2021 LI CorpFinance

Last Revised: 11/23/2020
MarkMeldrum.com
Level I - Corporate Finance

Readings Page
Introduction to Corporate Governance and Other ESG Considerations 2
Capital Budgeting 17
Cost of Capital 29
Measures of Leverage 44
Working Capital Management 53
Reviews 70
This document should be used in conjunction with the corresponding readings in the 2020 Level I CFA® Program curriculum. Some of the graphs,
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1
Prepared exclusively for susana serna ,tuti_ese@hotmail.com Transaction: 0079224436,
Introduction to Corporate Governance

and Other ESG Considerations
a. describe corporate governance;
b. describe a company’s stakeholder groups and compare interests of

stakeholder groups;
c. describe principal – agent and other relationships in corporate governance

and the conflicts that may arise in these relationships;
d. describe stakeholder management;
e. describe mechanisms to manage stakeholder relationships and mitigate

associated risks;
f. describe functions and responsibilities of a company’s board of directors and

its committees;
g. describe market and non-market factors that can affect stakeholder

relationships and corporate governance;
h. identify potential risks of poor corporate governance and stakeholder

management and identify benefits from effective corporate governance and
stakeholder management;
i. describe factors relevant to the analysis of corporate governance and

stakeholder management;
j. describe environmental and social considerations in investment analysis;
k. describe how environmental, social, and governance factors may be used in

investment analysis.
2
Corporate Governance
E – environmental LOS a
-describe
S – social
Pg-1
G – governance – the system of internal controls and
procedures by which individual companies are managed
(defines the rights/responsibilities of various groups)
- the arrangement of checks, balances, and incentives a

company needs in order to minimize and manage the
conflicting interests between insiders & external shareowners
Shareholder Theory – the most important responsibility of

mgmt. is to maximize shareholder returns
Stakeholder Theory – broadens focus to also include customers,

suppliers, employees & society
Company Stakeholders
⇒ Shareholders/ interests focused on growth in LOS b

-describe
profits that maximize value of a company’s equity
Pg-2
vote for BOD
exercise control
vote for specific resolutions
Controlling shareholders – hold a %’age of shares that gives

them sufficient voting power to control the
election of the BOD
· non-controlling shareholders → minority shareholders
⇒ Creditors/ bondholders & banks (typically)

- exercise control through covenants
⇒ Managers & Employees/ senior exec. ➝ motivated to maximize

value of their equity-based remuneration
3
⇒ Managers & Employees/ lower level employees LOS b

-describe
desire decent wages + job security
Pg-3
- interests of – managers & employees may conflict
- managers & shareholders may conflict
⇒ Board of Directors/ elected to protect shareholder interests,

provide strategic direction, monitor company &
mgmt. performance
one-tier – single BOD of executive & non-executive directors
two-tier – 2 separate boards ➀ supervisory board

- non-executive directors
oversees ➁ management board
- executive directors
⇒ Customers/ product satisfaction for value paid LOS b

-describe
- some may have an interest in the long-term
Pg-4
viability of the company
⇒ Suppliers/ primary interest ➝ get paid in a timely manner
⇒ Governments/Regulators – seek to protect interests of the

general public and ensure the well-being of
the overall economy
4
Principal-Agent Relationships
- created when a principal hires an agent LOS c

-describe
to perform a specific task
Pg-5
- agent is expected to act in the best interests of
the principal
· Shareholder vs. Manager/Director

(principal) (agent)
⇒ may seek to maximize personal
benefits to the detriment of shareholders
· risk tolerance – mgmt. may be more risk averse

- protect their positions
· information asymmetry – difficult for shareholders to judge
soundness of strategic decisions
· board composition – too many insiders (executive directors)
LOS c
· Controlling & Minority Shareholders/
-describe
opinions outweighed by the influence Pg-6
of the controlling shareholder
- related-party transactions – controlling shareholder has

an interest in a transaction between the
company & a third party supplier (to the detriment
of minority shareholders)
- dual class shares – voting vs. non-voting
typically mgmt.
· Manager & BOD/ · relies on information

· oversight can be compromised if mgmt.
limits information (esp. non-executive directors)
5
· Shareholder vs. Creditor/ - prefer stable LOS c

-describe
performance &
prefer riskier projects Pg-7
lower risk activities
with higher return
· leverage levels low & manageable
potential
· lower levels of shareholder payout
· Other Stakeholder Conflicts/

· Customers vs. shareholders · cutting costs & quality/service
· Customers vs. Suppliers – lenient credit terms to

customers vs. timely payments to suppliers
· Shareholders vs. governments/regulators

- costly regulation
- tax minimization strategies
Shareholder Management
LOS d
-describe
· effective communication
· identify Pg-8
· prioritize · active engagement

· understand attempt to balance various interests
· legal infrastructure – rights established

interests of by law
stakeholder groups
· contractual infrastructure – define &
secure rights through contracts
· organizational infrastructure – internal

systems, governance procedures
· governmental infrastructure
- regulations imposed
6
Mechanisms of Stakeholder Mgmt.
⇒ General Meetings/ companies must hold an LOS e

-describe
AGM within a specified period of time
Pg-9
after year-end
- vote for directors, special resolutions
- provide performance overview, answer questions
- extraordinary GMs may also be called – M&A, sale of assets
- may require supermajority vote (⅔ - 75%)
· Proxy voting – allows another to vote on your behalf

· Cumulative voting – 100 shares, 4 directors ⇒ 400 votes
⇒ Board of Directors/ elected by shareholders to provide broad

oversight of the company (accountable to shareholders)
- BOD appoints top mgmt. of company
LOS e
⇒ The Audit Function/
-describe
· internal audits Pg-10
· external audits – annual audit of financial records
- provide reasonable & independent
assurance of accuracy & fair representation
⇒ Reporting & Transparency/ regulatory disclosures & investor relations

- reduces information asymmetry
- assess performance of directors & mgrs.
- aid in valuation
⇒ Policies on Related-Party Transactions/

- procedures for mitigating, managing, and disclosing
such cases
- directors/mgrs. must disclose any material interest
in a transaction
7
⇒ Remuneration Policies/ LOS e

- attempt to align mgmt. interests -describe
Pg-11
with shareholder interest (profit sharing, stock options)
- to avoid ‘short-termism’ – use shares instead of options
with longer-term vesting periods
⇒ Say on Pay – Shareholders vote on executive pay

- may be a) non-mandatory, non-binding e.g. Canada
b) mandatory, non-binding e.g. U.S., France
c) mandatory, binding e.g. U.K., Netherlands
⇒ Contractual Agreements with Creditors/

- indenture – legal contract with bondholders
- covenants – specific terms & conditions
- collateral – specific assets backing the debt
⇒ Employee Laws & Contracts/ LOS e

-describe
- labour laws, unions, employment contracts,
Pg-12
HR policies, ESOPs, Code of Ethics, Standards of
Conduct
⇒ Contractual Agreements with customers & suppliers/
⇒ Laws & Regulations

- consumers, environment
· Publicly traded companies are generally required to

annually publish corporate governance reports describing
their governance structure and explain any deviation
8
BOD & Committees
⇒ Composition of the Board/ LOS f

-describe
- a diverse mix of expertise, backgrounds
Pg-13
& competencies (e.g. specialized knowledge, functions)
- some even seek age/gender/cultural diversity
executive – members of senior mgmt.

one-tier
non-executive - external
· independent ➝ no material relationship with
the company (employment, ownership, remuneration)
supervisory
two-tier independent of each other
mgmt.
CEO & Chair position increasingly separated

- if not, use of a lead independent director
LOS f
⇒ Staggered Boards/ directors are divided into
-describe
classes that are elected separately in consecutive years Pg-14
- provides continuity but also entrenchment
⇒ Functions/Responsibilities/
duty of care – board members must act on a fully
informed basis, in good faith, with due
diligence and care
duty of loyalty – must act in the interest of the
company & shareholders
- guides/approves strategic direction of a company

- appoints CEO – delegates strategic implementation to top. mgmt.
- establishes performance criteria
- monitors & reviews performance
9
⇒ Functions/Responsibilities/ LOS f
- ensures effectiveness of company’s -describe
Pg-15
audit & control systems
- ensures proper ERM system in place
- reviews all major acquisitions, mergers, divestitures
before they are referred to shareholders
⇒ Committees/
a) Audit Committee – oversees the audit & control systems
- monitors financial reporting process
- supervises internal audit function
- recommends external auditor
b) Governance Committee – ensures that the company

adopts good corporate governance procedures
(plus charters of the board & committees, company’s
code of ethics, conflict of interest policy)
⇒ Committees/ LOS f
-describe
c) Remuneration/Compensation Committee Pg-16
- develops and proposes remuneration for the
Board & key executives
- may also set performance criteria and evaluate
the performance of managers
d) Nominations Committee – identifies candidates who are

qualified to serve as directors
- recommends their nomination by shareholders
e) Risk Committee – helps determine the risk policy,

profile & appetite of the company
- oversees establishment & implementation of ERM
system
10
⇒ Committees/ LOS f
-describe
f) Investment Committee Pg-17
- reviews material investment opportunities
proposed by mgmt. (large projects, acquisitions, expansion)
- establishes the investment policy of the company
· type of committee used may vary by jurisdiction

· composition depends on the scope of the committee
e.g. audit & compensation ➝ independent directors only

or/ external directors of which
a majority should be independent
Factors Affecting Relationships
LOS g
⇒ Market Factors/ (capital market related)
-describe
1) Shareholder engagement – being broadened Pg-18
beyond the AGM
- builds support for mgmt.’s position
2) Shareholder activism – attempts to compel mgmt. to

act in a desired manner
(proxy battles, shareholder resolutions, raising awareness)
- shareholder derivative lawsuits ➝ deemed to be acting
on behalf of the company since the BOD
& mgmt. have failed to do so
3) Competition & Takeovers

- proxy contest – shareholders are persuaded to
vote for a group seeking a controlling position on the BOD
11
⇒ Market Factors/ LOS g

-describe
3) Compensation & Takeovers Pg-19
· tender offer – shareholders sell their shares
directly to the group seeking control
· hostile takeover – acquire a company without
the consent of mgmt.
⇒ Non-market Factors/
1. Legal Environment – common law vs. civil law
superior protection of the

interests of shareholders and
creditors
- creditors generally have an easier time with

legal recourse than do shareholders
LOS g
⇒ Non-market Factors/
-describe
2. The Media – ability to spread info Pg-20
quickly and shape public opinion
- can spur politicians to introduce regulation or

enforce laws that protect shareholders
- social media – allows information sharing at little to
no cost
3. The Corporate Governance Industry

