unusual for a company that has recently expanded to see a drop in asset turnover until the new facility is fully utilized.

c. For internal use, it is desirable to calculate this ratio comparing divisional sales to divisional assets.

d. Comparison between firms within an industry can be difficult due to the fact that the age of the assets used in the production of the sales may vary. This is a limitation caused by the use of historical costs as opposed to fair market values for the productive assets. There is also a problem when comparing a capital‐intensive firm to a labor‐intensive firm.

e. There are also problems created due to the fact that the generally used formula does not take into account that certain assets make no tangible contribution to sales. It is assumed that an asset’s participation in generating sales is related to its recorded amount. Adjustments to the asset figure are used in attempts to compensate for this problem. For example, long‐term investments are not involved in the production and sale of the product and are often not included in the calculation.

f. Calculation using data from the Sample Company for 20X2:

Asset turnover = Net sales revenue Average total assets

= $1,000,000 $1,050,000 + $1,000,000

= 0.98

2



2124.05 Return on assets (ROA)

a. The return on assets ratio measures the productivity of assets in terms of producing income. This ratio depends upon the organization’s ability to get a high profit from each sales dollar while generating high sales per dollar of invested capital. A consistently high ROA is an indication that management is making effective decisions and that the organization is a growth company.

Return on assets = Net income Average total assets

b. The DuPont equation breaks ROA down to the asset turnover and profit margin.

Return on assets = Net income Net sales

× Net sales Average total assets

Through the use of the DuPont equation, ROA is broken down to the profit margin showing the effective control of cost (Net income/Net sales) and the asset turnover showing the efficient use of assets (Net sales/Average total assets).

c. Since neither profit margin nor asset turnover can increase indefinitely, at some point the only way to create further increases in earnings is to increase the asset base by adding to production capacity.

d. Limitations specific to this ratio include the use of accrual net income that is subject to estimates and does not reflect actual cash return. The rate of return is also based upon historical asset costs that do not reflect current market values.

e. The numerator can use a variety of income figures, including EBIT. The philosophy behind the use of EBIT is that the earnings available to three parties, stockholders, creditors, and the government (taxes) is created through the use of the assets available to the organization. The denominator is often restricted to only income‐producing assets by excluding long‐term investments and intangibles.

f. Calculation using data from the Sample Company for 20X2:

Return on assets = Net income Average total assets

$75,000 ($1,050,000 + $1,000,000) ÷ 2

= 7.3



2124.06 Return on equity (ROE)

a. The return on equity ratio measures the return to common stockholders. The ratio calculates how many dollars were earned for each dollar of common equity. When comparing this ratio with ROA (return on assets), the investment of the creditors is removed. This ratio is affected by the net income available to the stockholders (Net income – Preferred dividends), the profit margin available to the stockholders, the asset turnover, and the extent to which assets are financed by common stockholders. The method of financing used (debt vs. equity) has a major effect on this ratio.

Return on equity = Net income – Preferred

dividends Average common equity

or, using the DuPont equation:

ROE = Net income – Preferred dividends

Sales ×

Sales

Average assets ×

Average assets Average stockholders’

equity

b. The denominator consists of the average of the total equity less preferred shares and minority interest. One of the major problems with this ratio is that the historical issue price is used as opposed to the current market value.

c. The common stockholders’ leverage ratio (Average assets/Average stockholders’ equity used above) measures the portion of assets that are financed through common equity (also called the equity multiplier). The larger this ratio, the greater the financial leverage will be. Various organizations within an industry will have potentially dramatic differences in ROE resulting from financing decisions—debt vs. equity. If ROA is greater than the cost of borrowing, then ROE will be higher than ROA due to the impact of financial leverage.


Net income – Preferred dividends Average common equity

= Return on equity

$75,000 – $15,000 ($300,000 + $250,000) ÷ 2

= 22%



2125 Market

2125.01 Market measures

Investors use a variety of ratios to analyze the price and yield behavior of securities. These measures use a variety of market data as well as financial statement information.

2125.02 Price‐earnings ratio

a. The price‐earnings ratio indicates the relationship of common stock to net earnings. The market price is the investors’ perception of the future; therefore, this ratio combines the performance measure of the past (EPS) to perceptions of the future.

Price‐earnings ratio = Price market of stock Earnings per share

b. The earnings per share computation is subject to arbitrary assumptions and accrual income. EPS is not the only factor affecting market prices.

c. A high P/E ratio is a possible indication of a growth company and/or of a low‐risk organization.



= $17.00 $3.00

= 5.67

2125.03 Dividend yield

a. The dividend yield ratio shows the return to the stockholder based on the current market price of the stock.

Dividend yield = Dividend per common share Market price per common share

b. Dividend payments to stockholders are subject to many variables. The relationship between dividends paid and market prices is a reciprocal one.

c. This ratio is calculated using the current market price; however, most of the shareholders did not purchase their shares at the current price, thus making their personal yield different than the calculated yield.



=$10,000 ÷ 20,000 shares

$17.00 per share = 2.9%



2125.04 Payout ratio to common shareholders

a. The payout ratio to common shareholders measures the portion of net income to common shareholders that is paid out in dividends.

Payout ratio common

shareholders =

Common dividends Net income – Preferred dividends

b. Income does not necessarily measure cash available for dividend payment. Payments are heavily influenced by management policy, the nature of the industry, and the stage of development of the particular firm. All of these items diminish comparability between companies.

c. Organizations that have high growth rates generally have low payout ratios since most earnings are kept as retained earnings with the funds being reinvested in the company instead of providing cash dividends. A firm that has consistently paid a dividend and suddenly lowers its dividend payout often is signaling a lack of available cash and the existence of liquidity or solvency problems.


Payout ratio common shareholders

= Common dividends Net income – Preferred dividends

= $10,000 $75,000 – $15,000

= 16.67%

2125.05 Economic value added (EVA)

a. Economic value added (EVA) is the economic profit as opposed to the GAAP profit. The focus of this ratio is on the earnings above the required cost of capital for shareholders. In other words, if the required rate of return is 12% and the company earns 16%, then value has been created for the shareholders; therefore, it could be said that the investors value the firm above the amount of capital that was originally invested.



b. Another way of looking at EVA is that a cost is assigned to the equity capital in addition to the cost of debt. On the traditional income statement, interest expense represents the cost of debt; however, there is nothing to denote the cost of equity. Since EVA focuses on economic profits, the opportunity cost of the equity capital must be taken into consideration. For example, if the shareholders could earn 12% on an investment of similar risk, then this opportunity cost of 12% must also be accounted for. The cost of all capital employed in the first would be considered to be the weighted‐average cost of capital (WACC). NOPAT is the after‐tax profit of operating income and is equal to the operating profit times (1 – Tax rate).

EVA = NOPAT – (Cost of all capital × Total assets)

c. The EVA concept is often used by firms during the decision‐making process when determining whether a large investment in plant and equipment would be in the best interest of the shareholder.

d. Calculation using the data from the Sample Company for the year ended December 31, 20X2, assuming that the WACC is 10%:

EVA = NOPAT – (Cost of all capital × Total assets)

= ($175,000 × (1 – 0.40)) – (10% × $1,000,000) = $5,000

2125.06 Price‐to‐sales (P/S)

The price‐to‐sales (P/S) ratio is a valuation ratio that compares a company’s stock price to its revenues (an income statement item). The price‐to‐sales ratio is a key analysis and valuation tool for investors and analysts. The ratio shows how much investors are willing to pay per dollar of sales. Like all ratios, the P/S ratio is most relevant when used to compare companies in the same sector. A low ratio may indicate the stock is undervalued, while a ratio that is significantly above the average may suggest overvaluation.

The formula for the price‐to‐sales (P/S) ratio is:

P/S ratio = Market value per share

Sales per share



2125.07 Price‐to‐cash flow (P/CF)

The price‐to‐cash flow (P/CF) ratio is a stock valuation indicator or multiple that measures the value of a stock’s price relative to its operating cash flow per share. The ratio uses operating cash flow, which adds back noncash expenses such as depreciation and amortization to net income. It is especially useful for valuing stocks that have positive cash flow but are not profitable because of large noncash charges.

The formula for the price‐to‐cash flow (P/CF) ratio is:

Price to cash flow = Share price Operating cash flow per share

2125.08 Price‐to‐book (P/B)

Companies use the price‐to‐book (P/B) ratio to compare a firm's market to book value by dividing price per share by book value per share (BVPS). An asset's book value is equal to its carrying value on the balance sheet, and companies calculate it by netting the asset against its accumulated depreciation. Book value is also the net asset value of a company calculated as total assets minus intangible assets (patents, goodwill) and liabilities.

A lower P/B ratio could mean the stock is undervalued. However, it could also mean something is fundamentally wrong with the company. As with most ratios, this varies by industry. This ratio is also known as the price‐equity ratio.

The formula for the price‐to‐book (P/B) ratio is:

P/B ratio = Market price per share Book value per share

2125.09 Other price multiples

A price multiple is any ratio that uses the share price of a company in conjunction with some specific per‐share financial metric for a snapshot on valuation. The share price is typically divided by a chosen per‐share metric to form a ratio.

Some common price multiples are the price‐to‐earnings (P/E) ratio, forward price‐to‐earnings (forward P/E) ratio, price‐to‐book (P/B) ratio, and price‐to‐sales (P/S) ratio. Other ratios include price‐to‐tangible book value (P/TBV), price‐to‐cash flow (P/CF), price‐to‐EBITDA (earnings before interest, taxes, depreciation, and amortization) (P/EBITDA), and price‐to‐free cash flow (P/FCF). These price multiples are easy to compute on the surface, but care must be taken to analyze the components of the denominator to make sure the numbers are clean, i.e., no extraordinary items, one‐offs or nonrecurring factors that may distort a normalized financial metric.



2130 Profitability Analysis

2131 Income Measurement Analysis

2131.01 Factors Affecting Income: Various income statement items are typically used when analyzing profitability. These financial statement values do not necessarily represent a company’s economic performance, thus complicating the analysis. Below are several important factors that affect the quality of reported income statement values.

a. Accounting Estimates: Income is affected by a number of accounting estimates, including the allowance for doubtful accounts, the salvage values and depreciation lives of fixed assets, lower of cost or market adjustments to inventory, and warranty or other contingent liabilities. These accounting estimates may be influenced by managers and are also subject to uncertain outcomes.

b. Accounting Methods: GAAP includes certain conventions, such as historical cost and a stable monetary unit, which may distort reported revenues and expenses. In addition, managers are allowed to adopt a variety of different accounting methods that may reduce comparability across companies. Examples of accounting method choices include inventory cost flow assumptions, depreciation methods, and accounting for long‐term contracts.

c. Disclosures and Presentation: Substantial leeway exists within GAAP for the detail provided in financial statement disclosures. Some companies combine items that are reported separately by others. For example, one company might report selling costs separately from general and administration, while another company might combine these items. Also, some managers present earnings on temporary investments as part of operating income, while other managers present it as nonoperating. In addition, companies vary in the amount of detail provided in footnote disclosures. Differing definitions and materiality judgments provide opportunities for manages to use their discretion when preparing financial statements.



d. Needs of Different Users: As discussed in the section on leverage, different users have different perspectives about income. Common shareholders are primarily interested in their return on equity, while creditors are primarily interested in the ability of a company to pay their obligations. Thus, shareholders might focus on the change in value of a company’s assets, while creditors might focus more on liquidity. In addition, some users are interested only in short‐term results, while others have long‐term investments. These differences lead to conflicting attitudes toward profitability measures. Nevertheless, most users are interested in a company’s ability to generate revenues and to control costs.

2131.02 Analysis of Revenues: The analysis of revenues often focuses on revenue growth, or the percent change in revenues from one period to the next. Below are several factors that should be considered in conjunction with revenue growth.

a. Importance of Source, Stability, and Trend: Revenues are most valuable when they are expected to continue into the future. Analysts often monitor the stability and trend of revenues as indicators of a company’s ability to continue generating revenues in the future. These analyses may also highlight seasonal patterns or a company’s exposure to economic downturns. In addition, some revenue sources are riskier than others. For example, sometimes companies have sources of revenue that may not continue in the future, such as revenue from products subject to patents that will expire, or revenue from one‐time contracts. Some companies rely heavily on one or more major customers, and the loss of a single customer could be devastating. Companies subject to rapidly changing technology face similar risk; products they sell today may be worthless in the near future.

b. Relationship to Receivables and Inventory: Revenues are usually analyzed in conjunction with receivables and inventories. Negative trends often appear in these balance sheet accounts before they appear on the income statement. For example, when sales volumes begin to drop some managers engage in “channel stuffing,” in which they force their customers (particularly in distributor relationships) to accept unneeded shipments. This type of activity generally triggers a decline in receivables turnover. A decline in receivables turnover might also indicate that a company’s customers are having financial difficulties. A decline in inventory turnover often indicates that managers anticipated higher sales than occurred, suggesting unforeseen sales difficulties. It might also suggest product quality or other problems. Thus, declines in receivables and inventory turnover might indicate impending declines in revenues.



c. Accounting Methods: Alternative accounting methods are available for some types of revenues, such as under long‐term contracts (completed contract versus percent of completion). Obviously, managers’ choices of accounting methods can have major effects on the analysis of revenues. In addition, the SEC investigates instances of potential financial reporting fraud related to revenues more often than for any other accounting area. Sometimes managers are overly aggressive in recognizing revenues earlier than they should (such as in the case of “channel stuffing”). Other times managers are overly optimistic in accounting estimates.

2131.03 Analysis of Expenses

a. Major Expense Categories:

Cost of sales

Selling

Depreciation

Maintenance

Amortization

General and Administrative

Financing Expenses

Income Taxes

b. Gross Profit Margin: Cost of sales is often analyzed using the gross profit margin, which measures the proportion of each sales dollar remaining after covering cost of sales. Gross Profit = Sales – Cost of Sales

Sales Sales

c. Analyzing Changes in Expenses as a Percent of Revenue: Expenses are often analyzed as a percent of revenues. This form of analysis takes into account the idea that expenses are expected to fluctuate at least partly with revenues. The trend in expenses as a percent of revenues provides information about how well managers are controlling costs. CMA candidates should be prepared to identify possible reasons for increases over time in an expense as a percent of revenue.

2131.04 Analyzing Income With Common‐Size Statements: Common‐size statements — in particular, a common‐size income statement — can be used to evaluate a company’s profitability.



2131.05 Book Value per Share: Used as a basis for evaluating changes in the net worth of a company from year to year. Remember that book value means historical cost, not the value of the stock nor what the shareholder would receive in liquidation.

Net Assets Less Preferred Stock Redemption

Number of Common Shares Outstanding

2131.06 Operating Cash Flow to Income: The ratio of operating cash flow to net income is a measure of the strength and quality of reporting earnings. In the absence of unusual income statement items, manager manipulation, or other economic changes, this ratio is expected to remain fairly constant over time. Thus, changes in the ratio from year to year suggest that further analysis is called for.

Operating Cash Flow

Net Income

2132 Revenue Analysis

2132.01 The analysis of revenues often focuses on revenue growth, or the percent change in revenues from one period to the next. Below are several factors that should be considered in conjunction with revenue growth.

2132.02 Importance of Source, Stability, and Trend: Revenues are most valuable when they are expected to continue into the future. Analysts often monitor the stability and trend of revenues as indicators of a company’s ability to continue generating revenues in the future. These analyses may also highlight seasonal patterns or a company’s exposure to economic downturns. In addition, some revenue sources are riskier than others. For example, sometimes companies have sources of revenue that may not continue in the future, such as revenue from products subject to patents that will expire, or revenue from one‐time contracts. Some companies rely heavily on one or more major customers, and the loss of a single customer could be devastating. Companies subject to rapidly changing technology face similar risk; products they sell today may be worthless in the near future.



2132.03 Relationship to Receivables and Inventory: Revenues are usually analyzed in conjunction with receivables and inventories. Negative trends often appear in these balance sheet accounts before they appear on the income statement. For example, when sales volumes begin to drop some managers engage in “channel stuffing,” in which they force their customers (particularly in distributor relationships) to accept unneeded shipments. This type of activity generally triggers a decline in receivables turnover. A decline in receivables turnover might also indicate that a company’s customers are having financial difficulties. A decline in inventory turnover often indicates that managers anticipated higher sales than occurred, suggesting unforeseen sales difficulties. It might also suggest product quality or other problems. Thus, declines in receivables and inventory turnover might indicate impending declines in revenues.

2132.04 Accounting Methods: Alternative accounting methods are available for some types of revenues, such as under long‐term contracts (completed contract versus percent of completion). Obviously, managers’ choices of accounting methods can have major effects on the analysis of revenues. In addition, the SEC investigates instances of potential financial reporting fraud related to revenues more often than for any other accounting area. Sometimes managers are overly aggressive in recognizing revenues earlier than they should (such as in the case of “channel stuffing”). Other times managers are overly optimistic in accounting estimates.

2133 Cost of Sales Analysis

2133.01 CVP analysis/margin of safety

a. In the context of capital budgeting, cost‐volume‐profit analysis (CVP) is often used to determine the margin of safety for a project. In other words, how much could projected sales fall and still not fall below the breakeven point?

b. The CVP formula:

Profit = Sales – Variable costs – Fixed costs

Sales = Number of units sold times sales price per unit

Variable costs = Number of units sold times variable costs per unit

Fixed costs = Total fixed costs for anticipated range

The breakeven point is a special case of CVP analysis where the profit equals zero. In other words, sales revenue equals total costs.



Illustration: Product A sells for $5 per unit. Variable production costs are $3 per unit and fixed costs per period are $50,000. What will the profit be if 100,000 units are produced and sold? What is the breakeven point?

Solution:

Profit = Sales - Variable costs - Fixed costs

= ($5 100,000) ($3 100,000) - $50,000

= $150,000

Breakeven in units: 0 = $5x - $3x - $50,000 x = 25,000 units

c. Margin of safety is the excess sales over the breakeven sales point. This can be important when looking at projects with projected sales. The methods used to evaluate capital budgeting decisions use projected sales (savings). If, however, the projections are incorrect, then there could be significant changes in the calculations of the payback period, NPV, and IRR. When evaluating a project, the likelihood that the sales/production projected will be achieved needs to assessed.

Illustration: Using the above illustration, calculate the margin of safety:

Margin of safety = 100,000 projected unit - 25,000 breakeven units = 75,000 units

This could also be expressed in term of dollars. The margin of safety for

sales is $375,000 ($5 per unit 75,000 units). In this case, sales could fall significantly (by 75%) and there would still be a profit.

2134 Expense Analysis

2134.01 Major Expense Categories

Cost of sales

Selling

Depreciation

Maintenance

Amortization

General and Administrative

Financing Expenses



2134.02 Gross Profit Margin: Cost of sales is often analyzed using the gross profit margin, which measures the proportion of each sales dollar remaining after covering cost of sales.

Gross Profit = Sales – Cost of Sales

Sales Sales

2134.03 Analyzing Changes in Expenses as a Percent of Revenue: Expenses are often analyzed as a percent of revenues. This form of analysis takes into account the idea that expenses are expected to fluctuate at least partly with revenues. The trend in expenses as a percent of revenues provides information about how well managers are controlling costs.

CMA candidates should be prepared to identify possible reasons for increases over time in an expense as a percent of revenue.

2135 Variation Analysis

2135.01 Common Size Analysis: Common size ratios are used to compare financial statements of a company from year to year, or of different size companies. By relating items on the statements to a common measure, financial statements can be created in a standardized format that reveal trends and insights for comparison.

a. Horizontal Common Size Analysis: One of the ways to facilitate comparisons between companies or across years for a single company is horizontal common size analysis. All financial statement figures are expressed as a percentage of base year figures. Actual dollar amounts may also be shown. Trends may be analyzed using time series analysis. Past trends may indicate the direction of possible future trends. Analysis may be able to determine if a change from a prior year was part of a past trend, the start of a new trend or just normal variation in annual data.

b. Vertical Common Size Analysis: All figures are converted to percentages of a specific figure. Income Statement figures, for example, would all be expressed as percentage of sales and Balance Sheet figures could be a percentage of total assets.



2135.02 Comparison With Industry: Publishers of industry information, such as Dun and Bradstreet and Robert Morris Associates, analyze financial data from thousands of companies which can be used for comparison. It can sometimes be difficult to compare a firm to a specific industry, especially if the firm is in more than one line of business. Also, the published ratios are averages for the industry. The disadvantage is that the industry as a whole may not be performing satisfactorily, or a large segment may be performing poorly enough to bring the average down. Therefore, average may not be good. Another problem using comparisons between companies is the differences in accounting methods used by the various companies. However, one can generally get an indication of comparative performance, especially in conjunction with the firm’s own past performance.

2140 Special Issues

2141 Impact of Foreign Operations

International Financial Reporting Standards (IFRS)

2141.01 International Financial Reporting Standards (IFRS) are Standards, Interpretations and the Framework adopted by the International Accounting Standards Board (IASB). Many of the standards forming part of IFRS are known by the older name of International Accounting Standards (IAS). IAS were issued between 1973 and 2001 by the Board of the International Accounting Standards Committee (IASC). In 2001 the new IASB took over the responsibility for setting International Accounting Standards. During its first meeting the new Board adopted existing IAS and SICs. The IASB has continued to develop standards calling the new standards IFRS.

IFRS are considered a “principles based” set of standards in that they establish broad rules as well as dictating specific treatments. International Financial Reporting Standards comprise:

International Financial Reporting Standards (IFRS) – standards issued after 2001

International Accounting Standards (IAS) – standards issued before 2001

Interpretations originated from the International Financial Reporting Interpretations Committee (IFRIC) – issued after 2001

Standing Interpretations Committee (SIC) – issued before 2001



There is also a Framework for the Preparation and Presentation of Financial Statements which describes the principles underlying IFRS. The U.S. will be following the IFRS standards so that financial statements of other countries will be comparable.

U.S. Generally Accepted Accounting Principles (GAAP) have several key differences from International Financial Reporting Standards (IFRS, which is used in more than 100 countries). IFRS is considered to be principles based, whereas GAAP is considered to be rules based prescribing industry and/or transaction guidance. Some say that this allows IFRS to better reflect the economic view of a transaction than U.S. GAAP. As cross‐border transactions and U.S. owned foreign subsidiaries continue to grow, convergence of U.S. GAAP and IFRS is occurring. The goal is one set of uniform global accounting reporting standards. Some of the differences that exist are shown below.



Comparison Chart

Item U.S. GAAP IFRS Objectives of Financial Statements

GAAP provides separate objectives for business entities and non‐business entities

IFRS only has one objective for all types of entities

Financial Statements Required Components

Balance sheet, income statement, statement of comprehensive income, changes in equity, cash flow statement, and footnotes. Separation of current and non‐current assets and liabilities are recommended.

Balance sheet, income statement, changes in equity, cash flow statement, and footnotes. Separation of current and non‐current assets and liabilities are required.

Comparative Financial Information

Two years minimum normally must be presented in a format full set of financial statements.

One year minimum required.

Intangible Assets Purchased

Acquired intangible assets are recorded at fair value.

Intangible assets are only recognized if the asset has future economic benefit and has measured reliability.

Intangible Assets Developed

Development costs are to be expensed. Costs in the development phase may be capitalized.

Inventory Costs Last‐in, first‐out (LIFO) and first‐in, first‐out (FIFO) inventory valuations are acceptable.

FIFO method of valuation is acceptable, but LIFO is not allowed under IFRS.

Inventory Write Downs

Once inventory is written down the write down cannot be reversed in future periods.

If inventory is written down, the write down can be reversed in a future period if specific criteria is met.

Fixed Assets Property, plant, and equipment are valued at cost less any accumulated depreciation.

A revaluation method is allowed based on fair value of the asset on the date of evaluation, less subsequent accumulated depreciation and impairment losses.

Extraordinary Items Extraordinary items are reported separately as a special item on the income statement.

Extraordinary items are not usually reported under IFRS.

Tax deferrals Allows for the classification of the deferrals as current or non‐current, depending on the circumstances.

Only allows non‐current treatment of deferrals.

International Considerations

2141.02 Accounting Methods: When analyzing the financial data of companies from different countries, it is necessary to take into account the fact that accounting methods may differ across countries.



2141.03 Foreign Exchange Fluctuations: Companies having transactions in other currencies are exposed to currency exchange risk. Suppose a U.S. company sells merchandise to a company in Spain for €1,000. Between the time the transaction is negotiated and the time payment is received from the customer, the exchange rate between the U.S. dollar and the euro may become higher or lower. Some companies enter into hedging arrangements to minimize this type of risk. In general, foreign currency exchange gains or losses are not considered part of a company’s core earnings; they tend to distort accounting profit. Foreign exchange fluctuations may also affect the quantity of product demanded. The price of products sold internationally becomes higher or lower as currencies fluctuate. Sometimes companies experience declining (increasing) revenues because the prices of their products become higher (lower) in other countries.

2142 Effects of Changing Prices and Inflation

2142.01 Inflation: Traditional financial statements prepared according to generally accepted accounting principles (GAAP) are based on the historical cost concept; this requires the asset to be recorded and carried at its past historical acquisition price, less allowable reductions such as depreciation and declines in value below cost.

a. Balance Sheet: During periods of inflation, historical cost accounting understates the value of nonmonetary assets such as inventory and fixed assets. At the same time, the purchasing power declines for monetary assets such as cash and accounts receivable. On the other hand, it is beneficial during times of inflation to owe monetary liabilities such as accounts payable and long‐term debt.

b. Profitability: During periods of inflation, the costs of nonmonetary resources that are used up during a period (such as inventory sold and depreciation of fixed assets) are understated using historical cost. Suppose an inventory item costing $100 was sold, but must be replaced at a cost of $110. When historical cost ($100) is used on the income statement, accounting income is overstated by $10 compared to economic profit. Ratios such as return on assets (ROA) can become very distorted. Under inflation, the numerator (income) tends to be overstated, and the denominator (total assets) tends to be understated. Thus, inflation causes ROA to appear artificially high. Inflation also distorts financial statement trends. Revenues may appear to grow due simply due to inflation.



c. Adjusting for Inflation: Price indices may be used to adjust historical cost financial statement values for inflation. In the U.S., the Consumer Price Index (CPI) is often used as a general price index. Indices are also available for prices within individual industries.

Example: A company had sales of $300,000 in 20x1 and the price index for its industry is expected to rise from 300 in 20x1 to 320 in 20x2. The level of sales that the company must reach in 20x2 to achieve a real growth rate of 20% is:

a. $360,000

b. $320,000

c. 337,500

d. $384,000

Answer: d. If sales are $300,000 when the price index is 300, then sales must be $320,000 ($300,000 × 300/320) to maintain the same relative position when the price index is 320. To achieve 20% growth, multiply $320,000 by 120%. This is $384,000.

General Price‐Level Accounting

2142.02 General price‐level accounting is a process by which the effect of current changes in the purchasing power of the monetary unit is reflected in the financial statements. In price‐level accounting, the historical dollar basis of items reflected in the financial statements is retained, but the units in which the items are expressed are adjusted by means of price index numbers applied to the original transaction basis of the item.

2142.03 The following definitions are important in understanding price‐level accounting:

a. Monetary items: Those assets and liabilities whose amounts are fixed by contract or otherwise in terms of numbers of dollars, regardless of changes in specific prices or in the general level of prices

b. Nonmonetary items: Items reported in the financial statements other than monetary assets and liabilities

c. Purchasing power gains or losses: Occur when claims to a fixed amount of money are held during periods in which price levels change. For example, cash held through a period of inflation results in a decline in purchasing power and thus a purchasing power loss.



Preparing General Price‐Level Adjusted Financial Statements

2142.04 Accounting principles used in preparing price‐level adjusted financial statements (PLAFS) are the same as those used in conventional statements. Changes in the price level are measured in terms of a general price‐level index. PLAFS are presented in terms of the purchasing power of the dollar at the latest financial statement date.

2142.05 Monetary and nonmonetary items are distinguished in preparing price‐level adjusted financial statements (PLAFS). Monetary assets and liabilities are already stated in terms of current purchasing power and require no adjustment. Nonmonetary items are restated at the end of the current period based on the index in effect when the item originated. The price‐level adjusted amount of an item is determined by applying a ratio of index numbers to the historical cost of the item, as follows:

2142.06 Income statement items are restated to dollars of current purchasing power at the end of the current period.

2142.07 The purchasing power gain or loss is included in current income and reported as a separate income statement item.



Example

2142.08 Financial statements and other data for the P‐L Company are presented as follows. The steps and computations necessary to adjust the conventional financial statements to PLAFS are included in the following chart:

General information: Fiscal year 01/01-12/31/X2

Price indexes 01/01/X1 90 12/31/X1 98 12/31/X2 110

Unadjusted financial statements at December 31, 20X2, are as follows:

Balance Sheet Income Statement

Assets: Revenue $150,000 Currenta $100,000 Cash expenses 120,000 Fixedb 200,000 Depreciation 10,000 $300,000 Total expense 130,000 Net income $ 20,000 Liabilities: Currenta $ 50,000 Noncurrentb 75,000 Stockholders’ equity: Capital stock 100,000 Retained earnings 75,000 $300,000 a assumed to be monetary in this example b assumed to be nonmonetary in this example



Steps Computations

(1) Treatment of monetary items No restatement

(2) Restatement of nonmonetary items Nonmonetary items are converted by the ratio of Fixed assets: the current index (numerator) over the index at ($200,000) (110/90) = $244,444

the date of origination. Capital stock: Assume the following: ($50,000) (110/90) = $ 61,111

– Fixed assets acquired at 01/01/X1 ($50,000) (110/98) = 56,122

– Capital stock sold 1/2 at 01/01/X1 and 1/2 at $117,233 12/31/X1

(3) Preparation of balance sheet Price‐level adjusted figures used with retained Assets: earnings forced. Current $100,000 Fixed 244,444 $344,444 Liabilities: Current $ 50,000 Noncurrent 75,000 Stockholders’ equity: Capital stock 117,233 Retained earnings 102,211 $344,444

(4) Determine net income via change in retained earnings

Assume the following: Retained earnings, 12/31/X2: – No entries were made to retained earnings As determined previously $102,211 during the period. – Retained earnings as reported in the 12/31/X1 Retained earnings, 01/01/X2: price‐level adjusted balance sheet was $68,788. Restated: ($68,788) (110/98) 77,211

Net income, 20X2 $ 25,000

(5) Prepare income statement, forcing price‐level gain/loss

Revenues and expenses restated based on Revenues: appropriate indexes. ($150,000) (110/104) = $158,654

– Average index for year used for revenue and Expenses: expenses other than depreciation: (98 + 110) ÷ Cash: ($120,000) (110/104) = 126,923

2 = 104 Depreciation: – Index for depreciation is index for related ($10,000) (110/90) = 12,222

asset, 90. 139,145 – The purchasing power gain is “plugged” as the 19,509 difference between the $25,000 net income Purchasing power gain 5,491 from Step 4 and the $19,509 computed in Step 5.

Net income $ 25,000



2142.09 Additional considerations in preparing PLAFS

The distinction between monetary and nonmonetary items is an important one, because monetary items are not converted and nonmonetary items are converted. Following is a list of items that normally are considered monetary:

Assets: Cash on hand and demand bank deposits Time deposits Accounts and notes receivable Advances to employees Inventories produced under fixed‐price contracts Prepaid interest Receivables under capitalized leases Long‐term receivables Refundable deposits Advances to unconsolidated subsidiaries Cash surrender value of life insurance Liabilities: Accounts and notes payable Accrued expenses payable Cash dividend payable Refundable deposits Accrued losses on firm purchase commitments Bonds payable (and related discount or premium) Convertible bonds payable Obligations under capitalized leases Other long‐term debt Accrued pension costs

Some items have characteristics of both monetary and nonmonetary items and are classified according to the purpose for which they exist, which can usually be determined by their treatment in historical‐dollar financial statements. For example, debentures carried at the lower of cost or market and classified as current are dependent on the market price and are classified as nonmonetary. On the other hand, the same debentures carried at cost (adjusted for unamortized premium or discount) and classified as noncurrent are dependent on the fixed cash flow of principal and interest and thus are treated as monetary.

2142.10 The restatement of nonmonetary items requires an analysis of the account being converted to determine the timing of the origination of the account balance. Several observations and additional considerations are presented as follows:

a. Items originating at several points in time require a layering of the individual items to determine the converted balance.



b. Long‐lived assets are converted based on the index at their origin, as are their related depreciation (amortization) expense and accumulated depreciation (amortization).

c. Accounting principles selected to measure financial statement elements influence the proper index to use for conversion. For example, inventory must be analyzed based on the flow assumption used to identify indexes or averages of indexes that will approximate price levels during the time the inventory balances came about.

2142.11 The purchasing power gain or loss is computed independently, given sufficient information, by the following process:

a. Convert net monetary items at the beginning of the period to the current price level.

b. Add increases in monetary assets and decreases in monetary liabilities, adjusted to the current price level.

c. Deduct decreases in monetary assets and increases in monetary liabilities, adjusted to the current price level.

d. Determine net monetary items at the end of the period.

e. The difference between (d) and the total of (a), (b), and (c) is the purchasing power gain or loss. If (d) is greater, a gain exists; if (d) is less, a loss exists.

Example

2142.12 Rosie Company had monetary assets and monetary liabilities at the beginning and end of 20X1 as follows:

01/01/X1 12/31/X1 Monetary assets $100,000 $135,000 Monetary liabilities (75,000) (70,000) $ 25,000 $ 65,000

The price level index was 110 at January 1, 20X1, and 120 at December 31, 20X1. The following transactions took place during 20X1:

a. Sales affecting net monetary items of $750,000, spread evenly throughout the year

b. Expenses affecting net monetary items, $650,000, spread evenly throughout the year

c. Equipment acquired for $60,000 when the price index was 116



The purchasing power loss is computed as follows:

Restatement of 01/01/X1 net monetary items:

$25,000 1.09a $ 27,250

Increases in net monetary items

Sales: $750,000 1.04b 780,000

Decreases in net monetary items

Expenses: $650,000 1.04b (676,000)

Equipment: $60,000 1.03c (61,800)

69,450 Net monetary items, 12/31/X1 65,000 Purchasing power loss $ 4,450 Conversion indexes: a120/110 = 1.09

b120/((120 + 110)/2) = 1.04

c120/116 = 1.03

2142.13 Financial statements of previous periods, which are to be presented for comparative purposes, must be restated to current dollar terms as of the current financial statement date. This is done by the following computation for all financial statement items:

2142.14 A major point to remember about price‐level adjusted financial statements (PLAFS) is that the resulting financial statement amounts are not designed to approximate current values and will do so only in unusual cases. The amounts represent the application of GAAP, adjusted for changes in the general purchasing power of the dollar since origination. The purchasing power (P‐P) gain or loss represents the impact on general purchasing power of holding a net monetary asset or liability position through a period of inflation or deflation. The P‐P gain or loss may be generalized as follows:

Period of: Inflation Deflation

Holding net monetary liability position P‐P gain P‐P loss Holding net monetary asset position P‐P loss P‐P gain



2143 Impact of Changes in Accounting Treatment

2143.01 Accounting Standards Codification (ASC) Topic 250 (Accounting Changes and Error Corrections) requires retrospective application to prior periods’ financial statements of changes in accounting principle unless it is impracticable to determine either the period‐specific effects or the cumulative effect of the change. If impracticable to apply, ASC Topic 250 requires that the new accounting principle be applied to the balances of assets and liabilities as of the earliest period for which retrospective application is practicable. Also, an adjustment must be made to the opening balance of retained earnings rather than being reported on the income statement.

A retrospective application as defined by ASC Topic 250 is the application of a different accounting principle to prior accounting periods as if that principle had always been used or as the adjustment of previously issued financial statements to reflect a change in the reporting entity.

2143.02 Definition: A change in accounting principle results from adoption of a generally accepted accounting principle different from the one used previously for reporting purposes.

a. Exclusion: Neither initial adoption of an accounting principle nor adoption of a principle for transactions or events which are clearly different from previous transactions or events are considered changes in accounting principle. Examples of changes in accounting principle include:

A change in the method of inventory pricing (e.g., a change from FIFO

to LIFO)

A change in depreciation method (e.g., a change from straight line to

double declining balance, now accounted for as a change in

accounting estimate effected by a change in accounting principle)

A change in the method of accounting for long‐term construction

contracts (e.g., a change from the completed‐contract method to the

percentage‐of‐completion method)

b. Change in Principle: There is a presumption that an accounting principle, once adopted, should not be changed. That presumption can be overcome only if the enterprise justifies the change to an alternative accounting principle on the basis that it is preferable. The nature of and justification for an accounting change must be disclosed in the year in which the change is made.



2143.03 Reporting Changes in Accounting Principle: ASC Topic 250 requires a retrospective approach to changes in accounting principles. Previously, a cumulative effect of a change in principle was used which was included in the year of change.

a. Retrospective Approach: Using a retrospective accounting change approach, an entity reporting the change adjusts its financial statements for each prior period presented to the same basis as the new accounting principle. An adjustment is made to the carrying amounts of assets and liabilities as of the beginning of the first year presented, plus an adjustment to the opening balance of retained earnings.

b. Impracticability: Entities should not use retrospective application if one of the following conditions exists.

The entity cannot determine the effects of the retrospective application.

Retrospective application requires assumptions about management’s intent in a prior period.

Retrospective application requires significant estimates that the entity cannot develop.

If any of the above conditions exists, the entity prospectively applies the new accounting principle.

2143.04 Change in Accounting Estimate: Estimates are necessary in accounting because financial statements must be prepared periodically before the ultimate consequences of many transactions are known. Examples of items for which estimates are necessary are uncollectible receivables, inventory obsolescence, service lives and salvage values of depreciable assets, warranty costs, recoverable mineral reserves, and periods benefited by a deferred cost.

A change in accounting estimate is accounted for prospectively, i.e. in the period of the change if the change affects that period only or in the period of the change and future periods if the change also affects future periods. Financial statements for previous periods should not be restated nor should pro forma amounts for prior periods be reported. The effect of a change in estimate on income before extraordinary items, net income, and related per share amounts of the current period must be disclosed for changes which affect several periods.



2143.05 Change in Reporting Entity: Some accounting changes are the result of formation of a new reporting entity. (Note that purchase, creation, disposition, or cessation of a business unit does not constitute a change in reporting entity.) These changes are accounted for by restating the financial statements of all prior periods presented to show how the financial information would have appeared for the new reporting entity. The financial statements should describe the nature of the change and the reason for it. Examples of a change in entity include:

a. Presenting consolidated statements in place of statements for individual companies

b. Changing the set of subsidiaries or companies included in consolidated or combined financial statements

2143.06 Correction of an Error: A correction of an error is accounted for as a prior period adjustment and comparative statements for prior periods are restated to correct for the effect of the error. Any effect attributable to years prior to the earliest year presented is shown as an adjustment of beginning retained earnings for the earliest year. Examples of errors include:

a. A change from an accounting principle which is not generally accepted to an accepted principle

b. Mathematical mistakes

c. Changes in estimates due to errors or inappropriate assumptions in preparing the original estimates

d. Mistakes in application of an accounting principle

e. Incorrect classification of a cost as an expense rather than an asset or vice versa

2144 Accounting and Economic Concepts of Value and Income

2144.01 Fair Value Accounting: Fair value is a concept used in accounting and economics defined as a rational and unbiased estimate of the market price of a good, service, or asset, taking into account such objective factors as:

acquisition/production/distribution costs, replacement costs, or costs of close substitutes

actual utility at a given level of development of social productive capability

supply vs. demand and subjective factors such as

risk characteristics

cost of and return on capital

individually perceived utility



2144.02 Estimate of Value: In accounting, fair value is used as an estimate of the market value of an asset (or liability) does not have a market price because there is no established market for the asset. Under GAAP (FAS 157), fair value is the amount an asset could be bought or sold in a transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale.

2144.03 Example: An example of where fair value is an issue is where an asset is purchased several years ago that has no active resale market. If you wanted to put a fair value measurement on the asset it would be a subjective estimate because of the lack of a market for such items. Another example would be if two companies purchased similar land parcels, but one purchased their parcel in 20x2 for $800,000 while the second company purchased theirs for $2,000,000 in 20x7. Historical costs have been presented in the balance sheet, but there would be no way to show the comparable value of the assets. Fair value would allow the two assets to be presented at their current value, $2,000,000.

2145 Earnings Quality

Fundamental Earnings‐per‐Share Concepts

2145.01 Earnings per share (EPS) is a comparison of the earnings applicable to common stock with the number of shares of common stock of that enterprise. The concept relates only to common stock and should be thought of as “earnings per common share.”

2145.02 Assuming that there is no preferred stock outstanding, the fundamental EPS computation is:

EPS = Net income Weighted‐average common shares outstanding

2145.03 If the enterprise has preferred stock outstanding, the fundamental EPS computation is:

EPS = Net income – Preferred dividends Weighted‐average common shares outstanding

2145.04 All EPS computations involve the division of a dollar amount of earnings (earnings applicable to common stock) by a number of common shares. The resulting fraction or index represents the pro rata share of earnings (the numerator) allocated to each share of common stock (the denominator).



2145.05 Conceptually, earnings per share is a very simple notion. There are, however, securities that, because of their conversion feature (e.g., convertible preferred, convertible debt), right to acquire common stock (e.g., stock options, stock warrants), or capability of sharing in earnings in a manner similar to common stock (e.g., freestanding instruments with down round features or contingent issuance of common shares in conjunction with a business combination), create the potential for earnings per share to be less than if it is based solely on the number of outstanding shares of common stock. The existence of these other potential common shares makes it important to show their possible dilutive effect on earnings per share.

2145.06 The objective is to show (a) basic EPS—an earnings per share based only on the actual outstanding common stock—and (b) diluted EPS—an earnings per share after giving consideration to these potential common shares. In the former case, the earnings per share calculation takes into consideration the triggering of the down round feature and deducts its effect from income available to common shareholders. In the latter case, the earnings per share calculation takes into consideration the impact that the assumed conversion or exercise of the securities that constitute potential common stock would have on both the numerator earnings and the denominator shares. All earnings‐per‐share computations are based on a weighted‐average number of common shares outstanding or assumed to be outstanding.

2145.07 Earnings per share (EPS) must be presented on the face of the income statement of publicly held enterprises as follows:

Type of Capital Structure EPS Presentation

SIMPLE (only common stock outstanding, with no potential common stock)

BASIC EPS (based on weighted‐average number of actual common shares outstanding)

COMPLEX (common stock outstanding and one or more types of potential common stock)

DUAL EPS:

BASIC EPS (based on weighted‐average number of actual common shares outstanding during the period)

DILUTED EPS (based on weighted‐average number of actual common shares outstanding during the period plus the weighted‐average number of common shares that would result from the assumed conversion or exercise of all dilutive potential common stock)



2145.08 Because simple capital structures include no potential common stock, earnings per share is computed based only on the weighted‐average number of common shares outstanding during the period. Complex capital structures, on the other hand, include the potential for dilution, and a dual presentation of EPS is required. Basic EPS is based on the weighted‐average number of actual common shares outstanding during the period. Diluted EPS is based on the weighted‐average number of actual common shares outstanding plus the weighted‐average number of common shares that would result from the assumed conversion or exercise of all dilutive potential common stock

2145.09 In certain circumstances, potential common stock may actually increase rather than decrease EPS. In that case, the potential common stock is said to be antidilutive. Since the objective of the dual presentation of EPS is to show the potential dilution of EPS by the assumed conversion or exercise of potential common stock, EPS calculations should include only those potential common shares whose inclusion would decrease EPS (i.e., those that are dilutive).

2145.10 Several definitions are important in an understanding of the dual presentation of EPS for enterprises with a complex capital structure.

a. Dilution (dilutive): A reduction in EPS resulting from the assumption that convertible securities were converted, that options or warrants were exercised, or that other shares were issued on the satisfaction of certain conditions

b. Antidilution (antidilutive): An increase in earnings‐per‐share amounts or a decrease in loss‐per‐share amounts

c. Potential common stock (PCS): A security or other contract that may entitle its holder to obtain common stock during the reporting period or after the end of the reporting period

d. Weighted‐average common shares (WACS): The number of shares determined by relating (a) the portion of time within a reporting period that common shares have been outstanding to (b) the total time in that period. In computing WACS, retroactive application is given to stock splits, stock dividends, and shares of common stock issued in a business combination accounted for as a pooling of interests (i.e., they are treated as if they were outstanding for all of any periods presented).



e. Basic EPS: The amount of earnings for the period available to each share of common stock outstanding during the reporting period

f. Diluted EPS: The amount of earnings for the period available to each share of common stock outstanding during the reporting period and to each share that would have been outstanding assuming the issuance of common shares for all dilutive potential common shares outstanding during the reporting period

2145.11 The most common types of potential common stock are convertible securities, stock options and warrants, and other contingent issuances (i.e., arrangements whereby the enterprise is required to issue common stock on the satisfaction of certain conditions). Each potential common stock must be evaluated to determine if it is dilutive.

EPS Computational Guidelines

2145.12 The basic EPS and diluted EPS computations can be generalized as follows:

Basic EPS = Net income – Dividends on preferred stock

WACS

Diluted EPS = Net income – Dividends on preferred stock + PCS adjustments

WACS + WPCS

WACS is the weighted‐average number of actual common shares outstanding. WPCS is the weighted‐average number of common shares that would result from the assumed conversion or exercise of dilutive potential common shares outstanding.

Preferred Stock Dividends

2145.13 In computing EPS, dividends on preferred stock are subtracted from net income for all EPS computations for which the preferred stock is assumed to be outstanding. If the preferred stock is cumulative, the amount to be deducted is the total dividend for the period whether it is declared or not. If the preferred stock is noncumulative, the amount to be deducted is the amount actually declared during the current period. This adjustment (deduction) is made to convert net income to the amount of earnings applicable to common stock only.

2145.14 In making the EPS computations for any given period, dividends in arrears are ignored. The preferred dividends applicable to those prior periods (i.e., the dividends in arrears with respect to the current period) should have been taken into consideration for the EPS computations for those prior periods.



2145.15 If there are preferred dividends and a net loss occurs, the preferred dividends are added to the net loss for purposes of computing the loss per share.

2145.16 Treasury stock method (for stock options and warrants): Stock options and warrants outstanding (whether or not presently exercisable) should be included in EPS calculations unless they are antidilutive.

2145.17 The dilutive effect of stock options and warrants is computed by the treasury stock method. This method is based on the assumption that the options or warrants are exercised at the beginning of the period (or date of issuance if later) and the proceeds from the exercise used to purchase outstanding common stock that would then become treasury stock. (Hence, the name “treasury stock” method.) The dilutive effect is the net increase in outstanding shares from the assumed sale of the shares (arising from the exercise of the options or warrants) and the reacquisition of outstanding shares with the proceeds from the exercise of the options or warrants.

2145.18 If the average market price for the period (e.g., for the year) of the enterprise’s common stock exceeds the exercise price of the options or warrants, the proceeds from the assumed exercise are not sufficient to buy back as many shares as were issued on the assumed exercise of the options or warrants. The net result is an increase in the number of shares outstanding. Assuming a net income (as opposed to a net loss), this increase in the number of shares outstanding would reduce EPS and, thus, the options or warrants would be dilutive for EPS purposes.

2145.19 If the average market price of the enterprise’s common stock is less than the exercise price of the options or warrants, the proceeds from the assumed exercise are sufficient to buy back more shares than those issued on the assumed exercise of the options or warrants. The net result would be a decrease in the number of shares outstanding. Since a decrease in the number of shares assumed outstanding (the denominator shares) would cause EPS to increase, the options or warrants would be antidilutive. In that case, one would not assume the exercise of the options or warrants in calculating EPS.

2145.20 In summary, options or warrants are assumed exercised only if the average market price of the stock exceeds the exercise price of the options or warrants.



2145.21 Example: An enterprise has outstanding 10,000 options to acquire common stock at $20 and the average market price of the stock for the period is $25.

1. Shares assumed issued on exercise of the options (Proceeds = 10,000 $20 exercise price = $200,000) 10,000

2. Shares assumed reacquired with proceeds: $200,000 $25 average market price 8,000

3. Incremental denominator shares 2,000

2145.22 Alternatively, the incremental denominator shares could be computed as follows:

Incremental shares = Market price - Exercise price

Market price Number of options

= $25 - $20

$25 10,000

= 2,000 shares

2145.23 Assuming net income of $100,000 and WACS of 50,000, basic EPS and diluted EPS are computed as follows:

Basic EPS = Net income

WACS =

$100,000 50,000 shares

= $2.00

Diluted EPS = Net income WACS + WPCS

= $100,000 50,000 + 2,000

= $1.92

Freestanding Equity‐Classified Financial Instruments (Nonconvertible Instruments) with a Down Round Feature

2145.24 If an entity has a freestanding equity‐classified financial instrument with a down round feature that has been triggered, the entity shall deduct the effect of the down round feature when computing income available to common stockholders.

a. The effect is treated as a dividend and a reduction of income available to common stockholders in basic earnings per share.

b. The effect, determined immediately after triggering, is the difference between the fair values of the financial instrument (without the down round feature) using the strike price (1) before and (2) after the reduction.



2145.25 Example (based on FASB ASC 260‐10‐55‐95 through 55‐97): Assume all are met to classify warrants as an equity freestanding financial instrument. Warrants, with a 10‐year life, allow the holder to buy 1,000 shares of common stock for $20 per share. The warrants have a down round feature to protect the holder from the firm issuing additional shares at a price below $20 per share or issuing equity‐classified financial instruments with a strike price below $20 per share. The strike price would be reduced to the most recent issuance or strike price but the down round feature limits the strike price reduction to $16 at most. Assume the entity issues common stock shares for $12 per share. This would trigger the down round feature and the strike price would be reduced to $16. Assume the fair value of the warrants before the down round feature is triggered is $12,000 and that the fair value of the warrants (using a strike price of $16) immediately after the down round feature is $15,000. The fair value increase resulting from the triggering of the down round feature is $3,000. The journal entry would be:

Retained Earnings 3,000 Additional Paid‐in Capital 3,000

The entity would reduce the income available to common stockholders in its basic earnings per share (EPS) calculation by $3,000. The treasury stock method, if the effect is dilutive, would be used to calculate diluted EPS and the $3,000 would be added back to income available to common stockholders during that calculation.

“If Converted” Method (for Convertible Securities)

2145.26 The “if converted” method assumes that convertible securities are converted into common stock for purposes of computing EPS. It requires that the numerator in the basic EPS computation be adjusted for the interest savings (net of the related tax effect) or the dividend savings that would be experienced if a convertible security is assumed to be converted into common stock for purposes of the diluted EPS computation. In other words, if one assumes that a convertible security is converted, it would be inconsistent to assume that interest or dividends would be paid on that security after it is assumed to be converted. Therefore, the numerator earnings must be adjusted for the effect that the assumed conversion of the security would have on the amount of interest or dividends.



2145.27 Example: A $200,000, 10% bond issue is convertible into 8,000 shares of common stock. Assuming net income of $100,000, WACS of 50,000, and a tax rate of 40%, basic EPS and diluted EPS are computed as follows:


WACS

Basic EPS = $100,000 50,000 shares

= $2.00

Diluted EPS = Net income + Interest (net of tax) WACS + Incremental common shares from assumed conversion of bonds

Diluted EPS = $100,000 + $12,000a

50,000 + 8,000b = $1.93

a Interest savings, after tax ($200,000 0.10) (1 – 0.40 tax rate) = $12,000 b Incremental common shares resulting from assumed conversion of bonds: 8,000

Computation of Weighted Average

2145.28 Both basic EPS and diluted EPS computations are based on a weighted‐average shares concept. Under this concept, the computation of the denominator shares takes into consideration the portion of the period that the common shares were outstanding or assumed to be outstanding for purposes of EPS computations. To illustrate, assume that an enterprise had common stock outstanding as shown:

01/01/X1—15,000 common shares outstanding 05/01/X1—9,000 common shares issued 08/01/X1—6,000 outstanding common shares reacquired as treasury stock WACS for 20X1:

15,000 4/12 = 5,000 (a total of 15,000 shares for 4 months)



18,500

2145.29 In like manner, if a potential common stock is outstanding for only part of a period for which EPS is computed, the computation of the number of common shares that would result from the assumed conversion or exercise of the potential common stock would be based on the portion of the period that the potential common stock was actually outstanding.



2145.30 Example: A $100,000, 6% bond issue was sold on April 1, 20X1, convertible into 10,000 shares of common stock. Assuming that net income is $200,000, WACS is 100,000, and the effective tax rate is 40%, earnings per share is as follows:


WACS =

$200,000 100,000 shares

= $2.00

Diluted EPS = Net income + Interest (net of tax)

WACS + WPCS =$200,000 + $2,700a

100,000 + 7,500b = $1.89

a [$100,000 0.06 (1 – 0.40)] 9/12 = $2,700 b 10,000 shares 9/12 = 7,500 shares

2145.31 As the example illustrates, the computation of common shares resulting from the assumed conversion of the bonds takes into consideration that the bonds were not outstanding during the entire period. The incremental shares of common stock that would result from the assumed conversion of the bonds are weighted for the portion of the year (9/12) the bonds were outstanding. The numerator adjustment for the interest is similarly weighted for the portion of the year the bonds were outstanding.

Retroactive Application of Stock Splits and Stock Dividends

2145.32 Stock splits and stock dividends are treated retroactively in the computation of EPS, both for the current period and any prior periods presented for comparative purposes.

2145.33 Example: In 20X1, net income was $560,000 and WACS was 100,000 shares, giving an EPS figure of $5.60. In 20X2, a 10% stock dividend is issued on August 31 and net income for the year is $725,000. EPS for 20X2 is computed as follows:

EPS = $725,000 100,000 + (0.10 × 100,000)

= $6.59

The 10,000 incremental shares issued as a stock dividend are treated as if they were outstanding for the entire year, even though the stock dividend was issued on August 31 and the resulting 10,000 shares were outstanding for only part of the year.

2145.34 EPS computations treat stock dividends and stock splits as if they occurred at the beginning of the earliest year presented in the current financial report.



2145.35 The EPS of $5.60 for 20X1 must be restated (in the 20X2 financial statements) to give effect to the 10% stock dividend declared in 20X2. The comparative years’ presentation in the 20X2 financial statements would show EPS for the two years as follows:

20X1 20X2

Earnings per share $5.09 $6.59

2145.36 The $5.09 is determined by dividing the 20X1 net income of $560,000 by the equivalent share that would have been outstanding if the stock dividend

were applied retroactively to the beginning of 20X1 ($560,000 110,000 = $5.09).

2145.37 The retroactive application of a stock dividend applies to all shares issued or assumed to be issued prior to the stock dividend or split.

2145.38 Example: Assume the following events in 20X1 related to common stock:

01/01/X1 15,000 shares outstanding 05/01/X1 9,000 shares issued for cash 06/01/X1 4,800 shares issued as a 20% stock dividend (20% of 24,000 shares) 08/01/X1 6,000 outstanding shares reacquired as treasury stock

Dates Outstanding Shares

Outstanding

Restatement for 20% Stock

Dividend Fraction of Year Weighted‐

Average Shares

Jan. 1-May 1 15,000 1.20 4/12 6,000 May 1-June 1 24,000 1.20 1/12 2,400 June 1-Aug. 1 28,800 2/12 4,800

Aug. 1-Dec. 31 22,800 5/12 9,500

12/12 22,700

2145.39 Note that the shares outstanding prior to June 1 are retroactively restated to reflect the effect of the 20% stock dividend on June 1. Of course, the shares outstanding after June 1 already reflect the effect of the 20% stock dividend.

2145.40 If a stock dividend or split occurs after the end of the year but before the financial statements are issued, the weighted‐average number of shares outstanding for the current year and any prior years presented in the current period in comparative form must be restated. For example, if a 2:1 stock split were issued on January 8, 20X2 (prior to the issuance of the 20X1 financial statements), the weighted‐average common shares for 20X1 would be

45,400 (i.e., 22,700 2).



Inclusion of Only Dilutive Potential Common Stock

2145.41 The computation of diluted EPS includes only those potential common shares (PCS) that are dilutive. A convenient way to determine if all potential common shares are dilutive is to first calculate the per‐share effect of each PCS and then include each PCS in the calculation of diluted EPS by starting with the PCS with the lowest per‐share effect and continuing as long as the next lowest per‐share effect is lower than the previously calculated diluted EPS. The per‐share effect of a PCS is the ratio of (a) the change in the numerator earnings resulting from the assumed exercise or conversion of the PCS to (b) the change in the denominator shares resulting from the assumed exercise or conversion of that PCS.

2145.42 Example: In 20X1, Alpha Company reported net income of $200,000 and had 20,000 shares of common stock during the entire year. Alpha also had outstanding during all of 20X1 the following convertible securities:

a. Convertible preferred stock, 6%, $100 par, 1,000 shares, each share convertible into 15 shares of common stock

b. Convertible bonds, 15%, $100,000 face amount, each $1,000 bond convertible into 10 shares of common stock

Assume a tax rate of 40%.

2145.43 Basic EPS is:

BEPS = Net income

WACS =

$200,000 20,000

= $10.00

2145.44 The per‐share effect of each of the convertible securities is as follows:

Convertible preferred:

$0.40shares 15,000

$6,000

Shares lIncrementa

DividendsEffect SharePer

b

a

a Dividends = $100,000 × 0.06 = $6,000

b Incremental shares = 1,000 preferred shares × 15 common shares per preferred share

= 15,000 common shares

Convertible bonds:

$9.00shares 1,000

$9,000

Shares lIncrementa

)Interest(Effect SharePer

b

a

net-of-tax

a Interest = $100,000 × 0.15 × (1 - .40 tax rate) = $9,000

b Incremental shares = $100,000 total face of bonds ÷ $1,000 face per bond = 100 bonds

= 100 bonds × 10 shares of common per $1,000 bond = 1,000 common shares



2145.45 Since the convertible preferred stock has the lowest per‐share effect ($.40), it is the most dilutive and, therefore, should be assumed to be converted before the convertible bonds which have a higher per‐share effect ($9.00). If only the preferred stock is assumed to be converted, the diluted EPS is:

Diluted EPS = Net income – Preferred dividends

WACS + WPCS =

$200,000 – $6,000 20,000 + 15,000

= $5.54

2145.46 Note that even though the $9.00 per‐share effect of the convertible bonds is less than basic EPS of $10.00, the convertible bonds are antidilutive because their per‐share effect of $9.00 is greater than the $5.54 diluted EPS computed with only the convertible preferred stock assumed to be converted. Thus, by computing the per‐share effect of each potential common stock and assuming their exercise or conversion in ascending order (smallest to largest per‐share effects) and continuing until the next lowest per‐share effect is greater than diluted EPS without including that next PCS (or until all PCS have been included in the computation of diluted EPS if all prove to be dilutive), one is assured that the final diluted EPS calculated is the lowest diluted EPS (and therefore the most dilutive diluted EPS) for that period.

Comprehensive EPS Illustration

2145.47 You are responsible for completing the income statement of the Mars Company at year‐end 20X2. Your workpapers disclose the following opening balances and transactions in the company’s capital stock accounts during the year:

a. Common stock (at October 1, 20X1, stated value $10, authorized 300,000 shares; effective December 1, 20X1, stated value $5, authorized 600,000 shares):

Balance, October 1, 20X1 — issued and outstanding 60,000 shares December 1, 20X1 — 60,000 shares issued in a 2‐for‐1 stock split December 1, 20X1 — 280,000 shares (stated value $5) issued at $39 per share

b. Treasury stock—common:

March 1, 20X2 — purchased 40,000 shares at $38 per share April 1, 20X2 — sold 40,000 shares at $40 per share

c. Stock purchase warrants, Series A (initially, each warrant was exchangeable with $60 for one common share; effective December 1, 20X1, each warrant became exchangeable for two common shares at $30 per‐share):

October 1, 20X1 — 25,000 warrants issued at $6 each



d. Stock purchase warrants, Series B (each warrant is exchangeable with $50 for one common share):

April 1, 20X2 — 20,000 warrants authorized and issued at $10 each

e. First mortgage bonds, 5½%, due 20X5 (nonconvertible; priced to yield 5% when issued):

Balance October 1, 20X1 — authorized, issued, and outstanding—the face value of $1,400,000

f. Convertible debentures, 7%, due 20X9 (initially, each $1,000 bond was convertible at any time until maturity into 15 common shares; effective December 1, 20X1, the conversion rate became 30 shares for each bond):

October 1, 20X1 — authorized and issued at their face value (no premium or discount) of

$2,400,000

g. The market price for the company’s common stock was as follows:

10/01/X1 $66 04/01/X2 $40 09/30/X2 $43 Average for year ended 09/30/X2—$37.50

h. Net income for the year ended September 30, 20X2, was $540,000. The appropriate tax rate is 40%.

i. Required:

(1) Compute WACS.