- external corporate governance services
(governance ratings, proxy advice)
12
Risks & Benefits
⇒ risks of poor governance & stakeholder mgmt. LOS h

-identify
1. weak control systems Pg-21
(poor audit procedures, insufficient scrutiny by the board)
- one stakeholder group may benefit at the expense of another
2. ineffective decision making

- when mgmt. has information not available to the board
- when remuneration policies encourage mgmt. self-interest
vs. shareholder interest
3. legal, regulatory or reputational risks

- violations of applicable laws
- lawsuits by shareholders, employees, creditors
4. default & bankruptcy risk
LOS h
⇒ benefits of effective governance & stakeholder mgmt.
-identify
1. Operational efficiency Pg-22
- clear delegation of responsibility & reporting
lines across the company
- decisions & activities are properly monitored & controlled
2. improved control
- identify and manage risks at early stages
3. better operating & financial performance

- reduces costs associated with weak control systems
4. lower default risk and cost of debt

- help protect creditors rights ➝ lower risk
- governance systems a relevant criteria among
credit rating agencies
13
Analyst Considerations
⇒ Economic Ownership & Voting Control/ LOS i

-describe
- dual-class structures (voting power decoupled Pg-23
one will have superior from ownership)
voting rights
- typically held by insiders or family members

or/ one class of shares elects a majority of the board
- outside shareholders elect a minority
- tend to trade at discount to peers
⇒ Board of Director Representation/

- independence, expertise, experience, tenure, diversity
match the current and future

needs of the company
LOS i
⇒ Remuneration & Company Performance/
-describe
- executive remuneration generally consists of: Pg-24
1. base salary
2. short-term bonus (cash-based)
3. multi-year incentive plan
(options, time-vested shares and/or
performance-vested shares)
· warning signs
1. plans offering little alignment with shareholders
2. plans exhibiting little variation over multiple years
3. plans with excessive payouts relative to comparable

companies with comparable performance
4. plans based on incentives from an earlier period in the

company’s life
14
⇒ Investors in the Company/ LOS i

-describe
can shield - cross-shareholdings Pg-25
a company - sizeable affiliated Shareholder (family trust,
from the endowment, individual)
effects of voting by
outside shareholders
- activist shareholders – catalyst for new strategic

directions or short-term arbitrageur?
⇒ Strength of Shareholder Rights/
+ look for a history of fines, accidents, regulatory penalties, etc. …
Environmental & Social Factors
⇒ sustainable/responsible investing (SI/RI) LOS j, k

-describe
- the practice of considering ESG factors
Pg-26
in the investment process
⇒ impact investing/ seeks to achieve targeted social or

environmental objectives along with measurable
financial returns
⇒ universal owners/ ➝ long-term investors that have significant

assets invested in diversified portfolios that are
representative of global capital markets
exposed to costs from environmental damage
Factors/ · natural resource mgmt. · energy efficiency

· pollution prevention · reduced emissions
· water conversation · adherence to environmental safety
& regulatory standards
15
Factors/ LOS j, k
-describe
⇒ stranded assets – carbon assets no longer
Pg-27
economically viable due to changing recommendations
Social/
- human rights, workplace welfare, community impact
⇒ ESG Implementation methods/
1) negative screening – excluding certain sectors or

companies that violate accepted standards in
such areas as human rights or environmental concerns
2) positive screening & best-in-class – focus on

investments with positive ESG aspects
3) thematic investing – typically consider a single factor

such as energy efficiency or climate change
16
Capital Budgeting
a. describe the capital budgeting process and distinguish among the various
categories of capital projects;
b. describe the basic principles of capital budgeting;
c. explain how the evaluation and selection of capital projects is affected by

mutually exclusive projects, project sequencing, and capital rationing;
d. calculate and interpret net present value (NPV), internal rate of return (IRR),
payback period, discounted payback period, and profitability index (PI) of a
single capital project;
e. explain the NPV profile, compare the NPV and IRR methods when
evaluating independent and mutually exclusive projects, and describe the
problems associated with each of the evaluation methods;
f. contrast the NPV decision rule to the IRR decision rule and identify
problems associated with the IRR rule;
g. describe expected relations among an investment’s NPV, company value,

and share price.
17
Capital Budgeting
LOS a
- allocation of funds to long-lived capital projects
-describe
-distinguish
Process Pg-1
Analyze Monitoring
Generate Individual Planning the and Post
Ideas Proposals Capital Budget Auditing
- inside/outside - based on cash - fit, timing, - compare
the company flow analysis required planned with
resources actual results
NPV
IRR
Payback/Discounted Payback
Profitability Index
LOS a
Categories:
-describe
1) Replacement Projects ⇒ maintain productive capacity -distinguish
or to gain an efficiency/productivity improvement Pg-2
2) Expansion Projects
3) New products/services
4) Regulatory, safety, environmental – often mandatory, may

result in exit
5) Lease/buy, make/outsource, either/or
18
Basic Principles
- some terms first LOS b

-describe
a) sunk cost ⇒ costs that cannot be recovered
Pg-1
- ignored
b) opportunity cost ⇒ value that is forgone in making
one decision over another
- included
c) incremental cash flow ⇒ additional cash realized as a
result of a decision
(CF with decision – CF without the decision)
d) externality ⇒ the effect of a decision on things other
than the investment itself
- included (i.e. cannibalization)
e) Conventional cash flows LOS b

-describe
$ $ $ $ $ - initial outflow Pg-2
| | | | | | followed by a series
-$ of inflows
only 1 sign change
$ $ $
| | | | | |
-$ -$ -$
- unconventional cash flows 3 sign changes

➀ $ $ ➂ $ - not a problem for
| | | | | | NPV, huge problem
-$ -$ ➁ -$
for IRR
19
Principles/ LOS b
1) Decisions are based on actual cash flows -describe
Pg-3
- only incremental cash flows
- if a cost/benefit cannot be expressed as a CF, ignored!
2) Timing of CF is crucial
- money sooner is worth more
3) CFs are based on opportunity costs
4) Financing costs ignored - reflected in the required rate

of return
5) CFs are on an after-tax basis
6) Accounting net income is not used
Evaluation/Selection
LOS c
Independent Projects
-explain
- projects whose cash flows are independent of each other
- can all be selected
Mutually exclusive projects – either/or
Project sequencing ⇒ staged investments with go/no-go options

go B go
A
no-go no-go end
Capital rationing (vs. unlimited funds)
requires allocating funds to ranked projects
20
Decision Criteria
after-tax CF LOS d
𝐧 -calculate
𝐂𝐅𝐭
⇒ 𝐍𝐏𝐕 = ( − 𝐎𝐮𝐭𝐥𝐚𝐲 -interpret
(𝟏 + 𝐫)𝐭
𝐭#𝟏 investment at t0 Pg-1
- conventional cash flows
e.g./ investment of $50, after-tax CF of $16M YR 1–YR 4

r = 10% 20M YR 5
16 16 16 16 20
| | | | | |
-50
𝟓
𝐂𝐅𝐭 𝟏𝟔 𝟏𝟔 𝟏𝟔 𝟏𝟔 𝟐𝟎
𝐍𝐏𝐕 = ( − 𝐂𝐅𝟎 = + + + + − 𝟓𝟎
(𝟏 + 𝐫)𝐭 (𝟏. 𝟏)𝟏 (𝟏. 𝟏)𝟐 (𝟏. 𝟏)𝟑 (𝟏. 𝟏)𝟒 (𝟏. 𝟏)𝟓
𝐭#𝟏
= $𝟏𝟑. 𝟏𝟑𝟔𝐌
LOS d
⇒ NPV Invest if NPV > 0
-calculate
else no! -interpret
⇒ IRR – discount rate at which NPV = 0 Pg-2
𝐧
𝐂𝐅𝐭
( = 𝐎𝐮𝐭𝐥𝐚𝐲 Invest if IRR > r
(𝟏 + 𝐈𝐑𝐑)𝐭
𝐭#𝟏 else no!
e.g./ 𝟏𝟔 𝟏𝟔 𝟏𝟔 𝟏𝟔 𝟐𝟎
𝟏
+ 𝟐
+ 𝟑
+ 𝟒
+ = 𝟓𝟎 solve for
(𝟏 + 𝐈𝐑𝐑) (𝟏 + 𝐈𝐑𝐑) (𝟏 + 𝐈𝐑𝐑) (𝟏 + 𝐈𝐑𝐑) (𝟏 + 𝐈𝐑𝐑)𝟓 IRR
⇒ unconventional cash flows ⇒ IRR may give multiple answers
21
16 16 16 16 20 LOS d
| | | | | | -calculate
-50 -interpret
Calculator - NPV Display Pg-3
CF 2nd CE/C - clears CF memory CFO = 0.0000
5O +/- ENTER - initial cash outlay CFO = -50.0000
↓ 16 ENTER - Period 1 CF CO1 = 16.0000
↓ ↓ 16 ENTER 2 CO2 = 16.0000
↓ ↓ 16 ENTER 3 CO3 = 16.0000
↓ ↓ 16 ENTER 4 CO4 = 16.0000
↓ ↓ 20 ENTER 5 CO5 = 20.0000
NPV 10 ENTER 10% discount rate I = 10.0000
↓ CPT Calculate NPV NPV = 13.1362
16 16 16 16 20 LOS d
| | | | | | -calculate
-50 -interpret
Pg-4
Calculator - IRR Display
CF 2nd CE/C - clears CF memory CFO = 0.0000
5O +/- ENTER - initial cash outlay CFO = -50.0000
↓ 16 ENTER - Period 1 CF CO1 = 16.0000
↓ ↓ 16 ENTER 2 CO2 = 16.0000
↓ ↓ 16 ENTER 3 CO3 = 16.0000
↓ ↓ 16 ENTER 4 CO4 = 16.0000
↓ ↓ 20 ENTER 5 CO5 = 20.0000
IRR CPT Calculate IRR IRR = 19.519
22
⇒ Payback Period – number of years required to recover initial inv. LOS d