(2) Compute basic EPS.

(3) Determine the per‐share effect of each potential common stock (PCS).

(4) Compute diluted EPS.

2145.48 Requirement 1: Compute WACS.

Dates Outstanding Shares

Outstanding Restatement for 2:1 Stock Split

Fraction of Year

Weighted Average Shares (WACS)

Oct. 1–Dec. 1 60,000 2.00 2/12 20,000

Dec. 1–Mar. 1 400,000 3/12 100,000

Mar. 1–Apr. 1 360,000 1/12 30,000

Apr. 1–Sept. 30 400,000 6/12 200,000

12/12 350,000

2145.49 Requirement 2: Compute basic EPS.


WAC =

$540,000 350,000 shares

= $1.54



2145.50 Requirement 3: Determine the per‐share effect of each potential common stock (PCS).

Series A warrants: Numerator effect = $0 Denominator effect:

Shares issued on exercise (25,000 2 shares per warrant) 50,000

Proceeds = 25,000 2 $30 = $1,500,000

Shares reacquired with proceeds ($1,500,000 $37.50 market price) 40,000

Incremental denominator shares 10,000

Per‐share effect = Numerator effect Incremental shares

= $0 10,000 shares

= $ 0.00

Series B warrants: Antidilutive because the average market price of $37.50 is less than the exercise price of $50

5.5% first‐mortgage bonds: Not a potential common stock (PCS) because the bonds are not convertible

7% convertible debentures:

Per share effect

$1.40shares 72,000

$100,800

Shares lIncrementa

tax)-of-etInterest(n

Shares lIncrementa

EffectNumerator b

a

a Interest net of tax = $2,400,000 × 0.07 × (1 – 0.40) = $100,800

b Incremental shares = $2,400,000 total face ÷ $1,000 face per bond = 2,400 bonds

2,400 bonds × 30 common shares per bond = 72,000 shares

2145.51 The per‐share effects of the relevant potential common stocks arranged in ascending order are:

Series A stock purchase warrants $0.00 7% convertible debentures 1.40

2145.52 Since the per‐share effect of the Series A warrants is the lowest, one would assume exercise of these warrants provided that the per‐share effect of the warrants ($0.00) is also less than the basic EPS of $1.54. Since that is the case, the Series A warrants are dilutive. Assuming the Series A warrants are exercised, the diluted EPS is:

Diluted EPS = Net income + Numerator effect of warrants WACS + Denominator effect of warrants

=

$540,000 + $0.00 350,000 + 10,000

= $540,000 360,000 shares

= $1.50



2145.53 Since the per‐share effect of the 7% convertible debentures ($1.40) is lower than the diluted EPS, assuming exercise of the warrants only, the assumed conversion of the debentures would reduce diluted EPS. Therefore, the debentures are dilutive and their conversion should be assumed. In that case, the diluted EPS is:

Diluted EPS = $540,000 + $0 + Numerator effect of warrants 350,000 + 10,000 + Denominator effect of debentures

=

$540,000 + $0 + $100,800 350,000 + 10,000 + 72,000

= $640 800 432,000 shares

= $1.48

2145.54 Thus, earnings per share would be presented for the year ended September 30, 20X2, as follows:

Basic earnings per share $1.54 Diluted earnings per share 1.48

Additional EPS Considerations

2145.55 This section contains discussion of several additional considerations with respect to the calculation and presentation of earnings per share.

2145.56 Periods for which EPS must be presented

Earnings per share must be presented for all periods for which an income statement or summary of earnings is presented. If diluted EPS is presented for any period included in the current financial report, it must be presented for all periods included in that financial report. In other words, if dual EPS is presented for any period, it must be presented for all periods presented.

2145.57 Income captions for which EPS are presented

EPS (if applicable, both basic EPS and diluted EPS) must be presented on the face of the income statement for each of the following income captions if they appear on the income statement:

a. Income from continuing operations

b. Net income

2145.58 EPS must also be presented for discontinued operations, either on the face of the income statement or in the notes to the financial statements.

2145.59 Income from continuing operations used as the “control number”

If an enterprise reports a discontinued operation, it must use income from continuing operations as the “control number” in determining whether potential common shares are dilutive or antidilutive.



2145.60 The importance of the control number is that the same number of potential common shares used in computing the diluted per‐share amount for the control number must be used in computing all other reported per‐share amounts, even if those amounts are antidilutive to their respective basic per‐share amounts.

2145.61 Example: Assume that an enterprise reports the following on its income statement:

Income from continuing operations $ 100,000 Discontinued operations (250,000) Net income $(150,000)

Assume that 10,000 shares of common stock were outstanding during the entire year. In addition, assume that the enterprise had outstanding all year stock options that would result in 2,000 incremental common shares if exercised.

2145.62 The stock options are dilutive with respect to income from continuing operations—the control number—because their assumed exercise would reduce EPS. In this case, EPS would be presented as follows:

For income from continuing operations:

Basic = Income from continuing operations

WACS =

$100,000 10,000

= $10.00

Diluted = Income from continuing operations

WACS + WPCS =

$100,000 10,000 + 2,000

= $8.33

For net income or loss:

Basic = Net income

WACS =

($150,000) 10,000

= ($15.00)

Diluted = Net income WACS + WPCS

= ($150,000) 10,000 + 2,000

= ($12.50)

2145.63 Note that the stock options are dilutive with respect to income from continuing operations; the diluted EPS of $8.33 is less than the basic EPS of $10.00. However, the stock options are antidilutive with respect to net income or loss; the diluted EPS of $(12.50) is greater than (rather than less than) the basic EPS of $(15.00). A smaller loss per share is “better than” a larger loss per share; therefore, a smaller loss per share is antidilutive.

2145.64 In this case, dual EPS (EPS and diluted EPS) would be required because income from continuing operations is the control number and the stock options are dilutive with respect to income from continuing operations. Therefore, the stock options are considered to be exercised with respect to all of the diluted earnings per share calculations (i.e., those for income from continuing operations, discontinued operations, and net income).



2145.65 In contrast, assume that the enterprise reported the following income statement information:

Income from continuing operations $(100,000) Discontinued operations 250,000 Net income $ 150,000

2145.66 Since income from continuing operations is a loss amount, the assumed exercise of the stock options would increase the denominator shares and, therefore, reduce the loss per share. Thus, the stock options are antidilutive with respect to income from continuing operations. Therefore, the stock options would not be assumed to be exercised because they are antidilutive with respect to the control number (income from continuing operations), even though they are dilutive with respect to net income (which is a positive amount). In this case, if this is the only year presented in the current financial report, the earnings per share would be reported as follows:

Basic EPS:

Income from continuing operations = $(100,000) 10,000

= $(10.00)

Net income = $150,000 10,000

= $15.00

Diluted EPS:

Income from continuing operations = $(100,000) 10,000

= $(10.00)

Net income = $150,000 10,000

= $15.00

2145.67 Note that, in this case, basic EPS and diluted EPS are the same. Even though they are the same, both must be presented because the enterprise has potential common stock (the stock options) outstanding.

Contingent Issuance of Common Stock

2145.68 In some circumstances, an enterprise may agree to issue additional shares of common stock if certain conditions are met. An example is in the case of a business combination in which the acquiring company agrees to issue additional shares of common stock (contingent shares) if certain conditions are met. These contingent shares should be considered outstanding and included in diluted EPS as follows:

a. If all necessary conditions have been satisfied by the end of the period, they should be included as of the beginning of the period in which the conditions were satisfied (or as of the date of the contingent stock agreement, if later).

b. If all necessary conditions have not been satisfied by the end of the period, the number of contingently issuable shares included in diluted EPS should be based on the number of shares, if any, that would be



issuable if the end of the reporting period were the end of the contingency period (e.g., the number of shares that would be issuable based on current‐period earnings or period‐end market price) and if the result would be dilutive.

2145.69 Assume that Beta Company purchased Delta Company and agreed to give the stockholders of Delta Company 10,000 additional shares of common stock in 20X3 if Delta’s net income in 20X2 is at least $100,000. If in 20X1 Beta’s net income is $120,000, the diluted EPS in 20X1 would include the 10,000 contingent shares in the outstanding shares computation because the net income in 20X1 (the reporting period) equals or exceeds the earnings level specified for the contingency period (20X2). Thus, if 20X1 were the end of the contingency period, the contingency would be satisfied. Therefore, the 10,000 contingent shares should be included in diluted EPS in the current reporting period (20X1).

2145.70 Nonpublic enterprises are not required to present earnings per share information. However, if they chose to do so, they must follow FASB ASC 260‐10, which is the official pronouncement that all publicly held enterprises must follow.

2145.71 Fixed awards and nonvested stock to be issued to employees under a stock‐based compensation arrangement should be considered the same as options for purposes of computing diluted EPS. Such stock‐based awards should be considered to be outstanding as of the grant date for purposes of computing diluted EPS, even though their exercise may be contingent on vesting.

Required Disclosures

2145.72 An enterprise should make the following disclosures for each period for which an income statement is presented:

a. A reconciliation of the numerators and the denominators of the basic and diluted per‐share computations for income from continuing operations (the reconciliation should include the individual income and share amount effects of all securities that affect earnings per share)

b. The effect that has been given to preferred dividends in arriving at income available to common stockholders in computing basic EPS

c. Securities that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS, because to do so would have been antidilutive for the period or periods presented



2145.73 Nonfinancial and Qualitative Considerations: A variety of nonfinancial considerations can affect financial statement analysis. For example, the openness of management disclosures or the independence of a company’s board of directors may affect perceptions of earnings quality. Some shareholders may consider factors such as environmental management or social responsibility when making investment decisions. Additional qualitative factors include degree of company innovation, product differentiation and quality, use of technology, distribution channels, and sustainability of barriers to entry.

2145.74 Limitations of Ratio Analysis

a. Financial Statement Values: Most ratios are based on financial statement values, which may not adequately represent economic values.

b. Lack of Comparability: Ratios are typically compared to prior year values or to industry data. However, such comparisons are sometimes misleading or inappropriate. For example, different accounting methods (LIFO vs. FIFO inventory methods) may be used by the firm being analyzed and the average industry figures. Also, a company’s year‐to‐year comparisons may be distorted by business acquisitions or other changes.

c. Cash Flow Timing and Risk: Measures of profitability such as return on equity suffer from deficiencies as indicators of performance. They do not take into account the risk or timing of cash flows.

d. Magnitude of Comparison Base: In most instances, the analyst must apply common sense when examining ratios. For instance, profit margins for most companies are quite small and may appear to be in line with industry averages. A difference of 2 percentage points between company and industry profit margins may at first appear to be small; however, if sales are $50 million, a 2 percentage‐point‐difference amounts to $1 million in net income, which may be considered significant.



Cash Flow Statement Reconciliation to Income Statement

2145.75 Cash Flows from Operating Activities: Operating activities include cash inflows and outflows from all transactions and other events that are not defined as investing or financing activities. Operating activities generally involve producing and selling goods and providing services. Therefore, cash flows from operating activities reflect the cash effects of transactions and other events that enter into the determination of net income. It should be noted that if a normal operating purpose of the entity is to trade investments, plant, equipment, property, etc., then the cash in and outflows associated with those activities are properly classified as operating, not investing cash flows. Examples include:

a. Cash Inflows:

Cash receipts from the sales of goods and services, including the

collection of accounts and notes arising from those sales.

Cash receipts from the sales of goods and services, including the

collection of accounts and notes arising from those sales.

Cash receipts from the sale of investments classified as “trading.”

All other cash receipts that do not stem from financing or investing

activities. Some less obvious inflows are insurance settlements not

considered as investing cash flows, refunds from outside entities, and

inflows from lawsuits not otherwise capitalized.

b. Cash Outflows:

Cash payments to acquire materials for manufacture or goods for

resale.

Cash payments for general and administrative expenses.

Cash payments to other suppliers and employees for other goods or

services.

Taxes, duties and fines paid.

Interest paid on indebtedness.

Cash paid for investments classified as “trading.”

All other cash payments that do not stem from transactions defined

as investing or financing activities. Some of the less obvious outflows

are charitable contributions, refunds to customers, and operating

leases.



2145.76 Reporting Cash Flows From Operating Activities

a. Direct Method: Firms are encouraged to report cash flows from operating activities by the direct method. The following is the minimum information to be included:

Cash collected from customers.

Interest and dividends received.

Other operating cash receipts.

Cash paid to employees and other suppliers of goods or services,

including suppliers of insurance, advertising, etc.

Interest and taxes paid.

Other operating cash payments.

If the direct method is used, a reconciliation of net income to net cash

flow from operating activities should be provided in a separate schedule.

This is essentially the application of the indirect method, which is

discussed below.

b. Indirect Method:

1. Net Income Adjustment: Firms that choose to report by the indirect

(reconciliation) method shall report the same amount for net cash

flow from operating activities as would be reported under the direct

method. This is accomplished by adjusting net income to net cash

flow from operations. Net income must be adjusted to eliminate:

The effects of all deferrals of past operating cash receipts and

payments.

o Inventory

o Deferred income

o Deferred expenses

o Prepaid expenses (i.e., assets)

The effects of all accruals of expected future operating cash

receipts and payments.

o Accounts receivable

o Notes receivable from customers arising from sale of

goods or services

o Interest receivable

o Accounts payable

o Notes payable to suppliers to acquire materials for

manufacture or goods for sale

o Interest payable

o Income taxes payable



o Excess of income of equity‐method investees over

dividends received

o Other accrued expenses

The effects of all non‐cash operating expenses or income (e.g.,

depreciation).

o Depreciation

o Depletion

o Deferred income taxes

o Amortization of intangible assets

o Amortization of debt issuance costs

o Amortization of premiums and discounts on securities

o Provision for bad debts

o Provision for losses on long‐lived assets.

2. Reconciliation: This reconciliation may take place in the body of the

statement or in a separate schedule. If the indirect method is used,

taxes paid and interest paid should be reported in a separate

schedule. Since the effects of gains and losses from financing and

investing activities will be added or subtracted from net income to

determine operating cash flows, it may prove useful to first

determine those cash flows (investing and financing) before

determining operating cash flows.

3. Example Reconciliation:

HARRIS COMPANYPartial Statement of Cash Flows

For the Year Ended December 31, 20x3

Cash Provided from Operating Activities (Indirect Method)

Net Income $1,140

Loss on sale of equipment 260

Depreciation Expense 50

Gain on sale of land (400)

Decrease in Accounts Receivable 140

Increase in Inventory (50)

Increase in Accounts Payable 150

Net Cash from Operating Activities $1,290



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Surgent CMA Review

Section 2200 Corporate Finance (20%)

2210 Risk and Return

2211 Calculating Return

2211.01 Interest rate risk

a. Interest rate risk is the risk of holding fixed interest‐bearing instruments such as a bond when interest rates are changing. The price of long‐term bonds is more sensitive to changes in interest rates than the price of short‐term securities; thus, a rise in interest rates would cause the price of a fixed interest‐bearing instrument to drop. Generally, the longer the maturity value, the greater the interest rate risk.

b. Illustration: 8%, 20‐year bonds are purchased at par for $100,000 when the market was yielding 8%. If interest rates rise to 10%, the price of the bond will decrease so that the actual yield will equal 10% to match the current market rate. The market value is the PV of the future cash flows, and for a bond that matures in 20 years and pays $8,000 of interest annually to yield 10%, the PV would be calculated as follows:

$100,000 × .1486 = $14,860 + $8,000 × 8.5136 = 68,109 $82,969

The potential drop in market value is the risk associated with holding a long‐term fixed interest‐bearing instrument.

c. If a short‐term Treasury bill is held during a period of rising interest rates, the loss in market value related to that increase in interest rates is much less significant. For example, given the same interest rate scenario described above, the price of a $100,000, 180 T‐bill would decline to $99,069.

2211.02 Reinvestment risk

Reinvestment risk arises when investments must be rolled over. If rates have declined, the interest earned will decline.

Section 2200 – Corporate Finance


2211.03 Liquidity risk (marketability risk)

a. A highly liquid asset can be sold on short notice for close to its market value; however, an asset that changes hands infrequently often does not have a ready market. Therefore, a price reduction is often necessary if the asset is sold on short notice. Liquidity risk is the risk that an asset cannot be sold for market value on short notice.

b. Securities such as U.S. Treasury bills or stock in major corporations have a ready market and can be sold quickly for the quoted market price. Bonds issued by an obscure firm would probably have to be sold at a discount over market price in order to find a willing buyer on short notice. Bonds such as these have a high level of liquidity risk.

2211.04 Market risk

Market risk is the risk associated with a security that cannot be eliminated by diversification. This includes such items as recessions, inflation, and changing interest rates that affect all firms. This is also known as systematic risk.

2211.05 Company risk (company‐specific risk)

Company risk is risk that is specifically associated with a particular firm due to mix of products, new products, competition, patents, lawsuits, etc. Within a portfolio, company risk can be eliminated by proper diversification.

Credit Risk

2211.06 Credit risk is the risk that receivables will not be collected in full on a timely basis. Increased risk includes costs related to bad debt losses, higher receivable balances resulting in higher carrying costs, higher customer investigation fees, and collection costs.

2211.07 Credit risk can be evaluated by looking into the customer’s:

(1) character. Will the customer make an honest effort to pay all obligations?

(2) capacity. Does the customer have the ability to make necessary payments on a timely basis?

(3) capital position. Does the customer have a good financial position such as discovered or measured through ratio analysis?

(4) collateral. Are assets pledged as security on the obligation?

(5) general conditions. What are the probable economic conditions and how might they affect the customer’s ability to pay?



2211.08 Default risk

a. Default risk is the risk that the borrower will be unable to make interest and/or principal payments as scheduled on the obligation. The higher the possibility of default, the greater the return required by the lender.

b. U.S. Treasury bonds are considered to be default risk free. Securities and bonds do have some degree of risk, and several organizations such as Moody’s Investment Service and Standard & Poor’s Corporation rate bonds for default risk. The lower the quality of the bonds, the greater the interest rate the issuing firm is required to pay in order to compensate for the risk.

2211.09 Purchasing risk

Purchasing risk (purchasing power risk) is the risk that inflation will result in less purchasing power for a given sum of money. Assets that are expected to rise in value during a period of inflation have a lower risk. For example, real estate often appreciates during an inflationary period; however, cash loses value during that same period.

2212 Types of Risk

2212.01 What is financial risk management?

a. Financial risk management is the process of dealing with uncertainties resulting from events in the financial markets. It involves assessing the financial risks facing an organization and developing and implementing management strategies and policies consistent with the organization’s internal priorities and policies.

b. A firm must decide which risks are acceptable and which are not to optimize the amount of risk it is willing to accept, recognizing that a passive strategy of no decision means accepting all risks by default.

c. Whatever strategies are adopted, they need to be evaluated, monitored, and refined as market conditions change.

(1) Changes to be monitored include changes in market rates, changes in the business environment, and changes in international or political considerations.

(2) Effective monitoring often requires working with tactical risk takers such as portfolio managers.



2212.02 Financial risk management is one component of the concept of enterprise risk management of the firm, which includes items such as the following:

a. Business risk: the uncertainty associated with the ability to forecast EBIT due to factors such as sales variability and operating leverage

b. Operations risk: the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events

c. Supply‐chain risk: the potential disruptions to continued manufacturing production and thereby commercial financial exposure

d. Product liability risk: the responsibility of the firm or vendor of goods to compensate for injury caused by defective merchandise that it has provided for sale

e. Political and economic risk: the risk that a government buyer or a country prevents a transaction from being completed, or fails to meets its payment obligations; and/or the risk associated with the overall health of the economy

2212.03 Key elements of financial risk management include the following:

a. Interest rate risk: the risk to earnings or capital arising from changes in interest rates.

b. Liquidity risk: the risk that clearing or settlement payments will not be made when due, even though counterparties do have sufficient assets and net worth ultimately to make them. There is an inability to convert assets to cash in a timely fashion.

c. Foreign currency risk: the uncertainty of the value of net income that would result from the variability of the market value of foreign‐currency‐denominated assets and liabilities due to fluctuating exchange rates.

d. Credit risk: the risk that the counterparty will not meet an obligation when due and will never be able to meet the obligation at full value. Bankruptcy is a primary source of such risk, and losses are associated with loss of principal and foregone interest.

e. Default risk: the risk that the counterparty will default on clearing obligations. This risk is often related to the liquidity risk and/or credit risk inherent in the transaction.

f. Systemic risk: the risk that payment system failures will lead to one market participant being unable to meet its obligation when due that will lead to additional participants being unable to meet commitments as well.

g. Counterparty risk: the inability of a counterparty to meet its commitments.



The Risk Management Process

2212.04 The risk management process includes the strategies that allow a firm to manage its risks related to participating in financial markets.

2212.05 The firm has a choice to accept, transfer, or manage risk.

a. Management may choose to absorb the potential impact of volatility on earnings, assuming that over time the eventual upside may outweigh the short‐term downside.

b. A risk manager may attempt to transfer the risk along the supply chain. This would involve shifting the risk to the end customer or to suppliers.

2212.06 The risk management process includes an understanding the requirements for valuation of derivative securities and applicable accounting regulations per FASB ASC 815 or IAS 39. Often a firm will attempt to manage the risk through the use of some form of hedging program. (A hedge is a strategy to insulate a firm from exposure to price, interest rate, or foreign exchange fluctuations.)

2212.07 The risk management process includes both internal and external controls, and involves:

a. identifying and prioritizing risks and understanding their relevance.

b. understanding the stakeholder’s objectives and their tolerance for risk.

c. developing and implementing appropriate strategies in the context of a risk management policy.

2212.08 The risk management process requires understanding the interconnectedness among and between the basic components of economics, accounting, and control.

a. Economics requires being able to measure the risk before attempting to manage it.

b. The control function provides the needed guidelines for the hedging activity and any necessary oversight.



c. The accounting function requires understanding the requirements set forth in FASB ASC 815. As per the FASB, the following points relate to FASB ASC 815:

(1) Under FASB ASC 815, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk.

(2) For a derivative designated as hedging, the exposure to changes in the fair value of a recognized asset or liability, or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value.

(3) For a derivative designated as hedging, the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the effective portion of the derivative's gain or loss is initially reported as a component of other comprehensive income (outside earnings) and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately.

(4) For a derivative designated as hedging and the foreign currency exposure of a net investment in a foreign operation, the gain or loss is reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment. The accounting for a fair value hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of an unrecognized firm commitment or an available‐for‐sale security. Similarly, the accounting for a cash flow hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of a foreign‐currency‐denominated forecasted transaction.

(5) For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change.



2212.09 Special issues facing small businesses

a. Small firms have problems with various components of the financial risk management process that are effective for larger firms. While these problem areas exist for large firms as well, the specific problems facing smaller firms relate to dealing with the problems in a manner consistent with the firm’s resource capabilities, and include the following:

(1) The fact that small firms are unable to use broader capital markets (i.e., expand past the use of banks as a source of funds) because investors in these markets require higher rates of return on what would appear to be riskier investments (i.e., the investor would have little ability to assess the creditworthiness of the firm).

(2) These firms are generally unable to diversify their operations (i.e., reduce business risk).

(3) Such firms usually have few suppliers and/or the clout or logistical ability to purchase from a large number of vendors (i.e., unable to reduce supply‐chain risk).

b. A smaller firm must understand its full economic exposure to foreign exchange or interest rate risk and identify the degree to which there are any natural offsetting positions in its operations to take advantage of any benefits of diversification that exist. (Economic exposure is defined as the degree to which a firm’s present value of expected future cash flows can be impacted by unanticipated exchange rate fluctuations.)

c. If the firm chooses to hedge, they must be certain to use a derivative that is specifically related to the risk in question. Risks dealing with cash flow from operations are often best dealt with options (a derivative financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a reference price during a specified time frame). More predictable asset positions often are best dealt with forwards and futures.

d. Speculation with derivatives should never occur. It is helpful to employ some outside entity to monitor any hedge or derivative positions that are held.



2213 Relationship Between Risk and Return

2213.01 Mitigating financial risk from a regulatory perspective

a. In the new financial risk framework, regulators need to be more counter‐cyclical in their approach toward devising regulatory arrangements. Approaches being developed see regulators acting transparently to change capital requirements for market participants when early warnings of market “bubbles” first appear.

b. Regulators need to recognize capital as a “shock absorber” to deflate bubbles before they burst and to allow then capital “drawdowns” during periods of market stress, with the understanding capital will be replenished as market conditions improve.

c. There is a strong need for increased cooperation between national jurisdictions that would:

(1) develop an agreed‐upon risk management policy for key market‐wide risk indicators.

(2) manage and monitor risk indicators within that policy.

(3) publicly report macro‐risk indicators.

(4) facilitate risk identification and communication with appropriate decision makers, at both national and international levels.

Mitigating Financial Risk at the Firm Level

2213.02 There is growing consensus that the regulatory framework should apply a set of comprehensive risk management concepts that include key concepts used by insurance regulators and actuaries that use a “control cycle” approach:

a. Incorporating allowances (risk margin) for extreme or outlier events (i.e., black swan events):

(1) Traditional regulatory approaches previous to the 2008 financial crisis did not identify or lessen critical risk concentrations (e.g., the level of collateralized debt obligations (CDOs)).

(2) Historically, there has been inadequate capital support at both the system and individual institution level for accepting such risks that resulted in a significant underpricing of the risks as the 2008 financial crisis began.



(3) There must be an ability to track risk in the unregulated financial sector.

(4) There should be development of models that track the expected level of loss from an expected event rather than the current “value at risk” (VAR) approach that only measures the minimum amount of loss from a low‐probability event.

Note: A “black swan” event has a high impact, is hard to predict, and is a rare event that is beyond the realm of normal expectations in history, science, finance, and technology. The result is that there is a noncomputability of the probability of the consequential rare events using scientific methods owing to their very nature of small probabilities. A collateral debt obligation (CDO) is a type of structured asset‐backed security (ABS) whose value and payments are derived from a portfolio of fixed‐income underlying assets. The portfolio of fixed‐income assets are rated at different levels of risk with some collateralized debt obligations invested in subprime mortgage bonds.

b. There should be requirements for specific financial condition reporting.

c. There should be an independent sign‐off of liability and provisioning for regulatory purposes by someone such as an actuary who is subject to professional codes of conduct, and that individual should have the freedom and capability to take an objective view that may differ from management. This would be made possible by enforceable professional codes of ethics with disciplinary standards.

The incentive structures within the industries should not distort the proper evaluation of risk:

(1) Capital requirements should be increased for any market participant where remuneration and incentives focus excessively on short‐term results.

(2) Regulators should develop a deep understanding of the risk culture within a particular enterprise that often might mitigate against timely reporting of critical information.

(3) The concept of “risk margin” developed by actuaries to measure the value of illiquid assets should be used.



2213.03 Improved firm risk management practices

Reporting risk measures should require applying a total balance sheet approach, which evaluates on a consistent basis:

a. the amount of capital required to support the assets and liabilities of the business (given all the commitments and obligations to stakeholders).

b. increasing the actual level of capital available from time to time after excluding all interests that are not at “arm’s length.”

c. looking at what could happen in the future that requires sensitivity testing as to the potential value of assets and/or liabilities as market conditions change.

2213.04 The control cycle used by actuaries includes the following:

a. Modeling expected results using a set of initial assumptions

b. Doing a profit test to determine if the product provides a positive contribution margin

c. Measurement of actual results

d. Determination in both quantitative and qualitative terms, an understandable explanation of the differences between expected and actual results, and determining what actions need to be taken with respect to the product, including adjusting the reserves that might need to be held

e. Use of the findings to strengthen the model and update the assumptions as necessary with a feedback into the profit test (item b. above)

2213.05 Risk margin

a. The concept of risk margin is related to the insurance industry and is generally defined as a component of insurance liabilities that is established in addition to best estimate liabilities.

b. Risk margin reserves tend to create a cushion to cover any fluctuations or misestimation of errors in best estimate liabilities (reserves) and to cover risk of fluctuations under “normal situations” with required capital serving as a buffer against more extreme black swan events.

c. The risk margin covers risks linked to the future liability cash flows over their whole time horizon. It should be determined in a way that enables the (re)insurance obligations to be transferred or put into run‐off.

d. The goal is to have the concept of risk margin be made applicable to determining potential losses in the more broadly defined financial risk areas as well as to insurance.



2213.06 Exchange rates and risk

a. Arbitrage is an action undertaken to capitalize on inefficiencies in financial markets. It is a response to the belief in the “law of one price” that states that a product should sell for the same price in all markets, less the cost of transfer between markets. Arbitrage involves buying in the low‐priced market and reselling in the high‐priced market. The increased demand in the low‐priced market causes the price to increase and the increased supply in the high‐priced market causes the price to decline. Arbitrage profits are available until the two prices are equal.

b. Speculation is an attempt to use what is believed to be relevant information to “outguess the market.” Financial transactions in foreign exchange markets are very sensitive to market expectations regarding exchange rates. The decision to hold securities denominated in any particular currency is generally tied to expectations concerning the market value of the currency. If news causes expectations concerning currency values to change, it will affect the supply or demand for the particular currency, and thereby exchange rates.

2213.07 Exchange rate systems and practices

a. The exchange rate is simply the price of one currency expressed in terms of another. For example, assume that the exchange rate between the dollar and the yen is expressed as $1 = 120 yen. This could also be expressed as 1 yen = $0.008333 ($1/120).

b. Exchange rates are determined by the interaction of supply and demand for the various foreign currencies in foreign exchange markets. If the demand for a nation’s currency increases, the price of the currency will appreciate. If a currency appreciates, it increases in value in terms of the other currencies. In this instance, if the yen were to appreciate, it would take fewer yen to buy a dollar. For example, as the yen appreciates, the exchange rate might fall to $1 = 110 yen. This would make Japanese exports more expensive for American consumers. If the supply of the nation’s currency increases, the price of the currency will depreciate or decline in value in terms of other currencies.



c. Exchange rate determinants include the following:

(1) Changes in consumer tastes for the products of a particular country. If consumers wish to buy more products from a country, they will increase the demand for that country’s currency.

(2) Relative income changes. If, for example, disposable income rises more rapidly in Europe than in the United States, all other things being equal, Europeans will demand more American goods. The demand for dollars will increase and the supply of euros that will be required to purchase the additional dollars will increase.

(3) Relative interest rates. Suppose that real interest rates rise in the United States while they stay constant in Europe. Europeans will find the United States a more attractive place to make financial investments in fixed‐income securities and will increase the supply of euros.

d. Over time flexible exchange rates will adjust and eliminate balance‐of‐payments surpluses or deficits between two nations. Disadvantages of flexible exchange rate systems include:

(1) a flexible exchange rate produces uncertainty in the future price of a foreign currency and reduces the amount of trade.

(2) if a country’s currency strengthens, it will need to export fewer goods and services to get a specific level of imports from another country. Thus, in this instance, it would be said that the country’s terms of trade have improved.

2213.08 Fixed exchange rate system

a. Governments determine specific boundaries within which they will allow their currency’s exchange rate to fluctuate and commit to making economic policy adjustments which maintain the exchange rate within those limits. A government cannot do anything directly to stop changing patterns of the supply and demand for its currency in international financial markets.

b. The advantage of a fixed rate system is that multinational companies (MNCs) would be able to engage in international trade without worrying about exchange risk.

c. A key disadvantage of the fixed exchange rate system is that a government, faced by economic pressures, will choose to alter the value of its currency. While the exchange rate does not fluctuate on a regular basis, it may be revalued or devalued by a significant amount unexpectedly.



2213.09 Managed float system

Today most countries allow the value of their currency to float, but at times intervene in the market when exchange rate changes are counter to national objectives. Some nations peg their currency to the dollar and then allow their currency to fluctuate against other currencies as the dollar fluctuates. The key reasons for intervention are:

a. to smooth exchange rates, that is, to minimize volatility.

b. to respond to temporary disturbances that cause undesired exchange rate movements.

2213.10 Exchange rate determinants

a. Changes in demand and/or supply of the currency: As the demand for a currency increases, the exchange rate will also increase. As the supply of a currency increases, the exchange rates will decrease.

b. Changes in consumer tastes: If consumers desire a foreign product, the demand for that product and the resulting increase in demand for the foreign currency will affect exchange rates.

c. Relative income changes: As incomes rise, the demand for imports increases, thus having an effect on exchange rates.

d. Relative price changes: As prices decrease for a particular foreign product relative to domestic prices, the demand for that product will increase, thus having an effect on exchange rates.

e. Relative interest rates: As interest rates increase in a given country, interest in investing in securities in that country rises. As investing activities increase, the supply and demand for those currencies are affected as well as the exchange rates.

f. Relative inflation rates: Changes in inflation can have an effect on international trade activity. The changes in this activity will in turn influence the supply and demand for various currencies, resulting in changes in exchange rates.

g. Government controls: Governments can influence exchange rates by imposing exchange and trade barriers, buying and selling securities in foreign exchange markets, and changing interest rates in their home country.



2213.11 Mitigating risk related to dealing with foreign currencies

a. MNCs (multinational companies) constantly face the decision as to whether or not to hedge future payables and receivables. Often these decisions are based on the magnitude of the potential risks and the firm’s forecast of future foreign exchange rates.

b. Short‐term financing decisions: Firms that borrow often have access to loans denominated in several currencies. A favorable choice would be to borrow in the currency where market interest rates are low and the value of the currency is expected to weaken in value over the term of the loan.

c. Short‐term investment decisions: Firms often have significant amounts of excess cash available for short periods of time and can choose to make their deposits in a variety of currencies. A favorable choice for the deposit would be in a market with high interest rates where the value of the currency is expected to strengthen during the term of the deposit.

d. Capital budgeting decisions: As an MNC assesses the viability of investing in a foreign project, it must account for the fact that the project may generate cash flows that periodically must be converted to another currency. The analysis can only be completed when the estimated cash flows are ultimately measured in the parent’s local currency.

e. Long‐term financing decisions: Corporations that issue bonds may wish to consider denominating the bonds in a foreign currency. Their preference would be to have the bonds denominated in a currency that would depreciate over time against the currency they are receiving from the sale. Exchange rate forecasts are needed to estimate the expected cost differential from borrowing in different currencies.

f. Earnings assessment: When earnings are reported, subsidiary earnings are consolidated and translated into the currency of the parent’s home country.



2213.12 Forecasting techniques

The fact that firms must make decisions that can be impacted by exchange rate movements suggests that they either explicitly or implicitly make forecasts about exchange rate movements in the decision‐making process. If the firm engages in explicit forecasts, the basic techniques for forecasting include the following:

a. Technical forecasting involves the use of historical exchange rate data to predict future values. This type of forecasting is generally limited to forecasting the near future, which is often not effective for developing corporate policies. This type of forecasting is generally more relevant for speculators who are concerned with day‐to‐day exchange rate movements.

b. Fundamental forecasting is based on the presumed relationship between exchange rates and economic variables. This forecasting methodology is subject to a series of limitations, including:

(1) the precise timing of the relationships predicted by the regression model cannot be determined.

(2) some of the data for which relationships have been determined cannot be obtained in a timely manner so that it would be usable for current forecasts.

(3) the probability of many events that have an impact cannot be readily quantified.

(4) regression coefficients that are obtained from the forecasting model are often not constant over time.

c. Market‐based forecasting starts from the premise that financial markets provide an unbiased estimate of future events, and uses either the spot rate or the forward rate.

(1) Illustration: For example, if the current spot rate shows that the Japanese yen is expected to appreciate against the dollar in the very near future, this should encourage speculators to buy the yen with U.S. dollars today in anticipation of its appreciation. These purchases would tend to drive the yen’s value up at once and, therefore, the current value of the yen should reflect its expected value in the very near term.



(2) The forward rate that is quoted for a specific date in the future is commonly used as a proxy for the forecasted future spot rate on that date. An example would be as follows: If speculators expect the spot rate on the Japanese yen in 60 days to be $1 = 122 yen and the 60‐day forward rate is $1 = 119 yen, they might simply buy yen 60‐days forward at $1 = 119 yen, and then sell them when they are received at the spot rate. If this is the common speculator strategy, then the forward purchases of yen will cause the forward rate to increase until the speculative demand runs its course. Thus, the forward rate reflects the market’s expectations of the spot rate at the end of the period. To the degree that the forward rate is shown to be an unbiased estimate of the future spot rate, then corporations can monitor the forward rate as they develop their exchange rate expectations. Arbitrage activity would tend to eliminate any differential.

Types of Exposure

2213.13 The rationale for forecasting foreign exchange rates is to help the firm make decisions as to whether they should remain exposed to exchange rate fluctuations or if they should attempt to hedge their foreign exchange positions. Forecasting methodologies can be evaluated over time by comparing the actual values of the currencies to those predicted by the forecast over long periods of time.

2213.14 While exchange rates cannot be forecasted with perfect accuracy, a reasonable forecast can allow a firm to estimate its exposure to exchange rate fluctuations. To the degree that a firm discovers that it is highly exposed, it then can begin to consider approaches to reduce the exposure.

2213.15 Transactions exposure is simply defined as the degree to which the value of a firm’s future cash transactions can be affected by exchange rate fluctuations. It can be measured by determining (1) the projected net amount of inflows or outflows in a particular foreign currency and then (2) the overall risk of exposure for each of the currencies.

a. Exposure to “net” cash flows: Forecasts of net cash flows tend to be for relatively short periods where the anticipated cash flows can be predicted with reasonable accuracy. Such predictions require a reasonably sophisticated information system to track the positions in the various currencies.



The firm needs to project a consolidated “net” position in the currency. These positions must be converted into dollars so that the firm can measure the exposure in each currency using a standardized measure. Since the actual level of period cash flows and end‐of‐period exchange rates are unknown, it would be reasonable to construct a range of estimates for both cash flows and exchange rates.

b. The firm may not have its own method for forecasting end‐of‐period exchange rates, but at a minimum the firm can use historical data to measure the degree of currency variability. The standard deviation measure is a common way to define the variability of a particular currency. Currency variability can change over time, and use of this method would require periodic updating of the measure.

The key is to determine how each individual currency could affect the firm by assessing the standard deviations and correlations between the various currencies over the period of the transaction.

2213.16 Managing transactions exposure

a. The firm should identify the net transaction exposure on a currency‐by‐currency basis. This data would be gathered from all subsidiaries.

b. If possible, a firm may be able to modify its pricing policy. For example, by invoicing its exports in the same currency that would be needed to pay for imports, or in its domestic currency, the exchange rate risk could be shifted to the foreign firm.

c. To the degree that the firm cannot match the inflows and outflows with foreign currencies, hedging should be considered.

2213.17 Currency correlations: The correlation coefficient measures the degree to which the two currencies move in relation to each other. Over the long run, the correlations tend to be positive, which indicates that currencies tend to move in the same direction against the dollar, albeit not in the same magnitude. This information would help the firm determine the degree to which they have transaction risk among and between various currencies to which they might be exposed. For example, if the firm has exposure with the Swiss franc and the Japanese yen, and those two currencies are correlated vis‐a‐vis the dollar, then an expected inflow of Swiss francs can serve as a partial offset against an expected outflow of Japanese yen.

2213.18 An alternative method to assess exposure would be the value‐at‐risk (VAR) measure that would combine the methods above to predict the potential maximum one‐day loss for a firm that is exposed to exchange rate fluctuations. In this instance, the firm might have a policy that would trigger hedging activities if the VAR reaches a certain magnitude.



2213.19 Economic exposure measures the degree to which a firm’s present value of expected future cash flows can be impacted by exchange rate fluctuations. As an example, a firm’s local sales in its home country would be expected to decrease if its home currency appreciates because the firm will face increased foreign competition as foreign substitute products will now be cheaper in terms of the local currency. At the same time, cash inflows on exports denominated in the local currency will decline due to the appreciation of the currency since foreign importers will need more of their currency to pay for their imports.

2213.20 We must note that if a firm’s local currency depreciates, it would be impacted in the opposite direction from when the currency appreciates. Local sales would be expected to increase due to reduced foreign competition, and their exports denominated in local currency will appear cheaper to importers, which will lead to increased foreign demand for their products.

On the cost side with regard to cash outflows, imported supplies denominated in the local currency will not be directly affected by exchange rate movements. However, the cost of supplies denominated in foreign currencies will rise because more of the depreciated currency will be needed to acquire the foreign currency needed to make the purchase.

2213.21 Even firms that are not involved in foreign sale of goods or purchase of foreign supplies may be subject to economic exposure due to the impact of exchange rate movements on the price of substitute goods offered by foreign competitors in their local markets. The degree of economic exposure is likely to be much greater for multinational corporations (MNCs). An MNC needs to assess the degree to which economic exposure exists and then make a determination as to whether or not they wish to attempt to insulate themselves against it. Economic exposure can be measured by the following:

a. Sensitivity of earnings to exchange rates: This method involves classifying cash flows into specific income statement items and then making a subjective prediction about the value of these items based on an exchange rate forecast. The base forecast then can be compared with alternative exchange rate forecasts. Comparing the resulting income statements would allow the firm to assess the impact of exchange rate movements on earnings and cash flows.



b. Sensitivity of cash flows to interest rates: This method involves using regression analysis of historic cash flows and comparable exchange rates. The following formula illustrates:

ttot eaPCF 1

PCFt = Percentage change of inflation‐adjusted cash flows measures in the home country currency over period t

et = Percentage change in exchange rate of the currency over period t μt = Random error term α0 = y‐intercept a1 = Slope coefficient

The regression coefficient (a1) indicates the sensitivity of PCFt to et. This method is valid if the firm expects no major adjustments to its operating structure.

2213.22 Translation exposure is the exposure of the MNC’s consolidated financial statements to foreign exchange fluctuations. A subsidiary’s earnings are translated into the reporting currency and, therefore, are subject to exchange rate fluctuations.

There are some questions concerning the relevance of translation exposure, with arguments in favor including the following:

a. Cash flow perspective: The key consideration is the degree to which a subsidiary would remit earnings to the parent. If the earnings are retained by the subsidiary and reinvested if feasible investment opportunities exist, then the earnings would not be converted and sent to the parent. If a portion of the earnings are remitted, or expected to be remitted in the future, then it could be expected that future cash flows could be adversely affected if the foreign currency is weakening.

b. Stock price perspective: Investors tend to use expected future earnings forecasts to derive an expected value per share. If an MNC conducts a large portion of its business in foreign countries that have changing exchange rates that are expected to negatively affect the translation of future earnings, then it is likely that the market stock price for the MNC will decline.



2213.23 Determinants of translation exposure

a. Proportion of business conducted through foreign subsidiaries: The larger the percentage of the firm’s business conducted by foreign subsidiaries, the larger the percentage of a given financial statement item that is likely to be susceptible to translation exposure.

b. Location of foreign subsidiaries: Since the financial statements of a subsidiary are typically measured in the subsidiary home currency, the correlation between that currency and the parent’s home currency will determine the degree to which translation exposure is likely to become a problem.

c. Accounting methods used: Many of the important rules for financial statement consolidation for U.S.‐based firms are found in FASB ASC 830. Under FASB ASC 830, consolidated earnings are sensitive to the functional currency’s weighted‐average exchange rate.

2213.24 Managing translation exposure

Translation exposure exists when the future cash transactions of a firm are impacted by exchange rate fluctuations. The problem arises when a firm knows the amount of the foreign currency it will need to complete the transaction but not the amount of domestic currency that will be required to purchase it. Once the degree of transaction exposure is measured, if the firm decides to hedge all or part of the exposure, it must then choose among the various hedging techniques that are available.

There is one possible non‐hedging possibility that might be available to the firm to manage the exposure. Depending on the negotiating strength of the two parties involved in the transaction, it might be possible for the firm to invoice the transaction in the currency that will be used to pay for the import, effectively shifting the transaction exposure to the exporter.

Techniques to eliminate all or part of transaction exposure:

a. Future hedges: A firm buys a currency futures contract that gives the firm the right to receive a specified amount of a specified currency for a given price on a specific date. By buying such a contract, the firm is able to lock‐in the amount of the foreign currency needed to make the expected payment. These contracts are designed to hedge currency needs in the short term.

A firm could sell a futures contract if it desired to sell a specific amount of a specified currency for a stated price on a specific date. This type of hedge might be used to hedge future receivables denominated in a foreign currency.



b. Forward hedge: A forward hedge is very similar to a futures hedge except that it is designed to be used by large corporations who have relatively large positions to hedge. These hedges are negotiated between the corporation and a commercial bank with the contract specifying the currency, the exchange rate, and the settlement date. These contracts may be used to either purchase or sell foreign currency with a company that needs foreign currency in the future. A company expecting to need to sell currency in the future would negotiate a contract to sell the currency forward to lock in the rate at which the currency can be sold.

c. Money market hedge: This type of hedge involves the firm taking a position in domestic or foreign money markets to hedge a payables or receivables position.

d. Currency option hedge: This type of hedge ideally would insulate the firm from adverse foreign exchange movements, but also allow the firm to benefit from favorable exchange rate movements if the currency does not move in the expected manner during the hedging period. This could create a situation where not hedging a position could produce a better outcome than hedging. A currency option hedge resolves this problem by allowing the firm to hedge the exchange risk, and at the same time participate in any gains that might result from unexpected currency fluctuations.



2213.25 The techniques described above could be used in the following fashions to hedge specific transaction exposures:

Hedging Technique

Hedging Receivables Hedging Payables

Futures Hedge A currency futures contract could be sold in the local currency in the amount of the particular receivable.

A currency futures contract could be purchased in the local currency in the amount of the particular payable.

Forward Hedge A forward contract could be negotiated in the foreign currency to sell the amount of the receivable.

A forward contract could be negotiated in the foreign currency to purchase the amount of the payable.

Money Market Hedge

Borrow funds in the denominating currency of the receivable, convert the loan to the local currency, and invest it. When the receivables are received, the loan is then paid off with the cash inflows.

Borrow funds in the local currency of the payables, and invest the funds until they are needed to meet the payable obligation.

Currency Option Hedge

A currency put option is purchased in the local currency for the amount related to the receivables.

A currency call option is purchased in the local currency for the amount related to the payables.

2213.26 Mitigating risks related to changing interest rates

a. Interest rate risk is the risk of holding fixed interest‐bearing instruments such as a bond when interest rates are changing. The price of long‐term securities is more sensitive to changes in interest rates than the price of short‐term securities. There is an inverse relationship between the direction of the change in interest rates and the price of the fixed interest‐bearing security.

b. Although a nonfinancial firm will usually report its bonds on issue in financial statements at their market value at the time of issuance less premium or discount amortization, early redemptions must be done at the market value. These amounts may be significantly different as interest rates will change the value of fixed‐rate debt. This risk is not commonly considered by most nonfinancial firms.

c. This risk could be mitigated by hedging or acquiring an offsetting exposure, which could be a derivative such as an option, a futures contract, or a swap, or by acquiring an offsetting asset or liability.

d. The main reasons for hedging include reducing the volatility in cash flow, avoiding financial distress, or providing predictability. Financial distress could be as simple as a liquidity crunch with an inability to meet short‐term demands on cash, which could ultimately result in bankruptcy. A hedge would reduce the probability of the outcome.



e. A firm is concerned about the uncertainty of cash flows related to asset and liability structure caused by changes in interest rates that impact the value of the assets and liabilities.

f. A firm is concerned about the changes in market value of fixed‐rate assets as market interest rates change.

g. There is a flow risk that relates to the sensitivity of interest rate changes that could be hedged with fair value hedges or a risk on the ability to make interest payments that may be covered by developing a cash flow hedge (a hedge that is the result of the exposure to the variability of cash flow attributable to a particular risk associated with a recognized asset or liability (IAS 39.86)).

2213.27 An example of a cash flow hedge would be to use an interest rate swap to convert variable‐rate interest exposure to a fixed interest rate.

a. The swap is an instrument that, in its usual form, transforms one kind of interest stream to another, such as floating to fixed or fixed to floating. Each swap has two counterparties and, therefore, in each swap one party pays fixed and receives floating, while the other party receives fixed and pays floating.

b. There are two basic forms for a swap:

(1) First, a floating‐rate borrower converts to a fixed rate. In this case, a borrower has floating‐rate bank debt and carries out a pay‐fixed swap, converting the debt to a fixed rate.

(2) Second, a fixed‐rate borrower converts to a floating rate. In this case, a borrower has fixed‐rate bond debt and undertakes a receive‐fixed swap, converting the debt to a floating rate.

c. From an accounting perspective, the changes in the fair value of the interest rate swap would accumulate first in the statement of comprehensive income, and a portion of the gains or losses would be transferred from comprehensive income to the income statement whenever interest is paid on the hedged debt.



2213.28 There is a price risk related to the sensitivity of the market value of assets and liabilities to the level of changes in market interest rates that could be covered by a fair value hedge.

a. A derivative would be used to hedge changes in the fair value (market value) of a fixed‐rate bond that would occur when interest rates move up or down. Hedging the risk associated with a bond’s price risk would be a fair value hedge.

b. An example would be that a firm issues fixed‐rate debt and then uses a swap for floating‐rate debt.

c. The swap would be marked to market. Any change in value of the swap would be recognized as current earnings, and the change in the value of the debt instrument related to change in market interest rates would be recognized on the income statement as earnings.

2213.29 One must be aware of the differences between interest rate‐fixing products (such as a swap) and options:

a. A swap binds its user to the rate that is set when it is transacted. An option gives the buyer the right to walk away if it would be less expensive to do so.

b. So, a firm taking out a pay‐fixed swap after which rates decline is left paying the higher rates. The risk is transformed rather than transferred. Exposure to rising rates has become an exposure to falling rates.

c. Options offer an alternative, but with a cost. The two key factors determining the cost of the option are time (the longer an option has until expiration, the higher the premium) and volatility (the higher the volatility in the underlying risk being hedged, the higher the premium).

d. Both of these factors tend to deter firms from using options, and for longer‐term risk‐transfer alternatives, interest rate swaps are usually chosen.

Mitigating Risks Through the Use of Transfer Pricing

2213.30 Transfer pricing problems

a. Special problems arise when applying the rate of return or residual income approaches to performance evaluations whenever segments of a company do business with each other. One of the difficult issues has to do with the establishment of transfer prices for intracompany sales. A transfer price is the price charged for goods or services by one segment of a company for those goods or services to another segment of the company (intra‐company sale).



b. The determination of the transfer price can:

(1) include a “profit,”

(2) include only the accumulated costs to that point, or

(3) be negotiated between the two segments.

c. The problems arise when a division sells the product or service in question to outside companies as well as the sister organization. Since the price charged by one division becomes the cost to the second division, the purchasing division would like the price to be low while the selling division would like the price to be high.

2213.31 Transfer pricing approaches

a. Transfer prices can be set using:

(1) variable costs only or

(2) full absorption costs.

b. Transfer prices can equal current market prices.

c. Transfer prices can be set at a negotiated market price agreeable to both business segments. The negotiated price could be less than, equal to, or more than the current market price. Many times when a negotiated price is used, the selling segment does not have an outside market for the particular product or service.

2213.32 Transfer prices at cost

a. When transfer prices are set at cost, there will be no profits for the selling division for the sale.

b. When cost‐based transfer prices are used, dysfunctional decisions can result since there are no built‐in mechanisms for telling the manager when it is in the best interest of the organization for transfers to be made between divisions. As a result, profits for the company as a whole may be adversely affected if the savings to one segment is less than losses to the other.

c. Illustration: XYZ Company has two divisions, Relay and Motor. The Motor division needs 50,000 relays a year and could purchase them from the Relay division. The following information is available:

Relay division:

(1) Sells relays to the outside for $20 each.

(2) Has $12 of variable costs per relay.

(3) Has the capacity to produce 50,000 relays a year.



(4) Could produce relays for the Motor division for $10 of variable costs per relay since there would be no selling or marketing expenses.

(5) There is only capacity to produce 50,000 relays a year, so production can either be sold to the outside or internally, but not both.

Motor division:

(1) Needs 50,000 relays a year.

(2) Can purchase relays from the outside for $15 each.

(3) Adds $25 of additional variable costs to each motor.

(4) Sells the motors for $60 each.

(5) Has variable costs of $40 per relay. Relay

Division Motor Division

Total

Sales ($20, $60) $1,000,000 $3,000,000 $4,000,000 Less Variable ($12, $40) 600,000 2,000,000 2,600,000

Contribution Margin $ 400,000 $1,000,000 $1,400,000

If the Motor division purchases the relays from the Relay division for $12 each (the Relay division’s variable costs), the contribution margins of the divisions and the total organization will be changed to:

Sale of 50,000 units Relay

Division Motor Division

Total

Sales ($12, $60) $600,000 $3,000,000 $3,600,000 Less Variable ($12, $35) 600,000 1,750,000 2,350,000

Contribution Margin $ ‐0‐ $1,250,000 $1,250,000 Decrease in Contribution Margin $ 150,000

This situation, however, would potentially be different if the Relay division had excess capacity, and the sales to the Motor division at $12 each would not have an adverse effect on the outside sales.

d. Another problem with the above illustration is that the only division to show a profit is the one that makes the final sale to an outside party. Thus, there is little incentive for the first division to control costs since all of the costs are simply passed on to another division. Unless costs are subject to some type of competitive pressure at transfer points, waste and inefficiency almost invariably develop.

e. Despite the shortcoming of setting transfer prices at cost, this method is frequently used. It is easy to understand and highly convenient to use. If, however, transfer prices are based upon costs, standard costs should be used. This will avoid passing on inefficiencies from one division to another.



f. Transfer prices at cost frequently use a cost that includes at least some level of fixed costs. However, there are numerous variations of the definition of fixed costs:

(1) Only selling division fixed costs

(2) Only manufacturing fixed costs for the selling division

(3) Selling division’s fixed costs and corporate costs allocated to the selling division

Obviously, there would need to be an annual allocation rate for the fixed costs in question applied to the units transferred from one division to another if some level of defined fixed costs were to be included in the transfer price.

2213.33 Developing a formula for negotiated transfer prices

a. One method for developing transfer prices between divisions is to set the transfer price equal to the variable costs of the goods being transferred plus the contribution margin per unit that is lost to the selling division as a result of giving up the outside sales. The transfer price computed by this formula is a price based on competitive market conditions.

b. An important point to consider is that the price set by the transfer price formula represents the lower limit for the transfer price. In other words, the selling division must be at least as well off as if it only sold to outside customers.

c. Whenever the selling division must give up outside sales in order to sell internally, it has an opportunity cost that must be considered in setting the transfer price. The opportunity cost is the contribution margin that will be lost as a result of giving up outside sales. Unless the transfer price can be set high enough to cover this opportunity cost along with the variable costs associated with the sale, no transfers should be made.

d. Illustration: The pump division needs 20,000 special valves per year, requiring an unusual production process. The variable costs to manufacture the valve in the valve division would be $20 per unit. To produce the special valve that requires a complicated production process, the valve department would have to give up the production of 50,000 normal valves per year sold to the outside that would provide a contribution margin of $14 per unit. What would be the lowest price that the valve division would be willing to sell the special valve to the pump division?



Solution: The contribution margin that would be lost would be $700,000 (50,000 valves × $14 per unit). Spreading the lost contribution margin over the 20,000 special valves, it can be determined that the lost

contribution would be $35 per unit ($700,000 lost contribution margin 20,000 special valves).

Using the transfer pricing formula:

Transfer price = Variable costs per unit + Lost contribution margin = $20 + $35 = $55 per unit

The valve division would be indifferent to selling the special valve to the pump division and selling the other normal valves to the outside if it received a minimum of $55 per unit. Providing that the pump division cannot purchase the special valve for less than $55 on the outside, it should accept the $55 per unit price.

2213.34 Production for internal transfer by a division with idle capacity

a. When idle capacity exists, the selling division’s opportunity cost may be zero. Depending upon what alternative uses this division might have for its idle capacity it may be advantageous to sell to the purchasing division.

b. Under the idle capacity condition, as long as the selling division can receive a price greater than its variable costs, it will be better off—at least in the short run. As long as the purchasing division can purchase the product for less from the sister division than the current purchase price from the outside, it will be better off and, thus, the corporation as a whole will benefit.

Illustration: Returning to our original illustration, the Motor division (purchasing division) can purchase from the outside for $15. If the Relay division (selling division) has enough idle capacity to meet the purchasing division’s needs and there are no additional outside sales prospects at the current $20 per unit, then the organization will benefit from the transfer. Using the transfer price formula:

Transfer price = Variable costs per unit + Lost contribution margin per unit)



It can be determined that the minimum transfer price should be $12, the variable costs to produce the relays, since there is no lost contribution margin for sales that would not otherwise have occurred. The organization as a whole will benefit if the transfer price is set anywhere within the range of $12 and $15. If the Relay division (selling division) refuses to sell to the Motor division (purchasing division), the company as a whole will lose up to $3 of contribution margin on each unit. This can be summarized as follows:

Sale of 100,000 units (50,000 to the outside

and 50,000 to the Motor division) Relay

Division Motor Division Total

Original sales ($20, $60) $1,000,000 $3,000,000 $4,000,000 Additional internal sales 500,000 ‐0‐ 500,000

Total sales 1,500,000 3,000,000 4,500,000 Less outside sales variable costs ($12) (600,000) (600,000)

Less variable costs for internal sales ($10, $35) (500,000) (1,750,000) (2,250,000) Contribution margin $ 400,000 $1,250,000 $1,650,000

Original contribution margin $1,400,000 Increase in contribution margin $ 250,000

2213.35 International issues and transfer pricing

a. Many multinational corporations (MNCs) have international sales among the components of the organization. That means that transfer prices must be set between divisions and/or subsidiaries that reside in different countries. The MNCs have the same basic transfer pricing issues just discussed; however, there is an additional issue of taxes. Not all governments have identical tax rates; therefore, it is in the best interest of an MNC to use transfer pricing to shift the profit to subsidiaries in countries with lower tax rates when possible.

b. The flexibility to shift profit through the use of transfer pricing may be limited due to the fact that some host governments restrict such transfers when the intent is to avoid taxes. In other words, sales/purchases between subsidiaries of a firm are expected to use the principle of an arm’s‐length transaction when setting prices. There is still, however, a bit of flexibility in setting transfer prices without violating laws or regulations. Even though there is a limited range for setting transfer prices, subsidiaries often can shift costs for technology, research and development, etc. to subsidiaries in countries with high tax rates.



c. Currently, the U.S. tax code requires that transfer prices are “arm’s‐length transactions.” On March 12, 2003, the Pacific Association of Tax Administrators (PATA) reached an agreement for a final Transfer Pricing Documentation Package. The result is the PATA members have agreed to certain principles that allow taxpayers to prepare one set of documentation to meet the transfer pricing documentation provisions of each country. If a taxpayer complies with the provisions under the agreement, the taxpayer is shielded from transfer documentation penalties that might otherwise apply in each of the four jurisdictions (Australia, Canada, Japan, and the United States). The IRS extended the tax code to include transfer pricing of services as well as products in 2004.

d. Illustration: Two subsidiaries located in different countries transfer products. Subsidiary A supplies materials to Subsidiary B. Subsidiary A has a higher tax rate (50%) than Subsidiary B (30%). Subsidiary A is currently charging $200,000 to Subsidiary B for a component part.

Subsidiary A Subsidiary B Total

Sales $200,000 $400,000 $600,000 COGS 100,000 200,000 300,000

Gross profit 100,000 200,000 300,000 Operating expenses 40,000 150,000 190,000

Earnings before taxes 60,000 50,000 110,000 Income tax (50%, 30%) 30,000 15,000 45,000

Net income $ 30,000 $ 35,000 $ 65,000

If the transfer price is changed to favor Subsidiary B (only charging $150,000 for the component part), the total net income will increase due to the fact that Subsidiary B has a lower tax rate.

Subsidiary A Subsidiary B Total

Sales $150,000 $400,000 $550,000 COGS 100,000 150,000 250,000

Gross profit 50,000 250,000 300,000 Operating expenses 40,000 150,000 190,000

Earnings before taxes 10,000 100,000 110,000 Income tax (50%, 30%) 5,000 30,000 35,000

Net income $ 5,000 $ 70,000 $ 75,000 Increase in total net income $ 10,000

2213.36 Federal Financial Institutions Examination Council (FFIEC) expectations

a. On January 6, 2010, the Federal Financial Institutions Examination Council (FFIEC) issued an advisory dealing with the need for sound practices for mitigating interest rate risk with recommendations that all institutions manage their interest rate risk (IRR) exposures using processes and systems commensurate with their earnings and capital levels, complexity, business model, risk profile, and scope of operations.



b. This advisory held senior management responsible for ensuring that board‐approved strategies, policies, and procedures for managing interest rate risk are appropriately executed within the designated lines of authority and responsibility. Management must maintain:

(1) appropriate policies, procedures, and internal controls, including controls over risk‐taking to ensure that they stay within board‐approved tolerances.

(2) a provision for updating IRR measurement scenarios and key underlying assumptions that drive the institution’s IRR analysis.

(3) a sufficiently detailed reporting process to inform senior management and the board of the level of IRR exposure. The institution’s IRR tolerance should be communicated so the board and senior management clearly understand the institution’s risk tolerance limits and the capital adequacy based on those limits.

c. Institutions should engage in scenario planning and test stress scenarios that should, at a minimum, include tests of the following:

(1) Significant changes in the level of interest rates (instantaneous rate shocks)

(2) Substantial changes in rates over time (prolonged rate shocks)

(3) Changes in relationship between key market rates (basis risk)

(4) Changes in the shape and slope of the yield curve (yield curve risk)

d. Regulators suggest that under certain conditions, once institutions come close to reaching a limiting positions set for IRR within their policies, that balance sheet alterations of hedging might be an appropriate response. However, even then, they make several suggestions related to the conditions under which such hedging operations might be conducted, including the following:

(1) Balance sheet alterations designed to achieve an appropriate distribution of assets maturities or re‐pricing structures to avoid the potential for severe maturity or duration mismatches between assets and liabilities

(2) The level and formality of the process should be commensurate with the activities and level of risk approved by the board and should not be undertaken unless the board and senior management understand the institution’s hedging strategy.

(3) Reliance on outside consultants to assist in the establishment of such a strategy would be appropriate.



2213.37 If we compare rates of returns for various stocks over time, we would find that some stocks rates of return would go up and down in tandem and others may go in opposite directions (when one stock’s rate of return goes up, the other stock’s rate of return decreases). Correlation represents the degree to which a series of returns changes in comparison with another series.

a. Perfect Negative Correlation: This occurs when one series of numbers increases or decreases and the other series always does exactly the opposite. In other words, when the rate of return on one stock goes up, the rate of return on the second stock goes down, and vice versa. The following graph depicts two stocks with perfect negative correlation.

b. Perfect Positive Correlation: This occurs when, in comparing rates of returns on two stocks, one series of numbers increases or decreases and the other series always does the same. When the rate of return goes up on one stock it also goes up on the second stock. The following graph depicts two stocks with perfect positive correlation.

2213.38 Relationship of Risk and Correlation: A portfolio of two stocks that have perfect negative correlation will totally eliminate risk. If two stocks have perfect positive correlation, risk is not reduced. In actual practice, the correlation on most stocks is positive but not perfectly. Markets tend to move in the same direction. The rates of return tend to change in the same direction but not always. Since stocks do not show perfect positive correlation, diversification can be used to reduce risk.



2213.39 Portfolio Management: Most corporate portfolio managers are averse to risk. Because of this, investors normally diversify their investment portfolios. Total risk in a portfolio is divided into two parts, diversifiable risk and nondiversifiable risk. Well diversified portfolios can eliminate diversifiable risk, so the market rewards only nondiversifiable risk. The nominal rate of return required on an investment portfolio is equal to the risk‐free rate plus a risk premium for expected inflation. Several models have been developed to evaluate the required rate of return on an investment portfolio. The most significant is the Capital Asset Pricing Model (CAPM) which quantifies the trade‐off between risk and return.

2213.40 Capital Asset Pricing Model (CAPM): The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between risk and expected return. Under CAPM, expected returns include only systematic risk, which cannot be eliminated through diversification. CAPM is used to evaluate the required rate of return on an investment. CAPM gives the firm’s cost of equity capital, or the rate of return required by those investing in the firm’s common stock. This model adds the variables of capital gains potential and the risk that the dividend trend will continue. The CAPM expresses the theory that the expected rate of return on a firm’s common stock should equal the rate of return on risk‐free U.S. Treasury securities (typically T‐Bills) plus a risk premium. The calculation of the risk premium utilizes the security’s beta coefficient.

a. Expected Risk‐Adjusted Return: According to CAPM, the expected rate of return on a security (or a portfolio of securities) is equal to:

Risk‐Free Return + Individual Security Risk Premium

= Risk‐Free Return + (Beta Coefficient × Market Risk Premium)

= Risk‐Free Return + [Beta Coefficient × (Market Return ‐ Risk‐Free

Return)]

This can be expressed as an equation as follows:

KC = KRF + (KM – KRF)β

Where: KC = expected rate of return on common stock KRF = risk‐free rate of return KM = market rate of return β= The stock’s beta coefficient Example: Colt Inc. plans to issue stock to finance anticipated capital

expenditures. The beta coefficient for Colt’s stock is 1.15, the risk‐free

rate of interest on a U.S. Treasury bond is 8.5% and the market return



is estimated at 12.4%. What is the required CAPM cost of capital for

this issue?

Answer: Expected Rate of Return = 8.5% + 1.15(12.4% –8.5%) =

12.99%

b. Risk‐Free Rate: The risk‐free rate is usually estimated using the rate of return on U.S. Treasury securities (typically T‐Bills).

c. Risk Premium: A risk premium results from the amount of nondiversifiable risk (beta coefficient) of the investment and the market price of risk. The market price of risk is the difference between the required rate of return on the average market and the risk‐free rate of return.

d. Beta Coefficient: The beta coefficient for an individual security (or a portfolio) measures the degree of risk of that particular security, relative to the market as a whole. A beta value of zero would be that of a risk‐free security. A beta of exactly one means that the security moves perfectly with the market as a whole. A beta of less than one means that the security is less risky than the market. A beta higher than one indicates that the security is more risky than the market. Thus, the beta coefficient under CAPM reflects the idea that higher risk is associated with a higher return, on average.

1. Risk‐Price Relationship: Volatility is usually reflected in market

price variations. The higher the price change of a security

compared to the market as a whole the higher the beta. The

closer the price change of the security is to market, the lower the

risk.



2. Examples:

If the market rises 5% and an individual stock rises 4%, the

beta coefficient of the security is 0.8 (.04 ÷ .05).

Stallion Inc. has a portfolio overall risk weighted return of

13%. It is considering investing in two stocks. Stock 1 has a

return of 10% and a beta risk factor of 0.9 while stock 2

has a return of 16% and a beta factor of 1.2. Stallion

should invest only in stock 2.

Stock 1 .1

= .11 or 11.1% risk weighted value 0.9

Stock 2 .16

= .133 or 13.3% risk weighted value 1.2

If Stallion wants to raise the overall risk weighted return of the

portfolio it will only invest in stock 2. Only stock 2 has a risk

weighted return (13.3%) exceeding the present risk‐weighted

value of 13%.

e. Portfolio Betas: The portfolio beta is the weighted average beta of the stocks in the portfolio.

1. Calculation of the Portfolio Beta:

Portfolio Beta = (Weight of stock one × Beta1) + (Weight of stock two × Beta2) + ... + (weight of

stock N × BetaN).

All weights of stock are based on the stock’s market value as a

percentage to the total portfolio value.

2. Example: A portfolio consists of two stocks, 200 shares of Gamma

trading at $20.00 per share with a beta of 1.4 and 100 shares of

Epsilon trading at $10.00 per share with a beta of .90. What is the

portfolio beta?

Stock Shares

Price per Share

Total Market Value

% of Portfolio Value

Stock Beta

Weighted Portfolio Beta

Gamma 200 $20 $4,000 80% 1.40 1.12 Epsilon 100 10 1,000 20% 0.90 0.18 $5,000 1.30

The weighted average Beta for the portfolio is 1.30. Notice that

the beta of the portfolio is less than the beta of the stock with the

highest individual beta. This indicates that there is some

diversification with just two stocks in the portfolio.



f. Market Return: Theoretically, the market return should be measured using a weighted average of the return on all possible investments. However, as a practical matter market returns are usually measured using stock market data.

Example: Colt Inc. plans to issue stock to finance anticipated capital

expenditures. The beta coefficient for Colt’s stock is 1.15, the risk‐free

rate of interest on a U.S. Treasury bond is 8.5% and the market return

is estimated at 12.4%. What is the CAPM cost of equity capital (i.e.,

the expected risk‐adjusted return) for Colt?

Answer:

Cost of Capital = 8.5% + [1.15 × (12.4% – 8.5%)] = 8.5 + (1.15 × 3.9) = 12.99%

2213.41 Risk Tolerance: Risk tolerance refers to an investor’s financial ability and emotional willingness to withstand declines in investment value. Following are common attitudes toward risk and their effect on risk management.

a. Risk Averse: Risk averse investors prefer relatively low risk investments and are willing to give up a higher return in exchange for more predictable outcomes. When managing risk, these individuals seek ways to avoid risk.

b. Risk Neutral: Risk neutral investors are indifferent between two investment opportunities that have the same expected value. When managing risk, these individuals objectively weigh the risk/return trade‐off (i.e., costs and benefits of higher or lower risk).

2213.42 Security Market Line

a. Variables: The security market line (SML) graphically depicts the positively correlated relationship between the required rates of return (vertical axis) and the beta risk of stocks (horizontal axis). The higher the beta risk the higher the required rate of return. In the below graph, a 16% return is required for a security with a beta of 1.3; only a 12% return is required if the beta is 0.8. The steeper the slope of the line, the greater the average investor’s risk aversion for the security.



b. Graph of Security Market Line

Note: When beta is equal to zero, the required rate is equal to the risk‐free rate. If the beta equals 1.0, the required rate is equal to the required market rate of return. Those results are determined by substituting betas of 0.0 or 1.0 in the CAPM model, yielding answers of KRF and KM respectively.

c. Overpriced and Underpriced Stocks: A stock whose expected rate of return differs from the required rate of return (as depicted by the SML) is either overpriced or underpriced. An overpriced stock is one in which the expected rate of return is less than the required rate of return. The opposite is true for underpriced stocks. Investors will determine this situation and then bid down (or up) the price of the stock until the required rate and expected rate of returns are equal (equilibrium).

2220 Long‐Term Financial Management

2221 Term Structure of Interest Rates

2221.01 Introduction to interest rates

a. Interest rate risk arises from differences between the timing of interest rate changes and the timing of cash flows (re‐pricing risk); from the risk that changes in interest rates will re‐price interest‐incurring liabilities differently from re‐pricing the interest‐earning assets, thus causing an asset‐liability mismatch (basis risk); from changing rate relationship across the spectrum of maturities (yield curve risk); and from interest rate‐related options embedded in a financial institution’s products (option risk).

b. An evaluation of interest rate risk must consider the impact of complex, illiquid hedging strategies or products, and also the potential impact on fee income that is sensitive to changing interest rates.



c. Re‐pricing risk is the most common form of interest rate risk and some firms make a bet on the typical upward‐sloping nature of the yield curve and deliberately mismatch the portfolio by holding longer‐duration assets when compared to liabilities in an attempt to enhance earnings.

d. Basis risk may be seen in the following example. A retail bank generally funds loans from customer deposits. Thus, since loan rates tend to adjust upward more rapidly than deposit rates, there is a tendency for interest margins to increase spontaneously when rates are rising. However, as rates stabilize, the improvement may disappear as deposit rates catch up, and then interest margins would fall when rates began to decline.

e. Yield curve risk arises from variations in interest rate moves along the yield curve, such as different changes for the 90‐day T‐bill and a 10‐year Treasury bond. The yield curve flattens, steepens, or becomes inverted during an interest rate cycle. These types of changes tend to accentuate the possible impact of any asset‐liability mismatches held by the firm.

f. Option risk arises from legal rights to engage in a future transaction at a predetermined price (puts and calls). The owner of a put option has the right, but not the obligation, to sell a given quantity of an underlying asset at a specified strike price during a specified period to the seller of the put if the option is exercised. These protect against the risk of a decline in market value of the underlying asset.

For example, a farmer is concerned that the market price of a growing crop may decline before harvest. The farmer can buy a put option to guarantee a minimum price. If the price declines below that price the option is exercised and the crop sold for that minimum price. Of course, if after harvest the price is above the floor, the farmer has no obligation to sell the crop at the floor and will happily sell it for the higher market price.

The owner of a call option has the right, but not the obligation, to buy a given quantity of an underlying asset from the seller of the option during a specified period for a specific strike price. The seller of the option is obliged to sell the underlying asset if the option is exercised.



For example, an airline has sold a number of tickets for future flights assuming the cost of jet fuel stays constant, but a large increase in the cost of jet fuel would make those future flights uneconomic. The airline can buy a call option on the price of jet fuel in the future, giving the airline the right to buy the fuel at a maximum price. If the price of fuel rises, the airline will exercise the option, buying the fuel at the strike (maximum) price. If future jet fuel prices remain below the maximum price, the airline is not obligated to buy the fuel at that strike price. Instead, the airline will buy the fuel at the lower market price, saving the difference in cost.

2221.02 Various interest rate formulas and their uses

Short‐term debt is that debt that will be repaid within one year. Interest rates on short‐term bank debt are calculated in a number of ways, including the following:

a. Basic interest is calculated on an annual basis using the stated rate of interest.

Illustration: The customer takes out a $10,000 loan with a one‐year maturity and a 10% interest rate. The basic interest is:

Basic interest rate = Interest ÷ Amount borrowed = $1,000 ÷ $10,000 = 10%

b. Interest is discounted (discounted interest) when the amount of interest to be collected during the life of the loan is subtracted from the loan proceeds, with the customer repaying the loan principal amount.

Illustration: The customer takes out a $10,000 loan with a one‐year maturity and a 10% interest rate. The interest for the year is $1,000 and the individual receives $9,000. The effective interest rate on the loan is

11.11% ($1,000 $9,000).

The add‐on interest method is one where interest is calculated on the full amount of the original principal. The calculated interest is added to the principal and the payment is determined by dividing the sum of principal plus interest by the number of payments to be made. The add‐on interest rate can be calculated as follows using the following example:

(1) Approximate add‐on annual rate = Interest paid (Amount received 2)

= $1,000 ($10,000 2) = $1,000 $5,000 = 20%

(2) Add‐on effective rate = (1 + i)n - 1 = (1 + .0167)12 - 1 = 1.2199- 1

= 22%

(If the approximate annual rate is 20%, then the monthly rate is 1.67% (or 20% ÷ 12)).



Simple interest is computed on the remaining outstanding balance using the daily periodic rate times the number of days since the prior payment.

c. Under certain situations with add‐on loans where interest is paid according to the Rule of 78s, the monthly payment is allocated first to the payment of interest and then to principal. If the amount of interest due is greater than the amount of the payment, the difference would be added on to the loan principal and is termed negative amortization. This can commonly occur on longer‐term loans such as 15‐year mobile home loans.

(In the Rule of 78s, 78 is equal to the sum of the digits from 1 to 12. For an annual installment loan, 12/78ths or 15.4% of the interest due on the loan would be charged to the first payment before anything was credited to principal. This concept can be applied to installment loans of any maturity by summing the digits of the number of payments. For example, a 15‐year loan with monthly payments would sum the digits from 1 to 180.)

d. Miscellaneous considerations:

(1) Compound interest involves the paying or charging interest on interest. The most common usage relates to the effective return on deposits. Federal legislation in 1991 (the Truth in Savings Act) was designed to provide consumers with information that would allow them to be able to compare the effective yield on alternative instruments.

Illustration: Assume that an individual deposits $10,000 in a one‐year certificate of deposit paying 6% interest. If interest is compounded annually, he would receive $600 in interest. If the interest were compounded semi‐annually, there would be two payments received. The first payment would be $300 and the second payment would also include interest on that $300 and the consumer would receive $609. Quarterly compounding would result in interest earnings in the amount of $614, and daily compounding $618.

(2) 360‐day vs. a 365‐day year. Many credit card issuers compute the daily periodic rate using a 360‐day as opposed to a 365‐day year, yet charge interest for 365 days. This has the result of increasing the effective annual rate on a loan. (The effective annual interest rate is the investment’s annual rate of interest when compounding occurs more often than once a year.)

Illustration: Assume that you have an 18% loan. With a 365‐day year, the daily periodic rate would be 0.0493%, while with a 360‐day year the daily periodic rate would be 0.05%.



(a) Effective interest rate using a 365‐day year with a 365‐day daily periodic rate:

((1 + 0.000493)365 - 1) = 19.71%

(b) Effective interest rate using a 365‐day year with a 360‐day daily periodic rate:

((1 + 0.0005) 365 - 1) = 20.02%

2221.03 Why interest rates differ

a. There is risk that the borrower will not repay the loan in a timely fashion. The greater the likelihood that the borrower will default on the loan, the higher the interest rates will be in order to compensate the lender for bearing that risk.

b. Interest rates tend to be higher for longer‐term loans. Borrowers tend to like the certainty of a known fixed expense. Lenders are concerned about the possibility of an increase in their cost of funds over the period of the loan and charge a premium to compensate for this risk.

c. There are fixed and variable costs associated with making loans. There tend to be high administrative and processing costs associated with making loans. The costs tend to be higher per dollar loaned for smaller loans and for loans that require more frequent payments. This causes interest rates on smaller loans to be higher than on larger loans, and interest rates on short‐term loans to be higher than on longer‐term loans.

2221.04 Role of interest rates

Interest rates have a significant impact on the level and composition of investment goods purchased and the level of spending for research and development (R&D).

a. Lower interest rates encourage an increase in business investment. This would cause a firm to expand output and increase capital spending once the firm no longer has idle capacity. The reverse would be true if interest rates increase. The Federal Reserve can influence rates in an attempt to influence the level of economic activity.



b. Interest rates are the price of money and serve to ration the supply of available loanable funds to projects with the highest rate of return. The rationing is not perfect, however, because firms with market power and/or a strong financial position are able to obtain funds at lower rates, which gives them an advantage over other firms that might have more profitable projects but a relatively weak financial position.

Lower interest rates tend to make R&D expenditures more profitable. Thus, lower rates would cause firms to increase such expenditures.

2221.05 Determination of interest rates

The use of credit has become ubiquitous in the American economy. Individuals and households receive credit when they take out mortgage and auto loans and use credit cards. Many times it is difficult to determine the interest rate being paid on such loans. Truth‐in‐lending laws, which were passed in 1968, were passed to provide consumers with a method for comparing the true cost of loans.

2221.06 Methods for quoting rates of return

There are a myriad of methods for computing the rate of return on a loan. Returns on loans such as mortgage loans and bonds that have regular periodic payments are quoted in terms of annual percentage rates (APR). This APR can be translated into an effective annual rate (EAR).

a. APR = Period interest rate × Number of periods per year. The period interest can be defined as semi‐annual, quarterly, monthly, etc. For example, if the monthly rate is 1.5%, then the APR would be 18% (1.5% × 12 months).

b. To compute the effective annual rate (EAR) we would use the following formulas:

EAR = ((1 + Rate per period)2 – 1), where the rate per period = APR/2, or

APR = ((1 + EAR)1/n – 1) × n, where n is the number of periods



2221.07 Bond prices and yields

Since bond cash flows occur in the future, the price an investor is willing to pay for those payments depends on the value that can be received compared to the value of the dollars today. The nominal rate of return is a combination of the risk‐free rate plus a premium for expected inflation. The value of a bond can be computed as follows:

Bond value = PV of the interest payments + PV of par value

And, given a particular maturity, t, and a discount rate, r, the bond value can be defined as:

t

rt r1ValuePar r1

1-1PaymentCoupon Value Bond

Illustration: Assume that there is a bond with a 6% coupon, 20‐year remaining maturity with a $1,000 par value, paying 40 semiannual payments of $30 each. If the market interest is equal to the coupon rate (6%), the value of the bond can be calculated as:

000,1$

56.30644.693

40%31000,1$%3

40%31

1130$Value Bond

The interest payments represent an annuity, and the final payment is a lump‐sum payment. If the market interest rate were equal to the coupon rate, the price of the bond would be equal to the par value as shown above. If, however, the market rate was 8%, the value of the bond would decrease due to the fact that the bondholder would still be getting only the $30 semiannual payments. Given these circumstances, the bond’s value could be calculated as:

07.802$

29.20878.593

40%41000,1$%4

40%41

1130$Value Bond

2221.08 Usury laws

Many states have usury laws that set a maximum rate that can be charged for a certain type of credit. Such laws are designed to limit the cost of credit.

a. Today, many of these laws are designed to place a ceiling on the rates charged for “payday loans” or “title loans,” where these lenders often charge effective annual rates in excess of 400%.



b. If the state usury limits are restrictive enough, this type of lender often simply would not offer this type of loan in a state with such limitations.

c. Since interest rates (price) no longer ration funds, less creditworthy borrowers will be excluded from the market, and thus the credit for lower‐income borrowers will be reduced.

2221.09 Generally lenders will charge a higher rate for long‐term financing than for short‐term because unknown risks may arise and unknown opportunities may be foregone. This uncertainty includes expectations as to interest rate changes and future inflation.

2221.10 Term Structure Theories: Three principle theories exist to explain the shape of the normal yield curve.

a. Liquidity Preference Theory: The upward‐sloping yield curve is best explained because short‐term bonds return less interest than long‐term bonds. The two factors supporting the liquidity preference theory are:

(1) Creditor Objective: Lenders want shorter‐term liquidity and will thus accept less return.

(2) Debtor Objective: Borrowers prefer long‐term debt to avoid the risk of costly refunding and will thus pay a higher rate of return than on short‐term debt.

b. Market Segmentation Theory: Each lender and borrower has a preferred maturity and this creates two market segments. Merchants want working capital loans for short‐term periods while corporations building factories and home buyers want long‐term loans. The slope of the curve depends upon the relative demand and supply of funds in these two markets.

(1) Inflation Expectancy: This theory would add an inflation premium equal to the average expected inflation rate from the date of issue to the date of maturity. If future interest rates and/or inflation are expected to be higher than at present, the yield curve will be significantly upward sloping. If the inflation rate is expected to decline, the yield curve would have a flat or downward slope. In December 1998, long‐term mortgage rates were lower than short‐term loans; many financial analysts credit this phenomenon to the expectation theory.

(2) Recession and Interest Rates: When investors expect the economy to slow or contract, long‐term rates drop as inflation fears fade or deflation fears increase. By contrast short‐term interest rates are more anchored to interest rate policies set by the Federal Reserve.



(3) Inverted Yield Curve: This is where short‐term rates are higher than long‐term rates. Every recession since 1960 has been preceded by an inverted yield curve.

(4) Computational Problem: The CMA exam has infrequently asked the candidate to compute expected future interest rates. The question often gives associated years‐to‐maturity and interest rate values from a particular yield curve. This computation is used by investors who are debating whether to buy a two‐year bond today or to buy a one‐year bond today and reinvest the proceeds in another one‐year bond at the beginning of year 2. The formula to compute expected future interest rates is:

Expected Interest Rate in

Future Year F from Base Year B =

1 + Interest rate associated with Year F)YF – 1

(1 + Interest rate associated with Year B)YB

Where: YF = number of years in the future that the future year is from today YB = number of years in the future that the base year is from

today

Example: Today, the following yields on a given security are

observed:

Yield to Maturity Interest Rate1 year 4%2 years 4.5%3 years 6%

Required: Determine the market’s interest rate expectations

concerning one‐year rates on the security at the beginning of Year

2 (one year from today) and at the beginning of Year 3 (2 years

from today).

Answer: One year from today, the one‐year rate on the security is

expected to be 5.0%, computed as follows:

(1 + .045)2 – 1 = 1.092025 – 1 = 1.050024 – 1 = 0.050024 = 5.0%

(1 + .04) 1.04



Two years from today, the 4% bond would have to yield a 3‐year

average of around 6%. The rate in year 1 is 4%, in year 2 it’s 5%

for a total of 9%. Three years at 6% is 18% so there is a required

9+% in year three. The actual one‐year rate on the security is

expected to be 9.1%, computed as follows:

(1 + .06)3 – 1 = 1.191016 – 1 = 1.090649 – 1 = 0.090649 = 9.1%

(1 + .045)2 1.092025

2222 Types of Financial Instruments

2222.01 Bonds: A bond is a promise to pay a given amount (designated as par, face, or maturity value) on a given date (maturity date). The bond indenture is the contract between the issuing corporation and the bondholder. The indenture typically provides for periodic interest payments, stated as a fixed percentage of the face value (coupon rate). Bonds provide a creditor with security, a priority in both earnings and liquidation and a fixed return that is not dependent upon earnings (as opposed to common stockholders). The interest is deductible to the corporation and therefore this source is usually less expensive after‐tax than preferred or common stock. While this involves no dilution of equity, it increases the debt‐to‐equity ratio, thus creating more risk to the firm in the event of an economic downturn. Debt instruments with a coupon rate of interest less than the current market rate will sell at a discount.

a. Types of Bonds: There are several basic types of bonds, described as follows:

1. Mortgage Bonds: Mortgage bonds are secured by a lien on

property. This is the usual way to secure real property collateral.

2. Debentures: Debentures are bonds with no specific collateral to

secure the debt aside from the full faith and credit of the

company issuing the debt instrument. Thus debentures may have

a higher yield than other debt instruments.

b. Special Provisions: The bond indenture can also contain the following special provisions:

1. Call Provision: The issuer may reserve the right to call the bond

prior to the redemption date. The call price is generally above the

market price and may be exercised if interest rates decrease. A

call provision is usually considered detrimental to the investor and

thus may require a higher interest rate at issue.



2. Sinking Fund Provision: A sinking fund provision requires the

corporation to make periodic payments to a trustee and thereby

accumulate funds to retire the principle of bonds or the balloon

payment(s) when they are due. Such bonds are usually considered

safe because of the orderly retirement provisions and therefore

have lower yields.

3. Protective Covenants: The bond indenture may also contain one

or more required covenants or promises designed to protect the

creditor. These are intended to ensure that the firm will be able to

meet its obligations to the bondholders and may include:

Payment of dividends to shareholders and salaries to

officers may be restricted

The firm may be required to maintain a specified current

ratio or minimum level of working capital.

Further borrowing by the firm may be restricted.

2222.02 Convertible Securities: Convertible (Bonds or Preferred Stock) securities are exchangeable for common stock at the owner’s option on or before a stated time in the future.

a. Creditor Advantages: This allows a creditor to receive a fixed income today and the option to become an equity participant tomorrow. The latter feature provides the attraction of being able to share in possible future superior earnings. This may be a very attractive feature to an investor. This type of debt‐equity investment is very popular with venture capitalists.

b. Debtor Advantages: The issuer may find convertibles easier to float and less expensive than straight debt or equity instruments. The issuer may prefer convertibles because it involves less restrictive loan covenants and it allows a deferral of equity participation. Because of the conversion feature, the value of bonds with such features may be strongly influenced by the value of the issuer’s common stock and may sell at a lower yield than straight bonds. The conversion premium is the difference between the issue price and the conversion price.

2222.03 Warrants: warrant is an option to purchase a stated number of common stock shares at a specified price by a given expiration date. It is often sold as a detachable companion to a bond. The firm receives cash when the warrant is exercised and the common stock is issued.



a. Advantages: Warrants make the related bond sale more attractive. Thus, the cost of the indebtedness may be lower and/or funds may be raised that could not otherwise. Also, warrants can be used to effect delayed equity financing.

b. Disadvantages: Uncertainty exists as to whether or when outstanding warrants will be exercised. If warrants are not exercised, there will be no cash inflow from the sale of the stock. In addition, exercise of the warrants when the common stock market price is substantially higher than the option price can lead to a dilution of earnings per share. Notice that in such a circumstance the issuer would be better off if the stock had been sold directly and not available at such a “bargain” price.

2222.04 Leases

a. Advantages and Disadvantages: The advantage to leasing is that 100% financing is possible, thus conserving cash. The risk of obsolescence decreases, credit lines are preserved thus providing flexibility, and there is no violation of restrictive loan covenants which may prohibit the issuing of new debt securities. The disadvantage is that the real cost of leasing usually exceeds that of a term loan.

b. Lease vs. Term Borrowing Decision: Take the after‐tax present value of the expected cash outflow under both alternatives. The lease payment and interest portion of the term loan and related depreciation are usually net of tax. The present value factor is divided into the face amount of the net obligation to determine the payment amount. This calculation may become quite complicated.

2222.05 Preferred Stock: Preferred stock has features that are characteristic of both debt and equity instruments. It is generally preferable to straight debt because it is legally equity and has no maturity date. The dividend received deduction makes holding preferred stock more attractive than debt instruments to corporations.

a. Preferential Quality Specified: Preferred stock is defined in the corporate articles or bylaws as having some preferential quality(ies) over common shares. Usually they have superior rights upon liquidation and/or to dividends.

b. Cumulative Preferred: Preferred stock dividends may accumulate and must be paid current before any dividends may be paid to common shareholders.

c. Participating Preferred: Preferred shareholders may participate with common in additional dividends above a preset level.



d. Convertible Preferred: Preferred may also be convertible into common shares either at the end of a given period or upon the occurrence of some other condition.

e. Not a Legal Obligation: Preferred dividends are usually not legal obligations until declared by the Board of Directors.

f. No Voting Rights: Unlike common shareholders, preferred shareholders do not usually have voting rights as long as all conditions of the issue are met.

2222.06 Common Stock: Common stock has the last priority in liquidation and exposes investors to greater risk than debt. It is purchased for capital appreciation and dividend objectives. Common shares may increase in value quicker than other securities and generally have no right to dividends. But additional common stock issuances will decrease earnings per share and dilute existing shareholders’ voting power.

a. Different Classes of Common Stock: Companies may issue more than one class of common stock. One class may be voting, while the other is non‐voting.

b. Stated Capital: Stated or legal capital is that portion of corporate capital required by state law to be retained in the business to afford creditors a minimum degree of protection. The outstanding shares times par or stated value constitutes the dollar amount of legal capital. Stock dividends will increase stated capital by shares times par value. A stock split does not affect stated capital. Dividends paid out of legal capital are unlawful.

c. Paid‐In Surplus: Paid‐in surplus is the excess of the consideration received by the corporation for its shares less the par or stated capital amount.

d. Authorized Shares: Authorized shares are detailed in the articles of incorporation. To issue a larger amount requires that the articles be amended by the shareholders.

e. Outstanding Shares: Outstanding shares are that portion of issued shares which have not been redeemed. This is issued shares less those held in the treasury (see treasury shares below).

f. Stock Options: Options to purchase common shares may be sold or granted to executives or other employees as additional compensation. This may encourage employees to increase earnings and align their interests with the stockholders. The option price may be fixed or depend upon future conditions such as earning levels of the company. There is an active put and calls market for most listed corporations. Stock options may be a deterrent to a corporate raider.



2222.07 Treasury Shares: Treasury stock is corporate stock which has been issued and later reacquired by the issuing firm. As long as the articles of incorporation so provide, a corporation may repurchase or redeem its own shares. Redeemed shares may be cancelled or held in the treasury. There is no taxable gain or loss recognized by a corporation from transactions in its own treasury shares. Such transactions also have no affect on stated capital. Treasury shares do not have voting rights and cannot receive dividends.

a. Reasons for Reacquiring Stock: There are a number of reasons why a firm reacquires its own stock, including the following:

1. Provide Cash and Tax Savings for Shareholders: By repurchasing

its stock from its shareholders, the corporation can both pay cash

and provide a tax benefit to the shareholders. The shareholders

are taxed only on the gain (amount that the transaction price

exceeds their original basis in the stock). In contrast, cash

dividends paid to shareholders are usually fully taxable.

2. Employee Stock Ownership Plans (ESOPs): Federal corporate tax

law provides for the deductibility of contributions made to

qualified ESOPs. An ESOP typically borrows funds from a bank to

purchase shares of the corporation’s stock to be held in the name

and for the benefit of the firm’s employees. These shares may be

treasury shares accumulated and held by the corporation as well

as those shares newly issued by the corporation or purchased on

the open market. The corporation makes annual tax‐deductible

contributions to the ESOP, which uses the funds to repay the bank

loan. Employees may also contribute to the ESOP. The firm

benefits by receiving the proceeds from the sale of either treasury

stock or newly‐issued shares to the ESOP.

3. Automatic Dividend Reinvestment Plans (ADRIPs): Treasury stock

may be used to provide additional shares to shareholders in lieu

of cash dividends under an ADRIP.

4. Stock Repurchase Programs: The corporation may choose to

purchase some of its own shares from the market, thus increasing

the proportional ownership of the remaining shareholders.

Earnings per share of outstanding stock is then increased which,

together with the stimulative buying activity, is expected to result

in a higher market value per share. Shareholders have the

potential of realizing capital gains upon eventually selling their



shares, which may be taxable at lower rates than ordinary

dividends. Such a program is especially desirable if the book value

per share exceeds the market value per share of the stock.

b. Reasons for Reacquiring Stock: There are a number of reasons why a firm reacquires its own stock, including the following:

Advantages Disadvantages

Increase EPS to Remaining Shareholders May create liquidity problem

Increase market price per share Increase debt to equity ratio

Obtain control Increase financial risk of takeover

Buyout of dissident stockholder Decrease a firm’s current assets

Fund pension plans

2222.08 Retained Earnings: Retained Earnings, an internal source of funds, are the accumulated earnings of the firm which have not been distributed as dividends.

a. Advantages: One advantage to retention is that there is no disturbance of present ownership. Also, the price/earnings ratio of listed corporations may mean the net appreciation in share market value derived from the increased capital. Historically, retention of earnings has been the major source of capital investment for large business firms. This may be especially valuable during periods of capital rationing.

b. Disadvantages: The amount available from this source is limited, as it depends on the firm’s earnings and dividend policy. Financing in this manner can reduce the amount of dividends available to shareholders, and the dividends can become variable.

2222.09 Dividends: Dividend Policy addresses what percentage of net income to pay out and what to retain for internal growth. According to the residual financing theory, if a firm earns a high return on investment, it should retain more. The higher the capitalization factor or market price‐to‐earnings ratio, the more the increase in earnings will be multiplied to a higher stock market price. This may exceed the return a shareholder could realize by investing the dividend.



a. Relevant Dates

1. Declaration Date: The date the Board declares the dividend and it

becomes a corporate liability. For cumulative preferred stock, this

action may not be necessary to create a liability. The Board,

however, would be the responsible party in determining whether

to pass the dividend.

2. Ex‐Dividend Date: Because of the necessity to process buying and

selling orders, stock exchanges set a date before the holder‐of‐

record date to determine the identity of the dividend recipient.

This is usually four days, and on that date, the market price of the

stock usually falls by the dividend amount.

3. Holder‐of‐Record Date: Stock traders forward their final transfers

to the corporation or its transfer agent. The share ledger is then

brought current. The corporation then closes its share ledger and

produces a list of shareholders entitled to receive the dividend.

4. Payment Date: The date the check is mailed to the shareholder.

b. Factors Restricting Dividends: A corporation may find difficulty in paying cash dividends if it lacks liquidity. Corporations can only legally pay dividends up to earnings and profits (roughly retained earnings). Loan agreements or bond indentures may further restrict or prohibit dividends. Investment opportunities may not be available if cash dividends are paid. The type of investor desired may affect dividend policy such as a company owned predominantly by pensioners or trusts which maintains a large regular dividend.

c. Non‐Cash Dividend

1. Usefulness: A non‐cash dividend is a way a corporation can

placate shareholders without using cash that may be used in the

business. This method is especially appropriate if the business can

earn a higher return on its investments than shareholders on

theirs.

2. Stock Dividend: New shares of stock are issued to existing

shareholder. The corporation must transfer the par value of the

new shares (or stated value for no‐par stock) from retained

earnings to capital stock. Net worth and ownership interest are

unchanged but future earnings per share are reduced. A stock

dividend is non‐taxable to shareholders unless they receive the

right to receive cash instead of the stock dividend.



3. Stock Split: There is no change in capital accounts because

mechanically the reduction in the legal par or stated value of the

shares outstanding is offset by an increase in the number of

shares outstanding. This may make the share trading range more

attractive and lead to a market price above the split level price. In

addition, there may be an “information value” to a stock split

because a growth in earnings is expected. A stock split is non‐

taxable to shareholders.

4. Reverse Stock Split: This is the reverse of a split. It may be used

when a company desires to increase the market value per share.

2222.10 Derivatives: The markets for derivatives began as a form of hedge against changes in currency exchange rates. An investor with appreciated stocks overseas may desire to ensure that the fluctuations of foreign currencies wouldn’t dissipate the gains. So a forward instrument was created allowing the investor (for a small fee) to freeze the value of the foreign currency.

a. Definition: A derivative is a contract whose value is tied to, or derived from, the price of an underlying security, currency, or commodity. They are artificial and synthetic and became popular because the yields are higher than the prevailing market. Sophisticated investors may engage in arbitrage (profiting from the differences in prices) and use leverage. There is an estimated $12 trillion invested in over 2,000 different varieties of derivatives.

b. Varieties: The range is from a simple stock option to:

1. Forward Contracts: An asset is sold at a price determined today

but the seller is committed by contract to delivery at a later date.

This eliminates the purchaser’s fluctuation risk.

2. Futures: Similar to forward contracts, except futures are

standardized and traded on an organized future exchange.

Normally, futures are settled in cash rather than delivery of the

underlying commodity.

3. Swaps: This is an exchange of contracts; usually it is the

responsibility to make interest payments. An example is

exchanging a fixed rate of return obligation for an adjustable rate

obligation. Interest rate swaps enable management to hedge

interest rate risk. Because swaps do not involve an exchange of

principal, liquidity and risk management are increased.



4. Inverse Floaters: The two variable factors are opposite one

another. An example would involve mortgages with one pool

representing interest payments and another representing

principal payments.

5. Collateralized Mortgage Obligations: These are high‐quality, low‐

risk pools of mortgages. The derivatives are set up in three pools:

short‐term to 5 years; 5 to 15 years; and 30 years.

2223 Cost of Capital

2223.01 Overview

a. The sources of financing for an organization can be found on the right side of the balance sheet—debt and equity.

b. Since accounts payable and other accrued expenses are created spontaneously in the course of doing business and have no clear interest expense, they do not require a special approval by management. The financing structure items that do require the discretion of management are short and long‐term debt as well as preferred stock and common equity. These items are referred to as the firm’s capital structure. The relationship between financial structure and capital structure can be demonstrated as follows:

Financial structure = Non‐interest‐bearing liabilities + Capital structure

c. The goal of management is to minimize the firm’s cost of capital resulting in the maximization of the common stock price. This point is referred to as the optimal capital structure. There are two basic questions that must be answered by management related to capital structure:

(1) What mix of short‐ and long‐term debt should be employed?

(2) What mix of debt and equity should be employed?

d. The pecking order theory indicates that the order of financing of a company (or project) follows the path of least effort.

(1) Companies will use internal financing first.

(2) Dividend policy will be adapted to financing needs while at the same time attempting to avoid sudden changes in dividends paid.

(3) If outside financing is required, a company will start with the cheapest security, thus starting with debt financing, followed by hybrid securities, and ultimately equity securities.



e. Modigliani and Miller developed the MM theorem related to the financing of a firm, which can be summarized as follows:

(1) In a world with no taxes, no bankruptcy costs, or no agency costs, the value of a company would be indifferent to its capital structure due to the fact that the cost of capital would be the same for all financing sources.

(2) In a world with taxes but no bankruptcy costs, the value of a company would be highest with the use of 100% debt since the cost of debt financing would be lower than the cost of equity financing due to the interest tax shield.

(3) In a world with taxes and bankruptcy costs, the maximum value of the firm would be the point when the marginal cost of debt based upon the marginal tax shield would be equal to the marginal cost of bankruptcy or financial distress costs. In other words, the optimal capital structure would be a combination of debt and equity that would provide the lowest overall WACC (weighted‐average cost of capital).

f. When reviewing capital structure decisions, two basic models are regularly used:

(1) When comparing two funding options, the EBIT‐EPS indifference point is where the EPS will be the same no matter which financial funding plan is employed. After the indifference point is met, EBIT in excess of that amount will result in a higher EPS the more leverage that is employed. An EBIT less than the indifference point will result in a higher EPS the less leverage that is used. The tool can help management determine whether more or less leverage should be used based upon the likelihood of achieving a particular EBIT level. The indifference point can be determined mathematically using the following formula:

EPS with stock at level “a” = EPS with stock at level “b”

(EBIT – I)(1 – T) – P Sa

=(EBIT – I)(1 – T) – P

Sb

Where:

I = Interest expense

T = Tax rate

P = Preferred dividends

Sa = Number of common shares using plan “a”

Sb = Number of common shares using plan “b”



(2) Firms often use ratio analysis to aid in capital structure decisions. For example, an average company in the meat processing industry has a debt‐to‐equity ratio of 2.17. If ABC Meat Processing Company has a debt‐to‐equity ratio of 1.75, management may decide to use debt financing for a proposed expansion. If, however, that same company has a debt‐to‐equity ratio of 2.5, management may decide to use equity financing instead. The whole idea here is for an organization to keep their debt‐to‐equity ratio in line with the industry average.

g. Items that management may wish to consider when making capital structure decisions would include the following:

(1) Financial flexibility: As the proportion of debt increases, the less likely that additional debt will be available at a reasonable interest rate; therefore, management tends to act on the conservative side and use proportionally more debt increasingly sparingly.

(2) Tax position: Unlike dividends, interest expense provides a tax shield for companies and will generally make debt financing less expensive than equity financing.

(3) Interest rates: When interest rates are low, companies will look more favorably on long‐term borrowing than when rates are high.

(4) Industry comparison: Lenders often will use industry averages as a criterion when evaluating the creditworthiness of a firm, as will potential investors.

(5) Internal funds: Companies will generally use internally generated funds before seeking additional debt or issuing additional equity.

(6) Risk: The more debt a company has, the greater the financial distress costs and the higher the risk for bankruptcy. Also, the higher the debt level, the lower the potential credit rating. As a firm’s credit rating drops, the cost of borrowing increases.

(7) Stock values: If a company’s stock is undervalued, management is not likely to issue additional shares, since such an action could potentially have a negative effect on an already low stock price. Using an additional stock issue to raise necessary funds when a company’s stock is overvalued stock, however, would be desirable.



Weighted‐Average Cost of Capital

2223.02 Weighted‐average cost of capital

a. The cost of capital is an important element in making investment decisions, as projects with a higher rate of return than the firm’s cost of capital will increase the value of the firm. The relevant cost of capital is the firm’s long‐term cost of capital since we are evaluating long‐term projects or investments.

b. The weighted‐average cost of capital is the weighted average of the cost of debt and the various equity components of the firm’s capital structure. It is preferable to use weights based on the market value of the items or the firm’s target capital structure.

(1) The cost of debt for the issuing firm is based upon the required rate of return for debt holders and the marginal tax rate for the issuing company. Due to the tax shield associated with interest‐bearing debt, the effective cost of the debt is lower than the interest rate paid due to the reduction in the taxes paid.

Cost of debt = kd (1 – T)

Where:

kd = Cost of debt

T = Marginal tax rate

(2) Preferred stock provides the investor with a constant stream of dividends; however, these dividends do not provide a tax shield since they are not a deductible expense for the issuing company. The cost of preferred stock to the issuing company can be calculated by dividing the annual return (interest payment) by the net issuance price for the preferred stock.

kp =Dp Pp

Where:

kp = Cost of preferred stock

Dp = Preferred dividend

Pp = Price of preferred stock



Generally, however, when looking at the cost of issuing new preferred stock, the company would have to pay flotation costs to an investment house; thus, the proceeds received by the company would be less than the issue price. This would increase the cost of this form of financing. Taking flotation costs into consideration, the formula to calculate the cost of preferred stock to the issuing company would be:

Kp = Dp (1 – f)Pp

Where:

kp = Cost of preferred stock

Dp = Preferred dividend

Pp = Price of preferred stock

f = Flotation costs

(3) The cost of retained earnings is the opportunity cost that stockholders of a firm could earn elsewhere if they made investments of comparable risk. This figure would need to be imputed.

(4) The cost of equity (ke) is more expensive than the cost of debt since stockholders are subject to more risk than debt holders. There are a number of ways to estimate the cost of equity, and one commonly used method to obtain the estimate is the dividend growth model. The formula used is:

ke = (D1 ÷ Po (1 – F)) + g

This formula assumes that the firm pays a future dividend per share equal to D1, would issue new stock at price Po, and would pay a flotation cost (F) that is equal to some percentage of the value of the stock being issued. It is assumed that the firm’s dividend will grow at a constant rate (g). The result is the cost of using internally generated equity. If new stock is going to be issued, the cost of new equity would be the result obtained for internally generated equity divided (1 – Percent of flotation costs).

Illustration: The firm’s current dividend was $1.50 and is expected to grow 6% per year. They expect to be able to sell new stock at a price $30 per share and flotation costs are expected to be 10% of the value of the stock issue. What is the firm’s cost of equity?

ke = (($1.50 × 1.06) ÷ ($30 × (1 – 0.10))) + 6.0%

= ($1.59 ÷ $27.00) + 6.0% = 5.89% + 6.0% = 11.89%



c. Most analysts use the CAPM (capital asset pricing model) to estimate the required return on a firm’s cost of equity. The basic equation for estimating the required return on equity (Ri) is:

d. The primary conclusion of the capital‐asset pricing model (CAPM) is that the relevant risk on any security is its contribution to the risk of a well‐diversified portfolio. A commonly used benchmark portfolio for the market portfolio is the S&P 500.

e. Illustration: Assume that the current T‐bill rate is 3.35% and the market risk premium is 7% for a diversified market portfolio.

Ri = RF + βi (Rm – RF) = 3.35% + 1.0 (7.0%) = 10.35%

Under this scenario, investors would expect to earn 10.35% on a diversified market portfolio. (Note: The beta coefficient for the diversified market portfolio is 1.0.)

Given the information in the example above and assuming that the beta coefficient for an individual security is 1.4, what return would investors require to hold this security?

Solution: Using the formula from (c) above, that is, Ri = RF + βi (Rm – RF), the return required by investors would be 13.15%. Again, this is the cost of internally generated equity. The cost of issuing new stock would be the cost of internally generated equity divided by (1 – Percentage of flotation costs).

Ri = RF + βi (Rm – RF) = 3.35% + 1.4 (7.0%) = 13.15%

f. The weighted‐average cost of capital can be computed as follows:

WACC = (wtd × kd) + (wtpf × kpf) + (wte × ke)

Example: Assume that the firm can issue new debt at 5% and that the marginal tax rate is 40%. The firm has $1,000 par preferred stock that pays a dividend of 4%. Using the CAPM, it is estimated that investors require a 16% return on equity investments. The firm has a target capital structure of 30% debt, 10% preferred stock, and 60% equity. What is the firm’s WACC?

Solution:

WACC = (.30 × [.05 × (1 – .40)]) + (.10 × .04) + (.60 × .16) = .009 + .004 + .096 = .109 or 10.9%

Ri = RF + βi (Rm – RF)



2223.03 Optimal capital structure

a. Finance theory indicates that the goal for a firm should be to minimize its weighted‐average cost of capital, and it can do so by achieving its optimal capital structure.

b. The tax shield for debt makes debt a very attractive component of the capital structure. However, increasing the amount of debt in the structure beyond some point causes increasing financial distress costs that would cause the cost of additional debt to climb. Theoretically, the firm should continue to issue debt until the increasing financial distress costs offset the positive value of the tax shield.

c. It is very difficult to accurately determine the optimal capital structure, and in practice a firm attempts to find an optimal range of debt‐to‐equity that would minimize the weighted‐average cost of capital.

d. Key elements in making capital structure decisions include the following:

(1) Sales stability: A firm whose sales are stable can take on more debt than a firm with unstable sales.

(2) Asset structure: Firms with assets that are suitable to be pledged as security for a loan can use debt more heavily than firms with special purpose assets.

(3) Operating leverage: Firms with less operating leverage are better able to employ financial leverage.

(4) Growth rate: Faster‐growing companies are more likely to rely more heavily on debt.

(5) Profitability: Firms with high profitability are better able to support more of their financing needs with internally generated funds.

(6) Taxes: The higher a firm’s marginal tax rate, the greater the advantages of using debt.

(7) Management attitude: Management can exercise judgment as to the appropriate capital structure.

e. As shown by the following graphs, the lower the firm’s weighted‐average cost of capital (WACC), the greater the value of the firm since the WACC is used to discount the firm’s expected cash flows. Thus, many firms are concerned about creating a capital structure that minimizes its cost of capital. As a firm moves from being an all‐equity firm (that is, with debt equal to zero) to adding debt to the capital structure, the firm’s WACC will begin to decline. This is true because debt is less risky than equity (demanding a lower return) and debt has a “tax shield” in that the interest cost is tax deductible. Therefore, adding debt to the capital structure mix reduces WACC. This decline will continue until financial



markets perceive that the firm’s debt‐to‐asset (or equity) ratio has reached a point where additional debt will increase the firm’s “financial distress costs” (that is, the possibility of bankruptcy) and require a higher return on the debt to compensate for the increased risk. At this point, the firm’s WACC will begin to rise. A firm’s “optimal capital structure” is the ratio that minimizes WACC; in the example found in Graph B it is found to be 40%.

Graph A:

Graph B:



2224 Valuation of Financial Instruments

Valuation Fundamentals

2224.01 Fair value basics

a. As part of the FASB’s Convergence Project working with the IASB (International Accounting Standards Board) as well as other standard‐setting bodies to work toward compatible international reporting requirements, the FASB issued Fair Value Measurements and Disclosures (FASB ASC 820) to clarify the definition of fair value as well as to provide guidelines for measuring fair value. Per this statement, fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

b. Since the calculation of fair value assumes that the value determination is for a particular asset, liability, or equity ownership, the following items must be taken into consideration:

(1) Age and condition of the valuation object

(2) Attributes for the valuation object

(3) Ability of the valuation object to stand alone or the need to function as part of a unit

(4) Location of the valuation object

(5) Restriction placed on the use or sale of the valuation object

c. In determining the price under a fair value assumption, the conditions under which the hypothetical sale are assumed to occur would be orderly and not under conditions of liquidation or distress. The seller would be able to take advantage of normal market activities and would have the ability to take enough time prior to the date of measurement to take advantage of normal exposure to the market given the item being valued.



d. Under fair value assumptions, the hypothetical transaction is considered to have occurred in either the principal market for the subject transaction or, in the absence of such a market, in the most advantageous market for that transaction. The principal market is considered to be where the holder of the transaction asset or liability could locate the greatest volume of similar transfers. The most advantageous market is considered to be where either the sales price for an asset can be maximized or the transfer costs for a liability can be minimized. Note that these hypothetical transfers are considered from the perspective of the holder of the asset or liability. Also, if there is a principal market for the subject item, then the fair value measurement is determined using that market even if the most advantageous market would yield a more beneficial transfer for the holder.

e. The market participants to be considered when determining fair market value are the actual holder of the asset or liability being valued and the hypothetical buyer in the principal (or most advantageous) market. Characteristics for both the buyer and seller would include:

(1) buyer and seller are not related parties (independence).

(2) both parties are knowledgeable about the item being transferred and have access to usual and customary information.

(3) both parties have the ability to complete the transaction.

(4) both parties are willing to complete the transaction but are not being forced to do so.

f. A fair value measurement assumes that the item being valued will be put to the highest and best use resulting in the maximization of value that would be physically possible, legally permissible, and financially feasible. Note that the highest and best use is not determined from the perspective of the current holder but by the hypothetical market participants.

g. The fair value determination of an asset uses either an in‐use or an in‐exchange premise. An in‐use premise assumes that the maximum value from the purchaser’s perspective of the subject asset is when it is used in conjunction with other assets as a group. An in‐exchange premise assumes that the maximum value from the purchaser’s perspective of the subject asset is when it is used alone.

h. The fair value determination of a liability assumes that the liability will continue to exist after the transfer and maintain the same risk of nonperformance after the transfer as before.



2224.02 Approaches to determining fair value

a. Fair value can be determined by using one of three different approaches. The approach to be used is based upon the circumstances of the particular asset, liability, business segment, or business entity to be valued. The three approaches are the cost approach, the market approach, and the income approach.

b. The cost approach to determining fair value is based upon what it would cost to replace the subject item with an asset of like function and capacity. This is similar to the economic substitution principle. Such items as functional obsolescence, physical deterioration, and economic obsolescence need to be taken into consideration. Note that book value per GAAP using financial depreciation is not related to the fair value of an asset.

c. The market approach to determining fair value uses market comparison of identical or comparable assets or liabilities. A comparable is an item that has reasonable and justifiable similarity to the subject item being valued. This process is similar to that used by real estate agents in determining a reasonable market price for a home.

d. The income approach to determining fair value uses the company’s ability to create earnings or cash inflows and the risk involved in the specific investment. Capitalization or discount rates are applied to the benefit stream (earnings or cash inflows) in order to establish a value. The theory behind the use of the income approach is that an investor will require a particular investment to yield a benefit sufficient to recover the initial cost of the investment as well as a return to offset the riskiness of that investment. The higher the perceived risk, the higher the required return. The income methods incorporate the use of discounted cash flows. For example, future cash flows are estimated, and then those cash flows are discounted to present value using a discount rate suitable to reflect the risk of the subject investment. The income approaches require a careful analysis of cash inflows and outflows, capital assets, capital structure, the industry, and economic environment.

e. The method used to determine fair value should be based upon the particular circumstance of the valuation as well as the data that are available. In some cases, a single method will be used, and in others, multiple methods. When multiple methods are used, the results should be analyzed and weighted taking the range of the results into consideration. An acceptable fair value measurement should be the point that is most representative of the fair value given the particular circumstances.



f. When measuring fair value over multiple periods, methods should be used consistently; however, a change in methods is appropriate providing the change results in an equally or more representative fair value under the particular set of circumstances.

2224.03 Fair value hierarchy

a. FASB ASC 820 has grouped possible inputs used to determine value fair into three groups (hierarchies) in an attempt to achieve consistency and comparability. Note that it is the inputs that are classified as to the preferred usage and not the methods or techniques used to determine fair value. In determining fair value of a particular asset or liability when inputs from two or more levels are used, then the fair value measurement will be classified at the lowest input level that is significant to those measurements. For example, if significant inputs from both Level 2 and Level 3 are used to determine fair value, then the fair value measurement will be considered to be based upon Level 3.

b. Observable inputs are the most desirable ones to use when determining fair value. Observable inputs are those that reflect the assumptions based on market data obtained from sources independent of the reporting entity used in pricing an asset or liability. When possible, it is expected that more observable inputs will be used than unobservable inputs.

c. Unobservable inputs are the least desirable ones to use when determining fair value. Unobservable inputs are those based upon assumptions developed using the best information available in the circumstances reflecting the reporting entity’s own speculations used in pricing assets or liabilities.

d. Level 1 inputs are observable and considered to be the highest level and most desirable when determining fair value. Level 1 inputs would include unadjusted quoted active market prices of identical assets. An active market is where there is adequate trading to provide constant market data.

(1) Generally accepted business valuation techniques often apply a blockage discount to the quoted market price when valuing a large block of stock, since it is assumed that the market price would drop if a large block of stock was put on the market on a particular date. FASB ASC 820 specifically disallows the use of such a blockage discount.

(2) It is not unusual for a company to announce information that will have a negative impact on market price at the end of the day or shortly after the close of the market. If the quoted market price is



adjusted for the new information, then the fair value should be listed at the lower price.

e. Level 2 inputs are considered to be the middle level when determining fair value, and include such items as prices of assets or liabilities that can be either directly or indirectly observed but do not include the Level 1 quoted market prices. Often market values of similar assets or liabilities (as opposed to identical) are used to determine fair value. In such cases, the degree of comparability must be determined, and often adjustment must be made when determining fair value. A higher degree of adjustment could cause the fair value measure to fall to a Level 3 category. Level 2 items would include such items as the following:

(1) Active market prices for similar assets or liabilities

(2) Available market prices for identical or similar assets or liabilities when markets are not active

(3) Inputs such as interest rates, default rates, yield curves, and credit risks

(4) Other market‐corroborated inputs

f. Level 3 inputs are unobservable and considered to be the lowest and least desirable level when determining fair value.

(1) Level 3 inputs should be used to develop an exit price to represent fair value from the perspective of the reporting entity.

(2) Level 3 inputs should reflect the reporting entity’s market assumptions.

(3) Level 3 inputs should be based upon the best available information that can be obtained without undue cost and effort.

2224.04 Disclosures needed when using fair value

a. Information needs to be disclosed related to fair value measurement that:

(1) allows for enough information to be provided so that the user of that information can do a fair assessment of the inputs used to develop the fair value.

(2) provides enough information so that the use of significant unobservable inputs (Level 3) can be assessed.



b. When a fair value measurement is done on a recurring basis, the following information needs to be disclosed:

(1) The fair value measurement as of the reporting date

(2) The level within the hierarchy (Level 1 market information, Level 2 other significant observable inputs, and/or Level 3 significant unobservable inputs) of the inputs used in the fair value measurement

(3) Reconciliation of the beginning and ending balances when using significant unobservable inputs (Level 3)

(4) The amount of the total gains or losses that are attributable to the change in unrealized gains or losses still held at the date of measurement

(5) The valuation method(s) used

(6) A discussion of any changes in valuation techniques, if any, within the period

c. When a fair value measurement is done on a nonrecurring basis, the following information needs to be disclosed:

(1) The fair value measurement as of the reporting date and the reason for the measurement

(2) The level within the hierarchy (Level 1 market information, Level 2 other significant observable inputs, and/or Level 3 significant unobservable inputs) of the inputs used in the fair value measurement and a description of any Level 3 inputs used

(3) Reconciliation of the beginning and ending balances when using significant unobservable inputs (Level 3)

(4) A discussion of the valuation method(s) used

2224.05 Other standards of value

a. In a valuation engagement, a standard of value is the identification of the type of value being utilized. It is important that this standard be defined before the engagement begins since different standards lead to potentially different estimated values. Common standards include fair market value, fair value, intrinsic value, replacement value, and investment value. No matter how the standard of value is defined, the potential exists to use any of the three generally accepted valuations approaches (asset‐based, market, or income) in preparing the valuation.

b. Fair market value is probably the most common standard value used in business valuation work. In the International Glossary of Business Valuation Terms, it is defined as follows:



“The price, expressed in terms of the cash equivalent, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”

c. The differences between fair market value and fair value are quite substantial:

(1) Fair market value implies a willing buyer and seller, whereas the buyer and seller under fair value are not necessarily willing.

(2) Fair market value defines the seller as hypothetical, whereas there is a specific seller when using fair value.