-calculate
16 16 16 16 20 -interpret
| | | | | | Pg-5
-50 · ignores TVM &
risk
Cumulative:
· ignores CFs
-50 -34 -18 -2 +14 +34 after payback period
2/16 or 1/8th of a year

∴ Payback period – 3 1/8 yrs.
⇒ Discounted Payback
14.545 13.223 12.021 10.928 12.418
-50 -35.455 -22.232 -10.211 0.717 13.135
10.211/10.928 = 0.934
∴ Payback period = 3.934 YRS.
LOS d
-calculate
-interpret
Pg-6
much larger
CF after
payback
period
same Payback D has a shorter

period payback but
- NPV
- different NPV E has a higher
NPV
23
Profitability Index/ (a.k.a. benefit-cost ratio) LOS d

-calculate
𝐍𝐏𝐕 -interpret
𝐏𝐈 = 𝟏 +
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 Pg-7
e.g./
𝟏𝟑. 𝟏𝟑𝟔
𝐏𝐈 = 𝟏 + = 𝟏. 𝟐𝟔
𝟓𝟎
Note: 𝐏𝐕 𝟔𝟑. 𝟏𝟑𝟔
𝐏𝐈 = = = 𝟏. 𝟐𝟔 ⇒ the value we
𝐈𝐧𝐢𝐭. 𝐈𝐧𝐯. 𝟓𝟎
receive for one
unit of currency
invested
NPV vs. IRR
LOS e, f
NPV -explain
50 - -compare
40 - -describe
30 - Pg-1
- project’s NPV
20 -
graphed as a
10 -
function of various
convex from
the origin discount rates
-10 - r
| | |
10 20 30
e.g./
r NPV 𝐧
0 34 ⇒ " 𝐂𝐅𝐭 · for a single conventional

5 22.406 𝐭#𝟏 project, NPV & IRR will
10 13.136 - NPV agree
15 5.623
19.52 0 - IRR i.e. if NPV > 0
20 -0.543 then IRR > r
30 -9.954
24
LOS e, f
-explain
-compare
-describe
Pg-2
LOS e, f
- whenever NPV & IRR rank mutually exclusive
-explain
projects differently – choose the one with the higher NPV -compare
⇒ Reinvestment assumption of NPV -describe
Pg-3
25
LOS e, f
-explain
-compare
-describe
Pg-4
LOS e, f
- size of projects will also result in NPV and IRR ranking differently
-explain
- Select on NPV -compare
-describe
Pg-5
reinvestment at these rates

not likely
26
LOS e, f
⇒ Multiple IRR
-explain
e.g. 0 1 2 -compare
-1000 5000 -6000 CFs -describe
𝟓𝟎𝟎𝟎 𝟔𝟎𝟎𝟎 IRR = 100%
−𝟏𝟎𝟎𝟎 + − = 𝟎 2 solutions
NPV (𝟏 + 𝐈𝐑𝐑) (𝟏 + 𝐈𝐑𝐑)𝟐 IRR = 200%
0
- nonconventional
IRR
cash flows
- as many IRRs
as there are sign changes
| | | (possibly)
100 200 300 r
LOS e, f
⇒ No IRR Problem
-explain
e.g./ 0 1 2 -compare
100 -300 250 CFs -describe
𝟑𝟎𝟎 𝟐𝟓𝟎 Pg-7
𝟏𝟎𝟎 − +
(𝟏 + 𝐈𝐑𝐑) (𝟏 + 𝐈𝐑𝐑)𝟐
=𝟎 no solution
-
60
50 -
40 -
30 - NPV > 0
20 -
10 -
r
-
50 100 150 200 250 300
27
NPV & Company Value
LOS g
e.g./ Investment of $600M -describe
PV = $850M, NPV = $250M
200M shares outstanding at $32/sh.
Market value before investment 200M x 32 = $6,400M
Value of company should increase by NPV = $250M
𝟔, 𝟒𝟎𝟎 + 𝟐𝟓𝟎 $𝟐𝟓𝟎𝐌

= $𝟑𝟑. 𝟐𝟓 or = $𝟏. 𝟐𝟓
𝟐𝟎𝟎𝐌 𝟐𝟎𝟎𝐌 𝐬𝐡𝐚𝐫𝐞𝐬
∴ share price should
increase by $1.25 to $33.25
28
Cost of Capital
a. calculate and interpret the weighted average cost of capital (WACC) of a

company;
b. describe how taxes affect the cost of capital from different capital sources;
c. describe the use of target capital structure in estimating WACC and how
target capital structure weights may be determined;
d. explain how the marginal cost of capital and the investment opportunity
schedule are used to determine the optimal capital budget;
e. explain the marginal cost of capital’s role in determining the net present
value of a project;
f. calculate and interpret the cost of debt capital using the yield-to-maturity
approach and the debt-rating approach;
g. calculate and interpret the cost of noncallable, nonconvertible preferred

stock;
h. calculate and interpret the cost of equity capital using the capital asset
pricing model approach, the dividend discount model approach, and the
bond-yield-plus risk-premium approach;
i. calculate and interpret the beta and cost of capital for a project;
j. describe uses of country risk premiums in estimating the cost of equity;
k. describe the marginal cost of capital schedule, explain why it may be

upward-sloping with respect to additional capital, and calculate and interpret
its break-points;
l. explain and demonstrate the correct treatment of flotation costs.
29
WACC
Debt LOS a
⇒ Capital Pref. components of
Equity -calculate
common capital -interpret
each component Pg-1
has its own cost
⇒ new investments (i.e. capital projects)
dfdf will require
new capital ⇒ ∴ we need the ‘marginal cost of capital’
- what it costs to raise additional funds for the project
⇒ costs of capital for the entire company
- the required rate of return for the average risk
investment
⇒ costs of capital for the entire company LOS a

-calculate
⇒ calculate MC of each component
-interpret
⇒ weight each MC Pg-2
WACC - also called MCC
WACC = wdrd(1-t) + wprp + were w - weightings (Σ=1)

r - costs of
d - debt, p-pref., e-common
e.g./
ABC Cost t = 40%
Debt 30% 8%
Pref. 10% 10%
Common 60% 15%
WACC = .3(.08)(1-.4) + .1(.1) + .6(.15)
= 0.0144 + 0.01 + 0.09
= 11.44%
30
Taxes
LOS b
Components: 1) Debt - deductible for tax purposes
-describe
∴ Cost of debt = rd(1-t)
e.g./ $10M Debt @ 10% = $1M int. exp.

t = 40% . 𝟒𝐌
𝟔𝟎𝟎𝐊 - cost of debt ⇒ 6%
2) Preferred Stock dividends are dfdf
paid
∴ no tax treatment
3) Common Stock after-tax
e.g./ rd = 4% re = 6% After-tax rd After-tax re

t = 30% US .04(1-.3) = 2.8% 6%
t = 48% EUR .04(1-.48) = 2.08% 6%
Target Capital Structure
LOS c
⇒ Capital structure the company either -describe
explicitly wants to attain/maintain or implicitly does so Pg-1
rarely known outside the company
∴ needs to be estimated by:
1) assuming the current structure (at

investors expect
market value weights) represents the target
a return on the
full amount at 2) examine past trends
stake 3) use averages of comparables
31
LOS c
e.g./ Bonds outstanding $5M -describe
Pref. Stock 1M at market wd = .25 Pg-2
Common Stock 14M wp = .05

20M we = .70
e.g. 2/
MV Debt $50M
Company 1. Current Cap. Structure
MV Equity 60M
𝐰𝐝 = 𝟓𝟎M𝟏𝟏𝟎 = . 𝟒𝟓𝟒𝟓
Competitor MVd MVe
A $25M 50M 𝐰𝐞 = 𝟔𝟎M𝟏𝟏𝟎 = . 𝟓𝟒𝟓𝟒
B 101M 190M 2. Competitors Cap Structure
C 40M 60M Cap
𝟓𝟎 Structure
𝟏𝟗𝟎 𝟔𝟎
𝟕𝟓 + 𝟐𝟗𝟏 + 𝟏𝟎𝟎
𝟐𝟓 𝟏𝟎𝟏 𝟒𝟎 𝐰𝐞 =
𝟕𝟓 + 𝟐𝟗𝟏 + 𝟏𝟎𝟎 𝟑
𝐰𝐝 = = . 𝟑𝟔𝟎𝟏
𝟑 = . 𝟔𝟑𝟗𝟗
MCC & IOS
MCC ⇒ marginal cost of capital LOS d

-explain
- may increase as additional capital is raised
Pg-1
IOS ⇒ investment opportunity schedule
- a company’s investment opportunities generally decrease
as it makes additional investments
r
MCC
Cost
or Investment
n
Retur opportunity
schedule
IOS
Amount of New Capital

optimal capital
budget
32
r MCC1 Pg-2
MCC
Cost
or
Return
IOS
IOS1
OCB
OCB1
MCC
MCC2
IOS2
IOS
OCB OCB2
LOS e
⇒ for specific projects: -explain
Pg-3
⇒ if average-risk, use WACC as the discount rate
⇒ also assumes company will have a constant target capital
structure throughout the project’s cash flows life
⇒ if risk is above/below average, upward/downward adjustment

to WACC required
- ad hoc adjustment or more systematic
33
Cost of Debt
LOS f
1) Yield-to-Maturity approach -calculate
- the annual yield an investor earns on a bond if held -interpret
to maturity Pg-1
e.g./ Company X issues a 10-year 5% semi @ 102.50

rd =? FV = 100 PMT = 2.5 N = 20 PV = -102.50
CPT I/Y = 2.342
∴ rd = 2.342 × 2 = 4.684%
after-tax cost of debt if t = 35%
rd(1-t) = 0.04684(1-.35) = 3.045%
2) Debt Rating approach LOS f

-calculate
- when a market price for debt is not available
-interpret
- based on a company’s debt rating, use the yield on Pg-2
comparably rated bonds
(matrix pricing - fixed income)
Other Issues/
• Fixed vs Floating
• Debt with embedded options
• Non-rated debt
• Leases (should be included in the cost of capital)
Cost of Preferred Stock
- non-convertible, non-callable LOS g

-calculate
⇒ stated dividend yield ⇒ not tax deductible
-interpret
𝐃 Pg-1
𝐫𝐩 = 𝐩Q𝐏
𝟎
e.g./ $3.75 cumulative preferred with P0 = $72

𝐫𝐩 = 𝟑. 𝟕𝟓M𝟕𝟐 = 𝟓. 𝟐𝟏%
• Adjustments to rp may need to be made if new
issues diverge in terms of features
34
• historical
Pure Play
• DDM
• survey
• YTM
𝐃𝟎
• Debt Rating M𝐏 • CAPM
𝟎
= 𝐫𝐟 + 𝛃[𝐫𝐦 − 𝐫𝐟 ]
𝐃
WACC = wdrd (1-t) + wprp + were 𝐃𝐃𝐌 V 𝟏M𝐏 + 𝐠X
𝟎
estimating
capital structure • Bond yield
- assume existing + premium • prepublished
- comparables • Y𝟏 − 𝐃M𝐄𝐏𝐒\ 𝐑𝐎𝐄
(sustainable)
Cost of Common Equity
LOS h
1) CAPM estimated relative to a market index
-calculate
expected market risk premium -interpret
(equity risk premium - ERP) Pg-1
E(Ri) = Rf + βi [E(Rm) - Rf]
selection should be guided by the duration of the

project’s cash flows
⇒ β may not capture all the risks, ∴ use of a multi-factor

model with multiple βs
E(Ri) = Rf + βi1(Factor risk premium)1 + βi2 (Factor risk premium)2

+ . . . + βij (Factor risk premium)j
35
1) CAPM - estimating E(RM-RF) LOS h

-calculate
a) historical equity risk premium approach
-interpret
⇒ use historical data to find average RM & RF
Pg-2
- must consider time periods overlapping
i.e. 1 yr. returns, 5 yr., 10 yr.? non-overlapping
+ geometric or arithmetic means?
measures profitability of an investment over a multi-period horizon
-/ level of risk of the index can change over time

risk aversion levels can change
estimates sensitive to methodology
LOS h
1) CAPM - estimating E(RM-RF)
-calculate
b) Dividend Discount Model - implied risk premium approach
-interpret
Pg-3
dividends on the index
𝐃𝟏 𝐃𝟏
𝐏𝟎 = ⇒ 𝐫𝐞 = + 𝐠 - growth rate in dividends
𝐫𝐞 − 𝐠 𝐏𝟎
price of the index
c) Survey approach
- ask a panel of finance experts and take the mean of their responses
LOS h
2) Dividend Discount Model Approach -calculate
𝐃𝟏 -interpret
𝐕𝟎 = ⇒ letting V0 = P0 dividends on the stock Pg-4
𝐫𝐞 − 𝐠 𝐃𝟏
then 𝐫𝐞 = 𝐏 + 𝐠 - dividend growth rate
𝟎
price of equity
Note: 𝐃𝟏M - forward annual dividend yield

𝐏𝟎
𝐠 = Y𝟏 − 𝐃M𝐄𝐏𝐒\ 𝐑𝐎𝐄
sustainable growth rate

DPR
Retention Rate
36
3) Bond Yield + Risk Premium approach LOS h

-calculate
re = rd + Risk Premium ⇒ typically estimated from
-interpret
historical spreads between Pg-5
stocks and bonds
e.g./ (𝐑 𝐦 − 𝐑 𝐟 )
Citigroup - Jan./06
geometric mean ERP = 4.8% - historical
β = 1.3 re = rf + β(ERP)
10-yr. T-Bill = 4.38% = 4.38 + 1.3(4.8) = 10.72%
- DDM
DPR = 41%
𝐃𝟏 𝐃𝟏
M𝐏 = 𝟑. 𝟗% +𝐏 + g = 3.9 + (1 - .41)(16.6)
𝟎
𝟎
= 13.69%
ROEttn = 20% ROEf = 16.6% - BY + RP
𝐘𝐓𝐌V𝟓. 𝟑𝐬M𝟏𝟔X = 𝟒. 𝟗𝟓% rd + RP = 4.95 + 3.5% = 8.45%
est.
Estimating Project & Company β
a 𝐑 𝐦𝐭
⇒ regression 𝐑 𝐢𝐭 = 𝐚_ + 𝐛 LOS i
-calculate
-interpret
estimate of β - sensitive to the length of Pg-1
the estimation period
- periodicity within the period
company is private?
⇒ What if - selection of Rm
project is not average-risk?
Elasticity of
Sales
demand
Risk Business Financial Level
Cyclicality β
Risk Risk of
industry Operating ➀ ➁ Debt
structure Risk
FC vs. VC
37
⇒ Pure-Play Method - using a comparable publicity-traded LOS i

company’s beta and adjusting for financial leverage -calculate
-interpret
similar differences
Pg-2
business risk asset β
as the project - Comparable β is unlevered, then re-levered to
reflect cap. structure of the project
a - asset βa = βdwd + βewe

d - debt
e - equity the comparable’s asset β is a weighted average of its debt
and equity β
LOS i
βa = βd wd + βe we
-calculate
𝐃 𝐄 -interpret
𝐃 𝐄 ⇒ 𝛃𝐚 = 𝛃𝐝 b c + 𝛃𝐞 b c
𝐃+𝐄 𝐃+𝐄 Pg-3
𝐃+𝐄 𝐃+𝐄
⇒ now include taxes
(𝟏 − 𝐭)𝐃 𝐄
𝛃𝐚 = 𝛃𝐝 + 𝛃𝐞
(𝟏 − 𝐭)𝐃 + 𝐄 (𝟏 − 𝐭)𝐃 + 𝐄
Hamada equation:
𝐄
- assumes βd = 0 ⇒ 𝛃𝐚 = 𝛃𝐞 (𝟏 − 𝐭)𝐃 + 𝐄 divide all terms by E
𝐄M
𝛃𝐚 = 𝛃𝐞 𝐄
(𝟏 − 𝐭) M𝐄 + 𝐄M𝐄
𝐃
Comparable’s 𝟏
𝛃𝐚 = 𝛃𝐞 d e
unlevered β 𝟏 + (𝟏 − 𝐭) 𝐃M𝐄
38
𝟏 LOS i
𝛃𝐚 = 𝛃𝐞 ⇒ comp.’s capital structure -calculate
𝟏 + (𝟏 − 𝐭) 𝐃M𝐄 -interpret
Pg-4
comp.’s comp.’s comp.’s
βU βL tax rate
project’s
cap. structure
Rearrange: Let 𝟏 + (𝟏 − 𝐭) 𝐃M𝐄 = 𝐗
𝛃𝐋
𝛃𝐔 = ⇒ 𝛃𝐔 𝐗 = 𝛃𝐋 ∴ 𝛃𝐋 = 𝛃𝐔 g𝟏 + (𝟏 − 𝐭) 𝐃M𝐄h
re 𝐗
premium
project comp.’s project’s
for
βL βU tax rate
financial
premium for
risk
Rf business risk
𝐃M
𝐄
e.g. 1/ comp.’s ⇒ β = 1.3 LOS i

MVe = 540M βa = ? -calculate
t = 40% MVd = 720M -interpret
Pg-5
𝟏 𝟏
𝛃𝐚 = 𝛃𝐞 = 𝟏. 𝟑 i j = 𝟎. 𝟕𝟐
Y𝟏 + (𝟏 − 𝐭) 𝐃M𝐄\ 𝟏 + (𝟏−. 𝟒) 𝟕𝟐𝟎M𝟓𝟒𝟎
e.g. 2/ avg. comp. βU = 1.0 βL = 1.6

project 𝐃M𝐄 = 𝟏. 𝟒
project t = 34% βproject = ?
𝛃𝐋 = 𝛃𝐔 g𝟏 + (𝟏 − 𝐭) 𝐃M𝐄h
= 𝟏. 𝟎[𝟏 + (𝟏−. 𝟑𝟒)𝟏. 𝟒] = 𝟏. 𝟗𝟐𝟒
39
LOS i
-calculate
-interpret
Pg-6
BL = 0.60(1+(1-.38).7)
= 0.8604
re = rf + β(ERP)
= 4.5% + .8604(5.7)
= 9.4 %
𝟏
𝛃𝐔𝐁 = 𝟏. 𝟒𝟓 2 7 = 𝟎. 𝟕𝟓
𝟏 + (𝟏−. 𝟑) 𝟔𝟎𝟎𝟎+𝟒𝟓𝟎𝟎
𝐃 𝐃M
𝟏
𝐰𝐝 = = 𝐄 = . 𝟕 =. 𝟒𝟏
𝛃𝐔𝐂 = 𝟎. 𝟕𝟓 2 7 = 𝟎. 𝟒𝟓
𝟏 + (𝟏−. 𝟑𝟎𝟑) 𝟖𝟕𝟎𝟎+𝟗𝟑𝟎𝟎 𝐃+𝐄 𝐃M𝐄 + 𝟏 . 𝟕 + 𝟏
𝟏 𝐰𝐞 = 𝟏 − 𝐰𝐝 =. 𝟓𝟗
𝛃𝐔𝐃 = 𝟏. 𝟎𝟓 2 7 = 𝟎. 𝟓𝟗
𝟏 + (𝟏−. 𝟑𝟎𝟓) 𝟕𝟗𝟎𝟎+𝟕𝟎𝟎𝟎
𝐀𝐯𝐠. = 𝚺+𝟑 = 𝟎. 𝟔𝟎 WACC = (0.0675)(0.41)(.62) +

.59(0.094) = 7.26%
Country Risk
LOS j
re = rf + β(ERP + CRP)
-describe
country risk premium
sovereign yield spread = gov’t. yield - T-bond yield
denominated in
developed mkt. currency
or/
CRP = sovereign yield 𝛔𝐞
b c in terms of developed
spread 𝛔𝐝
market’s currency
e.g./ Company A in USA
ERP = 4.5%
CRP (developing) = 3% re = .04 + 1.2 (.045 + .03)
β = 1.2 = .04 + .09
Rf = 4% = .13
40
e.g. 2/ Developing Country LOS j

-describe
10-yr. gov’t. bond = 9.5%
US 10-yr. T-bond = 4.5 %
σe = 40% σd = 28%
𝟒𝟎%
𝐂𝐑𝐏 = (𝟗. 𝟓% − 𝟒. 𝟓%) b c
𝟐𝟖%
= 𝟓% Y. 𝟒M. 𝟐𝟖\
= 𝟕. 𝟏𝟒%
MCC Schedule
LOS k
r -describe
-calculate
- may not be able to issue -interpret
debt at same level of seniority Pg-1
(debt incurrence test)
Amount of
New Capital - deviations from optimal
capital structure
Amount of new capital at
which WACC changes (i.e. either rd or re changes) is referred to as a
break-point
more
realistic
MCC schedule break points
41
e.g./ LOS k
New Debt rd (1-t) New Equity re -describe
-calculate
≤ $2M 2% ≤ $6M 5%
-interpret
$2M ➝ $5M 2.5% $6M ➝ $8M 7%
Pg-2
$5M ➝ 3% $8M ➝ 9% target ⇒ 40:60
WACC WACC changes when rd or re changes