(3) Fair market value takes advantage of an unrestricted market, whereas fair value uses the principal or most advantageous market.

d. Per the International Glossary of Business Valuation Terms, intrinsic value is defined as follows:

“The value that an investor considers, on the basis of an evaluation of available facts, to be the ‘true’ or ‘real’ value that will become the market value when other investors reach the same conclusion.”

e. Per the International Glossary of Business Valuation Terms, replacement cost new is defined as “the current cost of a similar new property having the nearest equivalent utility to the property being valued.” Reproduction cost new is defined as “the current cost of an identical new property.”

f. Per the International Glossary of Business Valuation Terms, investment value is defined as “the value to a particular investor based on individual investment requirements and expectations.”

2224.06 Other valuation items

a. Valuations are often necessary for items such as a specific capital asset or investment, a business segment, or a complete business. Accountants have become increasingly involved in the valuation process, and the AICPA has developed the Statement on Standards for Valuation Services 1 (SSVS 1), Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, that became effective in 2008 to help provide guidance to practitioners and promote consistency within the valuation niche. A management should only undertake a valuation engagement providing the individual (or firm):



(1) possesses a good understanding of valuation principles and theory.

(2) has the skill necessary to apply the theoretical knowledge.

(3) has the professional judgment necessary to develop a conclusion or a calculation of value.

b. Beyond the identification of the subject of a valuation (asset, business segment, entire business, etc.), the date of the valuation, and the standard of value to be used, it is important to determine the premise of value before initiating any work on the engagement. The International Glossary of Business Valuation Terms defines the premise of value as an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject of the valuation. For example, if an entire business is being valued, is the entity considered to be a going concern or in the process of liquidation?

c. There are two types of business valuation engagements outlined in SSVS 1:

(1) In a valuation engagement, the valuation analyst is free to employ the use of any valuations approach or method that is professionally deemed appropriate under the circumstances. The results are expressed in terms of a conclusion of value and can either be a single number or a range.

(2) In a calculation engagement, the valuation analyst and the client agree upon the valuation methods and approaches to be used; therefore, the analyst is not free to use any approach or method available. The results are expressed in terms of a calculated valued and can be either a single number or a range.

Valuation Assumptions

2224.07 Price, worth, and value

a. Price, worth, and value are three terms that are often used interchangeably; however, they each have distinct meanings. It is important to understand which of these three items is being considered when evaluating assumptions used in valuations.

b. Price is the actual observed exchange price that is used in the marketplace.

c. Worth relates to the advantages of ownership based upon the perceived benefits at a particular point in time and for a particular use.

d. Value is based upon the amount that would be received in exchange for an asset or settlement of a liability between willing parties in an arm’s‐



length transaction where both parties had acted with knowledge, with prudence, and without compulsion.

When determining market value, assumptions are made about market conditions, sellers, and buyers. The more assumptions made or the greater the uncertainty related to those assumptions, the less the confidence in the valuation results.

e. Valuation is based upon events yet to occur and is therefore dependent upon various assumptions made during the valuation process. The use of assumptions results in the risk that either the assumptions were incorrect or that future events will not occur as assumed. It is crucial to carefully examine any assumption used in the process of a valuation in order to assess the validity of the valuation results.

2224.08 Premise of value

a. At the beginning of the valuation process, the premise of value must be determined. Per the International Glossary of Business Valuation Terms, the premise of value is defined as “an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation.”

b. The premise of value will be one of two situations—a going concern or liquidation. For a going concern, the company will be expected to continue operations into the future. This would include situations where a company will have to reorganize due to such events as a past poor business decision or a court judgment in order to continue. Companies can falter, regroup, and continue. A company in liquidation will have its assets sold or disposed of in some fashion and will ultimately discontinue operations completely.

c. The first assumption that needs to be carefully reviewed in the process of a valuation is the choice of the premise of value, due to the fact that generally a going concern is worth more than an organization in liquidation for the following reasons:

(1) When in liquidation, few if any additional receivables will be created, and the receivables currently on the book may be difficult to collect due to lack of staff and debtors trying to take advantage of a liquidating firm. A going concern would continue to create and collect receivables in the course of doing business.

(2) When in liquidation, inventories will likely have to be sold at dramatically reduced prices if they cannot be returned, and if returned, there is likely to be a high restocking charge. A going concern would continue to purchase and sell inventory in the course of doing business.



(3) When in liquidation, equipment on hand is not likely to be of the most recent technology; therefore, any disposal price would tend to be low. A going concern would continue to use the equipment on hand to create products to sell.

(4) When in liquidation, leasehold improvements would be of no further use and could not be sold. A going concern would continue to use leasehold improvements.

(5) When in liquidation, no goodwill would exist. A going concern would potentially continue to have goodwill associated with its good name, reputation, and brand.

(6) When in liquidation, the costs of asset disposal and the administration of the liquation process can be costly. A going concern would not have any costs related to a liquidation process.

d. When the premise of value is liquidation, the valuator will assume that historical records will provide little valuable information needed to predict future inflows and outflows for the organization.

e. When the premise of value is a going concern, the valuator will generally base future predictions at least in part on the firm’s historical performance.

f. The assumption related to the premise of value must be translated into estimates of future inflows and outflows.

2224.09 Due diligence

When evaluating assumptions used in a valuation of a particular asset, business segment, or business, it is important to verify the assumptions related the following items as appropriate:

a. Existence of physical assets and their value:

(1) A physical inspection should be performed.

(2) Inquiries should be made to possible liens and encumbrances.

(3) Inquiries should be made to determine that the physical assets are suitable for their intended use.



b. Projections of future benefit streams (e.g., income or cash flow):

(1) All assumptions related to the prediction of revenue streams should be examined for reasonableness, taking past trends, market share, economic conditions, etc. into consideration. Sales forecasts are affected by products produced, changes in product lines, changes in markets, changes in promotion, changes in the competition, etc. Each of these areas will require assumptions when predicting the future that need to be potentially challenged for validity and evaluated for reasonableness.

(2) The future of all product lines and/or projects should be reviewed for the likelihood for future profitability. Profit margins are affected by sales price of goods and services, physical capacity, human resource capacity, union contracts, cost and availability of raw materials, etc. Each of these areas will require assumptions when predicting the future that need to be potentially challenged for validity and evaluated for reasonableness.

(3) Past and future budgets should be examined for reasonableness of cost relationships with both the revenue stream and working capital requirements.

c. Existence of risk: All businesses operate in an environment filled with risk. When valuing a business or business segment, it is important to identify various risks that could have negative impacts on the subject of the valuation such as general market risk, labor efficiency, attrition, availability risk, supplier risk, and competitive risk. The higher the risk level, the lower the value of the subject of the valuation.

2224.10 Assumptions using cost (asset) approaches for valuation

a. The cost basis valuation approach is used when liquidation is defined as the premise of value or when the value for a firm is basically related to the assets held such as a holding company.

b. Since the basic value determined using the cost approach is related to the value of the assets including property, plant, and equipment, the use of an appraiser is often necessary. Statement on Standards for Valuation Services 1 (SSVS 1), Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, issued by the AICPA, states that the evaluation of the outside professional be based upon the following:

(1) The education, professional certification, license, or other indication of professional competence

(2) The reputation and standing of the specialist among peers



(3) The knowledge and understanding of valuation concepts by the specialist

(4) The experience of the specialist with like assignments

(5) The knowledge and experience of the specialist within the industry of the subject company

2224.11 Assumptions using market approaches for valuation

a. Using the market approach, the value of an asset is based upon what similar or comparable assets have recently sold for on the open market. The difficulty is to find guideline companies (comparables) that are truly comparable to the subject being valued. In the case of a business, it would be impossible to find guideline companies reasonably similar in all manners to the subject of the valuation.

b. There are data sources available containing information about publicly and privately held companies that can be used to help find appropriate guideline organizations. It is important that financials of the subject company be free of GAAP errors and that the guideline and subject company use similar GAAP choices such as a LIFO or FIFO inventory in order for a valid comparison to be made.

c. Some key assumptions related to finding compatible guideline companies would include the following:

(1) Diversification of operations: Are one or more products sold? A one‐product firm cannot successfully be compared to those having a variety of product lines.

(2) Markets served: Are one or more markets served? A firm serving only a limited market cannot be effectively compared to those serving many and varied markets.

(3) Geographic diversification: How diverse are the geographic regions served? A firm only serving one particular metropolitan area cannot be effectively compared to those serving all of North America or international markets.

(4) Size of organization: A company with annual sales of $100,000 cannot be successfully compared to those with annual revenues over $10 million.

(5) Operating leverage: A firm with a high degree of operating leverage cannot be effectively compared to those with few fixed costs.

(6) Comparability of products (services) sold: A company producing racing bikes cannot be reasonably compared to those manufacturing bicycles for children.



(7) Financial leverage: A company with a high debt‐to‐equity ratio cannot be successfully compared to those with low financial leverage.

(8) Liquidity: In order to be considered comparable, the subject company and the guideline organizations should have similar liquidity ratios.

(9) Asset and debt management: In order to be considered comparable, the subject company and the guideline organizations should have similar asset and debt management ratios.

(10) Profitability: In order to be considered comparable, the subject company and the guideline organizations should have similar profitability ratios.

(11) Growth: In order to be considered comparable, the subject company and the guideline organizations should have similar recent growth patterns.

It is not unusual that, after evaluating the items listed above, few if any guideline companies can be found.

d. One company does not make a comparable. In other words, if only one publicly traded company can be found to have reasonable comparability to the subject organization, then the market method cannot be use as an appropriate valuation method. As a general rule, four to six guideline firms need to be found in order to provide validity when using the market valuation method.

2224.12 Assumptions related to normalization adjustments

a. Publicly traded organizations are required to follow GAAP, and there is a great deal of oversight by various individuals or groups such as the board of directors, the CEO, the CFO, and internal and external auditors. On the other hand, smaller, private companies often do not follow GAAP religiously, and it is not unusual for business owners of such firms to have a mixing of business and personal expenses. In order to make comparisons to guideline organizations or predict future benefit streams to be employed when using an income approach to valuation, it is often necessary to make normalization adjustments so that the comparisons or predictions can be performed.

b. IRS Revenue Ruling 68‐608 provides guidance as to this normalization process. Although this passage refers to one specific valuation method (the treasury method), the direction as to the form that the financial statement should take in order to perform an adequate valuation is valid for all methods and approaches. The ruling states:

“The past earnings to which the formula is applied should fairly reflect the probable future earnings. Ordinarily, the period should not be less



than five years, and abnormal years, whether above or below the average, should be eliminated. If the business is a sole proprietorship or partnership, there should be deducted from the earnings of the business a reasonable amount for services performed by the owner or partners engaged in the business.”

c. When doing a valuation, it may be necessary to adjust the financial statements for the subject company when:

(1) it is necessary to compare non‐GAAP statements to guideline firms that employ the use of GAAP.

(2) items that are not considered to be part of normal operations are included in the financial statements of the subject company.

(3) items that are considered to be part of normal operations are not included in the financial statement of the subject company.

(4) an unusual item not considered to be recurring is included in the historical statements used to predict the future.

(5) discretionary items not considered to be normal business expenses are included in the financial statements. These would include such items as personal expenses run through the business, such as family members on the payroll being paid above‐market wages for the work done; personal vacations; and other items of a private as opposed to a business nature.

d. The valuator may need to make normalization adjusts for one or more of the following items:

(1) Nonoperating adjustments: The removal of nonoperating items included in the historical financial statements that are not assumed to be part of normal operations.

(2) Nonrecurring adjustments: The removal of unusual, unexpected, or infrequent items not likely to occur again from the historical financial statements.

(3) Comparability adjustments: Adjustment of the historical financial statements to match GAAP choices of potential guideline companies. For example, a company that used a LIFO inventory could not be compared to one using a FIFO inventory.

(4) Discretionary adjustments: Adjustments to the historical financial statements to include or remove items considered to be part of normal operations. For example, it is not unusual for owners of small, private companies to pay either excessive or below‐average salaries to themselves. It is also common for personal expenditures to be run through the business.



2224.13 Assumptions using income approaches for valuation

a. There are four basic assumptions that are crucial when using an income approach to valuation:

(1) The prediction the future benefit stream used to establish value

(2) The number of periods in the projection

(3) The terminal value at the end of the projection

(4) The discount/capitalization rate used

b. When predicting a future benefit stream (income or cash flow), the following assumptions need to be examined carefully since these future benefit streams need to be accurately predicted in order to develop a reasonable estimate of value.

(1) Historical growth patterns and whether they could be expected to continue into the future

(2) Expectations as to actions expected to be taken by competitors

(3) Expectations as to future economic conditions that are likely to affect operations

(4) The cost to innovate and remain competitive

(5) Expected capacity and the cost to enlarge capacity, if necessary, including increases in net working capital

c. When using an income approach, a benefit stream for some number of periods must be projected, which is then discounted to the present as part of the value of the subject company. The further out the projections go, the less likely it is that those projections will be accurate. Many valuators do not like to use increasingly speculative projections going out more than five years.

d. When using an income approach, the present value of the terminal value at the end of the projection period used needs to be calculated. Here the valuator must decide whether the company is expected to still be a going concern at the end of the projection period before calculating terminal value. If not, terminal value would be the present value of the liquidation value of the net assets at the end of the projection period. If the company would be expected to continue as a going concern at the end of the projection period, then terminal value would be based upon the projected cash flows during the first year of the terminal period, the expected growth rate into perpetuity, and the discount rate. Obviously, there are a number of assumptions that need to be examined closely.

e. A discount rate is the total required rate of return that an investor would expect on an investment given the risk level inherent in that investment.



The discount rate (also known as the cost of capital) is extremely critical in the valuation process since it is used to convert projected income streams to present value. The higher the risk, the higher the discount rate, and the lower the present value of the subject company. Discount rates reflect the risk involved in a particular investment. Techniques used to develop a discount rate include the capital asset pricing model (CAPM), build‐up methods, and the weighted‐average cost of capital (WACC). Again, many assumptions related to the development of discount rates need to be examined closely.

2224.14 Assumptions using rules of thumb

a. Rules of thumb have been used for many years in relation to business valuations. These are often based upon multiples or a percentage of revenues, earnings, book value, some type of measurement such as number of beds, number of rooms, number of tables, etc. These calculations are quick and easy; however, they do not take specifics related to a particular business into consideration since these rules of thumb are based upon the general averages for an industry.

b. Statement on Standards for Valuation Services 1 (SSVS 1), Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, specifically states that a rule of thumb not be used as the method to set value; however, it can be used as a reasonableness check for the results achieved using other methods. The use of a rule of thumb can:

(1) show that the valuator is knowledgeable about the subject company’s industry.

(2) support a valuation arrived at using another method with similar results.

(3) support a valuation arrived at using another method with different results along with arguments as to why the subject company is not “average” within the industry.

2224.15 Evaluating use of various approaches

a. The use of an asset‐based (cost) approach for a valuation is appropriate when the company:

(1) is in liquidation or is worth more in liquidation than as a going concern.

(2) is particularly asset‐rich.

(3) has no income in recent years and future benefit streams cannot be adequately predicted.



b. The use of a market‐based approach for a valuation is appropriate when relevant guideline (comparative) data are available.

c. The use of an income‐based approach for a valuation is appropriate when:

(1) a reliable benefit stream projection such as cash flow or income is available.

(2) the projected future benefit stream is expected to differ significantly from the past.

(3) a substantial amount of goodwill appears to exist.

d. It is not unusual in a litigated situation to have the choice of valuation methods dedicated by the court.

2224.16 Financial decision models: Generally it is assumed that the company being valued will continue to operate for the foreseeable future (i.e., is a going concern). On the operating side of the business, the objective is to value the earnings power and cash generation capability, while on the nonoperating side, intangible assets (e.g., trademarks, customer brand loyalty, supplier relationships, etc.) and nonoperating assets (e.g., financial interests in other companies) owned by the company are valued.

Black‐Scholes

2224.17 Black‐Scholes (also called Black‐Scholes‐Merton) is a price variation model of financial instruments that can be used to determine the price of a European call option by incorporating five input variables: the current stock price, the related stock option's strike price, the time to the option's expiration, the risk‐free rate, and the volatility.

a. Assumptions: The model assumes that stock prices follow a lognormal distribution given that asset prices cannot be negative; there are no transaction costs or taxes; the risk‐free interest rate is constant for all maturities; short selling of securities with use of proceeds is permitted; and there are no riskless arbitrage opportunities.

b. Formula: The call option formula is calculated by multiplying the stock price by the cumulative standard normal probability distribution function. In both of the formulas below, S is the stock price, K is the strike price, r is the risk‐free interest rate, and T is the time to maturity.

(1) The net present value of the strike price, multiplied by the cumulative standard normal distribution, is then subtracted from the resulting value of the previous calculation. In mathematical notation, C = S*N(d1) ‐ Ke^(‐r*T)*N(d2).



(2) The value of a put option could also be calculated using the formula P = Ke^(‐r*T)*N(‐d2) ‐ S*N(‐d1).

(3) The formula for d1 is (ln(S/K) + (r + (Annualized volatility)^2 / 2)*T) / (Annualized volatility * (T^(0.5))). The formula for d2 is d1 ‐ (Annualized volatility)*(T^(0.5)).

c. The binomial model of pricing options is a variation of the Black‐Scholes model. The binomial model incorporates the underlying security for a period of time rather than a point in time. This is accomplished by allowing for the specification of nodes, or points in time, during the time span between the valuation date and the option's expiration date.

(1) The model reduces possibilities of price changes and removes the possibility for arbitrage.

(2) With binomial option price models, the assumptions are that there are two possible outcomes, hence the binomial part of the model. The two outcomes are a move up or a move down.

(3) The major advantage to a binomial option pricing model is that it is mathematically simple.

Capital Asset Pricing Model

2224.18 Capital asset pricing model (CAPM): The capital asset pricing model, also called the security market line (SML), attempts to quantify the relationship between investment risk and the rate of return on the investment. The CAPM model assumes that the individual investment contains two types of risk, and is primarily concerned with measuring the former:

1. Systematic risk: Market risks that cannot be diversified away; examples include interest rates, recessions, and wars.

2. Unsystematic risk (also known as specific risk): This risk is specific to individual stocks and can be diversified away. In other words, it represents the component of a stock's return that is not correlated with general market moves.

2224.19 The return on an individual stock, or a portfolio of stocks, should equal its cost of capital. The CAPM formula is as follows:

ERi = Rf + βi (ERm – Rf)

Where: ERi = expected return of investment Rf = risk-free rate βi = beta of the investment (ERm – Rf) = market risk premium



a. Risk‐free rate of return: A default‐free rate of return is estimated as the rate of return on long‐term (i.e., 10 years) U.S. Treasury bonds.

b. Market risk premium: The market risk premium is the additional return over the default‐free rate required for the average stock.

c. Rate of return estimates: The required rate of return is the default‐free rate of return plus the beta times the market risk premium.

2224.20 Beta coefficients: CAPM assumes that the beta coefficient is the only relevant measure of a stock’s risk. It measures a stock’s volatility (i.e., how much a stock’s price increases or decreases compared to movement in the stock market). If a given stock moves precisely as the overall market, it is said to have a beta of 1.

Dividend Discount Model

2224.21 Dividend discount model (DDM): A procedure for valuing the price of a stock by using the predicted dividends and discounting them back to the present value. If the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.

a. There are many variations in this procedure. The most common DDM is the Gordon growth model (GGM), computed as follows:

Predicted dividend per share Discount rate ‐ Dividend growth rate

b. Limitation: The model assumes a constant dividend growth rate in perpetuity. This assumption is generally true for very mature companies, but newer companies have fluctuating dividend growth rates in their earlier years.

2230 Raising Capital

2231 Financial Markets and Regulation

2231.01 Financial markets, through various techniques and institutions, collect savings and make these funds available to those who wish to borrow money. Financial institutions have developed to collect, analyze, and disseminate information relevant to the market, thus making the markets efficient.

a. Financial Intermediation: Specialized institutions affect the structure of the transfer process. These institutions include banks, savings and loans, pension funds, insurance companies, and credit unions.



b. Exhibit: The following illustration shows a simple model of the financial intermediation process.

2231.02 Financial markets have been established to accomplish three major functions: (1) to transfer funds from savers to users, (2) to provide a method of liquidity for investors, and (3) to provide economic signals to financial managers.

a. Transfer Funds From Savers to Users: As an individual, it would be very difficult to find a buyer for a particular financial security. Financial markets facilitate the transfer of funds from savers to users.

(1) Sale of Securities: The issuance of long‐term stocks and bonds by corporations are facilitated through investment bankers. They advise the company, bear some of the risk of selling the securities, and actually sell the securities being issued.

(2) Sale of Short‐Term Debt: Dealers help with the placement of short‐term debt securities to be issued by corporations. These dealers act in the same fashion as investment bankers do in the issuance of long‐term securities.

b. Provide Liquidity: Investment liquidity represents the ease of which securities can be converted into cash without incurring losses in value. Financial markets give investors a means of converting securities into cash in a short period of time. Stockbrokers are used to buy and sell previously issued securities in the financial markets. This resale market increases the liquidity of investments.

c. Provide Economic Signals: The buying and selling of securities can indicate the future economy. For example, if financial managers feel that a recession is likely, they will sell their investments to increase funds necessary to help them through the recession. They will attempt to do this prior to the start of the recession to avoid losses from sale. The sale of securities can then signal the possibility of changes in the economy.



2231.03 Types of Markets and Exchanges: In order to raise capital, companies often sell new stocks and bonds in the primary securities markets. These markets are regulated by federal and state laws to reduce the possibility of fraud and misrepresentation. After securities have been issued they trade among investors in the secondary market.

a. Primary Market – Initial Public Offerings (IPO):

(1) Investment Banker: Corporations generally receive assistance from investment bankers in the initial sale of their shares.

(2) Federal and State Law: Before a company can issue securities in the primary market it must comply with a number of federal and/or state regulations.

(a) Federal Regulation: The Securities Act of 1933 requires registration and public disclosure of all relevant information pertaining to the issuance of new securities. Under this act, companies are required to prepare (1) a registration statement (Form S‐1) to be filed with the Securities and Exchange Commission (SEC) and (2) a prospectus to be delivered to investors prior to their purchase of the securities.

(b) State Registration: A sale with both the issuing corporation and all the shareholders in one state is regulated by the security agency of the state government. This is often referred to as a “blue sky” offering. Unlike the disclosure emphasis of the SEC, the state agency may look at the merits of the offering.

b. Secondary Market: The secondary market was established to facilitate on‐going trading among investors. Companies register with an exchange and a specialized trader‐dealer is appointed. Examples are the New York Stock Exchange or the over‐the‐counter (OTC) market. The OTC market is computerized and regulated by the National Association of Securities Dealers (NASDAQ).

(1) Liquidity Objective: Secondary markets give liquidity to investments by providing a means of buying and selling securities with other investors. The Exchange’s trader‐dealer is charged with maintaining an orderly and stable market in the security.

(2) Market Price: The market value placed on a share of stock reflects the evaluation investors place on the financial decisions made by management (investors’ expectations of the future profitability of the firm). The prices of individual stocks are also affected by the general price level of the securities markets. The Dow Jones Industrial average and Standard and Poor’s 500 Index are two indicators of the behavior in the stock market.



c. Debt and Equity Markets: Financial markets can be classified as either debt securities or equity securities. Transactions dealing with debt, such as bonds, are dealt with in the debt market. Those dealing with the issuance or resale of common stock are done in the equity market. The trading of securities are done on organized exchanges and in the over‐the‐counter (OTC) markets.

d. Money Market: The capital market deals in securities with maturities greater than one year. The money market is used for trading securities with maturities of one year or less.

(1) Importance of the Money Market: The money market is important for the transfer of short‐term funds.

(a) Raise Funds: It allows companies to sell short‐term debt to raise funds.

(b) Invest Excess Cash: Companies are able to invest excess cash in short‐term money market securities.

(2) Characteristics of Money Market Instruments: The money markets trade in debt securities which have short‐term maturities, there is minimal risk of default, and the expected rates of return are relatively small.

(3) Types of Money Market Instruments: There are several money market instruments including treasury bills, U.S. agency securities, commercial paper, negotiable certificate of deposits, banker’s acceptances, and federal funds.

(a) Treasury Bills and U.S. Treasury Securities: The market for U.S. treasury securities is the largest part of the money market. These securities have maturities from 13 to 52 weeks. T‐bills have almost no default risk and excellent liquidity and therefore carry relatively low returns. Short‐term debt securities issued by agencies of the U.S. government (such as the Federal Home Loan Mortgage Corporation and the Federal Land Bank) offer an investment standing similar to T‐bills with almost as low a yield.

(i) Investment Yield: T‐bills are purchased at less than face value (discount) by investors who receive the face value at maturity. The annual investment yield uses 365 days in a year and is calculated as follows:

Discount from Face or

(Face Value – Purchase Price)×

365

Purchase Price Purchase Price Days to Maturity



Example: A $10,000 face U.S. Treasury bill trades in the market

for $9,790.25 and matures in 85 days. The annual investment

yield is calculated as follows:

Yield = $10,000 – 9,790.25 × 365 = 209.75 × 365

9,790.25 85 9,790.25 85 = .0214244 × 4.2941176 = .09199 or 9.2% per year

(ii) Discount Yield: When dealers buy and sell T‐bills, they do so at a discount based on a 360‐day year. The calculation of the discount yield is similar to the calculation of the investment yield.

Annual Discount Yield = Discount from Face

= Face Value –Purchase Price

× 360

Face Value Face Value Days to Maturity

Example: A $10,000 face U.S. Treasury bill has 85 days to

maturity. The discount yield asked by the dealer is 8.75%. What is

the purchase price asked for the security?

Answer:

.0875= 10,000 – P

× 360

10,000 85

.0875 = 10,000 – P

× 4.2352941 10,000

.0875

= 10,000 – P

4.2352941 10,000

206.59722 = 10,000 – P

P = 10,000 – 206.59722 = 9,793.40

(b) Commercial Paper: Commercial paper is short‐term promissory notes issued by corporations and is an alternative to borrowing from a bank.

(i) Characteristics: Commercial paper is generally issued by finance companies (such as General Motors Acceptance Corporation) and banks. Commercial paper is unsecured and either placed directly with large purchasers or sold through dealers. Maturities on commercial paper generally range from 30 to 270 days and are issued at a discount usually in



$100,000 denominations. Because of its higher risk than T‐bills, commercial paper requires a higher rate of return. The annual investment yield on commercial paper is calculated the same way as for T‐bills. The secondary market for commercial paper is fairly weak.

(ii) Calculation of Interest Cost: The exam may require the candidate to calculate the annual interest cost of commercial paper or to compare the cost to some other source such as a bank loan.

Cost of commercial paper=

Costs incurred by using commercial paper

Net funds available from commercial paper

Example: Fancy Flow Inc. can issue three‐month commercial

paper with a face value of $1,000,000 for $980,000. Transaction

costs would be $1,200. The annualized percentage cost of the

financing would be:

Answer:

(20,000 + 1,200) × 4 =

21,200 × 4 = 8.65%

$1,000,000 – (20,000 + 1,200) 978,800

Example: Great Expectations, Inc. will need $4 million over the

next year to finance its short‐term cash requirements. The

company could sell $4 million of 90‐day maturity commercial

paper every three months at a rate of 7.75%. The dealer’s fee to

place the issue would be an initial annual 1/8% and will require

Great Expectations to maintain a $400,000 compensating balance.

Calculate the annual effective cost of this financing alternative for

each quarter of the year and the total annual effective cost.

Answer: Cost of commercial paper in the first quarter

Cost of issuing commercial paper: Interest ($4,000,000 × .0775 × ¼) $77,500 Placement Fee ($4,000,000 × .00125) 5,000 Total First quarter cost $82,500



Funds available for use: Funds raised $4,000,000 Less: Compensating balance $400,000 Less: Interest and placement fees 82,500 482,500 Net funds available in first quarter $3,517,500 Cost of commercial paper in the first quarter = $82,500 = 2.345%

$3,517,500 Cost of issuing commercial paper for other quarters: Interest ($4,000,000 × .0775 × 1/4) $77,500 Funds available for use: Funds raised $4,000,000 Less: Compensating balance $400,000 Less: Interest and Placement fees 77,500 477,500 Net funds available per quarter $3,522,500 Cost of commercial paper for other quarters = $77,500 = 2.2% $3,522,500 Total annual effective cost of commercial paper: Effective cost = 1st quarter cost + 3 (cost of 2nd, 3rd, 4th qtrs.) = .02345 + 3 (.02200) = .02345 + .06600 = .08945 = 8.95%

(iii) Annual Investment Yield: The exam may ask the candidate to calculate the annual yield of commercial paper based upon the investment. The calculation is the same as for T‐bills. The formula is:

Discount from Face or Face Value – Purchase Price × 365

Purchase Price Purchase Price Days to Maturity

Example: Pete Moss, financial manager of Golden Gardens, Inc., is

planning to buy $100,000 of commercial paper from Primary

Finance Company for $96,500, a discount of $3,500. The paper

matures in 120 days. What is the annual investment yield on the

commercial paper?

Answer:

100,000 – 96,500×

365=

3,500×

73

96,500 120 96,500 24 = 0.0362694 × 3.0416667 = 0.11032 = 11.03%



(c) Negotiable Certificate of Deposit: A negotiable certificate of deposit (CD) is a claim against funds that have been deposited in a bank. The bank issues a CD for the amount of the deposit plus interest at a specific rate for the specified period of time. CDs are traded among securities dealers in the secondary market and are generally denominated at $100,000 and above.

(d) Banker’s Acceptance: A banker’s acceptance is a draft drawn on deposits at a bank. This may be issued by an importer’s bank to guarantee payment of a foreign exporter’s invoice for goods. An acceptance trades in the secondary market at a discount. This is similar to a letter of credit except letters of credit do not have a secondary market.

2231.04 Rating Agencies:

a. Types of Agencies: A financial management accountant may consult rating agencies to assist in making investment decisions for listed securities. There are numerous rating services that are available to investors or portfolio managers. These can be classified by the nature of the agency.

(1) Brokerage Firm Analysts: Almost all the larger private brokerage firms have their own research department. Such firms often have specialists who focus on and follow particular industries and firms. Free newsletters to clients is the usual way such a firm disseminates information. Brokerage firms receive their revenue from the commissions on their client’s trades.

(2) Private Stock Analysts: There are also a number of private firms that are not involved in stock transactions. Firms such as Value Line or Fitch Investor Services offer yearly services to investors for a subscription fee. These firms’ analysis tends to be more quantitatively oriented. Many argue that their advice is more objective because they do not underwrite offerings or receive commissions resulting from their recommendations.

(3) Private Bond Rating Agencies: There are a number of independent rating agencies that focus primarily on debt instruments. Their independence ‐ like the private stock analysts ‐ creates the likelihood of a more objective evaluation.



b. Actual Services: Most serious portfolio managers subscribe to one or more independent services since they may quantify the subjective analysis inherent in the role of a risk‐return manager. The most widely known rating agencies are probably Standard & Poor’s, Moody’s and Duff & Phelps’. These agencies tend to rate all traded bonds using a uniform rating system. There are also numerous rating agencies that specialize in particular industries.

c. Variables: At base, most agencies focus on two variables: quality and default risk.

(1) Quality: While return is important to a portfolio manager, the quality grade is almost always inversely related to the risk. Debentures with speculative quality must pay investors a higher return (or interest rate) than high or medium quality issues.

(2) Default Risk: The quality‐risk rating in descending order is AAA, AA and A, which indicates the best quality, high quality, and upper medium grade respectively. BBB, BB, and B indicate medium grade, speculative issues, and very speculative (with little protection against future default). CCC, CC, and C are issues in poor standing and may be in default. D issues are in default.

d. Portfolio Manager’s Use: A corporate treasury function will involve investing excess working capital in marketable securities.

(1) Investment Policy: The corporate investment policy will often specify a diversification requirement. It may also dictate a minimum investment grade for each security on an overall average basis. For example, a federally chartered financial institution must now limit the quality of bonds in which they can invest to BBB or above. Similarly corporate decision makers may put such limits on the portfolio managers.

(2) Use and Loss Justification: Managers often follow the publications of a number of rating agencies as resources in making portfolio decisions. In addition, a security loss may be more easily justified if the purchase was based upon a rating agency’s standards and advice rather than a manager’s own personal subjective judgment. The more support for the decision, the better.



2231.05 Foreign Security Markets: Foreign companies have long sought U.S. security markets. U.S. companies are now considering foreign security markets as a place to list stock and raise capital. The U.S. capital markets in 2000 represent less than 40% of the total world capitalization. This is down from 65% in 1970.

a. Variables: There are three basic variables facing an issuer of securities contemplating an offering on any exchange. Most domestic U.S. markets do not have much variation in these three items. There is much more variation on foreign exchanges. The three factors are flotation costs, necessary yields, and capitalization factor.

(1) Flotation Costs: First, is the flotation costs. On large exchanges such as the London, Tokyo or Hong Kong market the cost efficiency is close to the U.S.

(2) Necessary Yields: Second, is the expected return or yield investors will demand, which includes dividends on stock or the interest paid on notes and bonds. Unlike the Dow, where the 10 highest‐yielding stocks pay below 4%, the highest yielding issues in Hong Kong or the United Kingdom pay better than 5.5%. In contrast, a U.S. corporation may find issuing U.S. dollar denominated bonds outside the country will lower their interest cost.

(3) Capitalization Factor: Third, is the market capitalization factor. This is the quality multiple the market places upon a company’s earnings. In the U.S., Standard & Poor’s 500 stock’s earnings are capitalized at about 25 times; on the Tokyo exchange the rate is nearly 40.

b. Objectives: Everything else being equal and disregarding market liquidity or volatility, management should have two objectives in picking a jurisdiction in which to issue new securities.

(1) Lowest Cost: First, is the lowest overall cost of capital. Because the required dividend yield may be higher outside the U.S. this favors enterprises listing on U.S. exchanges.

(2) Highest Capitalization: It may be in the stockholders’ best interest to own shares on an exchange that has a higher capitalization rate; this favors some foreign exchanges.



c. Examples:

(1) American Depository Receipts: ADRs are foreign shares which are bundled together and traded on a U.S. stock exchange. This bundling is done by brokerage firms or banks and is useful to foreign companies interested in lower dividend yields and increased liquidity.

(2) Euro or Asia Bonds: These are U.S. dollar designated debentures issued in a foreign country. The advantage is that interest rates may be lower in foreign countries than in the U.S and the cumbersome SEC filings may be avoided.

2232 Market Efficiency

2232.01 Two Factors

a. Efficiency: Markets are efficient when 1) prices respond quickly to new information, 2) successive trades are made at prices close to preceding trades, and 3) the market can absorb large amounts of securities without changing the price significantly. The closer the market adheres to the above three items, the more efficient the market becomes.

b. Liquidity: To be efficient, the market must be liquid (a measure of how quickly a security can be converted into cash). Markets become liquid if continuous trading occurs with a large number of traders. Lower costs of buying and selling enables more people to enter the market.

2232.02 Efficient Capital Markets: In efficient capital markets, expected cash flows and required rates of return are used to determine the intrinsic value of securities and its ultimate price. In large open markets such as the New York Stock Exchange, intrinsic value and market price have been determined to be the same; this is an efficient market. The market becomes efficient because all information available to investors is utilized in the determination of the market value.

a. The Efficient Market Hypothesis: This hypothesis asserts that security prices not only reflect all known information but also all that is expected. Based on various types of information, three versions of the hypothesis have been developed.

(1) Strong‐Form Efficiency: This hypothesis asserts that all information is reflected in the current market price. This includes even the use of insider information not available to outside investors. This means that corporate officers and other insiders will not be successful in using privately held information to make abnormally higher returns on investments of their own. Most authorities believe this is not realistic for most companies.



(2) Semistrong‐Form Efficiency: This form assumes the current market price of stocks reflects only all publicly available information. This information includes stock prices, dividends, earnings, and data contained in the company’s financial statements released to the public. Semistrong‐form efficiency implies that analysis of publicly available economic and financial factors affecting the corporation will not help an investor since the market has already used that information in determining the stock price. Insider information is excluded, so insiders have some advantage.

(3) Weak‐Form Efficiency: The assumption is that the market price of securities only reflects past price movements and rates of return. Studying stock price trends, such as in technical analysis, will not help in determining undervalued stocks.

b. Probable Actual Market Condition: The most widely accepted hypotheses are the weak‐form and semistrong‐form of efficiency. This means that there must be publicly available information that if properly researched or used by insiders, will lead to abnormal returns. Abnormal returns exceed the return justified by the risk of the investment.

2233 Financial Institutions

2233.01 Overview

a. As discussed earlier, financial leverage is created through the use of debt. If the firm has superior profits (excess return on total assets above the cost of debt), the return above the cost of the debt accrues to the shareholder. Thus assets financed through debt can provide increased worth to the stockholder. Borrowed funds generally require a fixed payment (interest) so debt holders cannot share in superior profits after receiving the necessary interest payments.

b. Financial structure (use of debt and equity) is influenced by:

(1) management’s attitude toward risk.

(a) Smaller firms are not likely to want to use additional equity sold to new shareholders as a source of financing due to the diluting effect; however, large firms generally will not be opposed to selling additional stock since a stock sale will have little effect on company control.

(b) A small firm may be reluctant to use debt as a source of funds due to the extreme risk that failure of one product or a slight down‐turn in the economy may have on cash flow. Default is more likely in a small firm than a large one.



(2) the industry norms.

Debt service is related to sales volume and the control of costs leading to profitability. Growth industries tend to have high profit margins. Mature industries tend to have stable sales and profit margins. Lenders are concerned about a specific company’s ability to make necessary payments. Generally, debt holders will not lend funds to a firm that has a debt to equity ratio above the normal range for the industry or a times interest earned ratio below the normal range for the industry without higher interest rates to compensate for the additional risk. Lenders are particularly interested in an organization’s solvency ratios as compared to the industry norms when deciding whether additional funds should be lent to the firm in question.

(3) the anticipated future growth rate.

If new financing is used to expand, it is important to estimate the future growth of sales in order to determine whether cash flows resulting from the new productive assets will create a cash flow large enough to service the debt.

(4) lenders’ attitudes toward the industry and the specific firm.

Lenders’ attitudes play an important role in capital structure. As lenders become concerned about rising debt levels, they will either demand higher interest rates to compensate for the additional risk, or they may refuse to lend the necessary funds. A firm’s ability to grow may often be limited to the funds available through the use of debt.

c. Whenever additional long‐term funds are needed, management can choose between debt and equity. Long‐term debt is likely to be used when:

(1) sales and profits are estimated to be stable or increasing.

(2) anticipated profits are sufficient to make good use of leverage.

(3) control (through voting privileges) is important.

(4) the existing capital structure has a low use of debt.

(5) requirements or covenants of debt issues are not arduous.



2233.02 Financing approaches

a. Assets are generally divided into current and long‐term, or permanent assets. Current assets can be further divided into:

(1) temporary current assets that would include assets that would fluctuate with the business cycle as sales vary with the corresponding changes in the levels of accounts receivable and inventory between the maximum and minimum levels over the annual business cycle.

(2) permanent current assets that would include assets that are more permanent in nature in that they are carried even at the low points of the business cycle such as the minimum accounts receivable and inventory levels during the lowest part of the business cycle.

b. The conservative approach to financing short‐term debt uses permanent assets to finance all of the permanent operating assets requirements and also some of the seasonal needs. Spontaneous credit (accounts payable) is used to finance the remaining seasonal needs. A firm using this approach would hold liquid assets in marketable securities during the low points of the seasonal cycle.

c. The maturity matching approach to financing matches assets to liability maturities. This approach minimizes default risk and is considered to be a moderate approach to financing.

Illustration: If a new factory is financed with short‐term funds, it is unlikely that the new facility would have been built and produced a large enough cash flow at the end of one year in order to repay the loan at maturity. In this scenario, if the lender refused to renew the loan, the company would be in a difficult position. If the new facility had been financed with long‐term debt, the cash flows provided by the new operation would have more closely matched the repayment cash outflows, and the need for refinancing is less likely to arise.

d. The difficulty with maturity matching is that imperfect estimates are used in determining the lives of assets. In reality, firms tend to attempt to develop a reasonable approximation of matching. Also, it is necessary to have some percentage of the financing come from equity that has no maturity.



e. The aggressive approach to financing short‐term debt would be to finance part of the permanent current assets with spontaneous credit such as accounts payable. The aggressive approach can be carried to a high degree by also financing part of the fixed assets with short‐term borrowing. Such a firm would be at risk if interest rates increase as well as face possible difficulties with loan renewals. The degree of aggressiveness is defined by the degree to which permanent NOWC (net operating working capital) and fixed assets are funded by spontaneous credit and/or short‐term debt.

2233.03 Financing sources

a. The right side of the balance sheet represents the sources of funds used to finance a company. These sources are:

(1) short‐term debt.

(2) long‐term debt.

(3) preferred stock.

(4) common stock.

(5) retained earnings.

b. When considering each of the above types of financing, management must consider:

(1) cost.

(2) risk.

(3) the lender’s (owner’s) point of view of the investment alternatives.

Short‐Term Debt Financing

2233.04 Types of short‐term debt:

a. Spontaneous financing created through the use of accounts payable and accruals generated in the course of doing business

b. Unsecured bank loans

c. Commercial paper

d. Secured loans



2233.05 Spontaneous financing

a. Accounts payable and accruals provide instant financing at no cost for a firm. For example, employees provide continual services and are paid only at set intervals. In a sense, employees provide the equivalent of small loans to the company.

b. Trade credit is an appealing source of financing since it is free; however, the length of this credit is only for a very limited time.

c. On occasion, vendors will offer discounts for prompt (early) payment of obligations. Not taking advantage of these offers is a particularly expensive form of short‐term financing. For example, if a vendor offers 1/10, net 30, this means that a 1% discount can be taken if the invoice is paid within 10 days as opposed to 30 days, but this is 1% discount for only paying 20 days earlier than required. This rate can be converted to an effective annual rate by using the following formula:

Days in year Lost trade credit days by taking discount

=36520

× 1% = 18.25%

Thus, if a company can borrow funds for less than 18.25% in order to take advantage of a prompt payment discount, it is in the firm’s best interest to do so.

2233.06 Unsecured bank loans

a. Unsecured loans are not backed by any collateral and come in a variety of forms.

b. A line of credit is an agreement with a bank to have up to a specific amount of funds available as a short‐term loan during a particular period. If the line of credit is for $100,000, a firm can borrow $20,000 in January, borrow an additional $35,000 in May, repay $40,000 in July, and borrow $50,000 in September, etc. As long as the total amount borrowed at a given point in time remains under $100,000 during the period of the agreement, the firm will continue to have access to additional funds. Interest is usually paid monthly and calculated on the average outstanding balance during the period. This method of financing allows a firm to smooth out its cash flow cycle as well as to have funds available for possibly both precautionary and speculative needs.

The use of the line of credit affects both current assets and current liabilities equally. They increase and decrease in a parallel fashion. However, as long as the current ratio is greater than one, an increase in a line of credit (increase to cash and an increase to current liabilities) will decrease the current ratio.



Illustration: A firm has $100,000 of current assets, $50,000 of current liabilities, and a current ratio of 2 to 1 ($100,000 ÷ $50,000). If $25,000 is borrowed on the line of credit, current assets will increase to $125,000, current liabilities to $75,000, and the current ratio will become 1.7 to 1 ($125,000 ÷ $75,000).

c. A variation on the line of credit is the revolving credit agreement that is generally used by large corporations. This is an agreement by a bank to extend credit to a company over a specified period of time; however, if the firm does not make use of the revolving credit, there still is an annual commitment fee. For example, the approved revolving credit could be for three years to allow a corporation to borrow up to $50 million. Even if the company does not use any of the credit during the year, it will still have to pay a significant commitment fee expressed in terms of a percent (for example, a quarter of 1% or $125,000 annually in the above illustration). If the corporation borrows $25 million on the revolving credit agreement, the commitment fee would drop to a percent of the unused portion of the agreement ($62,500 in this illustration), and the corporation would pay interest on the outstanding borrowed balance as well. The biggest difference between a line of credit and a revolving credit agreement is that there is a legal obligation with a revolving credit agreement that does not exist with a simple line of credit. This legal obligation guarantees the company access to the funds over the life of the agreement.

d. A letter of credit is an international financing tool that guarantees payment to an international supplier upon the safe arrival of the goods by issuing a loan to the purchaser. A letter of credit can be irrevocable (not subject to cancellation if the specific conditions are met) or revocable.

e. Commercial paper is an unsecured promissory note that is issued by large banks and big corporations to meet short‐term cash needs. It is a promise to repay the borrowed funds at a future given date with a maturity of no more than 270 days. Rates for these loans are normally lower than for bank loans. This financing option is considered to be quite safe due to the short time frame and the strength of the borrowing companies; however, there is no flexibility in the repayment date as might be received with a bank loan.



2233.07 Secured loans

a. Short‐term credit is often secured by current assets such as receivables and inventory, and is often used by seasonal businesses where cash flow and working capital needs are not synchronized.

b. Pledging of receivables entails using the cash value of the receivable as collateral for a loan. In this case, the borrowing company agrees to remit the cash received from the collection of particular receivables as repayment of the loan; however, the receivables continue to be owned by the borrowing company, and if a particular receivable proves to be uncollectible, the borrowing company is still liable for the repayment of the loan. Interest rates for these loans can range from 2% to 5% over prime, often with a fee equal to 1% to 2% of the receivable pledged.

c. Factoring involves selling accounts receivable to a factor as a form of short‐term financing. The factor assumes the risk of collection, and the purchaser is notified of the factoring arrangement and usually remits payments directly to the factor. (In some instances, factoring can be done with recourse.) Since the risk is shifted to the factor, the factor will take over the responsibility of doing the credit check on a potential customer. Therefore, functions performed by the factor include credit checks, lending, and bearing of default risk. Generally, the selling firm receives funds from the sale immediately upon shipment of goods to the purchaser. The amount received is the full amount of the sale less a factor fee (usually some percentage of the total sale). The fee incorporates a reserve for sales returns and allowances, interest costs, and profit for the factor. At the end of a specified period, the reserve amount is paid to the seller, providing there have not been sales returns and allowances in excess of the reserve assumed in the factoring agreement. It is not uncommon for factoring arrangements to be ongoing.

Illustration: A company sells $50,000 of goods with the terms net/30. The receivable is immediately factored with a 3% factor fee, 10% interest, and a reserve of 8%. How much does the selling firm immediately receive from the factor?

Solution: The factor fee will be $1,500 (3% of $50,000). The reserve will be $4,000 (8% of $50,000). The interest will be calculated on 10% of the balance available to the seller and adjusted for a monthly period length.



This can be summarized as follows:

Sales: $50,000 Less: Factor fee (3% × $50,000) $1,500 Reserve (8% × $50,000) 4,000 5,500 Amount due firm 44,500 Less interest on amount for 30 days (10% × $44,500 × 30/360) 371 Amount paid to seller $44,129

After 30 days, any remaining part of the reserve (maximum of $4,000 in this case) that was not absorbed by returns and allowances will be remitted to the seller.

The cost of factoring needs to be compared to the costs of running a credit department when making a decision as to which alternative to pursue.

d. Inventory financing entails the use of inventory as security for a short‐term loan. Such a loan can attach to all inventory held or a particular portion of inventory identified by serial numbers or placed in a particular location.

2233.08 Advantages of short‐term debt financing

a. A short‐term loan can generally be obtained quickly.

b. The cost of obtaining short‐term debt is generally low since the lender tends to only do a minimal financial examination of the firm applying for funds. Spontaneous credit has no cost.

c. There are generally no prepayment penalties.

d. Short‐term debt often provides flexibility for management as it generally has few restrictions.

e. Since the yield curve is typically upward sloping, short‐term interest rates are generally lower than long‐term interest rates.

f. Interest expense is tax deductible and, therefore, provides financial leverage.

g. Accounts payable is a primary source of short‐term debt and it is spontaneously created when inventory is purchased.

2233.09 Disadvantages of short‐term debt financing

a. Short‐term interest rates can vary widely over time, subjecting the firm to refinancing risk.

b. An unexpected need for cash during a recession could cause cash flows to be insufficient to meet the short‐term obligations.



c. Due to changing financial conditions, short‐term debt may not be renewable and thus, depending upon the level of short‐term debt, may put a firm in an illiquid position that could lead to bankruptcy.

d. On occasion, compensating balances are required when unsecured debt is received. This increases the effective cost of that debt.

Long‐Term Debt Financing

2233.10 A term loan is a legal agreement between a borrower and lender where the borrower promises to make interest and principal payments at specific times to the lender for the use of borrowed funds. It is a form of funded debt (long‐term debt).

a. Term loans have advantages over the issuance of bonds and equity.

b. Term loans can be drawn up quickly since the borrower and lender work directly together.

(1) The terms of the loan can have more flexibility since they are not registered with the Securities and Exchange Commissions (SEC). Also, modifications can potentially be made during the life of the loan.

(2) Term loans have low issuance costs.

c. Generally, term loans are paid off in equal installments. This is a protection to both the lender and the borrower that funds will be available for repayment. When funds from the loan are used to purchase equipment, the repayment schedule is frequently matched to the productive life of the equipment.

d. Interest rates can be either fixed or variable.

2233.11 A bond is generally a publicly offered form of long‐term debt where the borrower agrees to makes payments of interest and principal on specific dates to the bondholder. Most bond issues are advertised and held by many different investors as opposed to the one lender of a term loan. The bonds have a coupon rate (rate of interest) that is generally fixed.

2233.12 An indenture is the legal document that contains the terms of the bond issue. This document is approved by the SEC before the bond issue is offered to the public. It will clearly state the provisions of the issue. Common provisions include the following:

a. Call provision: The right of the issuer to redeem the bond issue prior to the maturity date under certain circumstances

b. Sinking fund: Requires the issuer to retire a portion of the bond issue each year or deposit funds into a restricted account to be accumulated for the retirement of the bonds



c. Restrictive covenants: Conditions that must be met by the issuer during the life of the bond issue, such as maintaining a debt ratio no higher than a specified amount, restricting dividend payments, maintaining a minimum current ratio, or other similar requirements

2233.13 Bond ratings are determined using a rating system such as Standard & Poor’s, based upon the probability that the issuing corporation will go into default. These ratings range from AAA (very strong) to D (in default). AAA and AA are considered to be of a high investment quality, and they along with A and BBB rated bonds are considered to be investment grade, BB and B are considered to be substandard, and CCC to D are considered to be speculative.

2233.14 The bond rating is based upon the financial health of the issuing organization (capital structure as well as stable profitability), bond provisions, pending legal actions, and time to maturity. The rating is done by rating agencies using subjective judgment. The bond rating has a direct effect on the bond’s coupon rate, and thus the firm’s cost of capital if a firm wishes to issue new debt. Since many bonds are purchased by institutional investors who are generally restricted to purchasing no lower than investment‐grade bonds, this rating is extremely important. The issue here is that there is an additional impact in the event a firm’s rating is downgraded. Then there would be a decrease in the market price of outstanding bonds.

2233.15 The market value of bonds is based upon the present value of discounted future cash flows, comprised of an annuity plus a lump sum. The bond’s market value fluctuates with changes in the market interest rates. If the coupon rate equals the market interest rate, then the market value of the bond will be equal to the face value (par value). If the market interest rate is above the coupon rate, the bond will be selling at a discount to par. If the market interest rate is lower than the coupon rate, the bond will sell at a premium to par.

As the bond approaches maturity, its market value will approach par. Changing interest rates will have an impact on the market value of the bond, the impact being greater the longer the remaining maturity of the bond. The issuing corporation, however, will be required to make the same semi‐annual interest payment no matter what changes occur in the interest rate over the life of the bond. When bonds are issued, the coupon rate on the bond generally is set close to the current market rate.

Illustration: A $1,000 bond with a 7% coupon rate, maturing in 10 years, is selling in a 6% market. What is the current market value of the bond?



Solution: The bond is valued by determining the PV of the future cash flows (maturity value of $1,000 and semi‐annual interest payments of $35 each ($1,000 × 3.5%)). Using present value tables for 3% (due to semi‐annual interest payments), 20 periods, the value of the bond can be calculated:

PV of maturity ($1,000 × .5537) $ 553.70 PV of interest payments ($35 × 14.8775) 520.71 Present value $1,074.41

Due to the fact that the coupon rate is higher than the current market rate, the bond will sell at a premium.

2233.16 Advantages of long‐term debt financing

a. Ownership of the company is not shared with the debt holder.

b. No matter how profitable an organization is, the bondholder will still only receive the same semi‐annual interest payments over the life of the bond. Operating income in excess of the bond interest goes to the equity holder.

c. The interest on the loan is a fixed amount that can be budgeted, or in the case of a variable interest rate, the interest for a particular period can be adequately estimated.

d. The interest paid on the debt is a tax‐deductible expense; the tax shield lowers the effective after‐tax cost of the debt.

e. Raising debt capital is less complicated than issuing either preferred or common stock.

f. Some debt issues have call provisions that supply flexibility to the issuing firm.

2233.17 Disadvantages of long‐term debt financing

a. Long‐term debt frequently has various restrictive covenants that can dramatically limit choices available to management. Examples include setting dividends, obtaining additional debt, holding compensation balances, maintaining levels of liquidity and/or solvency ratios, and prepayment penalties.

b. If interest rates fall, a firm could be locked into a high interest rate.

c. Long‐term debt has a maturity date at which time the principal needs to be repaid.

d. Interest payments are a fixed cost that increase the breakeven point of the firm. Interest must be paid whether a profit is made or not. During a downturn, making interest payments can become difficult.



e. Debt increases the financial leverage (risk) of the company, and the higher the leverage, the less flexibility a company has for raising future financing.

f. Long‐term debt is often obtained in larger amounts, and since predicting actual cash needs is not an exact science, long‐term borrowing is often out of tune with actual needs.

g. The amount of debt financing is limited, and as the percentage of debt in the capital structure increases, so does the cost of issuing additional debt.

2234 Initial and Secondary Public Offerings

2234.01 Initial Public Offerings (IPO)

a. Advantages: An IPO is a corporation’s first sale of securities to the public. This public offering may have been preceded by private placement or short‐to‐medium term bank financing. Public securities can achieve liquidity for shareholders and can be used as “currency” for subsequent acquisitions. Registration with the SEC is required.

b. Disadvantages: Private companies may find “going public” is a time consuming, expensive and exposing process. Professional advisors and investment bankers can be quite helpful in meeting the requirements. Still, many entrepreneurs find the required efforts, public scrutiny, and financial discipline of a public listing too demanding and opt for a private placement.

2234.02 Private Placements: If a private placement is chosen, a firm approaches one or a small number of investors directly such as insurance companies, venture capitalists, and commercial banks. Common and preferred stocks are usually sold by public offerings whereas debt instruments are more likely sold privately.

a. Advantages of Private Placements: The primary advantages of private placements are their flexibility and the elimination of flotation expenses (which means low transaction costs of bringing the securities to market) and the time‐consuming process of SEC registration. A specialized investor or private equity fund may provide assistance to management and have advantages in multi‐round venture financing. One variety of a private placement is when a corporation sells shares to an Employee Stock Ownership Plan (ESOP) owned by the employees.

b. No Underwriting Required: In a private placement, there is no underwriting involved. Therefore, the investment banker will bring together the buyer and seller to determine a fair price for the securities



and complete the transaction. The investment banker earns a fee for this service. A firm will choose between private placement or public sale depending upon which method will yield the lowest borrowing cost (after transaction costs).

c. Firms That Choose Private Placements: Generally, there are two types of firms that use private placements.

(1) Small Firms: The first is small, lesser known firms of comparatively low credit quality which generally issue small dollar amounts of securities. These firms generally find public sales more expensive than private sales after considering flotation costs.

(2) Large, Well Known Firms: The second type of firm using private placements are large, well known firms with a high credit rating. These companies have large issues which allow them to take advantage of economies of scale in flotation costs. Therefore, these companies will substitute between the two markets, selecting the market that provides the lowest expected borrowing cost for a particular offering.

2234.03 Secondary and Subsequent Offerings: The secondary market for corporate stock is the largest in dollar volume and number of trades of any security. The function of secondary markets is to provide liquidity to individuals who acquire securities in the primary market. The primary market would not function well if investors believed they would not be able to resell a security quickly at a fair price in a secondary market. Markets have a dealer(s) who specialize in a security. Dealers are charged with maintaining an orderly and stable market in the security.

a. Organized Exchanges: Organized markets, commonly called security exchanges, provide a meeting place and communication facility for members to complete transactions under specific rules and regulations. Only members of the exchange may use the facilities and only securities listed on the exchange may be traded. The New York Stock Exchange (NYSE), the largest organized exchange in the United States, is an example of an organized exchange. The American Stock Exchange is another large exchange.

b. Over‐the‐Counter Market (OTC): Securities not sold on an organized exchange are traded in the over‐the counter market. Dealers and brokers are connected through an elaborate communications network. In 1971, the National Association of Security Dealers (NASD) introduced an automatic computer‐based quotation system which provides continuous bid and ask prices for actively traded OTC stocks. When a quote is needed for a customer, all current bid and ask prices are printed out with the name of the dealer to contact. A customer will place an order with a



broker to purchase or sell a security in the OTC. The broker must then secure the best possible price with another broker or dealer who has that particular security for sale.

c. Repurchase of Common Shares: Corporations may repurchase their own common stock on the secondary market. They may accomplish this through a broker, by negotiating with a large investor such as a mutual fund manager, or by a tender offer. This is a use of cash other than for dividends and tends to drive the stock price up, causing a capital gain for the stockholders.

(1) Reasons for Repurchase:

(a) Change Financial Leverage: Management may want to change the company’s financial leverage. By issuing bonds and buying back common stock, the company will become more leveraged, probably in the direction of the optimal level, but will also cause an increase in the company’s financial risk.

(b) Undervalued: The company may feel that the stock is undervalued, making it a good investment (and at the same time increasing the share price).

(c) Resist Takeover: Stock may be repurchased to thwart a hostile takeover attempt. T. Boone Pickens is a well‐known corporate raider who has attempted several well publicized takeover attempts. However, tactics employed by the targeted companies (for example, Phillips Petroleum), including the repurchase of shares, thwarted Mr. Pickens’ attempts.

(d) Manipulate Market Price: Management may want to keep the stock price above what the market alone would dictate. A corporation with the necessary cash can place an open buy‐order for its stock at a particular price and thus create a short‐term floor at that price.

(e) Acquisition for Stock Dividends: The company may have a policy to repurchase common shares on a regular basis to support either an automatic dividend reinvestment plan with shareholders or to accommodate a proposed stock dividend.

(2) Tender Offer: In a repurchase tender offer, the corporation attempts to buy a specific number of shares of their own stock at a set price. A tender offer is made when the board of directors feels that it is an appropriate use of corporate funds that will not be needed for current operations. A tender offer is generally made through an investment banker.



2235 Dividend Policy and Share Repurchases

2235.01 Price‐earnings ratio

a. The price‐earnings ratio indicates the relationship of common stock to net earnings. The market price is the investors’ perception of the future; therefore, this ratio combines the performance measure of the past (EPS) to perceptions of the future.


b. The earnings per share computation is subject to arbitrary assumptions and accrual income. EPS is not the only factor affecting market prices.

c. A high P/E ratio is a possible indication of a growth company and/or of a low‐risk organization.



= $17.00 $3.00

= 5.67

2235.02 Dividend yield

a. The dividend yield ratio shows the return to the stockholder based on the current market price of the stock.


b. Dividend payments to stockholders are subject to many variables. The relationship between dividends paid and market prices is a reciprocal one.

c. This ratio is calculated using the current market price; however, most of the shareholders did not purchase their shares at the current price, thus making their personal yield different than the calculated yield.



=$10,000 ÷ 20,000 shares

$17.00 per share = 2.9%

2235.03 Payout ratio to common shareholders

a. The payout ratio to common shareholders measures the portion of net income to common shareholders that is paid out in dividends.

Payout ratio common

shareholders =

Common dividends Net income – Preferred dividends



b. Income does not necessarily measure cash available for dividend payment. Payments are heavily influenced by management policy, the nature of the industry, and the stage of development of the particular firm. All of these items diminish comparability between companies.

c. Organizations that have high growth rates generally have low payout ratios since most earnings are kept as retained earnings with the funds being reinvested in the company instead of providing cash dividends. A firm that has consistently paid a dividend and suddenly lowers its dividend payout often is signaling a lack of available cash and the existence of liquidity or solvency problems.


Payout ratio common shareholders

= Common dividends Net income – Preferred dividends

= $10,000 $75,000 – $15,000

= 16.67%

Share Repurchase

2235.04 Stock Repurchase Agreements: As long as the articles of incorporation so provide, a corporation may repurchase or redeem its own shares. Redeemed shares may be cancelled or held in the treasury. There is no taxable gain or loss recognized by a corporation from transaction in its own treasury shares. Such transactions also have no affect on stated capital. These shares do not have voting rights and cannot receive dividends.

a. Reasons for Reacquiring Stock: There are a number of reasons why a firm reacquires its own stock, including the following:

(1) Provide Cash and Tax Savings to Shareholders: By repurchasing its stock from its shareholders, the corporation can both pay cash and provide a tax benefit to the shareholders. The shareholders are taxed only on the gain (amount that the transaction price exceeds their original basis in the stock). In contrast, cash dividends paid to shareholders are usually fully taxable.

(2) Employee Stock Ownership Plans (ESOPs): Federal corporate tax law provides for the deductibility of contributions made to qualified ESOPs. An ESOP typically borrows funds from a bank to purchase shares of the corporation’s stock to be held in the name and for the benefit of the firm’s employees. These shares may be treasury shares accumulated and held by the corporation as well as those shares newly issued by the corporation or purchased on the open market. The corporation makes annual tax‐deductible contributions to the ESOP, which uses the funds to repay the bank loan. Employees may also contribute to the ESOP. The firm benefits by receiving the



proceeds from the sale of either treasury stock or newly‐issued shares to the ESOP.

(3) Automatic Dividend Reinvestment Plans (ADRIPs): Treasury stock may be used to provide additional shares to shareholders in lieu of cash dividends under an ADRIP. See the detailed discussion in the next section of this chapter.

(4) Stock Repurchase Programs: The corporation may choose to purchase some of its own shares from the market, thus increasing the proportional ownership of the remaining shareholders. Earnings per share of outstanding stock is then increased which, together with the stimulative buying activity, is expected to result in a higher market value per share. Shareholders have the potential of realizing capital gains upon eventually selling their shares, which may be taxable at lower rates than ordinary dividends. Such a program is especially desirable if the book value per share exceeds the market value per share of the stock.

2236 Lease Financing

2236.01 The FASB defines a lease in ASU 2016‐02 to be “a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.” An entity will determine whether a contract contains a lease by assessing whether the use of an identified asset is either explicitly or implicitly specified and whether the customer controls the use of the identified asset.

2236.02 There are two sets of lease criteria: the first set is for both lessees and lessors, and the second set is for lessors only.

2236.03 The first set of criteria result in a finance lease for a lessee or sales‐type lease for the lessor if the lease meets any of the following criteria at commencement:

a. Title (ownership) transfers to the lessee by the end of the lease term.

b. The lease contains a purchase option that the lessee is reasonably certain to exercise.

c. The lease term is for the major part of the remaining economic life of the underlying asset. This criterion shall not be used if the lease commencement date is near the end of the asset’s economic life.



d. The present value of the sum of the lease payments and any lessee guaranteed residual value not already in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.

e. The underlying asset is specialized and is not expected to have an alternative use to the lessor at the end of the lease term.

2236.04 For most leases of property (e.g., land or building), a lessee would classify the lease as an “operating” lease if none of the five criteria listed above are met and will recognize the following:

a. At commencement, a right‐of‐use (ROU) asset and a lease liability, initially measured at the present value of lease payments, using the interest rate implicit in the lease if known; otherwise, the lessee uses its incremental borrowing rate.

b. Subsequent to commencement, a single lease cost, combining the unwinding of the discount on the lease liability (i.e., interest expense) with the amortization of the ROU asset, on a straight‐line basis. In other words, the lease liability is reduced by the amount of the periodic payment less the amount of that payment attributable to interest. The lessee then “plugs” the ROU asset amortization at whatever amount is needed for interest plus amortization to equal the straight‐line payment in the lease contract. Impairment, if any, is recorded.

2236.05 If any of the five criteria above are met (control is deemed to have transferred), the lessor accounts for the lease as a sales‐type lease with or without a selling profit and will:

a. at commencement, recognize the net investment in the lease [lease receivable (lease payments plus guaranteed residual values) plus the unguaranteed residual asset]; derecognize the carrying amount of the underlying asset; and recognize sales revenue and cost of goods sold at the beginning of the lease such that selling profit (usually when the fair value of the asset exceeds the cost or book value of the asset) if any, is immediately recognized. Expense initial direct costs if a selling profit exists and defer initial direct costs by increasing the net investment in the lease if there is zero profit.

b. subsequent to commencement, recognize interest income (interest on the lease receivable and interest from the unguaranteed residual asset accretion) using the effective interest method and reduce the net investment in the lease.



2236.06 When none of the first set of criteria above are met, a lessor shall classify the lease as an operating lease unless both of the following second set of criteria are met to classify the lease as a direct financing lease:

a. The present value of the sum of the lease payments and any lessee or other third party guaranteed residual value not already in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.

b. It is probable that the lessor will collect the lease payments plus the residual value guarantee.

2236.07 The availability of credit is sometimes a major part of the decision to purchase or lease. If an organization wishes to maximize financial leverage while maintaining a high level of (superficial) solvency, operating leases may be chosen.

2236.08 Advantages of lease financing

a. It can be less expensive to lease than to borrow funds in order to purchase necessary equipment.

b. Generally, lessors do not require down payments and thus provide 100% financing. However, lenders commonly will not finance the entire purchase price of an asset.

c. Any restrictions placed by lessors are normally less restrictive (or non‐existent) than those of lenders.

d. Short lease periods allow a company to avoid the risk of obsolescence.

e. If land is leased, the lease payment is a tax‐deductible expense; however, land that is owned is not depreciable.

f. Leasing provides for fixed‐rate financing in that the lease payment is set for the life of the lease.

g. Commonly, it is easier to lease than to borrow.

2236.09 Disadvantages of lease financing

a. In general, all lease payments during the contracted period are required to be paid; thus, flexibility is taken away from management in the case of a downturn in business.

b. Although the leased equipment is not owned, frequently maintenance costs for the asset are the responsibility of the lease holder.



c. Over the life of a lease, the payments made on the lease are greater than if the asset were purchased for cash. The additional amounts of the basic cost of the asset are similar to the interest payments made on borrowed funds.

d. There is no ownership during the lease period, thus no effective equity related to ownership.

2240 Working Capital Management

2241 Working Capital Terminology

2241.01 Compensating balances

a. A compensating balance is a cash balance required to be held in an account by a bank in order to obtain a loan or to avoid paying directly for certain bank services. Required balances are either a fixed minimum amount or a minimum average balance for a given period such as a month.

b. Compensating balances increase the cost of a loan or impart a cost to services provided.

(1) Illustration: If a compensating balance of $10,000 is required in order to receive free bank services, the company would not hold these funds otherwise, and the money could be invested receiving a 5% return; then the actual cost of those services would be $500 per year ($10,000 × 5%). This could be compared with the actual cost of the services to determine if it would be less expensive to pay for the services directly.

(2) Illustration: If a compensating balance of $10,000 is required in order to receive a $100,000 bank loan at 10%, then the effective cost of that loan will be increased, since only $90,000 will actually be available for use. The stated rate of interest on a $100,000 loan at 10% would be $10,000 per year. The effective rate of interest would then be 11.1% ($10,000 ÷ $90,000).

2241.02 Trade credit

Trade credit is a source of funds that is spontaneously created as a result of the purchase transaction. Trade credit (accounts payable) is often the largest short‐term debt item held by firms. If a firm purchases an average of $10,000 a day under the terms of net 30, then financing of $300,000 has been spontaneously supplied to that firm providing the payment terms are met.



2241.03 Commercial paper

a. Commercial paper is short‐term, unsecured notes that are offered by stable companies. These are in large amounts with short‐term maturities generally ranging from one month to a maximum of 270 days. Access to the market for commercial paper is limited to a small number of companies that are exceptionally good credit risks. The interest rates on commercial paper tend to be somewhat below the prime rate.

b. The advantages of commercial paper include:

(1) providing the firm an additional source for funds that is readily accessible once the firm’s paper has been rated.

(2) lower rates than are available with traditional bank loans—generally ranging from 1½ to 3½ percentage points below the prime rate.

(3) absence of costly financing arrangements and the need for potential compensating balances.

(4) the repeated issuance of successful commercial paper improves a borrower’s reputation in the financial markets.

c. The primary disadvantage of commercial paper is that if a firm is facing temporary financial difficulties, it would not be able to utilize this source of funding.

2241.04 Zero balance accounts (sweep accounts)

a. Zero balance accounts are held at zero until a claim is made against the account. At that time, the holding bank transfers sufficient funds from an interest‐bearing account to the zero balance account. The firm must have at least one additional account with the bank, and there is generally a small fee associated with transfers.

b. A zero balance account can be effectively used by an organization when the interest earned in the interest‐bearing account is greater than the fees associated with the transfers of funds. Operationally, it reduces the need for the firm to monitor daily fund flows.

c. A hybrid of the zero balance account is a payroll account where funds necessary to cover payroll are transferred automatically as the payroll checks are being issued.



2241.05 Electronic funds transfers

a. Firms are increasingly expecting payment of large bills by use of automatic electronic debits. Funds are automatically deducted from one account and added to another. This is the ultimate in terms of speeding up the collection process. Today, many electronic transfers are done on the Internet.

b. The use of debit cards by individuals is an example of the application of this technology for small payments made by consumers.

2241.06 Lockbox systems

a. A lockbox is a system where checks are sent to post office boxes rather than corporate headquarters. The checks are collected several times a day by a local bank, and the funds are immediately deposited into the company’s local account.

b. A lockbox system can significantly reduce the time required to receive funds and make them available for use, often by two or three days, since multiple lockboxes can be located throughout the United States and internationally.

c. Today, the bank generally notifies the firm with a daily record of receipts collected via an electronic data transmission system and wires funds to the firm’s cash concentration account.

2241.07 Official bank checks (a.k.a. depository transfer checks)

a. Depository transfer checks (DTC) are official bank checks that provide a means of moving funds from one account to another within the banking system. A DTC is payable to a particular account in a particular bank.

(1) The payer prepares and mails a DTC.

(2) The DTC is deposited by the payee (often through the use of a lockbox).

(3) The DTC is sent to a concentration bank that serves as a clearing house for funds within the banking system. Often the lockbox is located at the concentration bank as a means of speeding up the collection process.

(4) The concentration bank begins the clearing process by sending the check to the central bank.

(5) Ultimately, the funds are deducted from the payer’s account when the payer’s bank is notified of the funds transfer.



b. Float is the difference between the company’s checkbook balance and the bank’s balance. It represents the net effect of checks in the process of collection. Checks written by the firm create disbursement float and reduce the book cash. Checks received and deposited by the firm create collection float and increase the book balance. As checks are cleared, the bank cash position is reconciled to the book cash position.

2242 Cash Management

2242.01 Reasons to hold cash

There are four primary reasons for a company to hold cash.

1. Transactions purposes: Cash is necessary for a company to conduct its day‐to‐day business.

2. Precaution purposes: Since cash flows do not flow evenly over time and often cash inflows are not matched with cash outflows (a business cycle consideration), it is necessary to have enough cash on hand to compensate for unanticipated fluctuations in cash flows.

a. Precautionary cash is often held in highly liquid marketable securities. This provides security and additional interest income.

b. Today, most companies have a line‐of‐credit arrangement to cover the precautionary needs.

3. Speculative purposes: Cash balances are also necessary to allow a firm to take advantage of potential business opportunities such as bargain purchases.

a. Near‐cash is advisable for speculative purposes so that additional interest/dividend income can be earned.

b. Organizations often do not hold cash for speculative purposes if they have a readily available source of funds such as a line of credit.

4. To meet compensating balance requirements: Compensating balances are amounts required to be kept in an account by a bank and are often mandatory in order to obtain a loan or to avoid paying fees for individual bank services.



2242.02 The cash budget

a. The cash budget is a cash management tool that details cash inflows and outflows over a specified period of time. It can be prepared on a yearly, quarterly, monthly, weekly, or even daily basis. Since cash inflows and outflows are not necessarily uniform throughout the year, the cash budget highlights when cash shortages are likely to occur, allowing management to plan necessary borrowing, and also highlights when cash surpluses will be available for repayments or investments.

b. The cash budget is based upon estimates of sales, credit terms, and bad debt levels (cash collections); estimates for purchases and payment terms (cash payments); estimates for production and payment terms for conversion costs (cash payments); estimates for borrowings (cash inflows), repayments, and associated interest payments (cash outflows); estimates for capital purchases (possible cash outflows) and disposals (possible cash inflows); and potential dividend payments (cash outflows). Since this budget is based upon estimates, it is necessary to update the cash budget on a regular basis when data on actual inflows and outflows become available.

c. The target cash balance is the desired cash balance management believes to be necessary to safely conduct business. This amount may vary during the year due to the cyclical nature of many industries. When estimated cash inflows exceed estimated cash outflows for a given period including planned capital expenditures, the excess can be used to repay short‐term credit and/or be invested. When estimated cash outflows exceed estimated cash inflows for a given period, investments can be turned into cash to meet these cash needs, or short‐term borrowing can be arranged. Many companies have line‐of‐credit arrangements to help them smooth out cash flows throughout the year.

2242.03 Synchronizing cash flows

Synchronizing cash flows matches the cash outflows with the timing of the receipt of cash inflows. This allows firms to keep transaction balances to a minimum. Many companies stagger the billing of customers throughout the month in an attempt to create fairly even daily cash inflows while planning the timing of payments for various obligations so that due dates are during various weeks of the month. The lower the target cash balance, the more funds that are available for productive uses.



2242.04 Speed of cash collections and disbursements

a. From the perspective of an individual firm, collections need to be made as quickly as possible and disbursements delayed as long as possible, providing discounts are not lost nor unnecessary interest charges incurred. This allows for the maximum cash balance at any given time.

b. When a check is received from a customer, it does not mean that funds are necessarily available at the time of receipt. Due to the check clearing process, it may be one to three days before the funds are available. The difference between the checks that have been received and those credited by the bank is the collection float. The goal of management is to keep this float as low as possible.

c. Techniques such as the use of lockboxes and electronic funds transfers allow firms to speed up the collection process.

d. The net float is the difference between the firm’s checkbook balance and the balance of the account in the bank’s records. The difference is due to the collection float and the disbursement float. The disbursement float is the amount of the checks written but that have yet to clear the bank. The disbursement float allows a firm to have lower cash balances.

e. Techniques such as the use of zero balance accounts allow a firm to not hold funds in non‐interest‐bearing accounts to meet anticipated disbursement needs.

2243 Marketable Securities Management

2243.01 Use of marketable securities

a. Marketable securities are generally low‐risk investments that can be quickly turned into cash. Marketable securities include:

(1) U.S. Treasury bills.

(2) bank certificates of deposit.

(3) commercial paper.

Since most firms attempt to minimize cash balances, excess cash is often invested in marketable securities that are purchased with maturities that coincide with seasonal needs, maturing debt, tax payments, or other potential needs.



b. Marketable securities have low risk and high liquidity.

(1) Since safety is an important factor, short‐term marketable securities are generally lower yielding since safety is traded for higher yield and minimizes default risk.

(2) Short‐term investments also minimize interest rate risk since their market values do not show a high degree of price fluctuation related to interest rate changes.

c. Marketable securities are held as a substitute for cash. By transferring excess cash to interest‐bearing investments, the surplus can add value to the firm. The funds are still readily available to meet transaction, precautionary, and speculative needs.

d. Marketable securities are held as temporary investments to be used to meet seasonal needs or to protect against business downturns.

e. Marketable securities are held to meet planned financial needs such as a maturing bond issue, upcoming tax payments, or a possible expenditure for plant or equipment.

f. Marketable securities can be used as a temporary place for funds received but yet to be invested in long‐term investments or capital additions.

g. With the use of lines of credit, the need for marketable securities has diminished for companies that have access to such financing options.

By using a line of credit to meet short‐term needs for funds as opposed to marketable securities:

(1) a firm’s current ratio could be lower without indicating a greater risk that the obligations would not be repaid on a timely basis. There is, however, a risk that funds available from this method of financing might not meet all of the firm’s actual short‐term needs.

(2) if excess cash is not expected to be needed for precautionary and speculative purposes, it might be feasible to put these additional funds to better use, such as by investing them in higher‐yield, medium‐term investments or to fund capital enhancements to improve the productivity of the existing capacity.



2243.02 Cash management and the multi‐company, international firm

a. A multi‐company firm has additional cash management issues. Each subsidiary needs to manage cash on an individual basis; however, a centralized cash management group needs to manage the cash flows between the parent‐subsidiary and within inter‐subsidiaries in order to optimize cash flows. Such management can benefit subsidiaries in need of funds by supplying the needed cash from excess funds from another subsidiary or the parent.

b. The need to increase the speed of cash inflows is magnified in the international setting due to increased mailing times. The use of lockboxes around the world is one method of speeding up collection. Another method is to have preauthorized payments where the firm can charge a customer’s account up to a specified limit. Today, most large firms use an electronic method such as the Internet to transfer funds.

c. International cash flows result in the need for currency conversions. By using a tool called netting, administrative and transaction costs resulting from currency conversions can be reduced. For example, if two subsidiaries are located in different countries and A purchases parts from B, transactions resulting from the sale of the parts from B to A are “netted” for a period of time (generally a month), and one net payment involving currency exchanges is made per period, thus reducing conversion costs.

A more complex multilateral netting system is used when there are a parent and several subsidiaries. The transactions among the various entities are netted so that conversion costs are minimized.

d. The use of various cash transfers for international organizations may be hampered by foreign government restrictions and characteristics of the banking systems in less developed countries.



2244 Accounts Receivable Management

2244.01 Introduction to accounts receivable management

a. Firms extend credit on sales in order to increase revenues. Since the objective of increased sales is to increase profit, a firm will theoretically extend credit until the cost of offering additional credit equals the costs incurred in generating those sales (incremental analysis).

b. The value of the trade accounts receivable at any given time is directly tied to sales volume, which in turn is influenced by factors some of which management has control of, such as product price and quality and advertising. Another major controllable factor influencing sales is the firm’s credit policy that consists of the following:

(1) Credit period: the length of time the customer is given to pay for the purchases. For example, credit terms of “3/10, net 30” allows buyers to take up to 30 days to pay without incurring interest charges.

(2) Discounts: the credit terms “3/10, net 30” allow customers to take a 3% discount if the payment is received within 10 days of the invoice. The full amount would be due in 30 days if the discount opportunity was not taken.

(3) Credit standards: the required financial strength of acceptable customers. Relaxing the standards is likely to boost sales, but also to increase bad debt losses.

(4) Collection policy: how tough or lax the firm is in terms of attempting to collect slow‐paying accounts. Again, there is a trade‐off between attempting to speed up the collection of an account and possibly losing a customer.

c. The credit manager is generally responsible for administering a firm’s credit policy. However, credit policy is generally set at an administrative level within the firm.

d. A change in credit policy involves the interaction between several variables. Below are some of the issues management would need to analyze when considering a change in the credit policy.

(1) Sales: What is the projected increase in the level of gross sales that would result from the change?

(2) Account receivable: There is generally a proportional relationship between an increase in sales and an increase in accounts receivable. An increase in accounts receivable would mean that additional funds would be tied up until collection. Increasing accounts receivable would require increasing funding (debt or equity) with a possible increase in interest costs.



(3) Discounts and bad debt losses: What proportion of customers would be expected to take the discount? What proportion of the additional receivable would become bad debts?

(4) Costs of running a collection department: Would more staff (higher costs) be needed to run collection department due to higher volume? Would there be fixed costs associated with the expansion of the credit collection efforts?

(5) Management would have to compare the increased revenues expected with the increased costs to determine whether the firm would be better off on an incremental profit basis.

e. A firm’s credit policy includes the credit standards, credit period, available discounts, and collection procedures.

f. The quality of credit is defined as the ability to collect receivables in full and in a timely manner.

g. A firm’s credit policy is often dictated or strongly influenced by competitors since unless the firm’s policies are competitive, sales will often be lost.

2244.02 Credit standards

Credit standards are the firm’s standards by which potential customers are measured in the process of being approved for credit. The lower the standards, the higher the sales and the higher the associated costs such as bad debt losses that come from extending credit to less creditworthy customers. Optimal credit standards allow for the marginal cost of extending the additional credit to equal the margin profits produced by the increased sales resulting from the relaxed credit standards.

2244.03 Credit period

a. The credit period is the length of time for which credit is extended. It is the time that elapses between the sale and the expected collection of funds. Lengthening the credit period often encourages sales, but also increases financing needs due to the fact that additional funds will be tied up in the additional receivables. Longer credit periods are also associated with higher bad debt expenses.

b. If the credit period is extended, trade accounts receivable will increase due to the increased holding time of receivables as well as increased credit sales.



c. The cost of extending the credit period can be calculated by multiplying the increase in accounts receivable by the marginal cost of capital.

Illustration: If a firm increases its credit period from 30 to 45 days, average accounts receivable are predicted to increase from $400,000 to $500,000. If the cost of capital is 10%, then the marginal cost of changing the credit period is $10,000 ($100,000 × 10%).

d. In poor economic times, a firm needs to be concerned that customers will unilaterally extend the credit period.

2244.04 Available discounts

a. Discounts are used as an incentive to get the customer to make an early payment. This would reduce the cash outflow needed by the customer to meet the obligation. A common discount would be stated as “2/10, net 30.” This is interpreted to mean that the customer may take a 2% discount if the payment is received within 10 days, with the full amount due and deemed current if received between 11 to 30 days.

b. Discounts provide:

(1) a price reduction for customers.

(2) a means to attract new customers.

(3) a way to reduce the average collection period.

c. Seasonal discounts are also offered by some organizations. By placing an order by a specified date, customers are offered discounts even if the merchandise is shipped months later. This is a tool designed to lock in sales that would help to facilitate scheduling production.

2244.05 Collection procedures

Collection procedures are steps that a firm takes to collect past‐due accounts. These steps might include a series of increasingly severe letters or telephone calls with the account ultimately turned over to a collection agency. Collection procedures are expensive and can often be reduced by screening customers more carefully or by tightening credit standards. These choices generally involve a cost/benefit issue.



2244.06 Alternative credit

The acceptance of bank credit cards and debit cards is an alternative to providing in‐house credit to customers and can often be less expensive. Retail organizations are often forced into accepting this form of payment due to widespread consumer use and the acceptance by competitors.

a. Charge tickets can be deposited daily, much like a check.

b. Funds are available immediately for debit card transactions and almost immediately for credit card transactions.

c. Banks charge fees in the range of 3% to 10% of the dollar sales volume based upon average transaction amount and total dollar volume. The higher the volumes and the larger the average per transaction, the lower the fee would be.

2245 Inventory Management

2245.01 The importance of inventory

Inventories can take many forms—raw materials, work‐in‐process, finished goods, supplies—and inventories are extremely important to many organizations. Without the appropriate inventories, there will possibly not be an adequate level of goods available to meet demand. Thus, it is important that management prepare adequate sales forecasts in order to assure that enough inventory will be available to meet the forecasted demand. Without the necessary inventory, sales are lost. On the other hand, excessive inventories lead to high carrying costs.

There are two major issues involved in inventory management—having the right inventory at the right place at the right time, and not having too much inventory, which would result in excessive carrying costs.

2245.02 Just‐in‐time

a. A just‐in‐time (JIT) production system purchases raw materials and component parts just as they are needed in the production process, thus reducing raw material inventory close to zero. It is part of a manufacturing philosophy that promotes the simplest, least costly means of production. Under ideal conditions, the company would receive raw materials just in time to go into production, manufacture parts just in time to be assembled into products, and complete products just in time to be shipped to customers. JIT shifts the production philosophy from a push approach to a pull approach.



(1) The push approach begins with the acquisition of raw materials that are pushed into production through the various stages of production, and finally into finished goods inventory. The goal is to have finished goods ultimately sold to customers without deep discounting.

(2) The pull approach starts with the demand for finished goods from a customer. The customer’s order triggers the production of the goods. Inventories are acquired only to meet production needs.

b. Under ideal conditions, the company would attempt to create a situation where both raw material inventory as well as finished goods inventory would be eliminated and work‐in‐process inventory kept to a minimum.

c. Raw materials are delivered just in time to meet the production schedule, with a guaranteed high level of product quality so that they can bypass inspection and go directly to production. This requires long‐term purchase agreements with suppliers and coordination between purchasing and production. The result is a virtual elimination of raw material inventory. The cost of carrying inventory is shifted to the supplier.

d. The rate of production for individual departments is determined by the needs of each succeeding department. Inventory buffers with a predetermined size are used to signal when a department should be working. The department works as long as the buffer is less than the desired level. This eliminates most work‐in‐process inventory.

e. As soon as products are finished, they are immediately shipped to the customer, thus eliminating finished goods inventory and immediately converting the product into cash or accounts receivable. Close supplier/customer relations can allow both supplier and customer to use JIT systems.

f. Generally there are changes required in several areas of the manufacturing process to make JIT successful.

(1) Activities that do not add value need to be eliminated. Activities are identified as value‐adding activities and nonvalue‐adding activities. A nonvalue‐adding activity is any activity that could be eliminated without detracting in any way from customers’ satisfaction with the final product. Moving time, inspection time, and times in queues are all nonvalue‐adding activities and should be eliminated as much as possible. Machining, milling, and polishing of products are all value‐adding activities, as customer satisfaction would be reduced without them.



(2) Supplier relationships are of key importance. It is important to select a small number of suppliers who can guarantee both the quality and timely delivery of raw materials. Raw materials are usually delivered in small quantities as needed for production. Responsibility for raw material quality is also shifted to the supplier.

(3) Manufacturing cells are developed. Traditional departments and processes are replaced with manufacturing cells that contain families of machines typically spread through several departments. A component or a complete product can be produced within one cell rather than being transferred between several departments.

(4) The workforce is highly trained and flexible. The cellular manufacturing environment requires a labor force that is capable of operating several different machines. The workforce must be capable of servicing the machines and performing inspections on finished products.

(5) Total quality control is implemented at the inventory and production level. The streamlined flow of raw materials and components through the production process does not allow for product defects. No defects can be allowed in parts or raw materials received from suppliers, in work‐in‐process, or in finished goods. Emphasis is placed on doing things right the first time and avoiding rework or waste of any type. Products are inspected for quality at each stage of the process. When a defect is discovered, the production process is halted until the problem is corrected. Responsibility for inspecting products is shifted from inspectors to production workers. There is a commitment for continuous improvement in all aspects of the company.

(6) Set‐up time is reduced. Set‐up time is the time required to change equipment, move materials, and obtain forms needed to shift production from one product to another. Meeting customer demand on short notice without any finished goods inventory requires the ability to shift production from one product to another with a short set‐up time.

g. When using JIT methods, the differences between net operating income using the absorption method or variable costing method will be reduced since the differences relating to the costing of inventory are eliminated with the elimination of the finished goods inventory. If inventories are almost non‐existent, then differences in inventory valuations will be extremely small, bringing the results of net income using absorption or variable costing extremely close.



h. Advantages of JIT production systems:

(1) Funds are no longer tied up in inventories and can be more effectively used elsewhere.

(2) Warehouses formerly used to store inventory can be put to more productive use.

(3) As defects are reduced, less waste occurs, and customers’ satisfaction is increased.

(4) As production time is decreased, a greater output potential is created.

(5) Customers’ satisfaction is increased due to the shorter delivery time from the point the order is received (order lead time).

i. Disadvantage of JIT production systems: Increased possibility of stockouts if delivery of a critical part is delayed due to strikes, disasters, or other unexpected occurrences

2245.03 Economic order quantity

a. The economic order quantity is the least amount of inventory that should be ordered given the various costs involved. The economic order quantity model (EOQ) provides a formula for determining the quantity of a particular inventory item that should be ordered in order to minimize inventory costs.

Ci

DSEOQ

2

b. Relevant items in determining the economic order quantity:

D = The demand per year in units

S = Setup or ordering cost per order or batch

C = The cost per unit

i = The carrying costs expressed as a percentage of inventory cost

c. Inventory decision models contain costs that move in opposite directions. Carrying costs increase as the size of the order increases. Set‐up or ordering costs, however, decrease as the size of the production run or order increases. The EOQ model seeks to minimize the combined total of these two costs, as illustrated in the following graph.



d. Assuming that there is constant demand and no change in lead time, the reorder point is equal to the sum of expected units of demand during the lead time plus any required safety stock. This relationship can be illustrated as follows:

The formula for the reorder point (RP) is:

RP = DLT + SS

DLT is the average demand during the lead time period. This can be calculated by determining the demand per day and multiplying that result by the number of days in the lead time. SS is the safety stock required.



e. Illustration: Use the following data to compute the economic order quantity and reorder point assuming 300 business days per year.

Demand (D) 40,000 units per year Unit cost (C) $50 Carrying cost rate (i) 20% per year Order cost (S) $115 per order Lead time (LT) 3 days Safety stock (SS) 500 units

Solution:

units

Ci

DSEOQ

960%2050$

115$000,402

2

unitsdaysxdaysunitsSSDRP LT

9005003300/000,40

2245.04 Reasons for not minimizing inventory levels

a. Larger inventory levels can guarantee the availability of inventory as needed. When stockout costs are high, carrying a larger safety stock may be appropriate.

b. Through use of large discounts or more favorable credit terms, customers may be convinced to purchase larger quantities. Thus, inventory policy needs to be coordinated with other policies such as credit policies.

c. If competition is very high, suppliers may feel the need to increase inventory levels to ensure prompt deliveries to customers.

d. Inventories can be a good hedge against inflation if the cost of replacing inventory is increasing.

e. Safety stock is a level of inventory that is held in excess of the desired inventory level to cover unanticipated demand. This additional inventory provides security from stockouts and lost sales when the time to replace inventory exceeds the anticipated period. The level of safety stock is determined by a balancing of the cost of holding additional inventory items and the cost, or lost revenue, associated with not having goods available for the customer when they wish to purchase them.



2246 Types of Short‐Term Credit

2246.01 Trade credit

a. Most companies purchase on credit, making trade credit a significant part of current liabilities. Trade credit is a spontaneous source of financing created when goods and services are purchased on account in the normal course of business. If a firm purchases $10,000 of goods per day on average, at the end of 30 days, $300,000 ($10,000 × 30) of financing has been created. If suppliers’ credit terms increase to 45 days, an additional $150,000 [$10,000 × (45 days – 30 days)] of credit can be generated.

b. As a general rule, firms will hold cash payments until the last minute that an obligation is due in order to increase their average cash balance. This is the case unless the cost of making an early payment is less than the firm’s cost of capital.

2246.02 Free trade credit

a. Firms frequently have credit terms that include offering a discount on invoices if paid within the discount period. “2/10, net 30” provides a discount of 2% if the invoice is paid within 10 days and full payment is expected within 30 days if the discount is not taken.

b. Free trade credit is credit received during the discount period. In the example mentioned above, the discount period would be the first 10 days of the net purchase period.

c. Illustration: A firm purchases $50,000 of merchandise on credit with the terms 2/10, net 30. What amount is paid to satisfy the obligation if the payment is made by the 10th day of the net 30 period?

Solution: $50,000 – ($50,000 × 2%) = $49,000 with the firm gaining a $1,000 discount

2246.03 Cost of trade credit

a. If payment is not made on trade credit within the discount period, the discount is lost, and the full amount of the credit is paid within 30 days. The results of this lost discount are:

(1) the savings of the discount are lost.

(2) the size of trade credit increases, thus increasing the debt load.



b. Illustration: A firm purchases $2 million of merchandise throughout the year (assuming a 360‐day year) and is offered a 2% discount on all invoices paid within 10 days. If all invoices are paid within the discount period, the full amount paid will be $1,960,000 ($2 million × 98%). This results in a savings of $40,000 per year.

If all discounts are taken, payables at any given time will average $54,444 [($1,960,000 ÷ 360 days) × 10 days]. If the discounts are not taken and payment is made within the 30‐day period, then average accounts payable will increase to $163,333 [($1,960,000 ÷ 360 days) × 30 days]. That is an additional $108,889 of trade credit that is being used.

There is a cost to this additional credit—the lost $40,000 in discounts. The lost discounts represent increased cost for the merchandise; therefore, the price of the additional $108,889 of trade credit is $40,000. The cost of this credit is computed as follows:

Lost discount Additional credit supplied

= $40,000 $108,889

= 36.7%

c. If a firm can borrow funds at an interest rate lower than the cost of the foregone discount, then the funds should be borrowed and the discounts taken. If the firm above can borrow $108,889 at 10% for an annual interest cost of $10,889, then $29,111 would be saved on an annual basis ($40,000 – $10,889).

d. The return on taking discount can also be calculated using the following formula:

360 Total credit period – Discount period

× Percentage of discount 100% - Percentage of discount

Using the above illustration, the return can be calculated:

360 30 days – 10 days

× 2% 100% – 2%

= 36.7%

e. Payment of trade credit beyond the normal credit terms will likely result in interest charges, thus increasing the cost of credit as well as hurting relations with the supplier. Firms that do not take advantage of discounts are generally in a weaker financial position with poor cash flow and/or limited access to other sources of funds.



2246.04 Trade credit and financial statements

a. Not taking discounts can have a dramatic effect on the financial statements—affecting profitability as well as liquidity.

b. The effect on profitability can be shown in the following tables comparing the results on income of a firm taking versus not taking trade discounts. In this example, it is assumed that a company will have to borrow at 10% ($10,889 annual interest) in order to take advantage of the available discounts (see above information).

Do Not Take

Discounts Take

Discounts

Sales $4,000,000 $4,000,000 Purchases 1,960,000 1,960,000 Other costs 1,500,000 1,500,000 Interest 0 10,889 Discounts lost 40,000 0 Total costs 3,500,000 3,470,889 Income before tax 500,000 529,111 Tax (40%) 200,000 211,644 Net income after tax $ 300,000 $ 317,467

Since the discounts exceed the cost of the interest expense, net income is increased by taking the discounts. In this case, income is increased by $17,467 or approximately 6%.

c. Assuming that the firm goes to the bank to finance a note payable so that funds are available to take advantage of the discounts, the liability/equity sections of the balance sheet will have the following comparison when taking versus not taking trade discounts:

Do Not Take

Discounts Take Discounts

Accounts payable $163,333 $54,444 Note payable 108,889 Accruals 50,000 50,000 Long‐term debt 75,000 75,000 Equity 250,000 250,000 Total liabilities and equity $538,333 $538,333

Thus, the total liabilities and equity will be the same. The only difference is that the firm will be able to choose how to finance the amount needed to take advantage of the discount for early payment and reduce the cost of financing—short‐term loan, long‐term loan, or equity. This example was presented using a short‐term note. The nature of the spontaneity of the trade credit financing often causes these cost‐saving options to be missed.



2247 Short‐Term Credit Management

2247.01 Types of short‐term debt:

a. Spontaneous financing created through the use of accounts payable and accruals generated in the course of doing business

b. Unsecured bank loans

c. Commercial paper

d. Secured loans

2247.02 Spontaneous financing

a. Accounts payable and accruals provide instant financing at no cost for a firm. For example, employees provide continual services and are paid only at set intervals. In a sense, employees provide the equivalent of small loans to the company.

b. Trade credit is an appealing source of financing since it is free; however, the length of this credit is only for a very limited time.

c. On occasion, vendors will offer discounts for prompt (early) payment of obligations. Not taking advantage of these offers is a particularly expensive form of short‐term financing. For example, if a vendor offers 1/10, net 30, this means that a 1% discount can be taken if the invoice is paid within 10 days as opposed to 30 days, but this is 1% discount for only paying 20 days earlier than required. This rate can be converted to an effective annual rate by using the following formula:

Days in year Lost trade credit days by taking discount

=365 20

× 1% = 18.25%

Thus, if a company can borrow funds for less than 18.25% in order to take advantage of a prompt payment discount, it is in the firm’s best interest to do so.

2247.03 Unsecured bank loans

a. Unsecured loans are not backed by any collateral and come in a variety of forms.

b. A line of credit is an agreement with a bank to have up to a specific amount of funds available as a short‐term loan during a particular period. If the line of credit is for $100,000, a firm can borrow $20,000 in January, borrow an additional $35,000 in May, repay $40,000 in July, and borrow $50,000 in September, etc. As long as the total amount borrowed at a given point in time remains under $100,000 during the period of the agreement, the firm will continue to have access to additional funds. Interest is usually paid monthly and calculated on the average



outstanding balance during the period. This method of financing allows a firm to smooth out its cash flow cycle as well as to have funds available for possibly both precautionary and speculative needs.

The use of the line of credit affects both current assets and current liabilities equally. They increase and decrease in a parallel fashion. However, as long as the current ratio is greater than one, an increase in a line of credit (increase to cash and an increase to current liabilities) will decrease the current ratio.

Illustration: A firm has $100,000 of current assets, $50,000 of current liabilities, and a current ratio of 2 to 1 ($100,000 ÷ $50,000). If $25,000 is borrowed on the line of credit, current assets will increase to $125,000, current liabilities to $75,000, and the current ratio will become 1.7 to 1 ($125,000 ÷ $75,000).

c. A variation on the line of credit is the revolving credit agreement that is generally used by large corporations. This is an agreement by a bank to extend credit to a company over a specified period of time; however, if the firm does not make use of the revolving credit, there still is an annual commitment fee. For example, the approved revolving credit could be for three years to allow a corporation to borrow up to $50 million. Even if the company does not use any of the credit during the year, it will still have to pay a significant commitment fee expressed in terms of a percent (for example, a quarter of 1% or $125,000 annually in the above illustration). If the corporation borrows $25 million on the revolving credit agreement, the commitment fee would drop to a percent of the unused portion of the agreement ($62,500 in this illustration), and the corporation would pay interest on the outstanding borrowed balance as well. The biggest difference between a line of credit and a revolving credit agreement is that there is a legal obligation with a revolving credit agreement that does not exist with a simple line of credit. This legal obligation guarantees the company access to the funds over the life of the agreement.

d. A letter of credit is an international financing tool that guarantees payment to an international supplier upon the safe arrival of the goods by issuing a loan to the purchaser. A letter of credit can be irrevocable (not subject to cancellation if the specific conditions are met) or revocable.



e. Commercial paper is an unsecured promissory note that is issued by large banks and big corporations to meet short‐term cash needs. It is a promise to repay the borrowed funds at a future given date with a maturity of no more than 270 days. Rates for these loans are normally lower than for bank loans. This financing option is considered to be quite safe due to the short time frame and the strength of the borrowing companies; however, there is no flexibility in the repayment date as might be received with a bank loan.

2247.04 Secured loans

a. Short‐term credit is often secured by current assets such as receivables and inventory, and is often used by seasonal businesses where cash flow and working capital needs are not synchronized.

b. Pledging of receivables entails using the cash value of the receivable as collateral for a loan. In this case, the borrowing company agrees to remit the cash received from the collection of particular receivables as repayment of the loan; however, the receivables continue to be owned by the borrowing company, and if a particular receivable proves to be uncollectible, the borrowing company is still liable for the repayment of the loan. Interest rates for these loans can range from 2% to 5% over prime, often with a fee equal to 1% to 2% of the receivable pledged.

c. Factoring involves selling accounts receivable to a factor as a form of short‐term financing. The factor assumes the risk of collection, and the purchaser is notified of the factoring arrangement and usually remits payments directly to the factor. (In some instances, factoring can be done with recourse.) Since the risk is shifted to the factor, the factor will take over the responsibility of doing the credit check on a potential customer. Therefore, functions performed by the factor include credit checks, lending, and bearing of default risk. Generally, the selling firm receives funds from the sale immediately upon shipment of goods to the purchaser. The amount received is the full amount of the sale less a factor fee (usually some percentage of the total sale). The fee incorporates a reserve for sales returns and allowances, interest costs, and profit for the factor. At the end of a specified period, the reserve amount is paid to the seller, providing there have not been sales returns and allowances in excess of the reserve assumed in the factoring agreement. It is not uncommon for factoring arrangements to be ongoing.



Illustration: A company sells $50,000 of goods with the terms net/30. The receivable is immediately factored with a 3% factor fee, 10% interest, and a reserve of 8%. How much does the selling firm immediately receive from the factor?

Solution: The factor fee will be $1,500 (3% of $50,000). The reserve will be $4,000 (8% of $50,000). The interest will be calculated on 10% of the balance available to the seller and adjusted for a monthly period length.

This can be summarized as follows:

Sales: $50,000 Less: Factor fee (3% × $50,000) $1,500 Reserve (8% × $50,000) 4,000 5,500 Amount due firm 44,500 Less interest on amount for 30 days (10% × $44,500 × 30/360) 371 Amount paid to seller $44,129

After 30 days, any remaining part of the reserve (maximum of $4,000 in this case) that was not absorbed by returns and allowances will be remitted to the seller.

The cost of factoring needs to be compared to the costs of running a credit department when making a decision as to which alternative to pursue.

d. Inventory financing entails the use of inventory as security for a short‐term loan. Such a loan can attach to all inventory held or a particular portion of inventory identified by serial numbers or placed in a particular location.

2247.05 Advantages of short‐term debt financing

a. A short‐term loan can generally be obtained quickly.

b. The cost of obtaining short‐term debt is generally low since the lender tends to only do a minimal financial examination of the firm applying for funds. Spontaneous credit has no cost.

c. There are generally no prepayment penalties.

d. Short‐term debt often provides flexibility for management as it generally has few restrictions.

e. Since the yield curve is typically upward sloping, short‐term interest rates are generally lower than long‐term interest rates.

f. Interest expense is tax deductible and, therefore, provides financial leverage.

g. Accounts payable is a primary source of short‐term debt and it is spontaneously created when inventory is purchased.



2247.06 Disadvantages of short‐term debt financing

a. Short‐term interest rates can vary widely over time, subjecting the firm to refinancing risk.

b. An unexpected need for cash during a recession could cause cash flows to be insufficient to meet the short‐term obligations.

c. Due to changing financial conditions, short‐term debt may not be renewable and thus, depending upon the level of short‐term debt, may put a firm in an illiquid position that could lead to bankruptcy.

d. On occasion, compensating balances are required when unsecured debt is received. This increases the effective cost of that debt.

2250 Corporate Restructuring

2250.01 Qualified Reorganizations / Divisions: IRC 354 specifies that qualified corporate restructuring including spin‐offs, split‐offs and split‐ups are non‐taxable. In all three of these restructuring methods there is no change in shareholders.

a. Spin‐off: A “spin‐off” occurs when Old corporation forms New Subsidiary corporation and transfers to it some assets in return for shares. Subsequently, Old distributes New stock to its shareholders; this is a dividend distribution.

b. Split‐off: A “split‐off” involves the same steps as a spin‐off except that the shareholders would surrender a portion of Old’s stock in exchange for New’s stock; this is a stock redemption.

c. Split‐up: In a “split‐up”, Old forms New Subsidiary, transfers to it all its assets in return for shares which are then totally distributed to its shareholders; this is a complete liquidation of Old corporation.

d. Tax‐Free Requirements: To avoid tax on the restructuring, there must be a valid business purpose for the division. In addition, a 5‐year continuity of interest requirement ensures that the division is not a disguised sell‐out.

2250.02 Divestiture: This is the sale of a division of a company by offering shares to the public. The corporation may treat the gain as capital, but it increases earnings and profits. The exam has called this procedure an “equity carve‐out.”



2250.03 Bankruptcy

a. Introduction: The 1978 Federal Bankruptcy Code was amended by the 1994 Bankruptcy Reform Act. The objective of the original Code and amending Act is to modernize our bankruptcy courts and procedures. This is accomplished by adding provisions aimed at curtailing abuses and requiring an equitable sharing of the debtor’s assets among the legitimate creditors.

b. Bankruptcy − The Process:

(1) Various Chapters: There are two relevant chapters under the new Act.

(a) Chapter 7: The liquidation section of the Act is discussed in detail below. All the corporation’s assets are to be liquidated and the proceeds distributed by the trustee to the creditors. This normally terminates the corporate existence.

(b) Chapter 11: This permits business reorganization by restructuring the debtor’s financing. If the financial crisis is only temporary, Chapter 11 is designed to avoid liquidation by providing court protection while the business continues to operate. A business in distress usually begins by petitioning the bankruptcy court for relief from the creditors’ foreclosure actions.

(i) Debtor in Possession: A debtor is usually allowed to keep possession of a business.

(ii) Creditors’ Committee: The Court is required to appoint a committee of unsecured creditors. The Committee investigates the business’ financial position and may make suggestions concerning the plan of reorganization. The Creditors’ Committee may also request a trustee be appointed to run the business. The trustee must submit financial statements to the court.

(iii) Trustee Appointment: The Court on motion or its own initiative may also appoint a trustee and/or examiner in cases such as management fraud or gross mismanagement.

(iv) Plan of Reorganization: Central to the Chapter 11 proceeding is the plan of reorganization; the debtor has an exclusive right for 120 days to submit a plan. If the debtor does not submit a plan during this period, any other party in interest may. Uncontested plans are usually approved (confirmed) if they are reasonably fair and equitable.



Secured Creditors: Secured creditors cannot lose their

senior position, but may not usually repossess or

otherwise execute on their collateral during the

bankruptcy period.

Unsecured Creditors: Unsecured general creditors are

forced to accept the “Cram Down” plan as long as they will

eventually receive as much as they would had the business

been liquidated. This is usually a percentage of their

claims.

Discharge: After all parties have input, the Judge approves

(confirms) the Chapter 11 reorganization plan. A

reorganized debtor will be discharged from all debts

except as otherwise provided in the plan and applicable

law.

Fast Track: The 1994 Act initiated a “fast track” procedure

for small business bankruptcy under Chapter 11. The judge

may order that a creditor’s committee not be appointed.

The debtor must have less than $2 million of liabilities.

This is raised to $4 million for secured debt on real

property.

(2) Legal Procedure: Chapter 7 bankruptcy begins when a petition is filed in federal bankruptcy court detailing the creditors and amounts owed.

(a) Initiation: The filing of the bankruptcy petition may be initiated either voluntarily by the debtor or involuntarily by a creditor or group of creditors.

(i) Voluntary: There are no restrictions on a debtor filing a voluntary petition; there is not even a requirement that the business be insolvent.

(ii) Involuntary: If the debtor has 12 or more creditors, at least 3 must sign the involuntary petition. The provable claims must aggregate $10,000 after deducting lien and collateral value. The debtor has the right to controvert the validity of the petition.

(iii) Current Debts Unpaid Requirement: The 1984 Law eliminates the necessity of proving an act of bankruptcy. The petition must now only allege the debtor cannot meet his debts as they mature.



(b) Order of Relief and “Stay”: Upon filing, the court issues an “order of relief” which automatically “stays” all legal actions and collection efforts by creditors on account of pre‐petition debts. IRS collections are included. The automatic stay even delays the execution of judgment liens. Secured creditors may not repossess their collateral or hold foreclosure sales.

(c) Relief from the Stay: A secured creditor may bring a motion for relief from the automatic stay for good cause. This may be granted if the creditor can show that without relief they lack adequate protection for their collateral, the debtor has no equity in the property (debt exceeds fair market value), and the property is unnecessary for effective reorganization.

(d) Debtor’s Responsibilities: If filed by the debtor, the debtor must prepare a Statement of Affairs listing assets and liabilities and individual creditors and amounts owed. The Court then gives creditors notice so they may file a proof of claim. The first meeting of creditors must be called within a reasonable time.

c. Trustee Duties and Powers: A trustee is always appointed by the court in Chapter 7 proceedings. In a Chapter 11 liquidation proceeding the court is required to appoint a committee of unsecured creditors. The committee may request a trustee be appointed. The trustee represents the interests of the unsecured creditors; the secured creditors can take care of their own interest.

(1) Duties: The trustee is charged with conducting the administration of the estate. This includes engaging professionals, and investigating the debtor’s financial affairs. The trustee may operate the debtor’s business. The trustee is charged with the duty of collecting the bankrupt’s assets which may involve liquidating the bankrupt estate’s assets into cash and make cash distributions to creditors.

(2) Preferential Transfers and Fraudulent Conveyances: In the liquidation process the trustee’s primary duty is to the unsecured creditors. Any creditor receiving a preference does so at the expense of the unsecured creditors. The bankrupt estate may be increased if the trustee can set aside transfers and conveyances made on the eve of bankruptcy.

(a) Property Transfers: The trustee may reclaim assets or cash given to third parties if such transfer was preferential. This includes payment for less than full consideration, payment of a debt within 90 days prior to the petition or pre‐payment of an obligation due in the future. The debt the payment reduced must be antecedent (pre‐existing) and not a contemporaneous exchange for new



value. Payment within the ordinary industry term (usually 45 days) of incurring a normal business debt is the safe harbor and not subject to attack. If the challenge is successful, the asset must be returned to the estate and the transferee becomes a mere unsecured creditor.

(b) Security Interests: The trustee may also attempt to void a collateral financing statement (UCC 1) given within 90 days of the petition to a third party on account of an antecedent debt. This applies if the creditor would receive more than he would otherwise receive as an unsecured creditor. Financing statements exchanged for new collateral are not voidable. If successful, the security interest is voided and the collateral becomes available for liquidation to the general creditors. An example would be a debtor on the eve of bankruptcy giving a financing statement (UCC 1) for a machine to a creditor who did not sell or finance that particular collateral.

(c) Time Period: The general time period of attack is 90 days from the petition date. This is extended to one year if the transferee was an “insider”, a related party or the transfer was a “fraudulent transfer”. This is an asset transfer which was made for less than the reasonable equivalent value or was made with the intent to hinder, delay or defraud any creditor. A fraudulent transfer would include the sale for $500 of a machine that is worth $2,000.

d. Claim Administration

(1) Creditor’s Claims: A creditor must file a formal claim against the bankrupt estate within 90 days of the first meeting of creditors. Because only authorized claims share in the asset distribution, the trustee examines all proof of claims. All contingent or unliquidated claims must be reduced to a dollar figure. Unless a party in interest objects, claims are generally allowed by the court.

(2) Set‐off Rights: The new Act restricts the right of creditors to improve their position in the estate by “setting‐off” against amounts they are owed by the bankrupt claim due to him.

(a) Time Period: A “set‐off” right is not allowed if the amount the creditor owed the bankrupt was incurred within 90 days of the petition date.

(b) Example: An example would be a debtor who owed a consultant $300 for services provided in January. If in March the consultant purchased a $300 computer from the debtor and in April the debtor corporation took bankruptcy, the consultant would have to pay the full $300 to the bankruptcy trustee. Because the



computer purchase was incurred within 90 days of the petition date, it may not be “set‐off” against the earlier receivable due for the consulting.

(3) Shareholder Personal Liability: Corporate law specifies that a shareholder is not liable for the acts or debts of a corporation. A shareholder’s liability is limited to the original investment in the shares. The general rule is therefore that a corporate bankruptcy does not affect a shareholder. Because of abuses, there have gradually developed exceptions where liability for corporate debts may become the personal liability of the stockholders.

(a) Subscription Agreement: Corporate law states that a shareholder is liable to pay the consideration specified in the subscription agreement. A corporate bankruptcy trustee could enforce this right.

(b) Watered Stock: Undercapitalizing the corporation at formation may lead to stockholder liability. Under the old model Act, the original purchaser of “watered stock” was liable for a deficiency. The liability amount was the difference between the fair market value of the consideration given and the shares’ par or stated value. This restriction did not apply to treasury shares. This liability was eliminated under the Revised Act, but the majority of states still retain this provision to protect other shareholders and creditors from a bargain sale of shares to an insider or related party.

(c) Capital Impairment: Dividends which “impair capital” by leaving creditors unpaid may expose shareholders receiving the dividends (and the directors who authorized the distribution) to deficiency liability. Corporate law applies an “insolvency in the equity sense” test (liabilities exceed assets) and allows unrealized appreciation to be included in the determination of whether capital is impaired because of the distribution. Original undercapitalization is not usually in and of itself grounds for shareholder liability.

(d) Equitable Liability: The corporate veil can also be pierced through an equity action to avoid unjust enrichment. If successful, the shareholder may be treated as a general partner for liability purposes. This may apply in the following situations:



(i) Concurrent Affiliates: Concurrent corporate affiliates may be liable, such as a parent‐subsidiary or brother‐sister where there is a high degree of integration and deceptive cross‐financing. This may apply if the entities were intended to operate as one or there was a commingling and confusion of records, assets, and personnel.

(ii) Subsequent Affiliates: Subsequent affiliate liability may apply if the new entity was a result of a de facto merger or consolidation, or is virtually the same as, and a mere continuation of, the bankrupt corporation. If the new entity takes benefits derived from the old corporation, it should also take the responsibility for its liabilities.

(iii) “Mere Sham”: “Mere sham” is where the shareholder treats the corporate shell as his or her “alter ego” or uses it to perpetuate a fraud. Failure to treat the corporation as a separate business entity and/or a total disregard for corporate formalities are the usual facts and circumstances that exist when a court invokes this form of equitable relief. Often this includes commingling personal and corporate funds and bank accounts and failing to keep books and records. Material advances and loans to shareholders without proper documentation and authorization by the board may also support the conclusion that the corporation is a “mere sham”.

e. Dischargeability and Surviving Claims: Certain debts survive bankruptcy against the directors, officers, and/or stockholders. Occasionally, the involved staff may also be liable.

(1) Fraud: Debts procured from a creditor where funds were extended in reliance on materially false financial statements may be personally assessed against the involved shareholders, directors, and statement preparers. This may include management accountants and financial managers.

(2) Taxes: Employment trust fund taxes withheld from employees but not paid over to the government may be personally assessed. Persons liable include any responsible party who had the discretion to allocate the funds of the business.

(3) Lack of Records: The petition may be rejected if the directors or management fail to keep or preserve financial records. Personal liability for involved staff usually follows.

(4) Asset Irregularities: An unexplained loss of assets or a transfer of assets within one year with the intention to defraud or hinder a creditor may expose the involved staff.



f. Order of Distribution: As of the date of the petition filing, the trustee acquires the status of a perfected lien creditor. All of the bankrupt’s assets are to be applied for the benefit of the unsecured creditors. Class members share pro rata in an amount that their claim bears to the total class claims.

(1) 10 Day Reclamation Rights: Aggrieved sellers or buyers are authorized by UCC 2.502 to reclaim goods sold to or purchased from the insolvent entity within ten days of the bankruptcy petition. The aggrieved party must tender any remaining payment due to the trustee with a written demand for reclamation. The 1994 Bankruptcy Act allows the seller ten additional days to request a reconveyance to the goods if the original deadline occurs after the bankruptcy petition was filed.

(2) Materialman or Workman Liens: A priority is given to liens which add value to collateral, if they comply with certain filing and notice requirements.

(3) Perfected Secured Creditors: Perfection of a security interest in collateral can be by filing, possession, or mere attachment. If the value of the collateral is less than the debt, the creditor is treated as unsecured (or general) for the deficiency. Remember the trustee’s voiding power may convert a perfected creditor to an unsecured status.

(4) Administrative Expenses: Compensation and reimbursements including the costs to operate the estate. This would include post‐petition costs of managing a business. The Bankruptcy Judge must approve the amounts of all compensation paid to professionals such as trustee fees, accountants, and attorneys. Any related costs are also to be paid in this category.

(5) Wages to $4,000: Wages, salaries, vacation and sick pay of up to $4,000 per employee if earned within 90 days of the petition date.

(6) Employee Benefit Plans: Claims of employee benefit plans for contributions accruing within 180 days of the petition date.

(7) Certain Deposits: Lease deposits of up to $1,800 or deposits made with the debtor for consumer goods purchases which were not provided. Examples include layaway plans, refunds of security deposits, etc.

(8) Taxes: This category includes the employment trust fund taxes.

(9) Unsecured Creditors: Allowed unsecured or general claims. This usually includes all creditors without the foresight to perfect their security interest.



(10) Fines, Penalties, and Punitive Damages: Allowed fines, penalties, and punitive damages.

(11) Shareholders: The distribution to shareholders is given the lowest priority. Such would only occur if all the above categories receive 100% of their claims.

(a) Preferred: The claims of the preferred shareholders must usually be satisfied in full before the common shareholders receive anything. This may include accumulated, but unpaid preferred dividends.

(b) Common: Common shareholders have the lowest priority.

2250.04 Dissolution: Dissolution is the legal termination of the corporate entity under state law.

a. Voluntary: Corporate law allows voluntary dissolutions when the corporate charter is surrendered.

(1) Resolution and Shareholder Approval: The Board of Directors must pass a resolution recommending dissolution and notify each shareholder. This requires a shareholder meeting and an affirmative majority shareholders’ vote.

(2) Articles of Dissolution: Articles of dissolution are then submitted to the secretary of state’s office. A dissolved corporation continues in existence but may not carry on any business except for winding up and liquidating its business and affairs.

(3) Creditors’ Claims: The dissolved corporation may dispose of any claims against it by actually notifying its known creditors that they have 120 days to put in a claim. For unknown claims, the notice must be published in a newspaper of general circulation in the county where the corporation’s principal office is or was last located. Claims tendered within the time period may be enforced against the shareholders to the extent they have received corporate assets.

b. Involuntary: Corporate law provides for involuntary dissolution.

(1) Non‐Compliance: The state attorney general may move to dissolve the corporation because of non‐filing of the annual report or nonpayment of the corporate license fees.

(2) Shareholder Suit: A shareholder may file a court petition to dissolve the corporation if the board is deadlocked and irreparable injury is threatened.



(3) Shareholder Suit: Other Grounds: Other grounds for dissolution are that the directors are involved in illegal or fraudulent activities or that there is a clear waste of assets occurring. A creditor who has reduced a claim to judgment which has been returned unsatisfied may also move to dissolve the corporation.

2251 Mergers and Acquisitions

2251.01 A statutory merger is of the form “A + B = A” in which one enterprise (A) acquires another enterprise (B) with the latter (B) ceasing to exist after the combination.

2251.02 A statutory consolidation is of the form “A + B = C” in which a new enterprise (C) is created to acquire the net assets of other enterprises (A and B). Enterprises A and B cease to exist after the combination.

2251.03 An acquisition is of the form “A + B = A + B” in which one enterprise (A) acquires a majority share of the stock of another enterprise (B), but both entities continue their legal existence after the combination in a parent‐subsidiary relationship.

2251.04 The statutory merger and statutory consolidation forms of business combinations may be categorized as fusions. In both forms, the acquired enterprise ceases to exist as a legal entity; thus, it is fused into the surviving enterprise.

2251.05 The acquisition form of business combination may be described as an affiliation, since the combining enterprises continue to exist as affiliated entities.

2251.06 In the remaining discussion, business combinations are identified as being either a fusion or an affiliation.

Methods of Accounting

2251.07 Combinations after December 2010 (i.e., the effective date for FASB ASC 805‐10‐05) must be accounted for under the acquisition method.

2251.08 The acquisition of all or part of a financial institution that meets the definition of a business combination also should be accounted for by the acquisition method.



Acquisition Method

2251.09 Under the acquisition method, a business combination is deemed to be the acquisition of one entity by another. Accordingly, the accounting for the combination follows the historical cost principle related to acquisitions. The accounting basis is the fair value of the consideration given or the fair value of the consideration (net assets) received, whichever is more clearly determinable. The acquirer is the entity that obtains control of one or more businesses in the business combination. The acquisition date is the date that the acquirer achieves control.

If the acquiring corporation gains control with smaller noncontrolling purchases eventually culminating in a purchase that achieves control, the assets and liabilities acquired in the series of purchases must all be marked to fair value as of the date control is achieved. Gains and losses from revaluing these former purchases must be included in current financial statements.