7% -
6% - $𝟐𝐌& = 𝟓𝐌 𝟐%(. 𝟒) + 𝟓%(. 𝟔𝟎) = 𝟑. 𝟖%

.𝟒
5% -
$𝟓& = 𝟏𝟐. 𝟓𝐌 𝟐. 𝟓(. 𝟒) + 𝟕%(. 𝟔𝟎) = 𝟓. 𝟐%
4% - .𝟒
3% - $𝟔𝐌& = 𝟏𝟎 𝐌 𝟐. 𝟓(. 𝟒) + 𝟓%(. 𝟔𝟎) = 𝟒%
.𝟔
2% -
𝟖𝐌& = 𝟏𝟑. 𝟑𝟑𝐌 𝟑%(. 𝟒) + 𝟕%(. 𝟔𝟎) = 𝟓. 𝟒%
1% -
.𝟔
𝟑%(. 𝟒𝟎) + 𝟗%(. 𝟔𝟎) = 𝟔. 𝟔%
4.5M 9.0M 13.5M 18M
Floatation Costs
LOS l
⇒ costs associated with raising capital -explain
- debts/pref. sh. ⇒ < 1% -demonstrate
Pg-1
- equity ⇒ can be significant
a) Include in cost of capital

𝐃𝟏 e.g./ D0 = 2.00 f = 4%
𝐫𝐞 = +𝐠 𝐅 = $𝐜𝐨𝐬𝐭
(𝐏𝟎 − 𝐅) P0 = $40 g = 5%
𝐃𝟏
𝐫𝐞 = +𝐠 𝐟 = %𝐜𝐨𝐬𝐭 𝟐. 𝟎𝟎(𝟏. 𝟎𝟓)
𝐏𝟎 (𝟏 − 𝐟) 𝐫𝐞 = +. 𝟎𝟓 = 𝟏𝟎. 𝟐𝟓%
𝟒𝟎
𝟐(𝟏. 𝟎𝟓)
𝐧
𝐂𝐅𝐢 𝐫𝐞 = + . 𝟎𝟓 = 𝟏𝟎. 𝟒𝟕%
𝟒𝟎(𝟏 − . 𝟎𝟒)
𝐏𝐫𝐨𝐛𝐥𝐞𝐦 ( ≠ 𝐏𝐕(𝐅)
∆𝐫𝐞
𝐢#𝟏 𝚫re = 22bps
42
b) Adjust cash flows for F LOS l

-explain
e.g./ 10K 10K 10K 10K -demonstrate
3 10 Pg-2
-60K 1 2
t = 40% D1 = $1
(D:E = 40:60) rd = 5% P0 = $20
g = 5%
Debt 24,000 .40 .05(1-.4) = .03 𝐃𝟏
&𝐏 + 𝐠 = 𝟏&𝟐𝟎 +. 𝟎𝟓 = . 𝟏𝟎
Equity 36,000 .60 = 10 𝟎
WACC = .40(.03) + .60(.1) = 7.2% FV = 0 PMT = 10,000 N = 10

Let f = 5% = 1800 𝐈& = 𝟕. 𝟐
𝐘 CPT PV – 60K
NPV = 9591 - 1800 - 7791
NPV = 9591
tax shield
𝐫𝐞 = 𝟏M(𝟐𝟎 × . 𝟗𝟓) + . 𝟎𝟓 = 𝟏𝟎. 𝟐𝟔
NPV = 9591 -1800(.6) = 8511
if F are tax ded. WACC = 7.36%
NPV = 9,081
43
Measures of Leverage
a. define and explain leverage, business risk, sales risk, operating risk, and
financial risk and classify a risk;
b. calculate and interpret the degree of operating leverage, the degree of

financial leverage, and the degree of total leverage;
c. analyze the effect of financial leverage on a company’s net income and return
on equity;
d. calculate the breakeven quantity of sales and determine the company’s net
income at various sales levels;
e. calculate and interpret the operating breakeven quantity of sales.
44
Risks
LOS a, d, e
elasticity of -define
demand -explain
Sales -calculate
cyclicality Risk -interpret
(Q×P) Financial level
industry Business
β of
structure Risk Risk
debt
Operating
MIX of Risk Financial
VC vs. FC
Leverage
Operating Leverage ⇒ use of debt in
the company’s capital
⇒ use of FC in company’s
structure
cost structure
increases the volatility of
earnings and cash flows
∴ increases risk, which increases rd & re, which increases WACC
LOS a, d, e
e.g./ A B -define
Q 100,000 100,000 -explain
SP/U $10 $10 -calculate
VC/U 2 6 -interpret
CM/U 8 4 Pg-2
FC/
𝐅𝐂 𝟔𝟎𝟎, 𝟎𝟎𝟎
Op. Exp. 500k 150k BEP(A) = 𝐂𝐌/𝐔 = = 𝟕𝟓, 𝟎𝟎𝟎
𝟖
Int. Exp. 100k - 50k -
𝟓𝟎𝟎, 𝟎𝟎𝟎
Sales $1M 1M Operating BEP = = 𝟔𝟐, 𝟓𝟎𝟎
- VC .2 .6 𝟖
= CM 800k 400k 𝐅𝐂 𝟐𝟎𝟎, 𝟎𝟎𝟎
BEP(B) = = = 𝟓𝟎, 𝟎𝟎𝟎
- Op Ex 500k 150k 𝐂𝐌/𝐔 𝟒
= Op Pr = ø 300k 250k
- INT 100k 50k 𝟏𝟓𝟎, 𝟎𝟎𝟎
Operating BEP = = 𝟑𝟕, 𝟓𝟎𝟎
= NI 200k 200k 𝟒
ø ø
45
e.g./ A B LOS a, d, e
Q 100,000 100,000 -define
SP/U $10 $10 -explain
VC/U 2 6 -calculate
$ -interpret
CM/U 8 4
Pg-3
FC/
Op. Exp. 500k 150k 100,000 Q A
400k - I
Int. Exp. 100k 50k 200,000 N B
Sales $1M 1M 200k -
•
- VC .2 .6 Q
-
= CM 800k 400k 50k 75k 100k
-200k -
- Op Ex 500k 150k
-400k - NI = -200,000 + 4Q
= Op Pr 300k 250k
- INT 100k 50k -600k -
NI = -600,000 + 8Q
= NI 200k 200k
CVP - Graph
LOS a
P industry structure -define
Sales
Business × elasticity of demand -explain
Risk
Risk G cyclicality - macro
Pg-4
Operating
FC
Risk - higher FC, higher operating
all companies in vs
the same line on risk, higher business risk
VC
business face the
somewhat dependent on the industry
same sales risk
structure but more discretionary than
Sale Risk
Debt
Financial - Level of - fixed financing charges
Risk Debt Pref.
46
Degree of Leverage
P Recall: from microeconomics LOS b, c, d

-calculate
𝐥𝐨𝐰 𝐐𝐝𝐱 %∆𝐐 -interpret
elastic 𝐡𝐢𝐠𝐡 𝐏𝐱 · elasticity is -analyze
%∆𝐏
at a particular Q Pg-1
unit elastic
• 𝐝
inelastic 𝐡𝐢𝐠𝐡 𝐐𝐱
𝐥𝐨𝐰 𝐏𝐱
D same concept
Q
Degree of Operating Leverage (DOL) - calculated at a

particular Q
%∆𝐎𝐩. 𝐏𝐫.
𝐃𝐎𝐋 = ⇒ %∆𝐎𝐩. 𝐏𝐫 = 𝐃𝐎𝐋(%∆𝐐)
%∆𝐐
𝐂𝐌 𝐐 × 𝐂𝐌/𝐔
=
𝐎𝐩 𝐏𝐫. (𝐐 × 𝐂𝐌/𝐔) − 𝐅𝐂
LOS b, c, d
A B -calculate
Sales $1M 1M -interpret
- VC 200k 600k -analyze
𝐂𝐌 𝟖𝟎𝟎𝐤
= CM 800k 400k 𝐃𝐎𝐋(𝐀) = = = 𝟐. 𝟔𝟔 Pg-2
𝐎𝐩𝐏𝐫. 𝟑𝟎𝟎𝐤
- Op Ex 500k 150k
= Op Pr 300k 250k 𝐐 × 𝐂𝐌/𝐔 𝟏𝟎𝟎, 𝟎𝟎𝟎 × 𝟒 𝟒𝟎𝟎𝐤
𝐃𝐎𝐋(𝐁) = = =
(𝐐 × 𝐂𝐌/𝐔) − 𝐅𝐂 (𝟏𝟎𝟎, 𝟎𝟎𝟎 × 𝟒) − 𝟏𝟓𝟎𝐤 𝟐𝟓𝟎𝐤
= 𝟏. 𝟔
∴ for a 1% change in Qi
up
A ➝ %∆𝐎𝐩 𝐏𝐫. = 𝐃𝐎𝐋(%∆𝐐) = 𝟐. 𝟔𝟔(𝟏) = 𝟐. 𝟔𝟔%
down given
(𝟏) up Q = 100k
B ➝ %∆𝐎𝐩 𝐏𝐫. = 𝐃𝐎𝐋(%∆𝐐) = 𝟏. 𝟔%
down
47
80,000 Q 100,000 Q 120,000 Q LOS b, c, d

A B A B A B -calculate
-interpret
Sales $1M 1M
-analyze
- VC 200k 600k
Pg-3
= CM 640k 320k 800k 400k 960k 480k
- Op Ex 500k 150k 500k 150k 500k 150k
= Op Pr 140k 170k 300k 250k 460k 330k
𝟑𝟎𝟎 − 𝟏𝟒𝟎 𝟑𝟑𝟎 − 𝟐𝟓𝟎