2251.10 The acquiring corporation must recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date. The acquirer must then recognize goodwill as of the acquisition date equal to the excess of the consideration transferred plus the fair value of any noncontrolling interest in the acquiree over the fair values of all identifiable net assets acquired (all assets other than goodwill). The tax basis of an asset or liability should not be a factor in determining its fair value. However, a deferred tax asset or liability should be recognized for any difference between the fair value and the tax basis of an asset or liability if the difference represents a temporary difference.

a. Contingent assets and liabilities should be included when a contractual contingency exists or a noncontractual contingency is more likely than not to give rise to an asset or a liability.

b. In‐process research and development results are classified as intangible assets with indefinite lives until the research and development phase is complete or the project is abandoned. These assets are originally recorded at fair value and will be subject to impairment tests.

c. Acquisition costs must be recognized separately from the acquisition. Restructuring costs are also recognized separately from the business combination. These costs must be recognized in the acquirer’s postcombination financial statements in accordance with generally accepted accounting principles—usually expensed.

d. For provisional amounts, an acquirer must:



(1) recognize adjustments to those provisional amounts identified during the measurement period in the reporting period in which the adjustment amounts are determined.

(2) record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects resulting from the change to the provisional amounts. This effect is required to be calculated as if the accounting had been completed at the acquisition date.

(3) present separately on the face of the income statement, or disclose in the notes, the portion of the amount recorded in current‐period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date.

2251.11 In an acquisition‐method business combination, the consideration given (paid) by the acquiring corporation may be assets, debt (payable by acquirer to acquired), stock, or combinations thereof. Any stock issued is recorded at fair value. Any difference between par (stated) value and fair value (FV) is recognized as additional paid‐in capital.

2251.12 When a private company is required to recognize or otherwise consider the fair value of intangible assets, the private company may make an accounting policy to apply the accounting alternative. This election may be applied for any one of the following transactions:

a. Applying the acquisition method

b. Assessing the nature of the difference between the carrying amount of an investment and the amount of underlying equity in net assets of an investee when applying the equity method

c. Adopting fresh‐start reporting

2251.13 Upon election of the accounting alternative, the private company shall apply all of the related recognition requirements and shall be applied to all future transactions.

2251.14 A private company that elects the accounting alternative must adopt the alternative for amortizing amortization. If the alternative was not adopted previously, it should be adopted on a prospective basis as of the adoption of the accounting alternative.



2251.15 An acquirer shall not recognize separately from goodwill the following intangible assets:

a. Customer‐related intangible assets unless they are capable of being sold or licensed independently

b. Noncompetition agreements

2251.16 Customer‐related intangible assets that meet the criterion for recognition include but are not limited to the following:

a. Mortgage servicing rights

b. Commodity supply contracts

c. Customer information

Recognition of Goodwill

2251.17 If the fair value of the consideration plus the fair value of a noncontrolling interest in the acquiree exceeds the fair value of the identifiable net assets acquired, this “excess” should be recognized as goodwill. The acquisition entry in that situation may be summarized as follows:

Fusion: Individual Identifiable Assets Acquired (at FV) XXX Goodwill (excess of cost over FV of identifiable net assets acquired)

XXX

Individual Liabilities Assumed (at FV) XXX Common Stock (par value of stock issued) XXX Additional Paid‐in Capital XXX Noncontrolling Interest in Acquiree XXX Affiliation: Investment in Subsidiary (cost of acquired enterprise)

XXX

Common Stock (par value of stock issued) XXX Additional Paid‐in Capital XXX

In the case of an affiliation, goodwill and the fair value of the individual identifiable net assets acquired would surface on the consolidated worksheet.

2251.18 Two examples of the acquisition entries to be recorded when the cost of the acquired enterprise exceeds the fair value of the identifiable net assets acquired are presented immediately following. Example 1 represents a situation in which the acquiring enterprise acquires 100% of the stock of the acquired enterprise. Example 2 relates to the acquiring enterprise’s acquisition of less than 100% of the acquired enterprise’s stock.



Example #1

2251.19 Acquisition of 100% of acquired company’s stock. The balance sheet of S Company (the acquired company) immediately before the combination appears as follows:

S Company

Balance Sheet ‐ Prior to Combination

Current assets $ 15 Liabilities $ 10 Plant assets 95 Common stock, par $1 20 Retained earnings 80 $110 $110

2251.20 P Company issues 10 shares of $1 par stock for 100% of the common stock of S Company. The fair value of the P Company stock issued is $200. Fair values of S Company’s net identifiable assets are the same as their book values, except for plant assets, which have a fair value of $100. The $200 fair value of P Company’s stock issued exceeds P’s equity (100%) in the book value (BV) of the net assets of S, allocated as follows:

Cost of investment (FV of P stock issued) $200 Less 100% of BV of identifiable net assets of S 100 Differential (excess of cost over book value of identifiable net assets) 100 Adjustments for P’s share of differences between FV and BV of identifiable assets and liabilities of S: Plant assets ($100 – $95) (5) Adjusted differential (excess of cost over FV of identifiable net assets)—goodwill

$ 95

2251.21 The entries to record the acquisition are presented for both a fusion and an affiliation:

Fusion: Current Assets 15 Plant Assets 100 Goodwill 95 Liabilities 10 Common Stock 10 Capital in Excess of Par 190 Affiliation: Investment in Subsidiary 200 Common Stock 10 Capital in Excess of Par 190



Example #2

2251.22 Acquisition of less than 100% of stock. Assume the same facts as presented in Example 1, except that P acquires only 80% of the stock of S for 8 shares of P. Thus, the $160 fair value of P Company’s stock issued exceeds P’s equity (80%) in the net assets of S. This excess of cost over book value (goodwill) is computed as follows:

Value of controlling interest (FV of P stock issued) $160 Value of noncontrolling interest 40 Total acquisition‐date fair value of S Company 200 Identifiable net assets 105 Goodwill $ 95

2251.23 The acquisition entry is:

Fusion: No fusion since less than 100% of S stock acquired. Affiliation: Investment in Subsidiary 160 Common Stock 8 Capital in Excess of Par 152

The $5 increment in plant assets and the $95 of goodwill would surface on the consolidated worksheet and would be included in the consolidated financial statements.

Bargain Purchase Gain

2251.24 If the values assigned to the identifiable net assets exceed the cost of the acquired company, such “excess” must be recognized as a gain in earnings of the acquisition date. Thus, the fair values of the “eligible” assets would be recognized on the acquisition date.

2251.25 The following example (Example 3) demonstrates the entries involved if the values assigned to the identifiable net assets exceed the cost of the acquired company. In Example 3, the “excess” (the credit differential) is less than the assigned amount of the “eligible” assets. In that case, the “excess” is recognized as an ordinary gain.



Example #3

2251.26 Excess of book value over cost. Assume the same facts as presented in Example 1 (P acquired 100% of S), except that the fair value of the P stock issued is $80 instead of $200. Thus, the fair value of P’s stock ($80) is less than P’s equity ($100) in the net assets of S. This difference is determined and allocated as follows:

Cost of investment (FV of P stock issued) $ 80 Less 100% of BV of net assets of S 100 Differential (excess of book value over cost) (20) 100% of excess of FV of plant assets over BV ($100 – $95) (5) Gain (excess of fair value of identifiable net assets over cost) $(25)

2251.27 The acquisition entries are:

Fusion: Current Assets 15 Plant Assets 100 Liabilities 10 Common Stock 10 Capital in Excess of Par 70 Gain on Acquisition 25 Affiliation: Investment in Subsidiary 80 Common Stock 10 Capital in Excess of Par 70

2251.28 The steps involved in determining and allocating any difference between cost and the acquiring company’s (P’s) equity in the net assets of the acquired company (S) are as follows:

a. Step 1: Subtract P’s equity in the book value of S from the cost of the investment.

b. Step 2: Adjust the differential computed in Step 1 for P’s share of any difference between the fair value and book value of the identifiable net assets of S. (This differential will be amortized on the consolidated worksheet in an affiliation.)

c. Step 3: Allocate the adjusted differential from Step 2. If positive, allocate to goodwill. If negative, recognize an ordinary gain.

2251.29 Fusion: The acquiring company records on its books the individual assets and liabilities of the acquired company at their fair value. Any goodwill resulting from the combination is also recorded on the books at that time.



2251.30 Affiliation: The acquiring company debits the investment in the subsidiary account for the fair value of the consideration given. The individual assets and liabilities of the acquired company are not recorded on the books of the acquiring company. The individual assets and liabilities, the parent’s share of any differences between their fair values and book values, and any goodwill arising from the business combination surface only at the time consolidated workpapers are prepared by the parent (acquiring) company.

2251.31 Acquisition: The acquiring company’s share of the net income of the acquired company should be included with that of the acquiring company only after the date of the business combination.

2251.32 In the case of consolidated financial statements, the consolidated net income in the period of a purchase business combination should include the parent’s net income for the entire year and the parent’s share of the subsidiary’s net income after the combination. The consolidated net income also should reflect the effect of any differential amortization (e.g., amortization of any differential associated with plant assets whose fair values at the date of the combination exceeded their book values) and the elimination of any intercompany transactions.

2251.33 The FASB requires a great deal of specific disclosure, including management’s description of the economic factors that validate the recorded goodwill, other unrecognized intangibles, and synergies expected from the combination.

2252 Other Forms of Restructuring

2252.01 Tender Offers: A tender offer is an acquirer’s offer to the shareholders of the target corporation to buy their shares of stock for a given consideration, usually cash. The objective in a corporate takeover is to acquire enough of the target’s outstanding common voting shares to gain effective control. The tender price is usually higher than the current market but less than the perceived potential market value after the merger or the value of the net assets in liquidation. The target shareholders thus benefit. A tender offer does not require the approval of the target company’s board of directors.

a. Friendly: A friendly tender offer is where the target’s Board and/or management agrees to be acquired because the terms offered are financially acceptable and in the best interest of the shareholders and management. Usually, the target’s management recommends that the shareholders accept the tender offer.

b. Unfriendly: An unfriendly tender offer is where the target’s Board and/or management disapproves of the terms of the tender offer. The



recommendation to the shareholders is negative; this may be because the tender price is inadequate or because of the adverse effects upon the corporation and/or its employees.

c. Tender Offer Deterrents:

(1) The Williams Act: The Williams Act of 1968 was passed to protect the interests of shareholders in a hostile merger. The SEC must be informed of the proxy fight or tender offer at least 10 days in advance. Tender offers must be preregistered with the SEC, and the offeror must accept all shares tendered during the offer period (minimum 20 days). In addition, anyone that acquires 5% of the target must register with the SEC.

(2) Fair Price: Fair price provisions in a corporate charter are designed to deter raiders. The usual stipulation is that all stockholders are to receive the same price. This is designed to prohibit two‐tiered bid takeovers where the share price to obtain control of the target is more than what is necessary to purchase the remaining shares. Such provisions may substantially raise the tender offer cost to the acquirer.

(3) Staggered Seats: Staggered election of directors also restricts the effectiveness of tender offers. Such a provision divides the corporation’s board of directors into classes so that only a portion of the board seats is elected in any year. Because removal of directors who are not up for election is prohibited (except for good cause), a raider could only gain control of the Board over a period longer than a year.

(4) Other Deterrents: A number of states have enacted other “poison pill” legislation which is designed to restrict hostile takeover attempts. In some states, a takeover attempt triggers the right of current shareholders to buy additional stock at discount prices.

(a) Freeze‐out: A freeze‐out law prohibits a raider from selling parts of an acquired company for a given time period.

(b) Control Share Acquisition: Close to half the states have “control share acquisition” laws which are designed to convert tender offers into proxy contests. This is accomplished by denying voting rights to raiders holding more than 20% of the shares unless approved by a majority of the other shareholders.

(c) Profit Disgorge: A few states have enacted requirements that those raiders who declare an intent to buy more than a 20% stake in a corporation must disgorge profits (return them to the corporation) on recently purchased shares sold within 18 months



after the announcement. This provision discourages bidders who hope to make a quick profit by putting a company’s stock into play.

(5) Golden Parachutes: Golden Parachutes are employment contract provisions that guarantee key executives substantial remuneration should they lose their jobs as a result of a takeover. Because the new company generally pays the benefits, such provisions deter takeovers by making acquisitions more costly. They may be desirable because they allow management to concentrate on issues more important to the corporation without concerns about their personal future financial security.

d. Leveraged Buyouts: A leveraged buyout (LBO) involves the purchase of a target with borrowed capital. Sales of a corporate division to management is often accomplished through this manner. Outsiders may also attempt to use this method.

(1) Attractive Targets: Acquirers look for targets with low debt levels so that after the purchase, the corporation can take on additional debt. Another attractive characteristic is where a portion of the target can be quickly sold to pay for the bridge borrowing incurred in the acquisition.

(2) Advantages and Disadvantages: The advantage to an LBO is that such an acquisition takes less cash than the traditional purchase. The disadvantage is that any bridge borrowing is more expensive than normal because of the high risk.

e. Greenmail: A target corporation offers to purchase its stock from a corporate raider for a premium price in order to end a takeover attempt. The raider must usually agree to refrain from similar takeover attempts against the target for some specified time period. While management may be able to regain control through this technique, it may deplete the assets of the corporation. Such a move usually forces management to concentrate on short‐term results and such distractions may adversely affect long‐run performance. Since 1988, corporate raiders are subject to a 50% federal excise tax on greenmail gains earned on shares held for less than two years.

f. Appraisal or Dissenter Rights: Shareholders dissenting from significant and fundamental changes such as a proposed merger have appraisal rights to receive the fair value of their shares in cash in most states. This rule protects minority shareholders from being forced to follow the majority rule.



(1) Procedure: Prior to the vote, the dissenter shareholders must give written notice of their objections to the change and intent to demand the appraisal rights if the proposed action is effectuated. The dissenter must also deposit his/her share certificates demanding the corporation purchase the shares.

(2) Fair Value: The corporation has 60 days to pay the dissenter its estimate of the fair value of the shares plus any accrued dividends and/or interest. The payment must be accompanied by the corporate explanation of the calculation used to arrive at value and the most recent set of financial statements.

(3) Value Contest: The shareholder then has 30 days to contest the corporation’s determination of fair value. If the demand for payment remains unsettled for 60 days, the corporation shall petition the appropriate court requesting a judicial determination of the fair value of the shares.

(4) Minority Shareholders: The appraisal procedure is the only relief available to a minority shareholder. Such a shareholder may not challenge the corporate action creating the entitlement unless the act was unlawful or fraudulent.

2252.02 Valuing Businesses: Valuations may be desirable to support the fairness of a transaction, when the corporation is the target of a tender offer or to help shareholders make informed analyses, decisions and settlements. There are three traditional methods used to evaluate and quantify the acquisition value of an on‐going entity.

a. Asset Method: The asset valuation method emphasizes the balance sheet.

(1) Valuation: Each asset item or group (including goodwill) the corporation owns is valued at current fair market value. Fair market value is the price which a willing seller and a willing buyer would arrive at when neither party is under a compulsion to deal and both have reasonable knowledge of relevant facts and market conditions. This is an arm’s length transactional valuation and has the advantage of having less judgment associated with future conditions. Appraisals are usually necessary.

(2) Qualitative Factors: Characteristics such a growth of sales, position of the firm in the industry, responsiveness of management, debt level, reputation for quality, etc., must also be considered.

(3) Price: The price to be paid would be based upon the excess of the asset values over liabilities associated with the assets or otherwise assumed by the buyer.



b. Earnings Multiple Method: The earnings capitalization method emphasizes the income statement and the target’s earning capacity.

(1) Approaches: There are three approaches used: future earnings are capitalized in perpetuity; earnings are discounted for a finite number of years; or a simple multiple is used to forecast annual earnings.

(2) Capitalization: The capitalization multiple is derived by dividing the stock price of comparable companies by their earnings. Since stock prices reflect expectations of future performance, the capitalization multiple provides a means of relating value and future expectations to the historical earnings. The forecast necessarily involves assumptions; the chances of changing trends and conditions may create uncertainty and perhaps a risk factor for the probability that it will all come true.

(3) Price: The price to be paid is based on some multiple of this expected future earnings stream.

c. Cash Flow Method: The discounted cash flow method uses the present value of the projected future cash flows for a reasonable period of time at a market‐derived discount rate.

(1) Discount Rate: The discount rate would usually be the combined corporate required cost of equity capital. It is necessary to prepare cash flow projections based on the most reasonable expectations of the company’s future performance.

(2) Assumptions and Terminal Value: Projections necessarily involve assumptions; the chances of changing trends and conditions may create uncertainty especially in the later years. A “risk” factor may be desirable. It is also necessary to estimate the terminal value of the acquired company at the end of the projection period.

(3) Price: The price to be paid is based on the discounted future cash flows plus the terminal value of the asset discounted to present value.

d. Multiples: Business valuation multiples can be used to value the business. Multiples such as Price/Earnings (P/E), Price/Revenue (price divided by annual net sales), or Price/seller’s discretionary earnings (SDE). Seller’s discretionary earnings is net income before owner’s compensation, other discretionary income or expenses (nonoperating or nonrecurring), depreciation, interest, and taxes. The value determined by this technique covers intangible assets, furniture, fixtures, and equipment. It does not include cash, receivables, inventory, real estate, or liabilities, so these items (at their fair market values) must be added/subtracted to determine the value of the business. To determine



the total value of the business, the average revenue or SDE is multiplied by the valuation multiple, and then the value of the cash, receivables, inventory, real estate, and liabilities are added/subtracted appropriately.

2252.03 Reasons for Business Combinations

a. Synergies: The positive benefits from business acquisitions are called synergies. This is essentially that the new combined entity will have more value than the sum of the old entities. It should be noted that synergies may be hard to quantitatively measure since they are in the future and may have a high qualitative content. There are five basic synergies.

(1) Greater Revenues: Marketing power gains may result from advertising efforts, stronger distribution networks and a more balanced product mix. Strategic gains may result from cross‐technologies. Market or monopoly power may allow product tying and price increases.

(2) Cost Reductions: Economies of scale drive many horizontal mergers in that duplicate operating functions can be eliminated. In addition, overhead may be spread over more units.

(3) Quality Increases: An integrated vertical distribution chain may be able to increase quality. Processes are more easy to change if a part of the enterprise.

(4) Tax Advantages: Net operating losses may be more fully used. Surplus funds in one corporation can be used to purchase the stock of another. This saves the tax the shareholder would have paid had they received a dividend and invested it in the same stock. In addition, a corporation is allowed at least a 50% dividend received deduction not directly available to individual shareholders.

(5) Capitalization Advantages: Three capitalization advantages are possible. First, if the price‐to‐earnings ratio of the acquirer exceeds that of the target, there may be an immediate market gain. Second is that the cost of issuing financial securities is subject to economies of scale. Underwriter and placement fees of larger offerings may cost less as a percentage of the net issue proceeds. Third is that the interest cost of debt instruments often fall for larger organizations.

b. Structural Integration: Due to a more relaxed federal anti‐trust policy and the availability of debt to finance mergers and acquisitions, the number of combinations increased radically in the 1980s and 90s. Traditional economic analysis recognizes three types of mergers.



(1) Conglomerate Expansion: A firm purchases or merges with a firm that has no significant overlap in products within its current marketing mix.

(a) Advantages: This diversification may provide cyclical stability in sales and earnings. Such investment opportunities in diversified ventures may be less expensive than starting a new business. In addition, a conglomerate merger may provide immediate availability of productive facilities, skilled management and established vendor sources and distribution channels. Greater financial strength and easier acquisition of capital for expansion may follow.

(b) Disadvantages: At present, there is a growing view that de‐diversification may increase productivity as management concentrates their attention on their core area of expertise.

(2) Horizontal Expansion: A firm merges with a competitor that produces or sells comparable products.

(a) Advantages: This may provide operating synergy through economies of scale and the fuller use of excess production and distribution capacity. In addition, it may allow increased market share and thus more control over pricing decisions.

(b) Anti‐Trust Consideration: Because the usual effect of horizontal expansion is to restrict competition, there may also be anti‐trust implications.

(3) Vertical Expansion: A firm expands its influence within its own industry. This may involve a purchase of an upstream supplier or a downstream distribution outlet.

(a) Upstream Advantages: Vertical integration can provide for more certainty and reliability in the input decisions and lessen chances of supply disruptions.

(b) Downstream Advantages: Quality standards may more easily be controlled and imposed upon a distributor if it is a part of the company.

(c) Competitive Advantages: Such expansion may also create a potential barrier to the entry of competitors into the industry. Vertical expansion usually produces a more efficient operation.

c. Requirements: Mergers require the creation of a formal plan of merger. The plan must be approved by the board of directors and stockholders of both corporations. Mergers cannot prejudice the rights of creditors. Creditors of either entity may sue the succeeding entity.



2260 International Finance

2261 Fixed, Flexible, and Floating Exchange Rates

2261.01 Currency Exchange: Exchange rates finance import and export trade. Over $150 billion is exchanged daily through the internationally based currency markets. A speculator buys or sells short a foreign currency; this risk may be undertaken to settle a foreign transaction or for a profit motive. An arbitrageur buys and sells a foreign currency at the same time in different markets and profits by the margin between the two transactions.

2261.02 Definition: The market exchange rate is the price of one country’s currency in terms of another country’s currency. A U.S. consumer uses dollars to purchase yen to pay for Japanese Toyota automobiles and Toshiba TVs.

a. Spot Transactions: A spot transaction provides purchasers with currency immediately (although it takes two business days for the transaction to be completed).

Example: The exchange rate of U.S. dollars to Hong Kong dollars is roughly 1 to 8; thus the Hong Kong dollar to U.S. dollar exchange rate is 8 to 1. The price of an American $3,000 computer is thus $24,000 in Hong Kong dollars. Similarly the price of a Hong Kong $3,200 suit is thus $400 in U.S. dollars.

b. Forward Transactions: A forward (or future) transaction allows a firm to hedge against a future currency change which may occur before the future settlement date. Currency options give the holder the right to buy or sell a currency for a specified price at a specified future date. The payment in foreign currency due at the settlement date is satisfied at a definite exchange rate today. If the forward rate exceeds the spot rate, the currency is selling at a premium and should appreciate. Conversely if the spot rate exceeds the future rate the currency should depreciate.

Example: The exchange rate of U.S. dollars to Hong Kong dollars is roughly 1 to 8; thus the Hong Kong dollar to U.S. dollar exchange rate is 8 to 1. The price of an American $3,000 computer is thus $24,000 in Hong Kong dollars. Similarly the price of a Hong Kong $3,200 suit is thus $400 in U.S. dollars.

c. Financial Accounting: For financial statement reporting purposes, all monetary assets held in foreign currencies must be translated into U.S. dollars at the current exchange rate.



2261.03 Exchange Rates: The Bretton Wood agreement pegged most major currencies to the U.S. dollar, which in turn was set to a gold standard. This proved to be inadequate. In the early 1970s, the U.S. halted gold convertibility ending fixed exchange rates. U.S. currency remained the world’s standard without rare metal backing.

a. Floating Rates: Now the actual exchange rates are determined by private currency traders’ supply and demand. Currencies float in the international market and fluctuate daily. The exchange rate is flexible. Governments and Central banks may intervene in this managed “dirty” float to maintain a country’s currency stability and prevent drastic changes in short periods of time.

b. Fixed Rates: A minority of governments attempt to peg their currency to an official dollar or Euro convertibility rate. These attempts have generally proven to be unstable and black markets develop. China, Brazil, Russia, and Hong Kong all have currencies pegged to the U.S. dollar. Typically such countries have a currency stabilization board and dollar‐to‐dollar reserves to the U.S. dollar. Many countries devalued their currencies at century‐end; these four countries held to fixed exchange rate and experienced a larger stock market and property value fall. This is an interesting test case to see if a pegged system can avoid devaluation. On July 31, 2005 China cut its currency link to the U.S. dollar; subsequently, the Yuan’s value has risen.

c. Complications: The accumulation of U.S. dollars outside the country have increased substantially in the last five years. Eurodollars and Asiadollars have complicated the effectiveness of government intervention.

2261.04 Exchange Rate Determinants: Various factors affect a flexible exchange rate system.

a. Short‐Run Factors: Short‐run exchange rates are determined by political events, trade or capital flow changes. Capital is now very mobile. Also important are intangible factors such as neighboring countries’ economic situations and interest rates change. Higher interest rates will stimulate demand for a currency and tend to push up exchange rates. Conversely, lower interest rates reduce a currency’s exchange rate and thus stimulate exports.

b. Intermediate Factors: Intermediate rates are affected by the balance of payment figures, relative price changes, wars, monetary reserves and the seasonal flow of funds. A positive balance of trade will stimulate demand for a nation’s currency so foreigners have currency to buy its goods; this will tend to cause a currency to appreciate. The exchange rates of Japan and China increased in the last decade.



c. Long‐Run Factors: The determinants of long‐run exchange rates are more complicated and subjective. Long‐run factors include a country’s geographical resources and talent base, expected economic and political stability, expected national income/productivity changes, rate of inflation and perceived safety of investment.

d. Purchasing Power Parity: The theory of purchasing power parity suggests that exchange rates will convert inflation differences into the pricing of goods. The exchange rates should move in an equal but opposite direction to the difference in inflation rates between two countries.

Example: If annual inflation is 6% in the U.S. and 4% in Japan, the Yen will appreciate 2% against the Dollar.

Example: If U.S. inflation is expected to be 5% per annum while the Euro is expected to depreciate against the U.S. Dollar by 10%, a German firm importing from the U.S. can expect its Euro costs for the imports to increase by about 15%.

2261.05 Currency Valuation

a. Overvaluation: An overvalued (or strong) currency produces trade deficits and job losses. Profits that might have been made by American producers go overseas.

b. Devaluation: Devaluation of the U.S. currency means the exchange rate falls so the dollar buys less of the foreign currency. This should improve a country’s balance of trade because foreign goods become more expensive in the domestic market. Conversely, domestic goods become less expensive in foreign markets, which stimulates exports. Increased exports may lead to a drop in domestic unemployment. Domestic inflation may increase because the cost of imports will increase. Devaluation would also reduce the relative price foreign capitalists must pay to purchase U.S. dollar denominated investments.

c. Exchange Rate Change: If rates change, there is a consequence to businesses. For instance, assume that one U.S. dollar was equivalent to 4 foreign currency units and then falls in value to one U.S. dollar to 3.5 foreign currency units. Now it only takes 3.5 F.C.U.s to get one dollar of U.S. goods. So the price of U.S. goods goes down in the foreign currency and the price of the other country’s goods goes up in U.S. dollars. Businesses expecting such an exchange rate change would want to pre‐pay foreign suppliers because they will pay less dollars today to settle the account payable due tomorrow.



d. Current Situation: In 2000 the dollar soared to a five‐year high against the Yen, Mark, and Swiss Franc because of the continuing strength of the U.S. economy. Since then the dollar has dropped. Economists argue that the U.S. dollar must continue to fall against foreign currencies (especially the Yen and Yuan) until the U.S. makes substantial improvement in balancing the trade deficits and increases its low savings rate. Most important is that the Yuan must rise at least 40%.

e. Consequences: The increase in import prices could lead to domestic inflation. The concern is that many southeast Asia countries that depend on the dollar as their currency anchor will shift to a standard of value they perceive as having less risk of future depreciation, such as the Euro or Yen. This would require raising U.S. interest rates to attract continual foreign purchases of U.S. securities which fund the fiscal and trade deficits.

2261.06 Balance of Payments: The balance of payments includes all international payments made to and from foreign countries.

a. Current Account: The current account is the net amount of a nation’s imports and exports of physical products (trade balance and non‐goods services such as accounting and education). Exports draw foreign currencies to a nation while imports deplete a nation’s currency.

b. Capital Account Balance: The capital account balance is the net of a nation’s international movement of financial capital. The capital account also includes the net surplus or deficit for tourist’s spending and loans. It is the difference between investments abroad and foreigners’ investments in the nation. A deficit in the current trade account is financed by a surplus in the capital accounts. Investments abroad deplete a nation’s currency while an increase in foreign investment in assets such as real estate, stocks and bonds has a positive effect.

c. Official Reserves: The official reserves in the financing account is the equalizer in a nation’s balance of payments. This account is used to settle net differences between the current account and the capital accounts. The official reserves are held by the central banks in the form of foreign currencies. A net credit in the reserve account implies a surplus in its current and capital accounts which is balanced by a net increase in the nation’s currency. A net deficit in the reserve account implies that a nation has a deficit in its current and capital account transactions which is balanced by selling a nation’s currency.



d. Long‐term Results: If a nation has a long‐term positive balance of payments in another country’s currency, it will accumulate foreign currency. This may be used to buy the other country’s goods, debt instruments, securities or real estate. Almost all the 2012 sale of $400 billion in U.S. treasuries were purchased by the central banks of Japan, China, and the Gulf States who are awash in U.S. dollars. Foreigners have also recently substantially increased their purchases of U.S. real estate and U.S. companies.

2262 Managing Transaction Exposure

2262.01 Cost‐Based Price: Where the “selling” division is a cost center (i.e., does not have a profit motive), it is appropriate to base the transfer price on some form of cost. The cost could be variable or full cost. However, whatever cost is selected, it must be at standard to avoid the potential for cost overruns to be passed on to the “buying” divisions. If the selling division is a profit center, the transfer price can be modified by an appropriate markup.

2262.02 Market‐Based Price: Where both segments are profit or investment centers, a market‐based price is typically used.

a. Perfectly Competitive Product: Where the selling division would be able to sell all it made of the product to external customers (i.e., it is a perfectly competitive product), the transfer price must be the market price.

b. Adjustments to Market Price: Where the market is not perfectly competitive, the market price may be modified by negotiation to allow for cost savings related to decreased selling and administrative costs because this is a transaction internal to the firm. If there is no outside market for exactly that product, a “market” price would be negotiated.

2262.03 Maximum and Minimum Transfer Price: There is typically a price range within which managers of the buying and selling units can agree. The buying division will not pay more than the market price it would have to pay to buy outside the company. Thus, the maximum price is the outside market price. In ordinary circumstances, the selling division would not sell at less than its incremental cost. Thus, the minimum price is equal to the seller’s variable cost plus opportunity cost. The seller’s opportunity cost depends on whether the selling division can use its capacity for other profitable business.



a. Full Capacity: If the selling division is operating at full capacity, it would have to reject outside sales in order to sell to the buying division. The lost revenue from those sales is the opportunity cost of selling inside the company. It would not be willing to forgo the contribution margin of those sales. Therefore the transfer price needs to include the lost contribution margin—i.e., the transfer price should not be less than the net revenue that would be received from an outside customer.

b. Excess Capacity: If the selling division is operating at less than full capacity, it may be able to sell to the buying division without losing outside sales. In that case the opportunity cost would be zero, and the transfer price could be as low as the selling division’s variable costs.

2262.04 Tax Considerations: When determining the appropriate transfer price to use, taxes must be considered. The objective is to keep taxes between the two entities to a minimum. In international transfers, you would want to have the highest sales value in the country with the lowest tax rate. Therefore, if you were transferring goods from a country with a relatively low tax rate in comparison to the U.S., you would want the transfer price as high as possible so that the majority of taxes are paid in the country with the lower tax rates.

2262.05 Political Risk Considerations: Political risk represents the potential that a foreign government will expropriate your business without paying any compensation or allowing profits to be taken out of the country. To reduce this risk large multinational firms use joint ventures with local partners, but they maintain the knowledge of the firm so that if the business was taken by the foreign government, there would be little value left.

2263 Financing International Trade

2263.01 G‐7 Group: The G‐8 members ‐ Britain, Canada, France, Germany, Italy, Japan, and U.S. finance ministers and central bankers coordinate global economic policies and plot free enterprise strategy. The G‐7 effectively acts as a steering committee for the world economy and promotes stable growth with low inflation. Under their direction is the World Bank and the International Monetary Fund.

2263.02 Basic Objectives: The World Bank and its sister organization, the International Monetary Fund (IMF), were founded in 1944 and have 188 member countries. Their basic historical objectives are to provide planning assistance, exchange rate stability, and short‐term loans to member nations experiencing temporary balance of payment difficulties. Over 180 non‐communist countries are members of the two organizations.



a. World Bank: The World Bank has been the largest source of aid to the Third World. For the 2013 fiscal year, the Bank made new loans and grants of $53 billion. Russia displaced China as the biggest borrower. The International Finance Corporation’s (IFC) is an affiliate of the World Bank and has the primary function of investing in private enterprises in less developed countries (LDCs). The World Bank and IFC are expected to play a big role in financing the re‐industrialization of Russia, Eastern Europe, and Iraq.

b. International Monetary Fund: The International Monetary Fund (IMF) has a $380 billion capital base derived from membership subscriptions. In the last four years, massive grants and loans were made to African and South American countries experiencing severe deflation and loan repayment defaults. The IMF conditioned these grants and loans on changes in the governments’ involvement in the free market. Overall, the IMF wants more open markets for imports from the industrialized countries and a transparent financial reporting system.

(1) Special Drawing Rights (SDRs): The IMF now has its own currency. SDRs are based on the value of a weighted basket of four major currencies (the U.S. dollar, Euro, Japanese yen, and British pound). SDRs were first introduced by the IMF to supplement existing reserves and create another country‐to‐country medium of transfer for non‐liquid members. SDRs are not used as internal circulating currency. Many third‐world countries would like the IMF to increase SDRs because it is a non‐banking way to sustain and increase debt.

(2) Outreach: The former Soviet Union and most of the other former Soviet republics have been granted full IMF membership status thus allowing economic advice, technical assistance, and loans. This has allowed billions of dollars of loans to ease the economic transition from communism to capitalism. In the 2012 meeting, the G‐8 endorsed an African “New Partnership” plan to spur foreign investments in Africa. Up to $6 billion per year is pledged as aid to countries that enact major economic and social reforms.

c. Potential Problems: The European Union, some African, Latin American and former Soviet Union debtor nations are close to default. These countries may not be able to repay their creditor nations and banks. Defaulting countries may be cut off from world credit. Their economies and foreign trade would contract. The IMF’s job is to ensure such a disaster does not occur. The IMF has accomplished this by selectively buying private banking debt and encouraging the rescheduling of debts.



d. Current Situation: In 2010, central bankers were happy that the U.S. lead the world’s economic recovery and expansion by way of a “strong dollar.” This makes foreign seller’s goods less expensive to American consumers. Still the U.S.’s massive current account deficits mean the central banks of China, Japan, and Saudi Arabia have been financing the U.S. consumer. It is not clear that this can continue indefinitely.


Surgent CMA Review

Section 2300 Decision Analysis (25%)

2310 Cost/Volume/Profit Analysis

2311 Breakeven Analysis

2311.01 Single Product: At the breakeven point, total revenue equals total expenses; therefore, net income equals zero.

a. Basic C‐V‐P Equations

Sales – Variable Costs – Fixed Costs = Net Income

Contribution Margin – Fixed Costs = Net Income

b. Breakeven Point (BEP)

(1) BEP in Units = Fixed Costs/Contribution Margin ($)

(2) BEP in Revenue Dollars = Fixed Costs/Contribution Margin Ratio (%)

Example

Fixed Costs $15,000

Unit Selling Price $4.00

Unit Variable Costs $2.50

Unit Contribution Margin ($4 – $2.50) $1.50

Contribution Margin Ration ($1.50/4) 37.5%

BEP (units) = $15,000

= 10,000 units $1.50

BEP ($s) = $15,000

= $40,000 (or 10,000 units × $4.00 per unit) 37.5%

Section 2300 –Decision Analysis


2311.02 Targeted Income for a Single Product: In addition to calculating a breakeven point, C‐V‐P analysis may be used to calculate the number of units or total revenues needed to achieve a targeted level of income.

a. Target Pretax Income:

(Fixed Costs + Target Pretax Income)/Contribution Margin

Example: Same facts as in the previous example, with a desired before‐

tax net income of $10,000.

BEP (units) = $15,000 + $10,000

= 16,667 units $1.50

BEP ($s) = $15,000 + $10,000

= $66,667 (or 16,667 units × $4.00 per unit) 37.5%

b. Target After‐Tax Income: Because income taxes reduce income, they increase the volume of sales needed to achieve a targeted level of after‐tax income. The after‐tax income (i.e., net income) must first be converted into a pretax figure. That is accomplished by dividing target net income by the complement of the tax rate and is reflected in the following formula:

Fixed Costs + Target Net Income

(1 – Tax Rate)

Contribution Margin

Example: Same facts as previous example, with a desired after‐tax net income of $8,000 and a tax rate of 40%.

BEP (Units) $15,000 +

$8,000

= 18,889 Units 60%

$1.50

BEP ($s) $15,000 + $13,333

= $75,555

37.5%



2311.03 Graphic Approach

a. Cost‐Volume‐Profit Graph: This graph illustrates the interrelationships of total revenue and total costs with the breakeven point and net profit and loss.

b. Profit‐Volume Graph: This graph illustrates the interrelationships of profit, volume, and breakeven point. In this graph, the breakeven point is the point at which the profit line crosses the volume axis. The profit line originates at the fixed cost point below $0. Thus, at zero volume, the profit line indicates a loss equal to the amount of the fixed costs. The slope of the profit line indicates the contribution margin per unit.

2312 Profit Performance and Alternative Operating Levels

2312.01 Using C‐V‐P Analysis for Decision Making: C‐V‐P analysis can help managers estimate the effects of alternative decisions or events on a company’s profits. Here are some examples:

a. Indifference Point: At an indifference point, a decision maker should be indifferent between two mutually exclusive alternatives. The indifference point in terms of total cost may be calculated as:

FC + VC of Alternative A = FC + VC of Alternative B



b. Evaluate Change in Assumptions: C‐V‐P analysis is very useful for determining the impact of proposed changes in costs, volume, or selling price on profitability.

Example: Using the same facts as in the single product example presented above, assume supply of a certain raw material is becoming scarce. Management expects an increase in the price of this product to increase variable cost per unit by 10%. Calculate the effect on breakeven.

New variable cost ‐ $2.50 x 1.1 = $2.75

New contribution margin ‐‐ $4.00 ‐ $2.65 = $1.25

New contribution margin ratio ‐‐ $1.25/$4.00 = 31.25%

BEP (units) = $15,000

= 12,000 units (2,000 additional units) 1.25

BEP ($s) = $15,000

= $48,000 ($8,000 additional dollars) 31.25%

2312.02 Assumptions Underlying C‐V‐P Analysis

a. Linear Costs: All costs are linear and can be divided into fixed and variable components.

b. Predictable Cost Behavior: Fixed costs remain constant, while variable costs change proportionally to changes in volume.

c. Linear Revenues: Sales price per unit does not change with changes in volume.

d. Constant Sales Mix: Sales mix remains constant.

e. Constant or Zero Inventory Levels: Inventories are kept constant or at zero.

f. Relevant Range: There is a relevant range of output for all assumptions.

2312.03 Advantages of C‐V‐P Analysis

a. Clear Relationship: Under this analysis, the interplay among sales revenue, variable, and fixed costs is clearly seen for a relevant range of both units and time.

b. Sensitivity Analysis: This is an excellent and simple tool for modeling different results under varying circumstances. (What happens if variable unit costs change? Fixed costs change? Selling price changes? Product mix changes? etc.)



2312.04 Limitations of C‐V‐P Analysis

a. Short‐Term Tool Only: Since all costs become variable in the long run, C‐V‐P analysis is valid only for short‐term decisions.

b. Underlying Assumptions: These are fragile and extremely sensitive to slight changes. The results of the analysis are only as good as the extent to which the underlying assumptions are, indeed, true.

c. Factors Ignored: Profit is a function of price, quantity, variable costs, fixed costs, and other factors. However, these other factors (e.g., inflation rates, resource accessibility, level of competition, government regulation, and the economy in general) are ignored in C‐V‐P analysis. However, these issues can significantly affect a company’s profits.

d. Rough Guide: Given the fragility of the assumptions, the short‐term period of relevancy, and the disregard for other factors, C‐V‐P analysis should be regarded as only a rough guide to potential results. It is not an accurate predictor.

2313 Analysis of Multiple Products

2313.01 No Unique Breakeven Point: To perform C‐V‐P calculations when more than one product is sold, it is necessary to assume a constant sales mix. Otherwise, there is no single point at which breakeven will occur. Assuming that different products have different contribution margin ratios, the sales mix determines the overall contribution margin ratio, which in turn determines the number of units and level of revenues needed to breakeven. Given a different sales mix having a different contribution margin ratio, a different number of units and level of revenue will be needed to breakeven.

2313.02 Weighted‐Average Contribution Margin Approach: One way to incorporate the effects of a sales mix in the C‐V‐P analysis is to use a weighted average contribution margin, given the expected sales mix.

Example: The Benson Co. manufactures two models of hair dryers, A and B. Budgeted sales data for the coming year is as follows:

Model A Model B

Units Sales Mix 30,000 50,000

Unit Selling Price $50 $20

Contribution Margin $20 $10

Unit Contribution Ratio 40% 50%



Required:

1. Compute the total number of units to be sold at the breakeven point.

2. Compute the number of units of each model to be sold at breakeven.

3. Compute the total sales dollars at breakeven.

4. Compute the sales dollars for each model at breakeven.

5. If sales revenue were to total $3,000,000 during the coming year, how much net income would be earned? Assume that the actual sales mix, fixed costs, and unit contribution margins were the same as budgeted and that the firm has an effective federal income tax rate of 35%.

Solution:

1. C Total number of units sold at breakeven:

Total budgeted sales in units: 30,000 + 50,000 = 80,000

% of total sales in units for each model: A: 30,000/80,000 = .375 B: 50,000/80,000 = .625

Weighted‐average contribution margin in dollars (unit CM x sales mix percent) ($20 × .375) + ($10 × .625) = $7.50 + 6.25 = $13.75

Total number of units sold at breakeven: $880,000/$13.75 = 64,000 units

2. Number of units of each model sold at breakeven: A: (64,000 × .375) = 24,000 B: (64,000 × .625) = 40,000

3. Total sales dollars at breakeven: Total budgeted sales dollars: [(30,000 × $50) +($50,000 × $20)] $1,500,000 + $1,000,000 = $2,500,000

% of budgeted sales dollars for each model: A: $1,500,000/$2,500,000 = .60 B: $1,000,000/$2,500,000 = .40

Weighted‐average CM percent (budgeted sales percent × contribution margin ratios) (.60 × .40) + (.40 × .50) = .24 + .20 = .44

Total sales dollars at breakeven: $880,000/.44 = $2,000,000

4. C Total number of units sold at breakeven:

A: ($2,000,000 × .60) = $1,200,000 B: ($2,000,000 × .40) = $800,000



5. Net income resulting from sales revenue of $3,000,000:

Contribution margin: $3,000,000 × .44 (weighted‐average CM %) = $1,320,000

Income before tax: $1,320,000 – $880,000 (fixed costs) = $440,000

Net income: $440,000 less taxes at 35% = $286,000

2313.03 Contribution Margin per Composite Unit: A second way to incorporate the effects of a sales mix in the C‐V‐P analysis is to use a composite unit, given the expected sales mix. A composite unit is the ratio in which the products are expected to sell; e.g. for every unit of A, 2 of B and 3 of C are sold. In this situation, the composite unit contribution margin would consist of CM of A x 1, CM of B x 2, and CM of C x 3.

Example: Refer to the preceding information for the Benson Co.

Required: If the composite unit approach were taken to the above example, calculate the breakeven in units and in revenue dollars.

Solution: Breakeven in units:

Determine CM per composite unit. Ratio of sales is 3 of A to 5 of B.

(3 × $20) + ($5 × $10) = $110 $880,000/$110 = 8,000 composite units Sales in units needed of each product to breakeven: A. 8,000 × 3 = 24,000 units B. 8,000 × 5 = 40,000 units

Breakeven in dollars:

Determine CM percentage per composite unit. Composite Unit CM/Composite Unit Selling Price [(3 × $50) + (5 × $20)] $110/$250 = 44% $880,000/44% = $2,000,000

Sales in dollars needed for each product to breakeven: Sales mix dollars ratio: A. $150/$250 60% B. $100/$250 40%

Use these percentages to determine product sales at breakeven. A. $2,000,000 × 60% $1,200,000 B. $2,000,000 × 40% $ 800,000



2320 Marginal Analysis

2320.01 Marginal analysis involves the identification and calculation of incremental revenues and costs (i.e., relevant cash flows) for decision alternatives.

2320.02 Short‐Term Decisions: In marginal analysis, decisions are made under a given set of conditions, including existing plant capacity, equipment, and operating conditions. These are essentially short‐term decisions, although they may have long run implications such as relationships with suppliers or customers.

2320.03 Long‐Term Profitability: An innate danger in short‐term decision making is that the process does not take into account costs throughout the value chain of a product. A product or service must be able to recover its full costs in the long run for profitable operations. If a company relies almost exclusively on short‐term decision scenarios, there is a very real danger of under‐costing products to the extent that the economic health of the firm is compromised. Short‐term decision making needs to be approached within the context of the overall strategic planning goals and objectives of the firm.

2320.04 Long‐Term Profitability: An innate danger in short‐term decision making is that the process does not take into account costs throughout the value chain of a product. A product or service must be able to recover its full costs in the long run for profitable operations. If a company relies almost exclusively on short‐term decision scenarios, there is a very real danger of under‐costing products to the extent that the economic health of the firm is compromised. Short‐term decision making needs to be approached within the context of the overall strategic planning goals and objectives of the firm.

2321 Sunk Costs, Opportunity Costs, and Other Related Concepts

2321.01 Economic Revenues and Costs v. Accounting Revenues and Costs: Economic revenues and costs are the cash flows that will be gained or foregone when one alternative is chosen over another, while accounting revenues and costs are usually measured using Generally Accepted Accounting Principles (GAAP). GAAP revenues and costs are often irrelevant or mismeasured for decision making. For example, GAAP is based on historical costs that might not provide a reasonable estimate of future alternative costs. In addition, accounting costs are a mixture of fixed and variable costs, and fixed costs are irrelevant for many types of decisions. At the same time, accounting does not recognize opportunity costs, which are relevant for making decisions.



2321.02 Relevant Revenues and Costs: For revenues or costs to be relevant for making a decision, they must occur in the future and be different among the alternative choices. Variable costs are often viewed as relevant while fixed costs are viewed as irrelevant. However, fixed costs may be relevant if they differ across the alternatives (e.g., if additional machinery needs to be purchased or leased to fill a special order).

a. Relevant Costs: Relevant costs include the following:

(1) Incremental/Marginal/Differential Costs: This term means the same thing as relevant costs.

(2) Avoidable Costs: Costs that may be avoided under an alternative are relevant. For example, a company may be able to avoid variable production costs and some or all fixed production costs by outsourcing its product manufacturing.

(3) Opportunity Costs: When only one alternative can be selected, other alternatives are precluded. Opportunity costs are the amount of profit that could have been earned on the best alternative which was not selected. An example would be any contribution margin forfeited related to the next best alternative use of manufacturing capacity. Opportunity costs are not transactional and are, therefore, not recorded in the financial accounting records. They are, however, relevant to the decision.

b. Irrelevant Costs: Costs that are the same, or present, regardless of which alternative is selected are not relevant to a decision. An example would be routine fixed costs that have to be covered regardless of whether an item is to be purchased from a supplier or manufactured in‐house. Irrelevant costs include the following:

(1) Sunk Costs: Costs that have already been incurred are past costs that cannot be changed. These costs have no effect on the current decision and should not be considered. An excellent example is joint processing costs in a “sell‐now‐or‐process‐further” decision.

(2) Historical Costs: These may be a basis to help predict future costs, but historical costs themselves are irrelevant. For example, the cost most often incorrectly included when making an equipment‐replacement decision is the purchase price of old equipment. This is irrelevant to the decision.



c. Income Taxes: Income taxes are often relevant to a decision because they are likely to differ across alternatives. However, income taxes do not always need to be explicitly measured. For example, suppose managers estimate that taking a special order will increase the company’s pretax income. As long as income taxes are less than 100% of the incremental income, then the after‐tax effect on income will also be positive. In this situation, the managers do not need to explicitly estimate the income tax effect to make a decision. However, incremental income taxes may need to be estimated in cases where different amounts of historical costs are tax deductible or where different income tax rates (e.g., capital gains versus ordinary income rates) apply to different decision alternatives.

2321.03 Cost Behavior and Relevance: The relevance of costs for a decision depends on cost behavior and traceability, which in turn depends on the cost object.

a. Cost Object: A cost object is the thing for which costs are measured. When accounting for inventory, the cost object is usually the individual unit. However, many other cost objects may be relevant, depending on the decision being made. Suppose managers are deciding whether to build a new manufacturing facility. In this case, the cost object is the new facility. Costs such as the plant manager’s salary would be fixed (i.e., irrelevant) if the cost object were the production of individual units. However, the plant manager’s salary would be variable (i.e., relevant) when the cost object is a new manufacturing facility.

b. Traceability: Some costs may be traced directly to a cost object, while other costs are indirect and must be allocated to a cost object. In general, direct costs are likely to be relevant, whereas indirect costs are likely to be irrelevant for decision making. However, the facts of the individual decision must be analyzed to make a final determination of relevant costs.

2321.04 Quantitative Factors: Quantitative factors are relevant information that can be measured in numerical terms. There are two general types of quantitative factors:

a. Financial: Factors that are measured in dollars (e.g., cost of direct labor) or ratios of dollars (e.g., return on investment).

b. Nonfinancial: Factors that cannot be measured in dollars (e.g., reduction in new‐product development time).



2321.05 Qualitative Factors: These factors are difficult or impossible to measure quantitatively, but still need to be considered because they will flow from the decision. Examples include the reaction of regular customers if they learn about a low special order price, the change in employee morale from an outsourcing decision, and the effects on remaining product sales if one product is dropped.

2322 Marginal Costs and Marginal Revenue

2322.01 Profit maximizing rule (MR = MC)

Marginal cost represents the change in total cost associated with producing one additional unit. Marginal revenue represents the change in total revenue derived from selling one more unit. If the marginal revenue from selling one more unit is greater than the marginal cost of producing the unit, it makes sense to produce and sell the unit as doing so will increase the firm’s profit.

If marginal revenue is greater than marginal costs, then producing more will increase profits. However, if marginal revenue is less than marginal cost, then producing more will lower profit. Thus, profit is at a maximum when marginal revenue equals marginal cost: MR = MC.

2323 Special Orders and Pricing

2323.01 This situation involves a one‐time special order from a customer, in which the proposed selling price is less than the normal selling price. There are both qualitative and quantitative issues to consider.

a. Qualitative Factors

(1) Regular Customers: The impact on other customers and on regular marketing channels must be examined. Will regular customers demand the same price‐break or go elsewhere to purchase if they learn of the deal? Also, is this really a one‐time deal, or will the new customer become a regular customer and expect the same price in the future?

(2) Legal Considerations: Note that the Robinson‐Patman Act prohibits price differentiation among customers unless they can be justified by significant differences in costs.

(3) Different Markets: Will the special order allow the company to enter a new market?



b. Quantitative Factors

(1) Production Capacity: This is the key factor. If the firm has idle production capacity, any revenue in excess of the incremental costs of producing the product will contribute to increasing net income or decreasing a net loss. If the firm does not have idle production capacity (or not enough idle capacity to make the entire order), the incremental revenue must exceed both the incremental costs and the contribution margin of other sales forfeited if this order is accepted.

(2) Minimum Acceptable Offer: This is the sum of incremental costs plus any opportunity costs from contribution margin forfeited.

(3) Relevant Costs: All variable costs that would be incurred are relevant. Committed fixed costs are sunk costs and are not economically relevant. Additional fixed costs that would be incurred only if the order were accepted are relevant.

Example: Award Plus manufactures medals for winners of athletic events. The company has a maximum manufacturing capacity per month of 10,000 medals, and is currently operating at 75% of that capacity. Each medal normally sells for $175. Current unit product costs are as follows:

Variable Costs

Manufacturing

Labor $50

Material 35

Marketing 25

Total Variable Costs $110

Fixed Costs

Manufacturing $37

Marketing 23

Total fixed costs 60

Total unit costs $170

Award Plus has received a special one‐time order for 2,500 medals at $100 per medal. No variable marketing costs would be incurred for this order. Determine the minimum acceptable price for a special order and whether the proposal should be accepted.



Solution: The minimum acceptable price is the sum of the incremental relevant costs.

1. Determine Status of Manufacturing Capacity. Maximum is 10,000 medals. Current operations are at 75% level (7,500 medals). Therefore the capacity to manufacture the 2,500 special order is available without disturbing normal production. No opportunity cost exists.

2. Minimum acceptable special order selling price is sum of relevant costs (labor and material costs, $50 + $35 = $85). Fixed costs are not relevant because they exist in both alternatives and no additional ones are identified.

3. Provided there are no negative qualitative issues, the order should be accepted because the $100 incremental revenue offered exceeds the incremental costs.

2324 Make vs. Buy

2324.01 These decisions can involve the following scenarios: manufacturing a part in‐house or purchasing from a supplier, or providing in‐house services or contracting with a provider (e.g., human resources or customer service).

a. Qualitative Factors: There are both advantages and disadvantages to producing a good or service internally that cannot necessarily be quantified. Below are several examples

(1) Advantages:

(a) Reduced Supplier Dependence: Producing a good or service internally reduces the firm’s dependence on outside suppliers.

(b) Quality Control: Quality control may be easier to maintain in‐house.

(c) Employee Morale: The increasing use of outsourcing can cause problems with morale for employees who are concerned about their own long‐term job stability. Producing goods and services internally avoids this type of employee morale problem.



(2) Disadvantages:

(a) Suppliers: Making a component may reduce the firm’s dependence on a supplier to the point of losing the relationship altogether. If demand increases and the firm needs to buy some components, it may not be able to because the supplier is full with other work.

(b) Expertise and Other Resources: If production of the good or service requires special knowledge, skills, or equipment that the company does not have, then it may not be possible to produce internally in the short‐term.

b. Quantitative Factors: Dollar cost, of course, is the key factor. The question is which costs?

(1) Relevant Costs: The variable costs that would be incurred if the component were made are relevant to the decision. However, fixed costs are relevant only if they represent additional costs that arise from one of the alternatives. In other words, the regular committed fixed costs that are present and must be covered regardless of which decision is selected are not relevant. Also, eliminate from any decision all allocated common costs, as these will continue regardless of which alternative is selected. The maximum price to be paid to a supplier for the component should be the sum of the marginal costs to manufacture the part, plus any opportunity cost.

(2) Opportunity Costs: The key to whether opportunity costs are relevant is utilization of facilities. If there are alternative profitable uses for the manufacturing capacity that would be needed to make the component, then the opportunity cost to be included in the analysis is the contribution margin forfeited of that other use. If there is no alternative use (i.e. the firm has idle or excess capacity equal to the needs to manufacture the part), then the opportunity cost is zero.



Example: The Jones Company currently manufactures all component parts used in the manufacture of various hand tools. A steel handle is used in three different tools. The budget for these handles is 20,000 units with the following unit cost:

Direct material $0.60

Direct labor 0.40

Variable overhead 0.10

Fixed overhead 0.20

Total unit cost $1.30

Steel Co has offered to supply 20,000 units of the handle to Jones Company for $1.25 each, delivered. If Jones currently has idle capacity that cannot be used, accepting the offer will:

Answer: increase the handle unit cost by $0.15. Use the incremental cost approach to solve this problem.

Cost per unit to purchase handle $1.25

Direct material cost per unit $0.60

Direct labor cost per unit 0.40

Variable overhead cost per unit 0.10 Opportunity Cost relating to alternative use of manufacturing capacity

0

Unit cost to make handle (and maximum purchase price) 1.10

Increase in unit cost to purchase $0.15

Note that the fixed cost allocation of $.20 per unit is not relevant, since it relates to committed fixed costs that are present and must be covered regardless of whether the part is made or purchased.

Example: Assume now that Jones Co. can use all available excess manufacturing capacity to manufacture a product that it could sell for $4. The variable costs to manufacture, market, and distribute this product total $3.30. How does this situation impact the above decision?

Answer: The opportunity cost of the contribution margin of the new product ($0.70) is relevant and must be added to the cost to manufacture the handle, to arrive at a total incremental cost of $1.80. The decision would now be to purchase the handle because its purchase price is $0.55 less than the cost to make it.



2325 Sell or Process Further

2325.01 Objective: These situations occur when determining whether joint products should be sold at the split‐off point, or whether they should be further processed at additional (separable) costs and sold at a later stage. Note that the joint processing costs are sunk costs. They will be allocated for financial accounting purposes, but for decision analysis these costs are irrelevant.

2325.02 Rule: The decision rule is simple in theory: If the incremental revenue exceeds the incremental cost of the additional processing, then process.

Example: A soap manufacturer has six main product lines which are produced from common inputs. Joint product costs up to the split‐off point constitute the bulk of the production costs for all six products lines. These joint product costs are allocated to the six product lines on the basis of relative market value.

The company also has a waste product that was discarded until the research department discovered that the waste could be sold as a fertilizer ingredient after some further processing. The further processing would cost $175,000 per year and the waste could be sold for $300,000 per year. The accounting department included the waste as a new product with an allocation of $150,000 in joint product costs.

Sales value of the waste product after further processing $300,000

Less costs assigned to the waste product 325,000

Net Loss $(25,000)

Management decided not to process the waste product. Was this the correct decision?

Answer: No, this was not the correct decision. The analysis presented to management should not have included any joint processing costs. Joint costs are past, sunk, irrelevant. The analysis should have been:

Sales value of the waste product after further processing $300,000

Additional processing costs 175,000

Contribution margin $125,000

This shows the actual benefit from processing the waste product.



2326 Add or Drop a Segment

2326.01 A business segment can be a product, product line, department, division, etc. Key issues in determining whether a segment should be added or eliminated focus on how revenue and cost items would change.

a. Qualitative Factors: These include positive or negative reputation effects when a company disposes of a segment. They may also include cross‐product customer relationships.

b. Quantitative Factors: A segment is contributing to the overall profitability of the organization as a whole so long as the segment contribution margin is at least equal to the segment’s avoidable direct fixed costs. Segment costs are divided into direct variable, direct fixed, and allocated common costs. Direct variable costs will disappear with the segment. Direct fixed costs may not. Each fixed cost needs to be analyzed to determine the extent to which it is avoidable.

(1) Avoidable Fixed Costs: These will be eliminated when the segment is dropped.

(2) Unavoidable Fixed Costs: These are items such as depreciation or salaries of key people who will be retained by the company and assigned to other segments upon the elimination of the segment under examination. Those costs will continue as direct costs of segments to which the related costs objects (equipment, personnel, etc.) are transferred.

(3) Allocated Common Costs: These also will continue, even if the segment is eliminated, and will be distributed among remaining segments. They must not be used to determine the segment’s profitability. In fact, allocated common costs are often the reason the segment is being considered for elimination, even though it is making a contribution to the firm. Sometimes a product is making a contribution even without a positive segment margin, because it is a loss leader bringing other sales to the firm.



Example: A store with four departments is considering closing one of its departments based on the following departmental income statement:

Sample Company Income Statement

(000 omitted)

Departments

Total A B C D

Sales $130 $40 $40 $30 $20

Variable Costs 86 21 21 26 15

Segment Contribution Margin 44 19 16 4 5

Fixed Costs:

Direct Costs 19 7 7 2 3*

Segment Margin 25 12 9 2 2

Allocated Common Costs** 12 4 4 1 3

Departmental Net Income (Loss) $13 $8 $5 $1 $(1)

* $1,000 depreciation, $2,000 salaries ** Allocated based on space occupied

Would closing Department D improve overall company profitability? (Assume that the equipment is retained but that personnel are laid off.)



Answer: The analysis depends upon which costs can be avoided in the future. Variable costs will disappear along with sales revenue and contribution margin. The initial assumption is that direct fixed costs will disappear as well, since they are directly traceable to the department. However this is too simplistic, each cost must be analyzed. This is a situation where sunk costs are relevant in the sense that they cannot be avoided by a future decision. The depreciation expense for store fixtures will not disappear. The cost for salaries of employees who will be laid off will disappear. Allocated common costs will not disappear. The analysis below shows the potential impact of eliminating Department D.