= 𝟓𝟑. 𝟑𝟑 ↓ % DOL(A) = 2.67 = 𝟑𝟐%
𝟑𝟎𝟎 𝟐𝟓𝟎
DOL(B) = 1.6
20 ↓ Q 20% ↑ Q
%ΔOpPr = 2.67(20) = 53.4% %ΔOpPr = 1.6(20) = 32%
80,000 Q 100,000 Q 120,000 Q LOS b, c, d

-calculate
A B A B A B
-interpret
Sales $1M 1M -analyze
- VC 200k 600k Pg-4
= CM 640k 320k 800k 400k 960k 480k
- Op Ex 500k 150k 500k 150k 500k 150k
= Op Pr 140k 170k 300k 250k 460k 330k
At Q = 80,000 25% ↑ Q At Q = 120,000

DOL(A) = 𝐎𝐩.𝐏𝐫 = 𝟔𝟒𝟎M𝟏𝟒𝟎 = 𝟒. 𝟓𝟕 DOL(A) = 𝟗𝟔𝟎M𝟒𝟔𝟎 = 𝟐. 𝟎𝟗
𝐂𝐌
DOL(B) = 𝟑𝟐𝟎M𝟏𝟕𝟎 = 𝟏. 𝟖𝟖 DOL(B) = 𝟒𝟖𝟎M𝟑𝟑𝟎 = 𝟏. 𝟒𝟓

%ΔOpPr = DOL(%ΔQ)
=1.88(25%) 𝟐𝟓𝟎 − 𝟏𝟕𝟎
= 𝟒𝟕. 𝟎𝟔%
= 47.06 𝟏𝟕𝟎
48
𝐂𝐌/𝐔 × 𝐐 LOS b, c, d
Operating BEP(A) ⇒ 𝐃𝐎𝐋 =
DOL (𝐂𝐌/𝐔 × 𝐐) − 𝐅𝐂 -calculate
-interpret
𝟖 × 𝟔𝟐, 𝟓𝟎𝟎 𝟓𝟎𝟎𝐤
= = =∅ -analyze
(𝟖 × 𝟔𝟐, 𝟓𝟎𝟎) − 𝟓𝟎𝟎𝐤 𝟎
40 - Pg-5
30 -
20 -
if FC = 0
10 - 𝐂𝐌
𝐃𝐎𝐋 = =𝟏
𝐂𝐌 − 𝟎
-
-
-10 -
62,500 units
DOL (80k) = 4.57
-20 -
DOL (100k) = 2.66
as Q↑
-30 -
DOL (120k) = 2.09 DOL → 1
DOL (500k) = 1.14
LOS b, c, d
units -calculate
-interpret
-analyze
Pg-6
- 62,500
DOL
-
30 20 10 -10 -20 -30
49
⇒ Degree of LOS b, c, d
%∆𝐍𝐈 · calculated at -calculate
Financial 𝐃𝐅𝐋 =
%∆𝐎𝐩𝐏𝐫. a particular level of -interpret
Leverage -analyze
Op.Pr.
Pg-7
re-arranging %ΔNI = DFL(%ΔOpPr)
𝐂𝐌 − 𝐅𝐂 c – fixed financing
(𝐂𝐌 − 𝐅𝐂) − 𝐂 costs
if Op.Pr ↑ 20%
𝐎𝐩𝐏𝐫 𝟑𝟎𝟎
e.g./ Op. Pr. 300,000 = = 𝟏. 𝟓 𝟑𝟔𝟎, 𝟎𝟎𝟎
𝐄𝐁𝐓 𝟐𝟎𝟎
- Int. Exp. 100,000 𝟏𝟎𝟎, 𝟎𝟎𝟎
(EBT) NI 200,000 1.5(20%) = 30% 𝟐𝟔𝟎, 𝟎𝟎𝟎
𝟐𝟔𝟎 − 𝟐𝟎𝟎
= 𝟑𝟎%
𝟐𝟎𝟎
e.g./ C = 150,000 LOS b, c, d

-calculate
-interpret
Op. Pr 300,000 + 20% 360,000
-analyze
Int. 150,000 × 2 150,000 Pg-8
NI 150,000 = 40% 210,000
𝟐𝟏𝟎 − 𝟏𝟓𝟎
= 𝟒𝟎%
𝟏𝟓𝟎
𝐃𝐅𝐋 = 𝟑𝟎𝟎M𝟏𝟓𝟎 = 𝟐
- Capital structure ⇒ choice by mgmt.
𝐭𝐚𝐧𝐠𝐢𝐛𝐥𝐞 𝐚𝐬𝐬𝐞𝐭𝐬
· If is high, capacity for higher DFL
𝐭𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬
· if revenues have below-average business-cycle

sensitivity, capacity for higher DFL
50
e.g./ DFL & ROE, $2M assets LOS b, c, d

(-40%) (+40%) -calculate
-interpret
EBIT 500,000 300,000 700,000
-analyze
I ø ø ø Pg-9
EBT 500,000 300,000 700,000
T 150,000 90,000 210,000
NI 350,000 210,000 490,000
ROE = 17.5% 10.5% 24.5%
$1M Equity $1M Debt @ 5%

(-40%) (+40%)
EBIT 500,000 300,000 700,000
I 50,000 50,000 50,000
EBT 450,000 250,000 650,000
T 135,000 75,000 195,000
NI 315,000 175,000 455,000
ROE = 31.5% 17.5% 45.5%
LOS b, c, d
%∆𝐎𝐩. 𝐏𝐫. %∆𝐍𝐈 %∆𝐍𝐈 -calculate
𝐓𝐨𝐭𝐚𝐥 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = × = -interpret
%∆𝐐 %∆𝐎𝐩. 𝐏𝐫. %∆𝐐
-analyze
Pg-10
DOL × DFL DOL
𝐂𝐌 𝐂𝐌 − 𝐅𝐂
𝐂𝐌 − 𝐅𝐂 𝐂𝐌 − 𝐅𝐂 − 𝐂 TL
𝐂𝐌 𝐂𝐌 DFL
𝐓𝐋 = =
𝐂𝐌 − 𝐅𝐂 − 𝐂 𝐄𝐁𝐓
∴ %∆𝐍𝐈 = 𝐓𝐋(%∆𝐐)
(1)
51
LOS b, c, d
e.g./ Q 100,000 -calculate
𝐂𝐌
SP/U $10 𝐃𝐎𝐋 = = 𝟖𝟎𝟎M𝟑𝟎𝟎 = 𝟐. 𝟔𝟕 -interpret
𝐎𝐩. 𝐏𝐫 -analyze
VC/U 2
Pg-11
CM/U 8 𝐎𝐩. 𝐏𝐫 𝟑𝟎𝟎
𝐃𝐅𝐋 = = M𝟐𝟎𝟎 = 𝟏. 𝟓
FC/ Op.Exp. 500k 𝐄𝐁𝐓
Int 100k 𝐃𝐓𝐋 = 𝐃𝐎𝐋 × 𝐃𝐅𝐋 = 𝟐. 𝟔𝟕 × 𝟏. 𝟓 = 𝟒. 𝟎
Sales $1M ∴ if Q ↑ 10%, @ 110,000 units

- VC 200k NI ↑ 40%
= CM 800k CM 880,000
- Op Ex 500k - OpEx 500,000
= Op Pr 300k 380,000
- Int 100k - Int 100,000
𝟐𝟖𝟎 − 𝟐𝟎𝟎
= EBT 200k (𝐄𝐁𝐓) = 𝟒𝟎% ↑
280,000
𝟐𝟎𝟎
- T 60k - T 84,000
𝟏𝟗𝟔 − 𝟏𝟒𝟎
= NI 140k (𝐍𝐈) = 𝟒𝟎% ↑ NI 196,000
𝟏𝟒𝟎
LOS b, c, d
DOL
-calculate
TL -interpret
-analyze
- bankruptcy Pg-12
↳ reorganization
- less likely to be
successful if high DOL
if the cause of distress
DOL
DFL ↳ liquidation
Q
52
Working Capital Management
a. describe primary and secondary sources of liquidity and factors that influence
a company’s liquidity position;
b. compare a company’s liquidity measures with those of peer companies;
c. evaluate working capital effectiveness of a company based on its operation

and cash conversion cycles and compare the company’s effectiveness with
that of peer companies;
d. describe how different types of cash flows affect a company’s net daily cash
position;
e. calculate and interpret comparable yields on various securities, compare

portfolio returns against a standard benchmark, and evaluate a company’s
short-term investment policy guidelines;
f. evaluate a company’s management of accounts receivable, inventory, and

accounts payable over time and compared to peer companies;
g. evaluate the choices of short-term funding available to a company and

recommend a financing method.
53
Sources of Liquidity
Q1: What is the appropriate amount of LOS a

working capital (in total and for each specific account)? -describe
Pg-1
Q2: How should working capital be financed?
Working Capital ⇒ simply refers to current assets used in operations
Net Working Capital ⇒ CA – CL
Net Operating Working Capital (NOWC)
Operating CA - Operating CL
- cash, AR, Inv. - AP, accruals
assets are LOS a

adequate funds for -describe
invested in the
day-to-day operations Pg-2
most productive way
WC mgmt.
maintain adequate to covert short-term assets
levels of cash to cash (i.e. AR, Inv.)
control outgoing payments
to vendors
⇒ investments in short-dates, highly liquid securities or credit reserves act as

shock-absorbers to fluctuating working capital needs
54
⇒ Liquidity – the extent to which a LOS a

-describe
company can meet its short-term obligations
Pg-3
using assets that can be readily transformed to cash
either by sale or
financing
Primary Sources of Liquidity
bank acct. balances

1) Ready cash balances
near-cash securities (< 90 days)
trade credit
2) Short-term funds
bank LOCs
investment portfolios
CCC mgmt.
3) Cash-flow management
centralized collections/payments
structure
Secondary Sources of Liquidity LOS a

-describe
longer-term new debt Pg-4
1) Debt contracts
re-negotiating existing contracts
(reduce int./pr. payments)
2) Liquidating assets
3) Bankruptcy protection/reorganization
Factors that influence liquidity/
Drags: · receipts lag
· uncollected receivables (DSO)
· obsolete inventory (D/H)
· tight credit (s.t. debt may be difficult to arrange)
55
Factors that influence liquidity/ LOS a