Total D Eliminated New Total

Sales $130 $20 $20 $110

Variable Costs 86 15 15 71

Segment Contribution Margin 44 5 5 39

Fixed Costs

Direct Costs 19 3 2 17

Allocated** 12 3 0 12

Total Fixed Costs 31 6 2 29

Net Income (Loss) $13 $(1) $3 $10

Closing the department would actually decrease net income. Note that if the original Income Statement had been on a segment basis without allocating the common fixed costs, the question of closing the department would not have arisen. The segment contribution margin for Department D is $5,000. Its unavoidable direct fixed costs are $1,000. By applying the decision rule (segment contribution margin at least equal to or greater than avoidable fixed costs), it is obvious that the department should remain in business.



2327 Capacity Considerations

2327.01 Introduce New Product or Change Output Levels: Addition of a new product or changes to output levels of existing products require consideration of how changes in the sales mix will affect the company both qualitatively and quantitatively.

a. Qualitative Factors: A variety of qualitative factors may affect this type of decision. For example, addition of a new product could increase or decrease company reputation, depending on the success and features of the new product. If productive capacity is limited, then changes to output levels could create or alleviate product shortages, which would have further effects on customer satisfaction.

b. Quantitative Factors: The quantitative analysis for this type of decision involves estimating the profit of effects, incorporating the expected changes in sales mix and volumes. The difference in profit includes changes in the contribution margin, as well as changes in total fixed costs (if any). If production capacity is limited so that increasing the output of one product reduces the output of another product, then the opportunity cost of foregone sales must also be considered. The computations are similar to those shown for a special order, below.

2330 Pricing

2331 Pricing Methodologies

2331.01 Pricing Decisions: Companies’ product pricing decisions are influenced by a number of factors.

a. Demand for the Product/Service: Customer willingness and ability to buy a given amount of goods or services at a given price. In general, customers demand lower quantities at higher prices. Some companies, such as Wal‐Mart, adopt a strategy of setting low prices, relying on high volumes to earn profits. Other companies sell differentiated products for which customers are willing to pay higher prices. Shifts in demand can also occur over time. For example, availability of a product substitute can reduce the price customers are willing to pay for a product. Also, product demand may shift downward or upward for a particular product because of changes in economic conditions.



(1) Demand Curve: A demand schedule shows the quantity consumers will purchase at various prices. The law of demand states that as unit price falls, consumers will purchase more quantity. As unit price increases, quantity demanded will decrease.

(2) Change in Quantity Demanded: A change in quantity demanded results from a change in price, with all other factors remaining the same. This is a movement along the demand curve from one price‐quantity combination to another.

(3) Change in Demand: A change in demand is caused by changes in consumers’ tastes, prices of complementary or substitute items, money income, expectations as to price or income changes, the range of available products, and the number of buyers. An increase in demand can be caused by an increase in income or the elimination of a substitute good. A decrease in demand can result from a decrease in income or an increase in substitute goods.

(4) Elasticity of Demand: Elasticity of Demand measures the responsiveness of quantity to a change in the product’s price.

(a) Characteristics: For most goods, the basic determinant of the demand elasticity is the number of substitutes available. The more close substitutes a good has, the greater its elasticity of demand. Also, elasticity is greater over a longer period of time or when a larger portion of the consumer’s income is required to purchase the commodity. The ultimate question is the effect of the change on total revenue. Demand is said to be elastic if total revenue increases from a decrease in price (i.e., the percentage change in quantity is greater than the percentage change in price). Demand is said to be inelastic if total revenue decreases from a decrease in price (i.e., the percentage change in quantity is less than the percentage change in price).

(b) In Practice: In practice, the degree of elasticity is often difficult to measure, and the decision‐maker has only a general idea of the relative elasticity and the slope of the demand curve. However, large retail companies such as Wal‐Mart may be able to estimate price elasticity from transaction data.



b. Supply Availability: Producers are willing to sell a given amount of goods or services at a given price. In general, they are willing to sell higher quantities at higher prices. Sometimes goods or services are scarce, causing the supply curve to cross the demand curve at a higher price. Increased competition has the opposite effect; as new competitors enter a market or as existing competitors increase the quantity available for sale, the supply curve shifts to the right and crosses the demand curve at a lower price. In addition, competitors may choose aggressive pricing policies to help them establish a market position, thus driving the market price downward.

(1) Supply Curve: The supply schedule shows the various quantities producers will bring to market at various prices. The law of supply states that sellers will offer more quantity at a higher price and less quantity at a lower price.

(2) Change in Quantity Supplied: A change in quantity supplied is due to a change in price, with other factors remaining the same.

(3) Change in Supply: A change in supply results from a change in one of the following: prices of inputs, technology, prices of other goods, the number of suppliers, and suppliers’ expectations. A decrease in the cost of the necessary inputs or a technological improvement are examples of changes that will increase the quantity offered by a supplier at all price levels. If there was no quantity change, the price would be reduced. A decrease in the number of suppliers or increase in input prices will decrease the supply.

c. Time Horizon: Pricing decisions may be short‐term or long‐term. Managers are willing to sell goods or services in the short‐term as long as the selling price exceeds marginal costs. For example, they may be willing to accept a special order at a price that is lower than the usual price charged for a good or service. However, the selling price must be high enough for revenues to exceed both fixed and variable costs for companies to stay in business over the long term.



2332 Target Costing

2332.01 Target pricing and costing is the practice of establishing the market price for a product and then determining whether the product can be produced at a sufficiently low cost (the target cost) to ensure a desired rate of return. The product is produced only if the targeted rate of return is achievable. Target pricing and costing is a strategic management tool related to product pricing. The focus of target costing is to focus product design and production on customer needs, while at the same time achieving desired long‐term profitability goals. An understanding of the degree to which costs are built into the product at the design stage is critical to cost control in target costing.

2332.02 Steps in Target Pricing and Costing: Target pricing and costing involves the following steps:

a. Determine Target Price: The process begins with estimation of a market price for the planned design of a product.

b. Calculate Target Cost: The target cost is the difference between the price a customer is willing to pay for a product (i.e., the target price) and the profit the company has determined it must earn from that sale. Because the target cost is calculated before production begins, costs include all resources used to produce the item, including design‐stage costs.

Example: If the target price for a product is $100 and the company

requires a 30% rate of return on cost, what is the target cost?

Answer: Convert the required rate of return to an algebraic equation,

and then solve for the target cost:

$100 – Cost = 30% × Cost

$100 = 1.30 × Cost

Target Cost = $100/1.30 = $76.92

Example: If the target price for a product is $100 and the company

requires a 30% profit margin, what is the target cost?

Answer: Calculate the required profit margin, and then solve for the

target cost:

Required profit margin = $100 × 30% = $30

Target Cost = $100 – $30 = $70

c. Compare Estimated Cost to Target Cost: The estimated cost to produce the product is then compared to the target cost. If the estimated cost is less than or equal to the target cost, then the product will be produced. If the estimated cost is higher than the target cost, then the company must either drop the product or seek ways to reduce costs.



d. Eliminate Non‐Value‐Added Costs: One method to achieve the target cost is to identify and eliminate non‐value added costs—i.e., costs incurred that do not add value to the customer. Value chain analysis is often used to identify non‐value‐added costs.

e. Other Cost Reductions: A variety of other methods may be used to achieve the target cost, including product redesign, improved production efficiency, outsourcing, and supplier price negotiations.

2333 Elasticity of Demand

2333.01 Price elasticity of demand

a. The price elasticity of demand is a measure of the responsiveness of consumers to a change in a product’s price.

b. The law of demand states that there is an inverse relationship between the price and quantity demanded of a product. However, it does not provide the information about the relationship between the two variables.

c. The formula for measuring the price elasticity of demand is:

dd

%QE

%P

the change in the particular variable

d. The law of demand states that price and quantity move in opposite directions. In other words, as price increases, quantity demanded falls. By convention, economists use the absolute value of the measure rather than using the minus sign when stating price elasticity of demand.



e. A problem arises depending upon which value is used as the base value when performing the calculation. The following situation could arise. If the base price is $10 and the price increases to $12, the price has increased by 20%. If the base were $12 and the price fell to $10, then the percentage change would be 16.67%. To solve this problem, the formula is modified to use a mid‐point and is calculated as follows:

2

2

1010

1010

PPPP

QQQQEd

QO = Original quantity Q1 = New quantity Po = Original price P1 = New price

f. Summary of price elasticity of demand (Ed):

Condition Elastic Ed > 1

Inelastic Ed < 1 Unit elastic Ed = 1

Perfectly elastic Ed = ∞ Perfectly inelastic Ed = 0

2333.02 Determinants of elasticity of demand

a. The larger the number of substitutes generally available for the product, the greater its price elasticity of demand.

Narrowness of definition of the product has a significant impact on the number of substitutes that are available. For example, the demand for Fords would be more elastic than the demand for automobiles. There are other brands that are readily substitutable for Fords, but there are few, if any, good substitutes for automobiles for most types of individual transportation.

b. All other things being equal, the higher the price of the good relative to the consumer’s income, the more elastic the demand for the product. Everything else being equal, the demand for a new automobile would be more responsive to a price change than the demand for clothing.



c. Generally speaking, the more the consumer considers the good to be a “luxury” rather than a “necessity,” the greater the price elasticity of demand. Everything else being equal, the demand for entertainment would be more responsive to price changes than the demand for food.

d. Generally, the longer consumers have to respond to a price change, the more elastic the demand would be. A classic example relates to the demand for gasoline. When gasoline prices rise, in the short run consumers have little opportunity to respond; however, if prices remain high, over the long run they can replace their automobiles and trucks with more fuel‐efficient vehicles.

2333.03 Price elasticity and total revenue (the total revenue rule)

Firms are interested in being able to estimate their revenue from sales. The concept of elasticity provides one method to facilitate making such measurement. In the simplest case, revenue is defined as the price of the product times the quantity sold.

a. If demand is elastic at the current price, then reducing the price will increase the total revenue and vice versa.

b. If demand is inelastic at the current price, then increasing the price will increase total revenue and vice versa.

c. If demand is unitarily elastic, then changing the price will have no impact on total revenue.

This set of relationships is known as the “total revenue rule” and allows a firm to determine the general impact that a price change would have on the firm’s revenue if the product’s elasticity of demand can be estimated.

2333.04 Other measures of elasticity

a. There are other measures of elasticity that could help a firm estimate the demand for their product as other demand determinants change. These measures are used to define various relationships among and between products.

b. Income elasticity of demand measures the responsiveness of consumer demand for a product relative to a change in income.

c. The formula for calculating income elasticity of demand is:

Ey = Percentage change in demand for the good

Percentage change in income

d. When Ey > 0, then the product is a normal good. If Ey is < 0, then the product is an inferior good.



e. Summary of income elasticity of demand (Ey):

Condition Normal good Ey > 0 Inferior good Ey < 0

f. Cross‐elasticity of demand measures responsiveness of consumer demand for a product relative to the change in the price of another product. If consumers buy less of the original product, then the goods are complements.

g. The formula for calculating cross‐elasticity of demand is:

EPy = Percentage change in the demand for one good Percentage change in the price of another good

h. If EPy > 0, then the goods are substitutes. If EPy < 0, then the goods are complements. A summary of elasticity:

Condition

Complements Epy < 0 Substitutes Epy > 0 Unrelated Epy = 0

2333.05 Other supply and demand topics

a. Complementary goods are goods and services that are used in conjunction with each other. When the price of one good falls and the quantity demanded of that good rises, the demand for the other good rises. The cross‐elasticity of demand of complementary goods is negative since as the price of product A declines, the more of product B will be purchased at any price. For example, if the price of hot dogs falls, consumers will purchase more hot dogs, and they will also purchase more hot dog buns, a complementary good.

b. Inferior goods are goods or services whose demand decreases as a consumer’s income increases, assuming prices remain constant. The “inferiority” being described has nothing to do with the actual quality of the item but with the consumer’s ability to purchase needed items. For example, when consumers have limited incomes, canned vegetables will often be purchased rather than fresh vegetables; however, as incomes rise, less canned vegetables will be purchased as the consumer substitutes fresh vegetables for the “inferior product” that was purchased only because of the consumer’s limited income. Inferior goods have a negative income elasticity of demand.

c. Normal goods are good or services whose demand increases as consumer’s income increases, assuming prices remain constant. Normal goods have a positive income elasticity of demand.



d. Substitute goods are goods and services that can be used in place of each other in at least some of their uses. When the price of one good falls, the quantity demanded of that good increases and the demand for the other good without a price decrease falls. If goods are perfect substitutes, the consumer is indifferent as to which product to purchase and will purchase the one with the lower price. If goods are imperfect substitutes, the purchase decision would be based on the price change of one good relative to trade‐offs being made such as differences in quality between the two goods. For example, a consumer may believe a Ford truck is of better quality that a Toyota truck, but at some difference in price, some consumers would substitute the Toyota truck. A substitute good is the opposite of a complementary good.

e. Law of diminishing marginal utility is a proposition that describes how an individual’s satisfaction (or marginal utility) derived from the consumption of each additional unit of the good or service declines as consumption of that good or service increases. For example, a guest may desire a piece of pie at the end of dinner on Thursday evening and derives a level of “satisfaction” from consuming it. The host offers the guest a second piece of pie and the “satisfaction” the guest receives from consuming that piece of pie is less than that received from consuming the first.

2334 Product Life‐Cycle Considerations

2334.01 Product life‐cycle costing is a strategic planning technique that incorporates all of the expected revenues and costs over a product’s life cycle. Products may originally sell at a loss, but are expected to generate sufficient profits over time.

2334.02 Upstream and Downstream Costs: In addition to production costs, all upstream (research, design, and development) and downstream (marketing, distribution, and customer support) costs are considered.

2334.03 Stages of Product Life Cycle: A product’s life cycle is the time period between the initial design and development of a product and the product’s ultimate termination. A successful product experiences the following general stages.

a. Development Stage: This stage is characterized by research and development and investments in plant and equipment, etc. Revenues may be zero or small during the development stage, resulting in losses.



b. Growth Stage: During this stage, revenue increases rapidly as volume increases. Manufacturing efficiencies can lead to improved contribution margin. Cash inflows are typically significant, but may be offset somewhat by expenditures required to increase production capacity and increased investment in inventory and accounts receivable.

c. Maturity Stage: Profits are at an optimum level during this stage. However, higher promotional costs may be incurred to counter increased competition, which may lead to decreased profit margins.

d. Decline Stage: Both sales volume and profits decline during this last stage, due to greater price competition and availability of substitute products. Unit costs tend to increase. However, significant cash inflows can result from the liquidation of inventories and other assets related to the product.

2334.04 Almost all products have life‐cycle stages and marketing strategies vary depending upon the particular stage. Because of this, companies must continually find and develop new product ideas.

a. New Product Development: Authorities identify the below steps although some of the functions may be combined.

(1) Idea Generation: This can come from internal sources and formal research such as surveys and focus groups. Customer feedback and suggestions for improvements may be a good source of ideas. Tracking competitive new products may lead to the idea of introducing a similar item. A written plan for each new product should be prepared.

(2) Idea Screening: Not all new ideas are good and not all good ideas are economically viable. The company will typically have a pre‐established set of new product criteria that must be met.

(3) Product Concept Development: The ideas that meet the company’s threshold criteria must then be analyzed in detail. This focuses on the detailed economics of the proposal and how the idea will be stated in meaningful consumer product images.

(4) Concept Testing: This is empirically verifying the conclusions reached to date. A test of the target consumers is undertaken to ensure that strong consumer demand exists.

(5) Marketing Strategy Development: This is a formal written statement that describes the product’s planned pricing, distribution, and marketing budget for the first year.



(6) Business Analysis: This is an accounting‐related review of the sales, cost, and profit projection of the proposed new product to determine if they meet the company’s threshold financial measures.

(7) Product Test Marketing: If the product passes the company’s business analysis, the stage of test marketing begins. This varies depending upon management’s faith in the strategy and steps discussed above.

b. Simulation: Many companies combine and expedite a number of the above steps by using cross‐functional teams to examine many aspects of the product at the same time. While reducing the time to get a new product ready to market there may be trade‐offs in terms of thoroughness. Rushing a product to market should not adversely affect quality.

c. Commercialization: This is incurring the high costs to introduce the new product into the markets. Variables include introduction timing and where to launch the new product.

d. Product Life‐Cycle: Authorities identify five stages marketed by different problems and opportunities. This can be applied to a product class (automobiles), a product form (station wagon), or a brand (Volvo).

(1) Product Development: This is discussed above. Revenue is zero and development costs are being incurred.

(2) Introduction: Sales begin slowly, promotion spending is relatively high, and cash flow may remain negative.

(3) Growth: There is rapid market acceptance, sales climb but marketing costs stay high. Still profits grow and cash flow turns positive. Competition is beginning to enter the market.

(4) Maturity: Competition drives down prices and companies may stay in the maturity stage for years. The emphasis changes from attracting new customers to increasing service to our existing customers. Companies modify their marketing mix and product lines to meet and beat competitors. Profits are good but towards the end may begin declining.

(5) Decline: Profits drop and management must decide whether to continue carrying a weak product which may adversely affect customer’s perception of all the products. Competitors may leave the market and the company may decide to stay but only serve the hard core customers and reduce marketing costs.



2335 Market Structure Considerations

2335.01 Perfect competition

a. The market structure of perfect competition is characterized by a large number of sellers producing a standardized product with easy entry and exit into and out of the industry. The seller has no ability to influence the product price.

b. There are a number of assumptions involving perfect competition:

(1) There are many small independently acting buyers and sellers who produce a standardized or homogeneous product, none of whom can influence price.

(2) Each firm produces such a small portion of total output that they have no influence over price. The firm is a price taker, that is, the firm must accept the market price.

(3) There is free entry into and exit from the industry. There are no significant legal, technological, or financial barriers to entry. Information is free and readily available.

(4) Firms face a perfectly elastic demand curve at the market price that is determined where consumer demand equals industry supply.

(5) For the perfectly competitive firm, Price = Average revenue = Marginal revenue.

(6) If the firm is making an economic profit, there is an incentive for new firms to enter the market. The entry of new firms will increase supply and shift the industry supply curve to the right, reducing the equilibrium price. Entry will continue until there is no economic profit, that is, the firm is earning only a normal profit.

c. The market equilibrium occurs where price equals marginal cost at the minimum point on the average cost curve. This means that in equilibrium, a firm is operating at its most efficient level of output. The following graph represents the equilibrium position in a perfectly competitive industry. Marginal revenue equals marginal cost as minimum average cost. At this point, the firm is making only a normal profit.



PO = Price Q0 = Quantity demanded D0 = Demand

MR0 = Marginal revenue MC = Marginal cost ATC = Average total cost

2335.02 Monopolistic competition

a. The market structure for monopolistic competition is characterized by having many small firms that produce differentiated products. The firm has some degree of control over product price.

b. There are a number of assumptions for monopolistic competition:

(1) There are a relatively large number of independent and small buyers and sellers.

(2) There is free entry into and exit from the industry.

(3) Firms are producing a differentiated product. The differences may be found in product attributes such as materials, design and workmanship, varying degrees of customer service, convenient location, packaging, and brand image.

c. In monopolistic competition:

(1) the firm faces a downward‐sloping demand curve and marginal revenue is less than price. Firms can make an economic profit in the short run.

(2) there tends to be significant use of advertising as a form of non‐price competition. The goal of advertising is to shift the firms demand curve to the right and to make demand less elastic; that is, to make consumers less responsive to price changes.



(3) product differentiation leads to firms competing on quality, price, and marketing.

(4) the existence of economic profit provides an incentive for firms to enter the industry, shifting the industry supply curve to the right. Entry will continue until economic profit disappears.

d. Firms in markets that are imperfectly competitive face a downward‐sloping demand curve, which implies that marginal revenue is less than price. In the graph below, the firm would maximize price at the point where marginal revenue equals marginal cost. At the profit maximizing level of output (Qo), the firm would change price (Po) and make an economic profit as shown in the area Po ABP.

P = Price Q = Quantity demanded D = Demand

MC = Marginal cost MR = Marginal revenue ATC = Average total cost

2335.03 Oligopoly

a. Oligopoly is a market structure characterized by a few firms that sell either a standardized or differentiated product and where entry into the industry is difficult.

b. There are a number of assumptions for an oligopoly:

(1) There are a small number of relatively large firms.

(2) Firms may produce either a standardized or differentiated product.

(3) Firms in the industry are interdependent.

(4) Firms tend to engage in non‐price competition.



c. In oligopolies:

(1) firms face a downward‐sloping demand curve and have some degree of control over price.

(2) there generally are barriers to the entry for new firms into the industry, including economies of scale (that is, the firm must be large to be efficient), ownership of raw materials, patents, and brand image.

(3) firms can benefit from collusion. A cartel is one form of collusion where producers create formal agreements specifying how much each member will produce and charge. OPEC is an example of a cartel. Such collusion is illegal in the United States.

d. A kinked demand curve is one type of demand curve that a firm operating in an oligopoly might face. One strategic assumption is that competitors will follow a price reduction but will not follow a price increase. Under these circumstances prices would tend to remain relatively stable.

(1) A firm will not gain market share by lowering prices and thus revenue would fall.

(2) A firm would lose market share if it raises prices, and thus revenue would fall if the firm were operating on the elastic portion of its demand curve.

(3) If competitors fail to understand this logic, there is a strong possibility of a price war as firms engage in successive rounds of price cutting in an attempt to maintain market share.



e. If a firm in an oligopoly faces a kinked demand curve, demand is relatively more elastic in response to a price increase and more inelastic if the firm reduces price. The theory indicates that in the range of costs between points A and B on the graph, the firm would not change price or output even though marginal costs increased.

P = Price q = Quantity

MR = Marginal revenue d = Demand

MC = Marginal cost

f. Since firms in an oligopoly prefer to engage in non‐price competition, advertising wars often occur. Product improvements and successful advertising campaigns cannot be easily replicated by the competition. Since many oligopolies have sufficient resources to finance advertising, an increase in advertising expenditures on the part of one firm may force competitors to respond or lose market share. This would be one example of a barrier to entry for competitors.

This often is akin to the inverse of a price war in that, in the end, advertising is self‐canceling, and firms have increased cost without increasing revenue.

Price leadership is another form of competition in oligopoly. It often results in an implicit agreement that coordinates prices without having the firms engage in illegal collusion. Basic tactics of leadership include the following:

(1) Infrequent price changes. The firm does not respond immediately to day‐to‐day fluctuations in demand. Price tends to change only when costs have increased significantly (an industry‐wide wage increase or increases in energy costs).



(2) Potential impending price changes are usually “announced” by the price leader.

(3) The goal is not to maximize short‐term profit but rather to discourage the entry of new firms into the industry and protect long‐term profitability. The price leader often has a cost advantage over other firms in the industry and can still be profitable at a price level that smaller, higher‐cost firms could not.

2335.04 Monopoly

a. In a monopoly, there is a single seller of a product for which there are no close substitutes. The firm has considerable control over price and is a price maker.

b. A monopolist:

(1) has strong barriers to entry that keep competitors out of the industry. These barriers might include economies of scale, legal barriers such as patents and licenses, advertising or competitive pricing strategies, and control of existing resources.

(2) faces a downward‐sloping demand curve with marginal revenue less than price.

(3) may have its monopoly position derived from government action. In this instance, the firm may go to great limits to maintain that monopoly by engaging in rent‐seeking activities such as lobbying legislators.

(4) will tend to set price in the elastic range of their demand curve.

(5) tends to have less incentive to innovate and improve efficiency than firms in monopolistically competitive or oligopolistic industries.

A public utility is a common example of a regulated monopoly.

c. Natural monopolies arise when economies of scale extend beyond the market’s size and total costs are minimized by having only one firm in the industry. Conditions often exist for local public utilities where competition is impractical.

(1) Often the government regulates the industry with a key form of regulation being the setting of prices that can be charged.

(2) In some instances in the United States, natural monopolies have been moved to private ownership. For example, the U.S. Postal Service has been privatized.

(3) Some regulation (for example, early regulation of the airline industry) was designed to prevent creation of a natural monopoly.



2335.05 Consumer surplus and producer surplus: The demand curve and supply curve show what consumers and producers are willing and able to buy or offer for sale at various alternative prices at a given moment in time. The interaction of buyers and sellers in the marketplace determines an equilibrium price. If a consumer is able to buy the product at the equilibrium price, and that price is below what the consumer would be willing to pay for the product, a “consumer surplus” exists. The same would be true for producers who are able to sell their product above the price they would have been willing to use. This difference is known as a “producer surplus.” The graph below demonstrates the degree of consumer and producer surplus at a market equilibrium.

p = Price q = Quantity D = Demand S = Supply

2335.06 Price discrimination

a. A firm can increase profits if different prices can be charged to different buyers. This would be price discrimination. Price discrimination is the practice of selling a product or service at different prices to different consumers when those price differences are not justified by cost differences.



b. Price discrimination is possible when:

(1) the firm is able to have some degree of control over output and price.

(2) buyers can be segregated into distinct classes that have different abilities (or willingness) to pay for the product or service often based upon different elasticities of demand. Prices are often varied for different age groups. For example, admission to entertainment facilities often varies with age, with children and senior citizens receiving discounts.

(3) purchasers from the lower‐priced market would not have the ability to resell to purchasers from the higher‐priced market. Examples would be airline tickets and legal or medical services. Price discrimination is widely used in the airline industry. For example, the business traveler often has an inelastic demand when the need for traveling arises. The vacationer, however, has a more elastic demand and is willing to buy advance purchase tickets to obtain lower fares.

c. The logic of price discrimination is to attempt to segment the market, change the price consumers would be willing to pay, and recapture a portion of the consumer surplus.


Surgent CMA Review

Section 2400 Risk Management (10%)

2410 Enterprise Risk

2411 Types of Risk

2411.01 Risk assessment is a step in the risk management process that determines the amount of risk related to a threat (or hazard). To calculate the amount of risk there must be an estimate of the potential loss and the probability the loss will occur. The risk may be related to financial decisions, or it could be environmental or a health risk issue. The risk will be accepted as long as the benefits derived are greater than the cost.

2411.02 Types of Risk

a. Operational Risk: Operational risk is defined as “The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.” Operational risk deals with the overall risk of operating a business and would include fraud risks, legal risks, and physical and environmental risks. Operational failures can lead to other risks, such as risk of damage to the reputation of the firm and customer satisfaction.

b. Hazard Risk: Hazard risk (liability torts, property damage, natural disaster) may be considered a part of operational risk and may involve environmental and health issues. An example of hazard risk is the uncertainty assumed by a pharmaceutical company in going to market with a new drug. Although the drug has gone through rigorous testing, there is still a risk that there will be reportable cases of bad side effects, or even death, from the use of the drug. Hazard risk can also be a factor in manufacturing since equipment could fail and cause bodily harm to the operator.

c. Financial Risk: Financial risk is the risk involved with financing an asset (pricing risk, asset risk, currency risk, liquidity risk). This risk exists because there is a probability that the actual return received from the asset will be less than the expected return. High risk investments have the potential for greater returns, but there is greater potential for loss of the investment (loss of capital). If an investment is held in another currency, you also have the risk that there will be exchange value

Section 2400 – Risk Management


changes that could affect the value of the investment at the point of liquidating the investment). The asset may have a limited sale market which increases the risk of the investment (liquidity risk).

d. Strategic Risk: Strategic risk (competition, capital availability) is the risk associated with the future business plans and strategies for the business. This risk arises because of the current or future impact on earnings that arise from improper decisions or implementation. This can include adding new products or entering a new line of business, expanding through merger or acquisition, or expansion through the purchase of additional plant and equipment. The expansion of the firm will expose the company to increased risk since it is possible the firm will not receive a large enough return on investment to recoup their costs and provide an appropriate return. Strategic plans should document that the risks have been examined and how the firm plans to mitigate the risks.

2412 Risk Identification and Assessment

2412.01 The risk management process includes the strategies that allow a firm to manage its risks related to participating in financial markets.

2412.02 The firm has a choice to accept, transfer, or manage risk.

a. Management may choose to absorb the potential impact of volatility on earnings, assuming that over time the eventual upside may outweigh the short‐term downside.

b. A risk manager may attempt to transfer the risk along the supply chain. This would involve shifting the risk to the end customer or to suppliers.

2412.03 The risk management process includes an understanding the requirements for valuation of derivative securities and applicable accounting regulations per FASB ASC 815 or IAS 39. Often a firm will attempt to manage the risk through the use of some form of hedging program. (A hedge is a strategy to insulate a firm from exposure to price, interest rate, or foreign exchange fluctuations.)

2412.04 The risk management process includes both internal and external controls, and involves:

a. identifying and prioritizing risks and understanding their relevance.

b. understanding the stakeholder’s objectives and their tolerance for risk.

c. developing and implementing appropriate strategies in the context of a risk management policy.



2412.05 The risk management process requires understanding the interconnectedness among and between the basic components of economics, accounting, and control.

a. Economics requires being able to measure the risk before attempting to manage it.

b. The control function provides the needed guidelines for the hedging activity and any necessary oversight.

c. The accounting function requires understanding the requirements set forth in FASB ASC 815. As per the FASB, the following points relate to FASB ASC 815:

(1) Under FASB ASC 815, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk.

(2) For a derivative designated as hedging, the exposure to changes in the fair value of a recognized asset or liability, or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value.

(3) For a derivative designated as hedging, the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the effective portion of the derivative's gain or loss is initially reported as a component of other comprehensive income (outside earnings) and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately.

(4) For a derivative designated as hedging and the foreign currency exposure of a net investment in a foreign operation, the gain or loss is reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment. The accounting for a fair value hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of an unrecognized firm commitment or an available‐for‐sale security. Similarly, the accounting for a cash flow hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of a foreign‐currency‐denominated forecasted transaction.



(5) For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change.

2412.06 Special issues facing small businesses

a. Small firms have problems with various components of the financial risk management process that are effective for larger firms. While these problem areas exist for large firms as well, the specific problems facing smaller firms relate to dealing with the problems in a manner consistent with the firm’s resource capabilities, and include the following:

(1) The fact that small firms are unable to use broader capital markets (i.e., expand past the use of banks as a source of funds) because investors in these markets require higher rates of return on what would appear to be riskier investments (i.e., the investor would have little ability to assess the creditworthiness of the firm).

(2) These firms are generally unable to diversify their operations (i.e., reduce business risk).

(3) Such firms usually have few suppliers and/or the clout or logistical ability to purchase from a large number of vendors (i.e., unable to reduce supply‐chain risk).

b. A smaller firm must understand its full economic exposure to foreign exchange or interest rate risk and identify the degree to which there are any natural offsetting positions in its operations to take advantage of any benefits of diversification that exist. (Economic exposure is defined as the degree to which a firm’s present value of expected future cash flows can be impacted by unanticipated exchange rate fluctuations.)

c. If the firm chooses to hedge, they must be certain to use a derivative that is specifically related to the risk in question. Risks dealing with cash flow from operations are often best dealt with options (a derivative financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a reference price during a specified time frame). More predictable asset positions often are best dealt with forwards and futures.

d. Speculation with derivatives should never occur. It is helpful to employ some outside entity to monitor any hedge or derivative positions that are held.



2413 Risk Mitigation Strategies

2413.01 The first step in mitigating risk is to determine what individual items of risk exists. Once this has been completed, a management activity should be associated with each risk. This can be entered into a table format (see below) for documentation. A poorly designed scope for a project may have several risk factors to document (cost estimates are not sound, cannot get complete requirements, etc.).

Risk Factor to Investigate Management Activity Required Cost estimates not sound Determine proper scope of the project, who is affected, what information is required, define business requirements.

2414 Managing Risk

2414.01 Enterprise Risk Management: Enterprise risk management (ERM) includes the methods and processes used by the organization to manage risks and take advantage of opportunities related to and furthering the objectives of the firm. This typically involves the determination of events or circumstances that is relevant to the organization’s objectives, risks and opportunities, determining their likelihood of occurrence and impact on the firm, determining a strategy in response, and monitor the progress (through the internal control system).

a. ERM Framework: The ERM framework is a system that identifies, analyzes, responds to, and monitors risks and opportunities, both internal and external, for the entity. Management selects a strategy for specific risks that may include avoidance (exit the activity), reduction (take an action that should reduce risk), share or insure (shares the risk with another entity), or accept (take no action because the benefits exceed the costs).

b. Steps in an ERM Program: The risk management process may include 1) an understanding of the internal environment of the firm, 2) an identification of the risks (material threats) to the firm, 3) assessing the risk by analyzing and quantifying (if possible) using probability distributions, 4) determine strategies for controlling risks, and 5) monitor the effectiveness of the risk strategies used.

(1) Environment

(2) Risks and Threats Identification

(3) Assessing Risk

(4) Strategy for Risk Control

(5) Monitor Effectiveness





Surgent CMA Review

Section 2500 Investment Decisions (10%)

2510 Capital Budgeting Process

2511 Stages of Capital Budgeting

2511.01 Capital budgeting fundamentals

a. Capital budgeting is the analysis of investment decisions that have a useful life longer than one year. Management uses capital budgeting to allocate resources to investment opportunities in an attempt to obtain the maximum value for the firm. Investment decisions are project oriented. Poor capital budgeting decisions can often be difficult to reverse. Questions such as the following are addressed:

(1) Should machinery be replaced by more expensive but more efficient models?

(2) Should a new product or market be added?

(3) Should existing debt be extinguished or refinanced?

(4) How can a constrained resource best be used?

b. The relevant data in capital budgeting is cash‐flow oriented. Regardless of the approach used, the following items are essential:

(1) Initial investment

(2) Future net cash inflows or net savings in cash outflows

c. Data for capital budgeting is relevant only if it affects the cash flows. Some data accumulated for financial reporting is either not useful or must be adjusted to be useful for capital budgeting purposes. Financial accounting is primarily concerned with computing periodic earnings using the accrual basis of accounting for the firm or a reportable segment of the firm. Accrual accounting is not relevant in capital budgeting. The decision is project oriented, and relevant data includes the expected cash flows associated with that project. Items such as the depreciation expense are sunk costs as they relate to capital decisions, and only become relevant as they relate to tax consequences.

Section 2500 – Investment Decisions


d. Because capital budgeting is long‐term oriented, the time value of money is very important. Some approaches to capital budgeting account for the time value of money and some do not. Those that account for it are considered preferable because of the difference between a $1 investment today and a $1 return sometime in the future. Inflation that persists and the opportunity cost of having money sit idle make present and future earnings unequal. Present‐value techniques are useful in adjusting dollar amounts received or paid at different points in time to a common point in time.

e. The statistical term expected value describes the numerical average of a probability distribution. It can be used to estimate future cash receipts from a capital budgeting project. This method is employed to estimate the weighted‐average amount of future cash receipts by (a) estimating the various amounts of cash receipts from the project each year under different assumptions or operating conditions, (b) assigning probabilities to the various amounts estimated for each year, and (c) determining the mean value of the estimated receipts for each year.

f. Cost of capital refers to an overall cost of obtaining investment funds. While different techniques may be used in computing cost of capital, it is generally agreed that a cost factor should be assigned to both debt and all stockholders’ equity (including retained earnings). Some authorities suggest using a weighted‐average cost of capital for capital budgeting purposes. Cost of capital is the desired or target rate of return used in the net present value method of discounted cash flow computations. It is also the minimum acceptable (cutoff) rate used in choosing among projects employing the time‐adjusted rate of return method, described below.

g. There are several techniques for capital budgeting. These approaches are often used, first to screen project possibilities, and second to rank existing choices. Those commonly used techniques include the following:

(1) Payback method

(2) Discounted payback

(3) Accounting rate of return

(4) Net present value

(5) Internal rate of return

(6) Profitability index

(7) CVP analysis/margin of safety



2511.02 Time value of money

a. Cash received at different points in time is not comparable because of the time value of money. Money held today has a greater value than money that will be received tomorrow. The time value of money is determined by the price of the money (interest) and the length of the time period. Present value or future value computations are made to adjust for time and interest so that all cash flows are set at a common point in time. There are two basic questions involving the time value of money computations. First, what is the future value (value at some specified point in the future) of a sum of money to be received today? Second, what is the present value (value today) of a sum of money received in the future? These questions can be answered for a single, lump‐sum cash flow or a series of cash flows. A series of equal cash flows is called an annuity.

b. Future value of a $1 sum. A sum of money (P) invested today at a given interest rate (i) will increase in value over time (n). The future value (F) of that sum can be computed as:

F = P(1 + i)n

Factors have been computed for various combinations of i and n where the interest factor is specified as fin = (1 + i)n and are contained in future value tables. A portion of a future value table is shown below.

Period 8% 10% 12%

1 1.0800 1.1000 1.1200 2 1.1664 1.2100 1.2544 3 1.2597 1.3310 1.4049 4 1.3605 1.4641 1.5735 5 1.4693 1.6105 1.7623

When using the factors from the table, the equation F = P(fin) is used.

Illustration: How much will $10,000 be worth in four years if the interest rate is 10%?

Formula solution: F = P (1 + i)n = $10,000 (1 + .10)4

= $14,641 Table solution: F = P(fin) when i = 10% and n = 4

= $10,000 (1.4641) = $14,641



c. Present value of a $1 sum: The method for computing the present value or discounted value of a $1 sum is just the opposite of future value. The question is, what amount (P) must be invested today at a given interest rate (i) to be worth a specified amount (F) in a given number of years (n)? The present value equation can be solved for P to obtain the following:

niFP

1

1

…where the PV factor for a sum received in the future is specified as:

nini

P

1

1

The present value tables contain various combinations of i and n. Note that Pin is the reciprocal of fin. A portion of the PV tables is shown below.

Period 8% 10% 12%

1 0.9259 0.9091 0.8929 2 0.8573 0.8264 0.7972 3 0.7938 0.7513 0.7118 4 0.7350 0.6830 0.6355 5 0.6806 0.6209 0.5674

Illustration: An investment will pay $15,000 in four years. What is the present value of the payout if the interest rate is 10%? In other words, what amount of money would have to be invested today to pay $15,000 in four years?

Formula solution:

1

x 1

1$15, 000 x 41.10

$15, 000 x (0.6830)

$10, 245

P F ni

Table solution:

P = F(Pin) where i = 10% and n = 4

= $15,000(0.6830)

= $10,245



d. Annuity: An ordinary annuity (annuity in arrears) is a series of equal cash flows received at the end of equal intervals of time. An annuity due (annuity in advance) is a series of equal cash flows received at the beginning of equal intervals of time. The difference between these two cash flows is that no interest is computed on the last payment of an annuity in arrears. When dealing with future value/present value tables, care must be taken that the correct annuity table is used.

An example of an annuity in arrears (regular, ordinary, or deferred annuity) with three annual payments of $1,000 each would be:

Time Period Payment

0 0 1 $1,000 2 $1,000 3 $1,000

An example of an annuity due (annuity in advance) with three annual payments of $1,000 each would be:

Time Period Payment

0 $1,000 1 $1,000 2 $1,000 3 0

e. Future value of an ordinary annuity: The future value of an ordinary annuity represents equal annual payments received at the end of the period that are accumulated and earn interest. In other words, what will be the value of a series of payments that are compounded at a given rate of interest at a point in the future? There will be no interest earned until the first payment is made, and no interest will be earned on the last payment. (FVA = future value of an annuity, PMT = the payment)

i

iPMTFVA

n 11

As with future value and present value of a $1 sum, there are tables available to speed the calculation of the future value of an annuity. A portion is shown below:

Period 8% 10% 12%

1 1.0000 1.0000 1.0000 2 2.0800 2.1000 2.1200 3 3.2464 3.3100 3.3744 4 4.5061 4.6410 4.7793 5 5.8666 6.1051 6.3528



Illustration: What is the future value of a three‐year, ordinary $1,000 annuity when money is worth 10%?

Formula solution:

1 1

31 .10 1

$1, 000.10

$1, 000(3.3100)

$3, 310

ni

FVA PMTi

Table solution:

FVA = PMT(FVIFAin) where i = 10% and n = 3

= $1,000(3.3100)

= $3,310

The future value of an annuity due has a similar formula to the one above. Remember, an annuity due has the cash flow occurring at the beginning of the period.

ii

iPMTFVA

n

due

1

11

There are also annuities due tables available in order to make calculations easy.

f. Present value of an annuity: The present value of an annuity is the value today of a future series of payments discounted at a particular interest rate. The present value of an annuity can be computed by restating each of the annuity amounts to the present time period using the present value of an annuity formula or the factor from a table of present values of an annuity of $1. Remember to be careful to determine whether an annuity in arrears (ordinary annuity) or an annuity in advance (annuity due) is appropriate.

The formula for the present value of an ordinary annuity is:

i

iPMTPVA

n

n11



There are tables available to speed the calculation of the present value of an annuity. A portion for an annuity due is shown below:

Period 8% 10% 12% 1 0.9259 0.9091 0.8929 2 1.7833 1.7355 1.6901 3 2.5771 2.4869 2.4018 4 3.3121 3.1699 3.0373 5 3.9927 3.7908 3.6048

Illustration: What is the present value of a $1,000 annuity received at the end of the year for three years when interest is 10% and payments are made at the end of the period?

Formula solution: PVAn = $1,000 ( 1 - (1 + i)‐n

i

)

= $1,000 ( 1 - (1 + .10)‐3 .10

)

= $1,000 (2.4869) = $2,489 Table solution: PVAn = PMT (PVIFAin) where i = 10% and n = 3

= $1,000 (2.4869) = $2,489

The present value of an annuity due has a similar formula to the one above. Remember, an annuity due has the cash flow occurring at the beginning of the period.

ii

iPVA

n

due

111

000,1$

There are also annuities due tables available in order to make calculations easy.

g. Compound interest: When dealing with capital budgeting problems, assume that interest is compounded annually. However, it is not unusual to have interest stated at an annual rate but paid semi‐annually (bonds), quarterly, or even monthly. In these cases, the interest rate and number of periods must be adjusted when making the calculation by using the following steps:

(1) Adjust the interest rate according to the compounding period. For example, 16% interest compounded semi‐annually is 8% each period.

(2) Adjust n from the number of years to the number of compounding periods. For example, five years compounded semi‐annually is 10 periods.



2511.03 Accounting rate of return (simple rate of return)

a. The accounting rate of return does not consider the time value of money. The annual net cash inflow is adjusted for depreciation to arrive at annual accounting income and divided by the investment. It focuses on the average income generated by a project in relation to the investment. Unlike other methods, it focuses on income and not cash flows.

Accounting rate of return = Net cash inflow - Depreciation

Investment

b. The average annual profits (or increased income) is the numerator. This method does not differentiate between projects that have high early cash inflows and projects that have high late cash inflows. Thus, the time value of money is not taken into account.

c. There is not unanimous agreement as to how the investment should be defined. Some alternatives include (a) initial cost, (b) average book value, or (c) annual book value. Either (a) or (b) is preferable to (c). The use of annual book value results in an increasing rate of return over the life of the investment, providing the accounting income was relatively stable over the life of the project, since the book value would decrease as accumulated depreciation increases.

d. When using this method as a screening tool, the accounting rate of return must be equal to or greater than the company’s hurdle rate for the project to be acceptable.

e. This method is popular due to consistency with financial reporting techniques commonly used to evaluate company and divisional performance; however, it does bring all of the accrual income problems into the formula. It is also simple and easy to understand.

f. Illustration: Accounting rate of return method (simple rate of return)

Problem: Compute the accounting rate of return for an investment opportunity that costs $100,000 and provides equal net cash inflows of $20,000 per year for 10 years. Straight‐line depreciation is used in calculating net income; therefore, annual depreciation will be $10,000 ($100,000 ÷ 10 years). The average investment will be the initial investment divided by 2, or $50,000.

Solution:

Accounting rate of return = Net cash inflow - Depreciation

Investment

= $20,000 - $10,000

$50,000

= 20%



2511.04 Net present value

a. The net present value method adjusts for the time value of money. It seeks to determine whether the present value of the estimated net future cash inflows at a desired (or required) rate of return will be greater or less than the cost of the proposed investment. Using this method, initial investment, net cash inflows (or cash savings), and the discount rate are givens. The present value (PV) of the net cash inflows is calculated and compared to the initial investment. An investment proposal is desirable if its net present value (NPV) is positive. In other words, the present value of the future cash inflows is greater than the cost of the investment.

b. When several investment proposals with reasonably similar investment sizes are being considered, they can be ranked by net present values. The proposal with the highest NPV should be chosen. An implicit assumption of this method is that all net cash inflows can be reinvested at the discount rate used in computing NPV. If the proposals have unequal investments, they should be ranked according to their profitability index. The profitability index is computed by dividing the present value of the cash flows by the initial investment.

The net present value method can also be used when examining cost‐saving projects. For example, when considering projects that would replace equipment with newer, more efficient models, the costs with the lowest NPV would be the most desirable alternative.

c. Illustration: Net present value

Problem: An investment costing $20,000 will reduce production costs by $5,000 per year. The useful life will be eight years, and there will be a zero salvage value. The desired minimum rate of return of 12% is used for capital budgeting purposes. Should this investment be considered?

Solution: The NPV is calculated by determining the PV of the $5,000 annual cash savings for eight periods using a 12% rate. The present value factor for eight periods at 12% is 4.968.

Net present value:

Cash flows ($5,000 4.968) $ 24,840

Initial investment (20,000) Net present value $ 4,840

Since the NPV is positive, this is a desirable investment at a 12% return.



d. The NPV method can easily be applied if the annual cash flows are not equal.

Illustration: An investment alternative costs $10,000 and results in cash flows of $5,000, $4,000, and $3,000, respectively, for three years. The desired minimum rate of return is 14%. In this case, the PV of cash flows for each year is calculated, summed, and compared to the cost of the investment. If the NPV is negative, the investment is rejected.

Solution: The NPV is calculated by determining the PV of the cash flows for each year using a 14% discount rate.

Net present value:

Cash flows

Year 1: $5,000 .877 $ 4,385.00

Year 2: $4,000 .769 3,076.00

Year 3: $3,000 .675 2,025.00

Total PV of cash flows 9,486.00 Initial investment (10,000.00) Net present value $ (514.00)

Since the NPV is negative, this is not a desirable investment at a 14% return.

e. The discount rate (or hurdle rate) is the required internal rate of return for projects considered by a company or investor. This rate is often based upon a company’s weighted‐average cost of capital, incorporating a risk premium related to the riskiness of the project in question. In other words, this rate must reward the investor for the risk that is being assumed when undertaking the investment.

2511.05 Profitability index (excess present value index)

a. The profitability index takes both the size of the original investment and the value of the discounted cash flows into account. This is calculated by dividing the present values of the cash flows after the initial investment by that investment.

Present value of cash flows not including the initial investment

Initial investment = Profitability index

This allows for the comparison of various projects with differing initial investment amounts. Note that any project with a positive NPV will, by definition, have a profitability index greater than 1. The present value of cash flows not including the initial investment equals the NPV of that project plus the initial investment.



b. The profitability index is often used to compare two or more mutually exclusive projects. Potential projects might be mutually exclusive in that they represent viable options to accomplish the same task. Other constraints might include a limited capital budget or lack of adequate resources to accomplish multiple projects. The alternative project with the highest profitability index is the most desirable.

c. Example: Assume that the information is available on two mutually exclusive projects:

Project 1 Project 2

Initial investment $50,000 $75,000 NPV $20,250 $25,000

Calculate the profitability index:

Project 1: $20,250 + $50,000 $50,000

= 1.41

Project 2: $25,000 + $75,000

$75,000 = 1.33

Assuming that funds are available, the most desirable project based upon the profitability index would be Project 1. Note that the profitability index uses the PV of the cash flows and not the NPV; therefore, the initial investment amount must be added back to the NPV.

d. The profitability index is also known as the benefit‐cost ratio.

e. An alternative formula used to calculate the profitability index is:

Net present value of the project Initial investment

+ 1 = Profitability index

Using this alternative formula and the above data for Project 1, the profitability index would be calculated as:

$20,250 $50,000

+ 1 = 0.41 + 1 = 1.41

f. The project profitability index is an additional variation of the profitability index. When an organization with limited funds is considering projects that require different initial investments, the NPV of one project cannot be directly compared to the NPV of another potential project. If the NPV of each project is divided by the required investment of that project, the project profitabilities can then be compared. The project with the highest project profitability index would be the most desirable project.

Project profitability index

= Net present value of the project

Investment required



g. Example: Look at the following information regarding two possible investment opportunities.

Project 1 Project 2 NPV of proposed project (a) $8,000 $4,500 Investment required (b) $10,000 $5,000 Project profitability index (a ÷ b) 0.80 0.90

Since the project profitability is higher for Project 2 than Project 1, Project 2 is the more desirable choice.

h. An additional variation of the profitability index is used when there is a constrained resource that can be used to produce incremental profits in multiple segments. Here the profitability index formula is:

Profitability index = Incremental profit from the segment Constrained resource required by the segment

If machine hours were the constraint (bottleneck) and multiple segments of the organization could use the limited machine hours to produce incremental profits, then by determining the profitability of one unit of the constraint, management can determine the most profitable way to use the constraint.

This formula is really the basis for the formula shown in section (a) to be used for projects of a more long‐term nature. For that formula, the incremental profits from the segment are defined as the positive net present values of the cash flows after the initial investment, and the amount of the constrained resource is defined as the investment required by the project.

i. Example: The following information is available regarding incremental profits that could be produced by two different segments using a constrained resource (machine hours).

Product 1 Product 2 Incremental profit possible $250,000 $400,000 Amount of machine hours necessary to produce the incremental profit 100 hours 200 hours

Segment 2 may appear to be more attractive since an additional $400,000 of profit is possible; however, more machine hours (constraint) are necessary for each dollar of profit; therefore, the constraint of machine hours can be best be utilized in producing Product 1 than Product 2.



2511.06 CVP analysis/margin of safety

a. In the context of capital budgeting, cost‐volume‐profit analysis (CVP) is often used to determine the margin of safety for a project. In other words, how much could projected sales fall and still not fall below the breakeven point?

b. The CVP formula:

Profit = Sales – Variable costs – Fixed costs

Sales = Number of units sold times sales price per unit

Variable costs = Number of units sold times variable costs per unit

Fixed costs = Total fixed costs for anticipated range

The breakeven point is a special case of CVP analysis where the profit equals zero. In other words, sales revenue equals total costs.

Illustration: Product A sells for $5 per unit. Variable production costs are $3 per unit and fixed costs per period are $50,000. What will the profit be if 100,000 units are produced and sold? What is the breakeven point?

Solution:

Profit = Sales - Variable costs - Fixed costs = ($5 100,000) ($3 100,000) - $50,000

= $150,000

Breakeven in units: 0 = $5x - $3x - $50,000 x = 25,000 units

c. Margin of safety is the excess sales over the breakeven sales point. This can be important when looking at projects with projected sales. The methods used to evaluate capital budgeting decisions use projected sales (savings). If, however, the projections are incorrect, then there could be significant changes in the calculations of the payback period, NPV, and IRR. When evaluating a project, the likelihood that the sales/production projected will be achieved needs to assessed.

Illustration: Using the above illustration, calculate the margin of safety:

Margin of safety = 100,000 projected unit - 25,000 breakeven units

= 75,000 units

This could also be expressed in term of dollars. The margin of safety for

sales is $375,000 ($5 per unit 75,000 units). In this case, sales could fall significantly (by 75%) and there would still be a profit.



2512 Incremental Cash Flows

2512.01 Internal rate of return (time‐adjusted rate of return)—equal annual cash flows

a. The internal rate of return (IRR) is the rate of discount (interest) that equates the present value of the net cash flows including the initial cash outlay to zero. This method can be used when the cost of the investment and annual cash flows are known, and the calculated rate of return is then compared to the firm’s desired rate of return (hurdle rate). If the return is less than the desired rate of return, the project should be rejected. This method is also known as the time‐adjusted rate of return.

Investment required Net annual cash inflow

= Factor of the internal rate of return

b. After the factor of the internal rate of return is calculated, the present value tables of an annuity are used in order to determine the rate of return that equates the present value of the cash inflows and outflows to zero. Since the discount factors frequently do not coincide with the annuity table, extrapolation is often necessary.

c. The IRR can be interpreted as the highest rate of interest an investor could pay for borrowed funds to finance the investment being considered and be no worse off than if the investment were not undertaken. In other words, the investment equals the present value of the payoff.

d. When more than one project is being considered, they are ranked according to their projected rate of return. Those with the highest rate of return are the most desirable. An implicit assumption of this method is that all net cash inflows from the project under consideration can be reinvested at the computed rate of return, and the method is, therefore, a less reliable method than the NPV method for ranking investments. This method is a good tool for making an accept/reject decision for potential projects that have met the initial requirements for consideration. Using this method, all projects that have a return greater than the company’s hurdle rate should be given further consideration.

e. The NPV and IRR methods will potentially rank projects differently if the initial investment differs and/or the timing of the cash flows differs between the projects. The NPV method is the better method since the reinvestment assumption is the cost of capital as opposed to the IRR assumption of reinvestment at the computed rate of return on the cash flows for the particular project.

f. The payback reciprocal can be used to approximate a project’s internal rate of return if the cash flow pattern is relatively stable.



g. Illustration: Internal rate of return

Problem: The company is considering the acquisition of a new machine that costs $20,000. It will provide a savings of $5,000 per year over its useful life of eight years. The salvage value is expected to be zero. What is the internal rate of return, and should the machine be acquired?

Solution: The cash flows are charted as follows:

Initial cash outflow $20,000 Cash inflows

Year 1 $5,000 Year 2 $5,000 Year 3 $5,000 Year 4 $5,000 Year 5 $5,000 Year 6 $5,000 Year 7 $5,000 Year 8 $5,000

When the cash flows are an annuity, the present value factor can be determined by dividing the initial investment by the annuity:

Investment required Net annual cash inflow

= Factor of the internal rate of return

=$20,000 $5,000

= 4.0000 present value factor

The internal rate of return (time‐adjusted rate of return) can be obtained from the present value table for an annuity in arrears (since it is assumed that the cash flows occur at the end of the period) by finding the rate for the number of periods (in this case, eight) that has a factor closest to 4.000. In this case, the rate is approximately 18.5%. This project would be desirable if the minimum acceptable rate of return (hurdle rate) is less than 18.5%.

Period 17% 18% 19% 20% 21%

8 4.207 4.078 3.954 3.837 3.726



Discounted Cash Flow Methods

2512.02 These methods involve some means of comparing the net cost of the investment project with the present value of the future cash flows expected to be generated by the project. They are the theoretically correct methods of capital budgeting, because they take into account the time value of money. They also focus on the cash flows involved, not on accrual accounting returns.

2512.03 Discount Rate: All present value methods require the discounting of future cash flows at some desired rate of return. Discount rate, hurdle rate, required rate of return, and cost of capital are all terms for the interest rate used to adjust future cash flows to the present.

a. Hurdle Rate: The hurdle rate minimum is sometimes established for all capital projects, sometimes based on the average return on projects. This is not theoretically correct, because this rate could be above or below what the investors could earn elsewhere for similar risk.

b. Short‐Term Borrowing Rate: The discount rate may be based on the cost of borrowing current funds, which is actually irrelevant to the rate that should be earned on projects.

c. Weighted Average Cost of Capital: The discount rate may be based on the company’s weighted average cost of capital (see Chapter 2). This rate is appropriate only if the risk level of the project is equal to the weighted average risk level of the firm.

d. Risk‐Adjusted Rate: Different discount rates may be established for different categories of projects to adjust for different levels of risk. Higher risk translates into a higher discount rate.

e. Real and Nominal Rates: An inflation adjustment is also possible. In practice, the “real rate of interest” is the pure rate of interest plus a risk factor. The “nominal rate of interest” is the real rate plus an inflation factor if prices are expected to increase.

2512.04 Assumptions

a. Timing: Cash flows occur at the beginning or end of a period as specified, not continuously during the period as in real life. In most CMA questions, cash flows are assumed to occur at the end of the period.

b. Certainty: Cash flows are known with certainty – both the amounts and the timing.



c. Reinvestment: In the net present value method, it is assumed that cash flows from the project can be reinvested at the discount (hurdle) rate. This is a conservative approach. In the internal rate of return method, it is assumed that cash inflows can be reinvested at the actual interest rate generated by the project. Since this is often a higher rate than the hurdle rate, this is an optimistic (and aggressive) approach to capital budgeting decision analysis.

d. Stability: It is assumed that the interest rate used is stable for the entire life of the project.

2512.05 Cash Flows: The after‐tax cash flows must be used. Note that this is different from the income from operations. Some of the following additional considerations may be appropriate depending on the fact pattern of the question.

a. Working Capital Adjustments

(1) Beginning Increase: If working capital increases at the beginning of a project, it is assumed that some cash has been used to acquire additional inventories, receivables, etc. This is treated as a cash outflow at the inception of the project. There is no tax adjustment for this, because acquisition of such items is not a taxable event. At the end of the project, a decrease in working capital is assumed as the additional working capital is liquidated. This liquidation is assumed to result in a gain, and is reduced by the tax on that gain. The resulting net‐of‐tax figure is treated as an additional cash flow in the final year of the project.

(2) Beginning Decrease: In some instances, working capital may decrease at the beginning of the project. In this situation, the liquidation (net of corresponding tax) is treated as a cash flow at the inception of the project, and the corresponding increase in working capital (with no tax effect) is a cash outflow in the final year.

b. Depreciation Issues: When the after‐tax cash flows from operations have been given in a fact pattern, the depreciation for financial statement purposes has already been factored in and no additional computations need to be made. However, when different depreciation methods are used for financial accounting purposes as opposed to tax purposes, the cash from operations must be adjusted for the taxes on the difference effect between the two depreciation amounts.



Example: Assume an increase in cash from operations of $20,000.

Straight‐line depreciation of $10,000 has been taken for financial

statement purposes, but $6,000 MACRS depreciation was deducted for

tax purposes. The tax rate is 40%. Since the taxable income under MACRS

would be $4,000 higher (the difference between the two depreciation

amounts), an additional $1,600 of taxes ($4,000 x 40%) must be

subtracted from the $20,000 cash flows to arrive at cash flows of

$18,400. The adjustment would obviously be an addition to the cash from

operations if the MACRS depreciation exceeded the financial statement

depreciation.

c. Salvage Values

(1) Fully Depreciated Asset: The salvage value of a fully depreciated old asset being disposed of at the inception of a new project is treated as a cash inflow at the inception of the new project, net of related tax. This amount is a reduction of the cost of the new asset in the determination of the net incremental cost of the new project.

(2) Non‐fully Depreciated Asset: Where the old asset has not been fully depreciated, the gain or loss on disposal must be computed and the related cash inflow (if a gain) or outflow (if a loss) – adjusted for taxes paid or tax benefit received – must be considered in determination of the net cost of the new investment.

(3) New Asset Treatment: The salvage value of a new asset is treated as an additional cash flow in the final year of its life. This figure must also be adjusted for transfer costs and any taxes. Some capital budgeting problems present a comparison between two different options. This is usually retaining and continuing to use an old piece of equipment as opposed to discarding the old and buying a new asset. If there are salvage values for both assets in the final year of the life of the new asset, the difference between these two values (adjusted for tax purposes) is treated as an additional cash flow in the final year of the project.



2513 Income Tax Considerations

2513.01 The implications of tax on capital budgeting decisions

a. Many items in capital budgeting have related tax effects. Items that do not affect cash flows such as depreciation are not relevant in basic PV calculations. They must, however, be taken into consideration when income taxes are relevant or the present value of the cash flows related to taxes is relevant. Items that do not affect cash flows except as they relate to the payment of income taxes include depreciation and gains and losses on asset dispositions.

b. The implications of income tax on capital budgeting include the following:

(1) Cash flows in the form of revenue are taxable. Revenues must be computed net of tax. This can have a dramatic effect on the NPV of a project.