Pulls: cash leaves to quickly -describe
Pg-5
- making payments early
- reduced credit limits
- limits on s.t. LOCs (‘resting’ requirements)
- low liquidity positions (growth, aggressive cash mgmt.)
Liquidity Measures
LOS b
Ratio 2016 2016 2015 2015 -compare
Comp. Ind. Comp. Ind.
CR 1.9 2.5 1.1 2.3
QR 0.7 1.0 0.4 0.9
Days AR 39 34 44 32.5
Days Inv. 41 30.3 45 27.4
Days AP 34.3 36 29.4 35.5
CCC (2015 – Comp.) = 44 + 45 - 29.4 = 59.6

(2016 – Comp.) = 39 + 41 – 34.3 = 45.7
CCC (2015 – Ind.) = 32.5 + 27.4 – 35.5 = 24.4

(2016 – Ind.) = 34 + 30.3 – 36 = 28.3
56
Cash Conversion Cycle
- company’s cash flows ultimately determine liquidity and solvency LOS c

-evaluate
Operating Cycle ⇒ the time needed to convert raw materials
-compare
into cash from a sale
# of days Inv. + # of day AR
Net Operating Cycle ⇒ Operating cycle - # of days AP
the time from paying suppliers to collecting cash
from customers
- also called ‘Cash Conversion Cycle’ (ccc)
Net Daily Cash Position
LOS d
first/ why hold cash?
-describe
1) transactions ⇒ payments & receipts involve cash
Pg-1
(transaction balances)
2) precautionary ⇒ cash inflows/outflows can be unpredictable
- unexpected requirements
3) speculative ⇒ capitalize on lucrative opportunities
⇒ firms attempt to forecast cash flows to ensure its net cash
position > 0 from day-to-day
57
Inflows LOS d
-describe
Pg-2
· Receipts
daily (s.t.)
· transfers from subsidiaries
· maturing investments s.t. to med.
· Debt Proceeds
med. term – long term
· Interest Income
· Payments
minimum daily (s.t.)
cash med. to s.t. · investments made
balance
Outflows · Debt Repayments
$0
· Interest Exp.
med-term
to long-term
· for most companies, it is typical to LOS d

manage cash positions with short-term investments -describe
Pg-3
and borrowings liquidity sources
- help counter
excess and deficits that
typically occur
very liquid, s.t. give up yield on longer –

investments dated, less liquid securities
Balance less
may be more economies in

short-term borrowings
borrowing for longer periods
for very short periods
(30-60 days)
of time
58
· Typical s.t. investments LOS d

⇒ T-Bills - 3 mon., 6 mos., 1 yr. -describe
Pg-4
⇒ agency debt 5-30 days
⇒ Bank CDs ($100k increments) 14-365 days
⇒ Banker’s Acceptance 30-180 days
⇒ Eurodollar time deposits (dep. outside the U.S.) 1-180 days
C.D. or T.D.
⇒ Commercial Paper 1-270 days
⇒ MMF – Varies
⇒ Repos 1 day+
· Typical s.t. borrowings ⇒ bank overdraft, commercial paper, LOCs
Yields, Returns, Policy
① Calculate comparable yields LOS e

-calculate
⇒ Interest–bearing securities
-interpret
· sell at par, mature at par + interest -evaluate
⇒ Discount securities -compare
(covered in Quant., Fixed-Income) Pg-1
· sell at discount, mature at par
all interest
𝟏𝟎𝟎 − 𝐏𝐕 𝟑𝟔𝟎 𝟑𝟔𝟎

Money Market Yield = b c × = 𝐇𝐏𝐘 ×
𝐏𝐕 𝐝𝐚𝐲𝐬 𝐝𝐚𝐲𝐬
Bond Equivalent Yield = b𝟏𝟎𝟎 − 𝐏𝐕c × 𝟑𝟔𝟓 gY√𝐄𝐀𝐘 − 𝟏\ × 𝟐h

𝐏𝐕 𝐝𝐚𝐲𝐬
𝟏𝟎𝟎 − 𝐏𝐕 𝟑𝟔𝟎
Discount basis Yield = b c × (Bank Discount)
𝟏𝟎𝟎 𝐝𝐚𝐲𝐬
59
① Calculate comparable yields LOS e

91-day U.S. T-Bill Sold at a discount of 7.91% -calculate
-interpret
𝟏𝟎𝟎 − 𝐏𝐕 𝟑𝟔𝟎 -evaluate
Disc. Basis Yield = b c × -compare
1. MMY Pg-2
𝟏𝟎𝟎 − 𝐏𝐕 𝟑𝟔𝟎 𝟏𝟎𝟎 − 𝟗𝟖. 𝟎𝟎𝟎𝟓𝟑 𝟑𝟔𝟎
. 𝟎𝟕𝟗𝟏 b c × b c × = 𝟖. 𝟎𝟕
𝟏𝟎𝟎 𝟗𝟏 𝟗𝟖. 𝟎𝟎𝟎𝟓𝟑 𝟗𝟏
𝟗𝟏 𝟏𝟎𝟎 − 𝐏𝐕
(. 𝟎𝟕𝟗𝟏) = b c
𝟑𝟔𝟎 𝟏𝟎𝟎
𝟗𝟏
𝟏𝟎𝟎 b c (. 𝟎𝟕𝟗𝟏) = 𝟏𝟎𝟎 − 𝐏𝐕
𝟑𝟔𝟎 2. BEY
𝟏. 𝟗𝟗𝟗𝟒𝟕 = 𝟏𝟎𝟎 − 𝐏𝐕 𝟏𝟎𝟎 − 𝟗𝟖. 𝟎𝟎𝟎𝟓𝟑 𝟑𝟔𝟓
b c × = 𝟖. 𝟏𝟖%
𝟗𝟖. 𝟎𝟎𝟎𝟓𝟑 𝟗𝟏
𝐏𝐕 = 𝟗𝟖. 𝟎𝟎𝟎𝟓𝟑
② Compare portfolio returns against a LOS e

benchmark (Port. Mgmt., Quant.) -calculate
-interpret
- returns should be expressed as BEY
-evaluate
- overall return is calculated as a weighted-average of -compare
the yields of the different assets in the portfolio Pg-3
③ Evaluate a company’s short-term investment policy guidelines
⇒ Passive – limited number of transactions
(safety & - very few rules
liquidity) - roll over maturities
- benchmark against T-bill rates
60
LOS e
③ Short-term Investment Policy -calculate
⇒ Active – Matching Strategy -interpret
- match the timing of cash outflows with investment -evaluate
maturities (similar securities as passive) -compare
Pg-4
- also called the ‘self-liquidating’ approach
$ short-term debt
Temporary
NOWC
Permanent Level
of NOWC
LTD + Equity
Total Perm.
Net Operating Fixed Assets
Assets
Time (Yrs.)
-
-
1 2 3 4 5
③ Short-term Investment Policy LOS e

-calculate
$ Temporary -interpret
NOWC s.t. debt
-evaluate
-compare
Pg-5
Permanent Level Marketable s.t. financing
of NOWC LTD Securities requirements
+ $
Temporary
Fixed Assets Equity
NOWC
-
1 2 3 4 5 Time
LTD
Aggressive Approach Permanent Level
+
of NOWC Equity
Fixed Assets
-
1 2 3 4 5 Time
Conservative Approach
61

-calculate
⇒ Mismatching strategy
-interpret
- intentional mismatching of outflows and maturities -evaluate
- take either a more aggressive/conservative stance with -compare
the use of debt Pg-6
i.e. s.t. debt ➞ temporary + permanent assets
(aggressive)
LTD ➞ permanent + temporary assets
(conservative)

⇒ Laddering Strategy -calculate
-interpret
- scheduling of maturities equally over the
-evaluate
term of the ladder -compare
Pg-7
not needed
in 30-day 30-day
$ $ $ 30-day $ 30-day
days
-
-
out $ etc.
-
30 31 32
needed
outflows
62

-calculate
⇒ Cash Management Invest Policy
-interpret
· Purpose – reasons why the portfolio exists, -evaluate
investment strategy and -compare
qualifying securities Pg-8
· Authorities – executives who oversee the PMs
- what happens if IP not followed
· Limitations/Restrictions – types of securities,
maximum positions, minimum credit ratings
AR, Inv., AP
① Accounts Receivable LOS f

-evaluate
i) Credit Management – balance lost sales with Bad Debts
-compare
ii) Receipts Management – time from receipt of payment Pg-9
to funds availability
𝐀𝐯𝐠. 𝐝𝐚𝐢𝐥𝐲 𝐟𝐥𝐨𝐚𝐭
𝐟𝐥𝐨𝐚𝐭 𝐟𝐚𝐜𝐭𝐨𝐫 = M𝐀𝐯𝐠. 𝐝𝐚𝐢𝐥𝐲 𝐝𝐞𝐩.
iii) Collection Management – monitoring and managing the time

from sale to payment
63
① Accounts Receivable LOS f

-evaluate
Sale funds available -compare
-
-
AR payment Pg-10
created sent
Average Collection Period

· increase effectiveness
improve by: changing credit of collections
terms, using discounts · move to electronic
to encourage shorter payment (mail float)
payment periods · lock box use (processing float)
· clearing float
LOS f
① Accounts Receivable current %
-evaluate
- aging schedules 1-30d past due % -compare
31-60d past due % Pg-11
etc.…
months (trend)
- weighted-average collections period
by months current days × weight =

(trends) 1-30d past due days × weight =
etc.…
Recap: Bad Debts Expense + Days Receivables outstanding
(payment)
(credit)
64
② Inventory – maintain a level of inventory that ensures LOS f

-evaluate
availability without excess
-compare
Pg-12
shortages can · inflates storage costs
hurt sales · increases obsolescence
& shrinkage
· requires financing
⇒ Inventory can be held for the

same reasons as holding money
⇒ transactions
⇒ precautions
⇒ speculation
② Inventory ⇒ Economic Order Quantity (EOQ) LOS f

-evaluate
- order size the minimizes total ordering and holding costs
-compare
Pg-13
𝟐𝑺𝟎 S – usage in units/period
𝑬𝑶𝑸 = ˆ
Inv. 𝑪 0 – order cost/order
Costs Total C – carrying cost/unit/period
Costs EOQ – reorder point method