(2) Cash outflows in the form of expenses are deductible in computing taxes payable. These cash outflows must be computed net of tax.

(3) Depreciation is not a cash flow, but it affects the amount of taxes payable. The reduction in taxes payable due to depreciation is a cash inflow item that must be included in the analysis.

(4) Gain or loss on the disposition of an existing facility (piece of equipment) is a taxable gain or a deductible loss for computing income tax.

(5) Salvage value at book value results in no gain (loss) and has no tax consequences.

c. The generally accepted approach is to compute all items net of tax and apply one of the capital budgeting approaches described previously. The marginal tax rate is most often used.



Illustration: ABC Company is considering the replacement of the current machine with a new one. The old machine has a book value of $0 and a salvage value of $8,000. The new machine would cost $30,000 and will result in an annual savings of $10,000 per year because of improved operating efficiency. It has a useful life of six years and an expected salvage value of $6,000. Straight‐line depreciation is used, and the company has a marginal tax rate of 40%. The desired minimum rate of return is 20%. (Note, when evaluating a project that would increase sales or reduce costs, the marginal tax rate should be used.)

Solution:

(1) After‐tax cash flow from selling the old machine:

Sales price $ 8,000 Book value 0 Gain 8,000 Taxes (40%) 3,200 Net cash inflow $ 4,800

(2) Net cash outflow to purchase the new machine:

Cost of new machine $30,000 Cash available from sale of old machine after tax 4,800 Net initial investment $25,200

(3) Annual cash inflows or cash savings:

Depreciation

=Cost - Salvage value

Life =

$30,000 - $6,000 6 years

= $4,000/year

Operating savings $10,000 Less: Depreciation 4,000 Taxable savings 6,000 Taxes (40%) 2,400 Net savings $ 3,600

Total annual cash flows:

Net savings $3,600 Add back depreciation 4,000 Annual cash flow $7,600

(4) The salvage value of the new machinery has no tax consequences in Year 6 since the salvage value will equal book value. The cash flows for the six years will look like:

Period Cash Flow

0 ($25,200) 1 7,600 2 7,600 3 7,600 4 7,600 5 7,600 6 7,600 + 6,000



The calculation of net present value at 20% for six years:

Cash savings Annual: $7,600 3.326 = $25,278 Salvage, Year 6: 6,000 0.335 = 2,010 Present value of cash flows 27,288 Less: Initial investment 25,200 Net present value $ 2,088

Since the NPV is positive, replacing the old machine would be a desirable investment.

2514 Evaluating Uncertainty

2514.01 A real options approach improves organization value by encouraging managers to take advantage of flexibility and strategic interactions when making capital budgeting decisions. Strategic investments are viewed as a series of options instead of as single “go‐no go” decisions. There are four important real options available in capital investment decisions which allow managers to add value by increasing returns or decreasing losses.

a. Wait and Learn Before Investing: Many projects require a decision to be made today so that the project can be started immediately. However, some projects can allow the decision maker to wait and learn before investing. This is best when there is high uncertainty and immediate cash flows from the project are low. Postponing or losing these cash flows will not be significant, and the decision to invest can still be made at a later date when cash flows are more certain. A wait and learn before investing opportunity is a type of call option because the holder has the right to make an additional investment in the future.

b. Follow‐on Investment Opportunities: When taking on an investment, there can be additional value to the project because of opportunities to extend or expand investments in the future.

(1) Flexibility: For example, a company may build a production facility that can easily be expanded if product demand exceeds the original capacity. In this case, the company can exercise an option to expand its production facility. Even when a project shows an initial negative NPV value, the project may be acceptable if follow‐on investments may add cash flows beyond the original investment’s cash flows.



(2) Hewlett Packard Example: For instance, when Hewlett Packard entered the market for peripheral computer equipment such as printers, its future opportunity was to extend into the personal computer market. Knowing that they could enter the PC market in the future and have larger cash flows associated with computer sales allowed Hewlett Packard’s managers to manufacture peripheral equipment whether or not they met their required rate of return on the initial projects. A follow‐on investment opportunity is a type of call option because the holder has the right to make an additional investment in the future.

c. Abandon a Project: An option to abandon a project if it is unsuccessful provides some insurance against failure. The value of this option is the amount received from the sale of the assets used on the project, or the value received from shifting the assets to another more valuable project. When making the decision to acquire equipment and machinery for a project, you may have the choice between equipment which would be worthless if the project fails or is abandoned, or equipment which could be sold or shifted to other uses if the project is abandoned. Include this abandonment option as part of your discounted cash flow analysis. An abandonment opportunity is a type of put option because the holder has the right to dispose of the investment in the future.

d. Vary Output or Production Methods: Existing facilities can be switched to different products or processing methods. In some cases, the cost may be relatively low to switch an existing facility to produce a new product or products of different grades, or to modify the quality of inputs used in production. To increase the value of this type of option, production facilities can be designed with future flexibility in mind.

2514.02 Real Option Value: Traditional capital budgeting techniques such as NPV analysis do not accurately measure the economic value of real options, and they divert management attention away from the series of decisions that could be made in the future to maximize value. Real option values incorporate the following variables and factors:

a. Managerial flexibility—actions that can increase value over time

b. Market leadership position—creates more real options and provides the financial and other resources needed to exploit options

c. Technical feasibility

d. Financial resources for project funding



e. Degree of uncertainty—probabilities associated with different outcomes

f. Expected cash flows from different decisions options and outcomes

g. Discount rate applied to expected cash flows

2514.03 Real option values are typically analyzed using a decision tree, with probabilities and cash flows assigned to the different outcomes. The expected cash flows are then discounted and valued using an option pricing model, such as the Black‐Scholes model. By using risk‐adjusting probabilities, a risk‐free rate can be used to discount the expected cash flows. The values generated from the model depend heavily on both the cash flows and the probabilities that are assigned to different outcomes. However, unlike NPV and similar methods, the value of a real option increases with the degree of uncertainty.

Ranking Investment Projects

2514.04 Capital Rationing: Capital rationing occurs when an organization has a limited number of dollars available for capital expenditures, and managers must choose among acceptable strategic investment opportunities. Potentially acceptable projects are those meeting the organization’s investment criteria, such as a positive NPV, a sufficiently short payback period, positive qualitative factors, etc.

2514.05 Mutually Exclusive (Independent) Projects: Mutually exclusive projects have cash flows that are independent of other projects. When projects are mutually exclusive, there is no interdependence among project cash flows; the cash flow of one project is not affected by whether or not an investment is made in another potential project.

2514.06 Profitability Index: A profitability index can be used to rank‐order the investment projects if there is capital rationing and the projects are mutually exclusive. It is difficult to determine the relative merits of projects when working from their absolute dollar figures. Therefore, the profitability index relates each project’s total present value of cash inflows to its initial net investment cost:

Profitability Index = Net Present Value of Cash Inflows

Initial Investment Cost

If the hurdle discount rate is exactly met and the NPV of the project is zero, then the profitability index will be exactly 1. Projects having a positive NPV will have profitability index greater than 1. Projects having the highest profitability index will be chosen for investment.



2514.07 Internal Capital Markets: Another method for allocating a limited capital budget among competing projects is to rely on an organization’s internal capital market — i.e., competition for limited funds among managers within an organization. An advantage of internal capital markets is that capital can be moved within an organization to more profitable projects without incurring the cost of raising capital externally. A disadvantage is that capital may be allocated inefficiently; strong projects might subsidize weak projects, reducing overall value.

2514.08 Linear Programming: Another alternative to the use of a profitability index is to allocate limited capital resources using linear programming techniques. Linear programming can be used to maximize a linear objective function (in this case, the sum of discounted or undiscounted expected future cash flows), given one or more constraints (in this case, financing and the minimum amount that may be invested in individual projects). Linear programming can take into account dependencies among the cash flows of multiple projects.

2520 Capital Investment Analysis Methods

2521 Net Present Value

2521.01 Net Present Value Method (NPV): The net present value (NPV) method evaluates the net difference between the total discounted cash inflows and outflows. If the NPV is positive, more cash came in than went out. On a simple problem with cash inflows that are the same amount each year, the annuity discount factor can be used. Otherwise, each year’s individual cash flow must be discounted separately.

a. Salvage Values

(1) Step One – Compute After‐tax Cash Flows: If the figure has not been given, compute the after‐tax cash flows for each period in the life of the new project.

(2) Step Two – Compute Total Present Value: Compute the total present value of the cash flows at the hurdle rate.

(3) Step Three – Determine Net Cost of New Asset: Determine the net cost of the new asset and any other outflows.

(4) Step Four – Subtract for Net Present Value: Subtract the net cost of the new asset from the total present value of the cash flows.



b. Significance of Results:

(1) Step One – Compute After‐tax Cash Flows: If the figure has not been given, compute the after‐tax cash flows for each period in the life of the new project.

(2) Net Present Value is Positive: Here, the total present value of the cash flows exceeds the net cost of the new asset. This means that the project generates a return higher than the hurdle rate used to discount the flows. This makes the project even more acceptable. Note that the internal rate of return method (the next method discussed) can be used to find out the actual rate being earned.

(3) Net Present Value is Negative: The total present value of the cash flows is less than the net cost of the new asset. This means that the project does not generate a return that is at least equal to the hurdle rate desired, and is, therefore, not acceptable.

2522 Internal Rate of Return

2522.01 Internal rate of return (time‐adjusted rate of return)—unequal annual cash flows

a. The internal rate of return (IRR) is not easily applied when the cash flows are not equal annuity payments. A trial‐and‐error method must be used to obtain the rate of return when hand‐calculated; however, computer software is available to compute the IRR that frequently uses an iterative trial‐and‐error method. Required inputs to such a program are cash flows (both inflows and outflows) by period and a seed internal rate of return. The computer program uses the seed (rough approximation) IRR on the initial calculation and refines the rate on subsequent calculations until it has a rate that produces a net present value of zero (or very close to zero).



b. Illustration: An investment opportunity costs $10,000 and returns $5,000, $4,000, and $3,000, respectively, the first three years. What is the internal rate of return (IRR)?

(1) First attempt: Using an interest rate of 10%, the net present value is $105, computed as follows:

Cash flows:

$5,000 .9091 $ 4,545.50

4,000 .8264 3,305.60

3,000 .7513 2,253.90

Present value cash inflows 10,105.00 Cash investment (10,000.00)

Net present value $ 105.00

Since this is a positive amount, a higher interest rate is selected.

(2) Second attempt: Using an interest rate of 11%, the net present value is ($55.50), computed as follows:

Cash flows:

$5,000 .9009 $4,504.50

4,000 .8116 3,246.40

3,000 .7312 2,193.60

Present value cash inflows 9,944.50 Cash investment (10,000.00)

Net present value ($ 55.50)

Since the NPV is a negative amount, the interest rate is somewhat less than 11%. By extrapolation, a rate of approximately 10.7% is obtained. If the desired minimum rate of return is greater than 10.7%, the project should be rejected.

2523 Payback

2523.01 Payback method

a. The payback period method does not adjust for the time value of money. It computes the length of time required to recover the initial cash investment with net cash flows. When the annual cash flows are equal, the payback period is computed by dividing the initial investment by the annual cash flow.

Payback period = Initial investment Annual cash flow

If the annual cash flows are not equal, they are accumulated until the cumulative amount equals the initial investment. The payback period is the length of time required to accumulate cash that equals the amount of the initial investment.



b. When several investment alternatives are being considered, they can be ranked according to the payback period. The investment alternatives with the shortest period are considered most desirable. This method is simple to compute and easy to understand and explain. Early paybacks provide managers with the flexibility to reinvest funds at an earlier date; therefore, managers who are uneasy about predicting cash flows into the distant future will often choose projects with early paybacks. Managers who expect to be transferred in the near future may also seek projects that will provide quick results.

c. The chief limitation is that the payback method emphasizes liquidity and disregards profitability. This method is most appropriate when precise estimates of profitability are not crucial. Its use often occurs when a firm has a weak cash and/or credit position, or if there is considerable risk involved in the proposed project. The time value of money is not considered. For example, two projects each requiring an initial investment of $1 million and yielding cash inflows of $250,000 a year would be considered to be identically attractive even if the first project has cash inflows for 5 years and the second project for 10 years.

d. The payback method can be a good screening tool but as a general rule should not be used as the primary investment evaluation tool.

e. Illustration: Payback method

Problem: Compute the payback period for an investment opportunity that costs $20,000 and provides equal annual cash flows of $4,000 per year for eight years.

Solution: $20,000

$4,000 = 5 years

Notice how the payback method does not even consider the cash flows between the end of the payback period and the end of the investment’s useful life—in this case, between years 5 through 8.

2523.02 Discounted payback

a. The discounted payback is the length of time required to recover the initial cash investment using a sum of the discounted future cash flows.

Since the discounted annual cash flows will not be equal, they are accumulated until the cumulative sum equals the initial investment. The discounted payback period is the length of time required to accumulate the amount of the initial investment using the discounted cash flows.



b. As with the payback method, the investment alternative with the shortest payback period is considered the most desirable. This method is simple to compute, easy to understand and explain, and also takes the time value of money into consideration, albeit in a very limited manner. The chief limitation is that the discounted payback method also emphasizes liquidity and disregards profitability.

c. Illustration: Discounted payback method

Problem: Compute the discounted payback period for an investment opportunity that costs $10,000 and provides equal annual cash flows of $5,000 per year for three years given an expected 10% return.

First, the cash flows need to be discounted.

Cash flows:

Initial Investment

Annual Cash Flows

Discounted Value

$10,000.00 $10,000.00 $5,000 .9091 4,545.50

5,000 .8264 4,132.00

5,000 .7513 3,756.50

Solution: $10,000 - [$4,545.50 (Year 1) + $4,132.00 (Year 2) + $1,322.50 (Year 3)] = 0

Since the discounted cash flows for Year 3 equal $3,756.50 and only $1,322.50 is needed in Year 3 to complete the payback, it can be extrapolated that approximately 2.4 years will be needed to pay back the initial investment in discounted terms. Note that using the traditional payback method, the payback period would be only 2 years. When using the discounted payback method, the payback period increases.



2524 Comparison of Investment Analysis Methods

Non‐Discounted Cash Flow Methods

2524.01 Since they ignore the time‐value of money, the non‐discounted cash flow methods are not considered to be theoretically correct. However, in practice, they are often used because they are relatively easy to understand by non‐accounting personnel and simple to calculate. In addition, these methods help managers focus on a potentially important aspect of risk under rapidly changing conditions – the time to recover the initial investment.

2524.02 Payback Method

a. Objective: This method measures the length of time required to receive the same amount of cash as the initial investment. It answers the question, “When am I going to get my money back?”

b. Advantages: This method can be useful in situations where liquidity is important. Projects with shorter payback periods are generally preferred over those with longer periods, because assumptions underlying present‐value models may not be valid for a long period of time. Also, since it is a cash‐flows method, it is not affected by accrual accounting procedures, and it is useful when precisely correct figures are not vital and as a preliminary screening tool.

c. Disadvantages: In addition to the non‐recognition of the time value of money, a significant disadvantage is that the method ignores total profitability and all cash flows after the payback period. It would be possible to have a situation where a machine with a shorter payback period also had a shorter useful life compared with another project, thereby reducing the potential for cash flows and profits beyond the narrow focus of the payback period.

d. Calculation: Where the periodic cash flows are uniform, the payback method is calculated by dividing the initial investment by the annual cash inflow to get the number of years to payback. If the cash inflows are not even, the calculation may have to be done on a year by year basis. If so, apply each year’s cash flow to the balance of the initial investment to determine the number of years.



Example: A corporation is contemplating the purchase of some

specialized machinery. The machinery will cost $250,000 and will be

depreciated over its five year life by using the straight line method.

Annual inflows of $300,000 and cash operating expenses of $220,000 are

anticipated as a result of this new machinery. The corporation is subject

to a 40 percent income tax rate. The payback period on this investment

(rounded to the nearest tenth) is:

Answer: 3.7 years.

Annual inflows $300,000

Cash operating expenses ‐220,000

Depreciation (5 yr SL) ‐50,000

Operating income 30,000

Tax expense (.40) ‐12,000

Net income 18,000

Depreciation (non‐cash) +50,000

After tax cash flow $68,000

Initial Investment = 250,000 = 3.676 = 3.7 years

After tax cash flow 68,000

The reciprocal of the payback calculation can be used to approximate the IRR.

2524.03 Discounted Payback: Under the discounted payback method, the payback period is calculated using discounted rather than undiscounted cash flows. Thus, this method incorporates the time value of money in evaluating potential strategic investments.



2524.04 Accrual Accounting Rate of Return

a. Method: This method divides the incremental income attributed to the project by either the initial investment or the average investment. As can be seen, it is simply the return on investment ratio (ROI). The incremental income is book income on the accrual basis, not cash flows.

b. Limitations: Accrual basis income includes or excludes items based on GAAP for external reporting, which may not be valid for internal decision making. Furthermore, it uses an average annual incremental figure rather than the explicit cash flows determined in both the discounted and payback methods. Note also that it, like the payback method, ignores the time value of money. However, it does take into account profitability, is easy to understand, and is useful in a situation where a divisional manager is evaluated on a comparable basis (i.e., use of ROI measures).





Surgent CMA Review

Section 2600 Professional Ethics (15%)

2610 Business Ethics

2611 Moral Philosophies and Values

2611.01 Kohlberg’s Theory of Ethics Development: Professor Larry Kohlberg from Harvard has identified six progressive stages of moral and ethical development. Each stage is characterized by the motivating factors which prompt an individual to make the right decision when confronted with an ethical dilemma. The higher the factor level the more ethical the individual.

a. Punishment: Fear of authorities’ ability to inflict punishment as a consequence of unethical or illegal behavior is the most basic driver. Punishment may be imposed within an organization or externally from legal or regulatory controls. An example is the Foreign Corrupt Practices Act which restricts bribes to foreign officials and governments.

b. Law and Order Adherence: Certain laws, rules, bylaws and obligations are necessary to assure business organizational and society social cohesion. Adherence to the letter and spirit of the law means “doing what’s required.” This behavior is rule based and facilitated by an understanding of why and how codes of ethics have developed.

c. Self‐Gratification: Benefits for oneself may be a motivating factor. Enlightened self‐interest is behind the Golden Rule, “Do unto others as you would have them do unto you.”

d. Role Expectation: Approval from others is a stimulant to act according to particular standards that are generally accepted and expected. “Professionalism” and acting “in a professional manner” are associated with integrity, peer approval and adherence to a set of expectations.

Section 2600 – Professional Ethics


e. Concern for Social Welfare: Individuals recognize that they have a “social responsibility” to act ethically and justly because this promotes the welfare of society as a whole. It is the right thing to do. Media coverage has recently promoted awareness of unethical behavior to be avoided. This individual social responsibility is imputed to businesses.

f. Concern for Moral Principle: Knowledge of underlying moral concepts and religious ethics is the basis for this personal conscience. Individuals in this category are motivated to do what is right simply for the sake of doing what is right. This stage is often called “moral imperative” similar to the Ten Commandments. Such individuals are operating on Professor Kohlberg’s highest ethical level.

2612 Ethical Decision Making

2612.01 Howard L. Siers, founding Chairperson of the official IMA Ethics Committee, identified four steps in the process of development, approval, communication, and administration of a corporate code of conduct. The Sarbanes‐Oxley Act of 2002 requires internal controls including a “disclosure controls and procedures” system that must be regularly reviewed; this is very similar to a Code of Ethics. The following are steps as they relate to a Company as a whole or as they relate to a particular function such as human resources, purchasing or financial statement preparation.

2612.02 Development of Code:

a. Top Management Involvement: The single most important influence on a firm’s ethics is top management. The “tone‐at‐the‐top” must create a positive, proactive environment. The code should be organized around the corporate purpose and mission statement. The mission statement creates a goal sense and communicates why trying hard in the corporation is important. Important themes include a true commitment to quality, candor and customer service.

b. Committee Vehicle and Documentation Details: It may be useful to form an ethics committee/board from a cross‐section of employees. An understandable written document must be created. This will promote precedential value. Employee involvement in the development process contributes to acceptance and implementation of the code. This is especially important at the middle management level where the code of ethics must be aligned with existing policies, procedures, and practices.



c. Different Approaches: The code can either set forth aspirational guideline “do’s” or detailed “don’ts.” “Don’ts” cover situations that may harm the strategic reputation of the firm. Critics of the latter approach contend that it is impossible to identify all of the “don’ts,” and a list of prohibitions may result in a voluminous code. Whichever approach is chosen, the code must be integrated into the decision‐making process. The code should emphasize relatively clear bright‐line cases, both for ease of understanding and to combat cynicism. If every situation is presented as ambiguous, many employees will retreat to an uneasy moral relativism and dismiss the whole project.

d. Unethical Behavior Drivers: It is useful to begin by studying the pressures and incentives that can drive unethical conduct in the entity. A compliance risk assessment of high sensitivity and/or vulnerable subjects may be useful. This may isolate and identify the topics to be included.

e. Comprehensive Coverage: The 1992 COSO Internal Control − Integrated Framework report suggests a comprehensive approach to the scope of the document. To be included are such topics as conflicts of interest, illegal or other improper payments, improper financial statement manipulation, equal and fair employment practices, proper use of company assets and resources, anti‐trust competitive guidelines, insider trading and confidentiality of proprietary information. Other matters particular to the entity in question should also be included.

f. Ethics Officer: There should be a formal Ethics Officer with ultimate authority. It may also be useful to create an ethics council/board consisting of employees from all levels of the organization. These representatives may serve as a liaison between peers and the ethics office. Experience shows that employees are more likely to discuss an ethical dilemma with a peer than with a supervisor.

2612.03 Approval of Code: For the “tone‐at‐the‐top” to pervade the ethics initiative, it is important for the code to be endorsed by executives and middle management.

a. Broad Participation: The more the employees at all levels have participated in the development of the code, the more the code will be accepted and followed. Those who are to be subject to the code’s jurisdiction must accept that authority. This is the best weapon to combat apathy and/or cynicism.

b. Review Process: A broadly based document review process may facilitate involvement. Input from a broad spectrum of constituents will generate support for the code. The board of directors, the audit committee and senior operating management should all approve the code.



2612.04 Communication of the Code: The corporation must implement the code. The message communicating corporate ethics should go to all employees. Implementation and communication activities range from distributing the code to all new employees to introducing a formal education program for existing employees.

a. Methods: It is possible to teach a process of identifying and considering the right/best solution to ethical dilemmas. Companies have used in‐house activities, external activities, employee indoctrination programs, counseling efforts and evaluation tools to disseminate the details of the code’s message. Dialogue should be encouraged whenever ambiguous situations arise.

b. Reinforcements: Not only must the details of the code be known, but the monitoring activities and sanctions in case of violations must be understood. Highly visible support by word and deed at all levels of management sensitizes employees and reinforces a sense of importance. An ethics column in the company newsletter may increase the awareness of employees. Seminars and workshops with case studies may also be useful tools in this process. Employees should sign‐off acknowledging receipt of the written code.

c. Third Parties: It may also be desirable to communicate information about the firm’s ethics programs to strategic partners such as some important customers and suppliers. These groups may be directly affected by some of the provisions and there may be a goodwill value to such communication.

2612.05 Administering the Corporate Ethics Program: Determining how monitoring should be accomplished and developing a reporting system are both necessary. Exception reporting of failure to comply is the usual monitoring method.

a. Ethics Officer: The administration falls on the corporate ethics officer. See www.eoa.org. The Sarbanes‐Oxley Act requires that as of April 1, 2003 all complaints by employees regarding accounting matters must be made to the audit committee if the corporation is publicly traded.

b. Advisory Services: Advisory services in the form of an ethical advisor or ombudsman should be available to assist in identifying ethical dilemmas and facilitating the resolution of serious dilemmas. The business should establish an “open door” policy by streamlining grievance channels; employees should receive a speedy and sympathetic hearing of concerns.



c. Reporting: Employees need to believe that management will address their grievances and rectify any abuses in a fair and equitable manner. There should be zero tolerance for retaliation of anyone who reports a real or perceived unethical act.

d. Performance Appraisals: Every employee must understand that ethical behavior is an individual responsibility. Integrity and ethical conduct should be discussed as a part of the employee’s annual performance appraisals. Employees should sign‐off to acknowledge that they have read the code of conduct every year.

e. Sanctions: Many enterprises find this the most difficult administration responsibility. Identified employee infractions must be subject to disciplinary and appropriate sanctions. Due process procedures must be in effect if employees are to feel they have been treated fairly. Sanctions usually begin with requiring attendance at an ethics workshop. Private warnings and letters of censure, to temporary suspension, to permanent termination are all possible.

f. System Improvement: Effectiveness of the code improves with feedback. When serious ethical misconduct arises and is identified, the problem may be an individual’s behavior or it may be because of a system deficiency. If the former, disciplinary procedures may be necessary. If the latter and the problem is that the system does not address the ethical dilemma or has an inadequate procedure, improvement should be initiated. Improvement in policies and procedures will hopefully reform corporate self‐governance and prevent similar occurrences in the future. A code of ethics audit measures the effectiveness of an enterprise’s current program and may suggest useful improvements.

2620 Ethical Considerations for Management Accounting

and Financial Management Professionals

2621 IMA’s Statement of Ethical Professional Practice

2621.01 The ICMA lists four general ethical standards which must be followed by CMAs. These are itemized in SMA 1C (July 1, 2017). Candidates should commit the SMA 1C CCIC standards to memory because the ethics questions may focus on the IMA’s official wording. Failure to comply with the following CCIC standards may result in discipline. Your answer analysis should apply the four standards to the particular fact pattern posed in a question.



2621.02 There is obviously considerable overlap between these four categories of ethical standards. Many ethical dilemma exam questions would cover all four standards (and the resolution of the ethical dilemma if appropriate under the facts). Most ethical dilemmas violate more than one standard. The overall objective of the Standards is to establish a theoretical ethical structure against which individual behavior can be measured. We have listed the four IMA standards below followed by editorial comments where useful.

a. Competence: Practitioners of management accounting and financial management have a responsibility to:

‐ Maintain an appropriate level of professional competence by continually developing their knowledge and skills.

‐ Perform their professional duties in accordance with relevant laws, regulations, and technical standards.

‐ Provide decision support information and recommendations that are accurate, clear, concise, and timely.

‐ Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity.

(1) Basic Standard: Competency is the most basic standard. The CMA examination measures the competence necessary to receive the credential, but this is only a one‐time threshold evaluation. The ICMA’s on‐going CPE requirements are designed to keep the member’s knowledge and proficiency current. The theoretical knowledge (of laws, regulations and technical standards) must be translated into high on‐the‐job performance and discriminating judgments.

(2) Violations: Frequently the exam poses facts where financial statements or performance reports are being manipulated by using incorrect accounting principles. Discrimination on the basis of sex, age, race, religion, national origin or physical handicap violates the standard.

(3) Factors: High‐quality work is the most important factor in achieving and maintaining credibility. This is especially true in preparing written reports. Oral presentations are also important and may involve developing presentation skills. There is a duty to make a reasonable investigation of relevant facts. In addition, these activities require effective interpersonal and communication skills to master the interaction with others in the organization.



b. Confidentiality: Practitioners of management accounting and financial management have a responsibility to:

‐ Keep information confidential except when disclosure is authorized or legally required.

‐ Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinates’ activities to ensure compliance.

‐ Refrain from using confidential information for unethical or illegal advantage.

(1) Importance: Confidentiality is important because it promotes full, honest and candid disclosures and open communications within an organization; breach of the confidentiality standard has a chilling effect on frank communications and disclosures. The confidentiality restraint applies to all proprietary information that is derived from the work activities including unauthorized use of computer data and software.

(2) Scope: Not only should the CMA not use confidential information acquired in the course of their work themselves, but they should not pass such information on to third parties for their use. This would include internal strategies, research and development projects, new products or sales, customer lists, forecasts and projections. Tipping off a third party security trader about financial information known only to insiders is an example of a breach of the confidentiality standard (and probably illegal under the Insider Trading Sanctions Act).

(3) Subordinate: The confidentiality duty extends to the requirement that CMAs supervise subordinates in such a manner so that they also observe the confidentiality standard.

(4) Not a Legal Privilege: This standard is not a valid defense for failure to comply with a subpoena, subpoena duces tecum or production request issued by a controlling court. Such information may usually be obtained by third parties where relevant to matters raised in litigation.



c. Integrity: Practitioners of management accounting and financial management have a responsibility to:

‐ Mitigate actual conflicts of interest. Regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts.

‐ Refrain from engaging in any conduct that would prejudice carrying out duties ethically.

‐ Abstain from engaging in or supporting any activity that might discredit the profession.

‐ Contribute to a positive ethical culture and place integrity of the profession above personal interests.

(1) Benchmark: Integrity is the benchmark against which all decisions must ultimately be tested. It involves exercising a high degree of professionalism in all one’s activities. CMAs have obligations to their employer, their profession, the public and themselves. Our profession’s ultimate objective must be to serve the public interest. CMAs must refrain from engaging in any activity that would prejudice their ability to carry out their duties ethically. This includes an obligation to supervise subordinates so that they also operate with integrity.

(2) Fiduciary Duty: CMAs must not (directly or indirectly) undermine the corporate objectives because it would constitute a breach of their fiduciary duty. If there are conflicting stakeholder interests and a fiduciary duty is involved, the interest of the stakeholder to whom the fiduciary interest is owed has priority. Usually this means the employer’s interest outweighs the interests of third parties. This fiduciary duty extends beyond the termination of employment.

(3) Conflict of Interest: Conflict of interest situations must be recognized and avoided. Most ethical dilemmas arise because what is right for one stakeholder is wrong for another. A CMA must serve only one principal. Positions where the CMA stands to benefit directly are always suspect. Examples include where a supplier is owned by the CMA or his relatives, a CMA is trading in the securities of his employer or a CMA receives a gratuity from a supplier. Similarly, offering a gratuity to a customer or government representative may violate the Anti‐Kickback or Foreign Corrupt Practices Acts.



(4) Test: The best way to evaluate a perceived conflict is through an independent examination of the situation conducted by a person preferably outside your framework. The question is, without your self‐interest in mind, would your action or non‐action be appropriate?

(5) Disclosure: Anything that may hinder a CMA’s judgment should be disclosed in writing. A CMA should refrain from the decision process involving a transaction in which he or she is “interested.” Both favorable and unfavorable information should be disclosed to all parties whose interests are at stake. Reports addressing a position should explain arguments both pro and con as well as the possible courses of action.

(6) Enterprise Resources: Company guidelines on the proper use of an enterprise’s resources (time, material, and equipment) must be complied with. Any acts that would discredit the CMA credential or management accounting must be avoided. This would include sexual harassment.

(7) Trust Fund Tax Responsibility: If a CMA has discretionary control over allocation of cash there may be personal liability for unpaid employment trust fund taxes withheld from employee’s wages. Some retirement plan funding is similarly protected under ERISA and criminal penalties may be imposed.

d. Credibility: Practitioners of management accounting and financial management have a responsibility to:

‐ Communicate information fairly and objectively.

‐ Provide all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations.

‐ Report any delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law.

‐ Communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity.

(1) Neutrality: Objectivity means a CMA must operate and make judgments in a neutral capacity. Communication must not be done in a biased or untruthful manner. It is important to be fair and impartial and state both the good and the bad aspects of any situation.



(2) Materiality: All relevant, material information must be disclosed. Materiality depends upon whether the information would have influenced an intended user’s understanding and decision; this is a lower threshold than whether the information would have been outcome determinant.

(3) Fraudulent Reporting: Fraudulent reporting violates both the credibility and integrity standards. This includes earnings management. Credibility is often associated with competence. Competent professionals are objective in their attitudes. Fair and impartial decisions are objectively based upon the merits.

(4) Assistance and Disclosure: An enterprise should have procedures in effect to assist employees in avoiding activities or personal interests that could adversely influence their objectivity in performing their corporate responsibilities. CMAs have a responsibility to communicate information fairly and objectively. Information that would mislead a user should be corrected. Disclose, disclose, disclose is the best rule.

2622 Fraud Triangle

2622.01 Fraud triangle is a model for explaining the reasons that result in someone committing fraud. The three most common reasons are:

a. Pressure or Incentive: This refers to the need that someone attempts to satisfy by committing fraud. Examples of the needs may include:

(1) Financial need arising because the individual is facing problems such as gambling, addiction, or personal financial strain.

(2) The need to meet high performance standards at work, or to cover up poor performance

b. Opportunity: This is the ability to commit fraud without being detected. The opportunity to commit fraud exists when workers have access to assets or information in a manner that allows them both to commit and conceal fraud. Opportunity is created by factors such as weak internal controls, poor management, lack of board oversight, or the use of one’s authority to override controls.



c. Rationalization: This is the ability for a person to justify a fraud in a way that is acceptable by his or her morals. Examples include justifying theft in the context of saving a family member by paying medical bills, labeling the theft as “borrowing” and intending to pay the stolen money back later, or justifying fraud by believing that the organization is not paying a fair enough salary. Rationalization may be reduced through:

(1) Implementing competitive work and pay practices

(2) Management practices that provide a model “tone at the top”

2623 Evaluation and Resolution of Ethical Issues

2623.01 The CMA exam questions may pose factual situations where it is clear that there is an illegal and/or unethical act or practice being promulgated which has come to the CMA’s attention. It is often far easier to spot an ethical dilemma than to resolve it through a theoretical framework. Besides not aiding and abetting the act or practice, it is not usually sufficient to do nothing and say nothing. This is a matter of professional judgment. The IMA’s counseling service may be of use. The IMA has also developed a list of the factors to be considered in such a situation and the procedures to be followed. PROORO is the memory acronym. The IMA’s official position is:

The CMA exam questions may pose factual situations where it is clear that there is an illegal and/or unethical act or practice being promulgated which has come to the CMA’s attention. It is often far easier to spot an ethical dilemma than to resolve it through a theoretical framework. Besides not aiding and abetting the act or practice, it is not usually sufficient to do nothing and say nothing. This is a matter of professional judgment. The IMA’s counseling service may be of use. The IMA has also developed a list of the factors to be considered in such a situation and the procedures to be followed. PROORO is the memory acronym. The IMA’s official position is:

Discuss such problems with the immediate superior except when it appears that the superior is involved. In that case the problem should be presented initially to the next higher managerial level. If a satisfactory resolution cannot be achieved, submit the issues to the next higher managerial level.



If the immediate superior is the chief executive officer or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with the superior’s knowledge, assuming he/she is not involved.

Communication of such problems to authorities or individuals not employed or engaged by the organization is not usually considered appropriate unless there is a clear violation of law.

Clarify relevant concepts by confidential discussion with an impartial advisor to obtain a better understanding of possible courses of action.

Consult your own attorney as to legal obligations and rights concerning the ethical conflict.

a. Policy of the Entity: Ethical issues should be resolved according to the policies of the entity, if such exist. If not, the matter should first be discussed with the CMA’s superior.

b. Report One Step Above Participants: If the superior is involved, the CMA must go to the management personnel one step above. The superior should be told in advance, unless it would be futile. This may lead to the ABC group: audit committee, board of directors, or chief executive officer.

c. Objective Advisor: It may be prudent under some circumstances to seek counsel with a qualified objective advisor; this may be the IMA counseling service discussed above. In theory, a person not involved in the dispute may be more objective than the participants.

d. Own Attorney: An attorney normally has a confidentiality advantage; the attorney‐client privilege may shield the internal investigation. The CMA should consider whether it is advisable to create a contemporaneous record of dissent to be held by the attorney to prove non‐concurrence.

e. Resignation and Informative Memorandum: If not resolvable and the matter has substantial significance, the CMA may be forced to resign. This resignation will often be accompanied by an informative memorandum submitted to the appropriate internal authority.



f. Outside Communications Questions: Communication to outside parties or the legal authorities is not usually permissible unless there is an affirmative legal duty. The reason is that this might violate the confidentiality standard. There may be exceptions for violations of law; typically this characterization is where the public interest is high and the employer’s legitimate interest is low.

(1) Legal Process: This “whistleblowing” prohibition is subordinate to an enforceable subpoena or subpoena duces tecum. Workpapers and records in the possession of the CMA may be obtained by third parties or the government where they appear to be relevant to issues raised in litigation.

(2) Whistleblowing: The 1997 changes to the IMA’s Code of Ethics would authorize disclosure to third parties “depending on the nature of the ethical conflict.” This provides the CMA support for disclosure (“whistleblowing”) under extreme circumstances. Examples might include a company dumping toxic waste or management affirmatively requiring employees to commit crimes.

(3) Balancing Test: The interest of the employer in confidentiality must be balanced against the probable harm to be suffered by third parties. Some states have whistleblower statutes that authorize good faith disclosures for certain important wrong doings and make retaliation illegal.

(4) Related Possible Litigation: Unethical employers may attack the messenger if the message has merit. Since whistleblowing may draw a lawsuit for defamation, interference, invasion of privacy etc., disclosure to third parties should not be done without the prior advice of counsel.

g. Retaliatory Discharge: Failure to participate in fraud may lead to discharge. At‐will employees (such as most internal CMAs) may be fired at any time for any reason unless that reason contravenes a clearly articulated statement of public policy. See Rocky Mountain Hospital v. Mariani, 916 P.2d 519 (Colo. 1996) which involved management’s termination of an internal accountant for refusing to falsify accounting information to increase the attractiveness of a proposed merger. Management’s action was held to violate the important public policy of accurate financial reporting.

h. Anonymous Helpline: IMA offers an anonymous helpline that the member may call to request how key elements of the IMA Statement of Ethical Professional Practice could be applied to their ethical issue at issue.



Enforcement Procedures

2623.02 Condition of IMA Membership: Compliance with IMA’s ethical standards are a condition of membership and are now incorporated into the Institute’s Bylaws. Monitoring and enforcement procedures are under the jurisdiction of the Institute’s Ethics Committee.

2623.03 Definitive Boundaries: There must be enforceable boundaries to the system if there is to be an effective firm‐wide code of ethics. This implies that there must be negative results which result from bright‐line violations; public discipline is the usual method of reinforcement.

2623.04 Disciplinary Procedures: Enforcement procedures include a variety of disciplinary actions.

a. Range: Letters of censure, letters of reprimand, to suspension of any member whose conduct is found (after formal due process procedures) not to be in compliance with the IMA standards. The maximum discipline authorized is the expulsion of members who have been convicted of a felony.

b. IMA Counseling Service: The IMA provides a confidential ethics counseling service of experienced professionals for members who wish to discuss any ethical dilemma.

c. Final Decision: However, the final resolution of any ethical conflict is the personal responsibility of the individual CMA.

American Account Association’s Framework ‐ ISAD

2623.05 In 1990, the American Accounting Association (AAA) published Ethics in the Accounting Curriculum: Cases & Readings. That publication includes a methodology or framework to be used to analyze a particular ethical dilemma. Our editors have reduced their decision model to four ISAD steps: issue, stakeholders, alternatives, and decision.

2623.06 Issue Recognition: Begin the analysis by asking what is known or should be known about the dilemma. A true analysis of the facts will usually lead to a recognition of the ethical issues in controversy. The candidate should identify the CCIC (Competence, Credibility, Integrity, and Confidentiality) elements discussed below in detail as they apply to the facts of the question.



2623.07 Stakeholders Identification: This identification step is important to ensure that the interests of all the effected parties’ are considered.

a. Direct Effect: Who will be directly affected by the outcome? The traditional view is that a company’s primary responsibility is its fiduciary duty to the shareholders.

b. Indirect Effect: The progressive view would include within the stakeholder group major customers, employees, directors, major suppliers, and the community where the business is located. Many would argue a healthy nationalism is also to be considered a stakeholder. There may also be other third parties who may be substantially affected by the decision.

c. Input Opportunity: Should they receive notice and be given an opportunity to be heard? Are there other public interest considerations which should be explored?

2623.08 Alternatives and Consequence Analysis: Is a clear, compelling decision possible? What feasible alternative conclusions are there to the ethical dilemma?

a. Consequences: What will be the short and long term positive and negative consequences of each alternative?

b. Constraints: Are there practical constraints that limit the alternatives?

c. Weight: How should we weigh the alternatives and the interests of the different stakeholders? Quantification may be helpful to create a common yardstick for comparison.

d. Compromises: Are any compromises possible that will reasonably satisfy all the stakeholders?

2623.09 Decision and Disclosures: The best course of action could be to do nothing.

a. Professional Judgment: The ultimate decision is usually a matter of professional judgment that involves a balancing of competing interests.

b. Disclosure: What disclosures should be made to the stakeholders, if any? Is there an affirmative duty to inform? In writing? How extensive should the disclosure be?

c. Other Influences: Are there confidentiality and/or legal influences impacting the desirability of communications to third parties?



2630 Ethical Considerations for the Organization

2631 Organizational Factors and Ethical Culture

2631.01 Tone‐at‐the‐Top: The Treadway Commission and COSO Report noted that “the tone‐at‐the‐top” is a vital ingredient to maintaining an ethical environment in a business. Water seldom runs uphill; neither does an ethics program. This includes three A, B, C groups: Audit Committee, Board of Directors and the Chief Executive Officer. The examples set by the behavior of senior corporate management is critical to maintaining a successful code of conduct. Policy is implicit in behavior.

2631.02 Enhancing Factors: A corporate code of ethics is enhanced when accompanied by the establishment of a corporate ethics committee/ethics review board and an ombudsman function. An ethics officer is appointed. Many authorities believe that the corporate audit committee should be the oversight body.

2631.03 Harmonization Factor: The ethics initiative may serve as a company rallying force for all individuals and teams within a business. Corporations that are merging and acquiring new entities will find the common bond helpful when organizations with different cultures merge.

2631.04 Ethics Reporting: Sarbanes‐Oxley requires corporations to disclose whether they have adopted a code of ethics for their senior officers. Management should report annually to the Board of Directors concerning their stewardship of the ethics policy.

Reasons and Purpose: A mission statement is the most public and concise part of a business strategic plan. A written document ensures unanimity of purpose within the organization and sets a general tone or climate for individuals to identify with. In a dynamically changing environment, this shared identity provides stability and goal congruence. Allocating organizational resources has a rational basis if it is related to the mission statement.



2632 IMA’s Statement on Management Accounting, “Values and Ethics: From

Inception to Practice”

2632.01 Purpose:

a. Identify the gaps between the ethical behavior expected from employees and their behavior.

b. Address these gaps through various plans

c. Have the desired ethical behaviors permeate every aspect of the organization’s operations

d. Develop indicators to ensure there is not degradation in ethical behavior, depleting the value of human capital with its negative impact on the organization

2632.02 Defining and Developing the Organization’s Behavioral Values : Conduct a cultural assessment answering such questions as:

a. What values does the organization believe in?

b. What principles drive this organization’s decision making?

c. By what ethical standards does this organization live?

d. What principles/beliefs do managers and leaders demonstrate?

Input from this activity gives insight to the reality within the organization. The same approach should be taken with organizational leadership to create a series of “should” answers to get insight into what the business leaders’ perception of what the culture should be.

Leaders will take the information from the above and define a set of ethical principles that will become the foundation of the ethical framework for ethical management and leadership.

2632.03 Leadership by example: Everyone in the organization is responsible for ethical behavior especially leadership. Leadership does this by:

a. Setting a good example

b. Keeping promises and commitments

c. Supporting others in adhering to ethics standards.



2632.04 Ethics and Internal Control: Process management and process thinking are an essential aspect of determining risk and internal controls. The following three tools can be used to combine aspects of process development, risk assessment, and internal controls.

a. Business Process Reengineering (BPR)

b. Quality Management

c. Continual Process Improvement (CPI)

2632.05 Converting Intent to Reality:

a. The Right People: During the interview process, include questions to ascertain the candidate’s alignment with the organization’s code of ethical behavior. Some of those questions could include:

(1) Interview questions that encourage candidates to define how they would respond to specific circumstances.

(2) Asking candidates what their own personal code of ethics (or values) might be

(3) Asking candidates to comment about what workplace behaviors would be unethical

(4) Creating a multiple choice test where candidates state their level of agreement or disagreement with various ethical statements

(5) Team based interviews where one interviewer poses an ethical question, other members offer alternatives, and the candidate is asked to add his or her personal view.

b. Employee Training: Ethics training for employees should focus on covering ethical concepts, the organization’s code, and compliance. To achieve this, training include:

(1) General employee behavior and personal conduct

(2) How ethics are built into work management methods

(3) How ethics affects specific jobs, processes, activities, and relationships

(4) How the organization monitors compliance with the code

(5) What routes are open to employees who have compliance issues (personal guidance, advice, and “whistleblowing” frameworks)

(6) What action is taken when a compliant or issue is identified

(7) The actions and penalties once noncompliance is proven



2632.06 Measuring and Improving Ethical Compliance

a. Human Performance Feedback Loop: Performance review and development systems must be fully aligned with the requirements for ethical conduct. Competencies, job descriptions, and objectives will include ethical expectations, and the employee review systems must assess employees against the same criteria

b. Survey tools: Ongoing surveys assist in assessing ethical performance, especially in areas such as management and leadership. Surveys are created using the organization’s code of ethics and asks employees to rate how well the organization is following the code of ethics contents.

2633 Ethical Leadership

2633.01 Corporate Mission Statement: A corporation’s purpose, values, and guiding philosophies are often referred to as its vision or culture. Corporate vision or culture is defined by a mission statement of the enterprise which guides the long‐run collective conduct of employees. The mission statement answers the question “Who are we and what business are we in?” This shared vision should be supported by specific objectives and implemented by medium‐term strategies.



a. Reasons and Purpose: A mission statement is the most public and concise part of a business strategic plan. A written document ensures unanimity of purpose within the organization and sets a general tone or climate for individuals to identify with. In a dynamically changing environment, this shared identity provides stability and goal congruence. Allocating organizational resources has a rational basis if it is related to the mission statement.

b. Components: Business organization behaviorists have identified nine key ingredients to a corporate mission statement.

(1) Customers: Who are the corporation’s customers?

(2) Products/Services: What are the corporation’s major products or services? Is horizontal integration or diversification necessary or desirable?

(3) Location: Where does the corporation operate and compete? Is it appealing to a local or global market?

(4) Technology: What is the corporation’s basic technology and/or core competency?

(5) Economic Objectives: What is the corporation’s commitment to economic goals? These objectives can be return on investment or growth orientated such as revenues, assets, sales, market share gains, new accounts, geographic coverage, product service quality, etc.

(6) Philosophy: What are the basic beliefs, values, aspirations and philosophical priorities of the corporation?

(7) Strengths/Opportunities: What are the corporation’s major strengths, weaknesses, opportunities and threats? These SWOT factors will determine the enterprise’s competitive advantages.

(8) Public Image Concerns: What are the corporation’s social responsibilities and what public image is desired? A well‐regarded corporate citizen image is the objective.

(9) Employee Concerns: What is the corporation’s attitude towards its employees? This may include opportunities for growth, advancement, increased salaries, challenges, etc.



c. Mission Statement/Code of Ethics Relationship: A mission statement defines the company’s culture including establishing the core values and long‐term objectives. Objective attainment requires a strategic policy. A code of conduct or code of ethics specifies the implementation details controlling day‐to‐day business dealings.

(1) Higher Level Objective: The code of conduct has been described as the “conscience of an organization.” It should rise above the required legal minimum behavior.

(2) Participatory Empowerment: As many employees as possible (or their representatives) should be involved in the development of both the vision statement and code of conduct.

2634 Legal Compliance

Sarbanes‐Oxley

2634.01 In General: The Sarbanes‐Oxley Act has changed many of the traditional roles and functions in the A, B, C groups (audit committee, board of directors, and chief executive officer) in publicly‐traded companies. The A, B, C groups are foremost in importance in creating the corporate code of ethics and in determining the effectiveness of the system in operation. Under the new law, all three group members have different independent roles and provide an integrated system of checks and balances. There are also internal and external reporting requirements placed on all three groups.

2634.02 Board of Directors: Of most import is that the Board of Directors is elected by the shareholders. As such they are to be considered the most public, non‐management oriented influence.

a. Voting System: Corporate directors are elected either through straight voting or cumulative voting. Cumulative voting allows minority shareholders a better chance at getting board of director representation. This system of democratic shareholder governance is especially important where the corporate share ownership is not widely disbursed and thus management proxies facilitate the appointment of family or “internal” people to the board.



b. Independence: The objective is that the board of directors be independent in both fact and appearance and thus are in a position to exercise significant oversight authority over senior management. The Board Chair should not also be the CEO. The dual role is incompatible. Some advocate term and age limits for Board members to ensure refreshing objective judgment.

(1) No Material Relationship: In 2004 a company’s board would need a majority of independent directors with no direct or indirect material relationship with the company to comprise over half of its board. Independence is clearly enhanced if the Board Chair is an outsider.

(2) Independence Requirement: Complete independence is required for members of the audit, compensation, and nominating committees. A director who was employed by the company in the last 3 years or receives over $100,000 a year is not independent. Insiders are thus limited so the director’s loyalty is more towards the shareholders and less towards management retention.

c. Objective: Larger public corporations ideally have a board with a diverse set of competencies; insiders and family members generally do not bring this to the table. The director’s fiduciary duty is owed to the stockholders and third parties, not top management.

d. Other Restrictions: Sarbanes‐Oxley has significant other restrictions on directors.

(1) Loans: There is a ban on direct or indirect corporate loans to directors and officers after July 30, 2002. [§402(a)]

(2) Black‐out Trading: Shareholders must be given at least 30 days advance notice of an impending “black‐out” period in trading corporate securities. Senior management and board members may not trade in corporation shares during “blackout” time periods if common rank and file employees are so restricted directly or through retirement and pension programs. [§306]

(3) Restatement Disgorgement: The law provides that all director and officer incentive bonuses and stock trading profits must be disgorged under certain circumstances. This applies if there is a subsequent restatement of financial statements due to a material error or irregularity arising from the period in which betterment was realized. [§305] The SEC may “freeze” extraordinary payments from the company to persons during an investigation. [§1103]

(4) Non‐dischargeable: Director’s and Officer’s debts and judgments for violation of the Act are not dischargeable in bankruptcy. [§803]



2634.03 Audit Committee: Historically this was the corporate organization that represented the board of directors in its dealings with the outside auditor.

a. Selection: The audit committee historically recommended to the board the selection or retention of the outside auditor and approved the level of auditor compensation. The board in turn normally passed on this recommendation to the shareholders at the annual meeting in the form of a resolution for their approval. As of April 2, 2003, the SEC requires that the audit committee, and not top management, be responsible for hiring, firing, and setting fees for all work of the outside auditor.

b. Independence Factors: This audit committee must have a minimum of 3 members. The independence concern is on two levels.

(1) Management: The audit committee members must sit on the corporate board and should be independent of the corporate management. On April 1, 2003, the SEC adopted a rule which effective in 2004 requires that the entire audit committee must be outsiders (not otherwise involved in the corporation, or family members). The stock exchanges are required to enforce this rule.

(2) No Other Compensation: No audit committee member may receive any consulting, advisory, or other fee from the company (or any affiliated entity) except for the normal compensation for board service [§301]. This is intended to avoid the tainted incidents of large “consulting contract” fees which may impair the independence of the audit committee member.

(3) Control Auditor: Second, the audit committee is charged with the responsibility to determine if the outside auditor is independent. This requires the committee to analyze the extent and details of the non‐attestation work performed by the auditor. If the company is publicly traded, the Sarbanes‐Oxley Act requires the proxy statement and annual report must segregate the amount the company paid for audit related activities, tax preparation and consulting, and all other fees including consulting. The audit committee is charged with the responsibility to make this allocation [§202].

(4) Tax Services: All tax services by the outside auditor must be pre‐approved by the audit committee [§201].

(5) Employee Complaints: The audit committee must establish procedures for receiving and handling complaints by company employees regarding accounting and financial related matters. This must include confidential anonymous submissions of complaints. Retaliation against whistle‐blowers is illegal. A written report must be completed for each complaint describing the substance, status, and any conclusions or recommendations. [§806].



c. Financial Expertise: At least one member of the audit committee must be a “financial expert.” While there remains debate on how this requirement is to be interpreted, the objective is that the auditing committee includes people with significant auditing experience [§407].

d. Reporting: The question is what does the audit committee do with an unresolved complaint involving an accounting or finance related matter? There are two duties of communication.

(1) Disclosure Committee: The audit committee must report to the full Board of Directors. Presumably this would be referred to the Disclosure Committee.

(2) Audit Committee: The outside auditor may contractually require the audit committee to report to them any fraud. This is now a required audit procedure under SAS 99. A CPA on the audit committee has a duty of disclosure to an external auditor that overrides the duty of confidentiality to the employer. (AICPA Rule 102)

2634.04 Certification Required

a. Concern: Historically, responsibility for breakdowns in internal governance and financial reporting irregularities was too easy to avoid. The Sarbanes‐Oxley Act is designed to ensure that no longer may CEOs and CFOs raise their hands and say “I/we didn’t know and relied upon the accountants and lawyers.” This concern is reinforced and made necessary by the Supreme Court’s holding in Central Bank of Denver v. First Interstate Bank, 511 U.S. 164 (1994) which eliminated private actions against secondary actors like outside accountants and lawyers for aiding and abetting management fraud unless they are deemed to be primary wrongdoers – this is a tough standard for an injured party to prove.

b. Focus: Sarbanes‐Oxley focuses on two procedural requirements.

(1) “Disclosure Controls and Procedures”: This first requirement emphasizes that the corporation must have an effective internal control structure which guarantees irregularities and fraud will be reported to top management. While the focus is more on financial problems than human resource ethical problems, it seems the same internal reporting system would be used.



(2) “Disclosure Committee”: The SEC suggests that the corporation establish a disclosure committee to coordinate the internal process. The disclosure committee might consist of the corporate CFO, general counsel, the risk management officer, and investor‐relations officer. They should review the information coming up the corporate chain through the disclosure control system. In many ways this committee operates like an audit committee except the reporting is to top management rather than the board or outside auditor. The corporate ethics officer seems like a logical participant in this committee. The disclosure committee must report to the SEC if management will not.

c. CEO and CFO Required Reporting: The above control system is designed so that top management can no longer avoid personal responsibility for financial statement restatements. Under the new law the responsibility is squarely fixed upon the CEO and CFO [§302]. Effective August 29, 2002 all 10‐K and 10‐Q must include a certification under penalty of perjury that:

(1) Fairly Represent: The information contained in the periodic financial statement and related disclosures fairly represents the corporate financial position. This includes an absence of material misstatements or omissions.

(2) GAAP Followed: The accounting procedures and principles used in compiling and presenting the financial reports are generally accepted. If GAAP is not followed the departure must be disclosed.

d. Officers Code of Ethics: Companies must disclose whether they have or have not adopted a code of ethics for their senior executive and financial officers. [§406] It seems highly unlikely any company would publicly state that they do not have such a Code.

e. Regular Reviews: The company must assume responsibility for maintaining and regularly reviewing internal controls covering the financial reporting process. The CFO has the responsibility to provide the necessary corporate internal control documentation. This is part and parcel of the annual §302 internal certification.



(1) Annual Assessment: Management must also annually assess their responsibility for establishing and maintaining the corporate internal controls [§404]. The internal control structure must include the financial reporting process and the code of ethics for senior executives and financial staff. Most ethics experts believe that it would be impossible (or at least very impractical) to have a code of ethics only for senior executives and finance officers and not the other departments of a corporation such as sales, human resources, purchasing, etc. Thus Sarbanes‐Oxley virtually guarantees that all public corporations will have a code of ethics which is thorough and integrated into the corporate internal control structure.

(2) Outside Auditor’s Attestation: The question then becomes how can the outside stakeholders be sure management is meeting their new code of ethics requirements. The outside auditor must attest to, and report on, the veracity of this management ethics system assertion and any changes made to increase effectiveness of the code of ethics. The auditor’s procedures and scope of the testing used to verify the assertion must be disclosed. Boiled down to the essence this assessment is a code of ethics audit. This opinion may be presented separately or in the basic audit report. [§404]

2635 Responsibility for Ethical Conduct

2635.01 Treadway Commission: The Committee of Sponsoring Organizations − COSO − (IMA, AAA, AICPA, IIA and FEI) sponsored the 1987 Na onal (Treadway) Commission on Fraudulent Financial Reporting. The report states that “A written code of corporate conduct strengthens the corporate ethical climate by signaling to all employees standards for conducting the company’s affairs.”

2635.02 COSO 1992 Report: In September, 1992, COSO released its first report called Internal Control − Integrated Framework in response to the Treadway Commission’s recommendations. Howard L. Siers, the accounting profession’s ethical intellect, served as the ethical advisor to COSO. This report concludes that the critical foundation of a company’s internal control structure is “integrity, ethical values, moral guidance, and competence.” Ethical values provide the foundation for behavior standards within an organization.



2635.03 COSO 1999 Report: A 1999 following report of over 200 corporate financial frauds indicated that 83% of financial frauds involved top management (the A, B, C group ‐ audit committee, board of directors, and chief executive officer). In addition, in almost every instance, the corporation did not have a code of conduct or management was able to effectively override it.

2635.04 Three Objectives: The three objectives of a Code should be:

a. Symbolic Function: To serve as a symbolic function by conveying what the organization stands for (and/or is opposed to).

b. Understandability: To reduce the standards to a brief, generalized set of written requirements that can be clearly understood. This will define the limits of acceptable behavior in the areas it addresses. This also will provide a yardstick to evaluate performance.

c. Organizational Utility: Ethics are most effective when they are an ongoing, integral part of a corporation’s culture. It should also facilitate dedication to common ethical standards.

2636 Sustainability and Social Responsibility

2636.01 A better‐informed, more inquisitive public is increasingly expecting businesses to do more than maximize profits to their shareholders, provide employment for workers and provide their customers with quality service and products. Similarly, labor must do more than maximize workers’ wages.

2636.02 Responsibility: Businesses are now seen as having responsibilities for the effect their actions have on society as a whole. In addition, there should be a concern for the quality of life in the local community where they operate.

a. Outreach Efforts: This may include philanthropy, community activities and service involvement, recycling efforts, human resource activities, environmental respect, affirmative actions, etc.

b. Stakes: Each publicized instance of corporate hypocrisy and extreme selfishness reinforces the notion that “everyone does it,” “it’s only wrong if you get caught,” and “good guys finish last.” The danger is that this becomes the role model for our children and business administration students. Business leaders must come forward and publicly rebut this impression. Walk the talk.



2636.03 Benefits: Employee volunteer charity and community programs build company‐wide morale and loyalty. Fulfilling corporate social responsibilities may add luster to the corporate image. This will also improve employee recruiting efforts.

a. Employee Retention: There is a positive reciprocal relationship between job satisfaction and ethical conduct. Good ethics promote a positive “us feeling” to employees thereby increasing motivation to do superior work.

b. Offensive Self‐interest: “Green consumers” may reward exemplary companies by voting with their purchasing dollars. Good business ethics can provide a comparative marketing advantage. The reverse is also possible; some groups may demand that a business operate with a social conscience or lose their patronage.

c. Defensive Self‐interest: On a more basic self‐interest level, a private, responsible ethics program avoids and minimizes the legal system and government involvement in corporate governance. Commercial freedom has as a correlate commercial responsibility.

2636.04 Social Audit: A social audit measures involvement of a business in these efforts.

2636.05 Labor Responsibility: Organized labor and unions have similar responsibilities to their community. Beyond promoting philanthropy and community involvement, the popular view in the new century is that labor should cooperate with management to allow the enterprise to be competitive in the world market place. This may include the responsibility to engage in meaningful collective bargaining and negotiate reasonable solutions to labor disputes. Unions may also have a social responsibility to participate with business in developing a transition program for displaced employees.

2636.06 Externalities: This is an attempt to quantify the negative environmental effect some businesses create for the community. Improper toxic waste disposal, uncontrolled air pollution from pulp mills, and adverse health effects of cigarette manufacturers are examples of instances where the corporation does not bear the full expense associated with producing the revenue. Could we quantify this with an accounting entry of a debit to externality expense and a credit to what? ‐‐ debt owed to community‐environment?

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