Carrying
max.
Costs
level
reorder point
Total order min. level

costs
-
Optimal order order size

size order lead time
65
② Inventory ⇒ Economic Order Quantity (EOQ) LOS f

e.g./ usage = 1600/annum -evaluate
-compare
order cost = $50/order
Pg-14
carrying cost = $1/unit/annum
lead time = 10 days
𝟐𝐒𝐎 𝐓𝐂 = 𝐎𝐂 + 𝐂𝐂 Reorder
𝐄𝐎𝐆 = ˆ
𝐂 Daily Usage
𝟏9
𝟐 × 𝟓𝟎 × 𝟏𝟔𝟎𝟎 𝟐
= Y𝟓𝟎 × 𝟏𝟔𝟎𝟎M𝟒𝟎𝟎\ + Y𝟏 × 𝟒𝟎𝟎M𝟐\ 𝟏𝟔𝟎𝟎M
= b
𝟏
c 𝟐𝟓𝟎 = 𝟔. 𝟒/𝐝𝐚𝐲
Lead Time = 10 days
𝟏9 = 𝟐𝟎𝟎 + 𝟐𝟎𝟎
= (𝟏𝟔𝟎, 𝟎𝟎𝟎) 𝟐 Reorder Point 64 units
= $𝟒𝟎𝟎
= 𝟒𝟎𝟎
② Inventory ⇒ Just-in-Time (JIT) LOS f

-evaluate
- reduces in-process inventory and associated
-compare
carrying costs
Pg-15
- reorder points determined by historical usage rates
External: 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐓𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐑𝐚𝐭𝐢𝐨 = 𝐂𝐎𝐆𝐒M𝐀𝐯𝐠. 𝐈𝐧𝐯.
𝟑𝟔𝟓
𝐃𝐚𝐲𝐬 𝐨𝐟 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 =
𝐈𝐧𝐯. 𝐓𝐮𝐫𝐧. 𝐑𝐚𝐭𝐢𝐨
(see also FRA)
66
③ Payables – longer the number of days of payable, LOS f

-evaluate
the shorter the CCC
-compare
Pg-16
Too late/ Balance too early/
· loss of interest income
· deterioration of
· increased interest expense
credit relationships
and credibility
· forgone discounts
𝟑𝟔𝟓9 d - # of days
𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭 𝐝
𝐈𝐦𝐩𝐥𝐢𝐜𝐢𝐭 𝐑𝐚𝐭𝐞 = 𝟏 + b c −𝟏 beyond
𝟏 − 𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭
discount
period
𝟑𝟔𝟓9 LOS f
③ Payables 𝐈𝐦𝐩𝐥𝐢𝐜𝐢𝐭 𝐑𝐚𝐭𝐞 = 𝟏 + b c −𝟏 -evaluate
-compare
e.g./ 2/10, n30 . 𝟎𝟐
𝟑𝟔𝟓9
𝟓 Pg-17
Pay on 15th day b𝟏 + c − 𝟏 = 𝟑𝟑𝟕. 𝟎𝟏%
. 𝟗𝟖
𝟑𝟔𝟓9
. 𝟎𝟐 𝟏𝟓
25th day b𝟏 + c − 𝟏 = 𝟔𝟑. 𝟒𝟗%
. 𝟗𝟖
𝟑𝟔𝟓9
. 𝟎𝟐 𝟐𝟎
30 th
day b𝟏 + c − 𝟏 = 𝟒𝟒. 𝟓𝟗%
. 𝟗𝟖
(𝟏. 𝟎𝟐𝟎𝟒𝟎𝟖)𝐱 − 𝟏 = 𝟎. 𝟎𝟖
Let 𝟑𝟔𝟓M𝐝 = 𝐱 𝟑𝟔𝟓M = 𝟑. 𝟖𝟎𝟗
𝐱
(𝟏. 𝟎𝟐𝟎𝟒𝟎𝟖) = 𝟏. 𝟎𝟖 𝐝
& 𝐖𝐀𝐂𝐂 = 𝟖%
𝐗 𝐈𝐧(𝟏. 𝟎𝟐𝟎𝟒𝟎𝟖) = 𝐈𝐧 𝟏. 𝟎𝟖 𝐝 = 𝟗𝟔 𝐝𝐚𝐲𝐬
𝒙 = 𝟑. 𝟖𝟎𝟗 Pay 106 days
67
③ Payables LOS f
-evaluate
· if taking the discount, pay -compare
on the last day of the discount Pg-18
period,
else pay last day of
100% -
credit term
44% / 22%
0% days
-
10 20 30
Externally/ # 𝐨𝐟 𝐝𝐚𝐲𝐬 𝐏𝐚𝐲𝐚𝐛𝐥𝐞 = 𝟑𝟔𝟓M𝐏𝐚𝐲𝐚𝐛𝐥𝐞𝐬 𝐓𝐮𝐫𝐧𝐨𝐯𝐞𝐫
Days AR + day INV – day AP
Short-term Funding Sources
LOS g
-evaluate
Bank
-recommend
· Short-term, self-liquidating loans
Money Market Pg-1
a) single payment notes
- Commercial Paper
b) lines of credit (364 days)
· committed – fees
· uncommitted
c) revolving credit (> 1 yr.)
agreements Others
d) Banker’s Acceptance · Asset-based loans
e) Factoring (non-bank finance)
· AR, Inv. used as collateral
68
capacity LOS g
Considerations/ • sufficient -evaluate
sources -compare
Pg-2
• cost-effective rates
Computing Cost/
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 + 𝐂𝐨𝐦𝐦𝐢𝐭𝐦𝐞𝐧𝐭 𝐅𝐞𝐞
𝐋𝐎𝐂 𝐂𝐨𝐬𝐭 =
𝐋𝐨𝐚𝐧 𝐀𝐦𝐨𝐮𝐧𝐭
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭
𝐁𝐀 = =
𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 𝐋𝐨𝐚𝐧 𝐀𝐦𝐨𝐮𝐧𝐭 − 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 + 𝐃𝐞𝐚𝐥𝐞𝐫 < 𝐬 𝐂𝐨𝐦𝐦. +𝐁𝐚𝐜𝐤𝐮𝐩 𝐋𝐢𝐧𝐞 𝐂𝐨𝐬𝐭

𝐂𝐏 =
𝐋𝐨𝐚𝐧 𝐀𝐦𝐨𝐮𝐧𝐭 − 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭
e.g./ borrow $ 1M short 30 days

LOS g
-evaluate
A. LOC @ 7%, 0.5% commitment fee 7.5%
-compare
Pg-3
gY. 𝟎𝟕 × 𝟏𝐌 × 𝟏M𝟏𝟐\ + Y. 𝟎𝟎𝟓 × $𝟏𝐌 × 𝟏M𝟏𝟐\h × 𝟏𝟐 = 𝟕. 𝟓%
𝟏𝐌
B. BA @ 8% all-in Y. 𝟎𝟖 × 𝟏𝑴 × 𝟏M𝟏𝟐\
d e × 𝟏𝟐 = 𝟖. 𝟎𝟓
𝟏𝑴 − Y. 𝟎𝟖 × 𝟏𝑴 × 𝟏M𝟏𝟐\
used to cover
C. CP @ 6%, dealer @ 𝟏M𝟒 %, backup line cost @ 𝟏M𝟐 % maturity if
roll-over not
possible
Y. 𝟎𝟔 × 𝟏𝑴 × 𝟏M𝟏𝟐\ × Y . 𝟎𝟎𝟐𝟓 × 𝟏𝑴 × 𝟏M𝟏𝟐\ + Y. 𝟎𝟎𝟓 × 𝟏𝑴 × 𝟏M𝟏𝟐\

d e × 𝟏𝟐
𝟏𝑴 − Y. 𝟎𝟔 × 𝟏𝑴 × 𝟏M𝟏𝟐\
=6.78 %
69
REVIEWS
70
Corporate Governance
E – environmental Pg-1
S – social checks, balances - review
G – governance ➝ internal controls incentives

rights, responsibilities
Shareholder Theory – mgmt. should max shareholder return

shareholders
Stakeholder Theory – mgmt. should max value for customers, suppliers
employees
1. Shareholders – exercise control (equity owners)
(controlling & non-controlling)
2. Creditors – bondholders/banks (debt holders)
3. Managers/Employees – max. sh. return vs. decent wages
4. Board of Directors – protect shareholder interests, elected
one-tier – single BoD
supervisory board (non-executives)
two-tier
management board (executives)
Stakeholders (cont’d) Pg-2

5. Customers – value for payment - review
6. Suppliers – get paid

7. Government/Regulators – protect interest of general public
must manage potential/real conflicts between stakeholder

- Principal-Agent Relationships
a) Shareholder vs. Manager
(principal) (agent) - expected to act in best
interest of principal
- potential agent issues/
- max. personal benefits
- too risk adverse – protect position
- information asymmetry – mgmt. knows more
- board composition – too many insiders
b) Controlling vs. Minority Shareholders
potential issues - related party transactions
- dual class shares
71
- Principal-Agent Relationships Pg-3

c) Manager & BoD - review
- potential issues · lack of info for BoD

d) Shareholder vs. Creditor (risky projects vs. stability)
e) Customers vs. Shareholders (higher quality vs. lower costs)
f) Customers vs. Suppliers (give me credit vs. you pay now!)
g) Shareholders vs. Government/Regulators (taxes/regulation)
Management/ identify interests of stakeholder groups

prioritize
(attempt to balance various interests)
understand
legal
must work within existing contractual
organization infrastructure
governmental
- Mechanisms of Stakeholder Management

1) General Meetings – AGM once a year (min.)
- vote for BoD, performance overview, resolutions
- proxy voting (others vote your shares) cumulative voting (100sh, 4 directors = 400 votes)
- Mechanisms of Stakeholder Management Pg-4

2) BoD – provides oversight (accountable to shareholders) - review
- appoints top mgmt.
3) Audit Function – internal/external
4) Reporting & Transparency – regulatory disclosures

- reduces information asymmetry
5) Policies on Related–Party Transactions – process for

mitigating, managing & disclosing such cases
6) Remuneration Policies – profit sharing, stock options
7) Say on Pay – sh. vote on executive pay

- may be 1) non-mandatory, non-binding 2) mandatory, non-binding
3) mandatory, binding
indenture
8) Contractual Agreements with Creditors covenants
collateral
9) Employee Laws/Contracts
10) Contractual Agreements with customers/suppliers
11) Laws & Regulations
72
Pg-5
executive - review
⇒ Composition of the Board/ one-tier
non-executive
independent
supervisory
two-tier mgmt.
- diverse mix of expertise, backgrounds, competencies
- CEO & Chair position increasingly separated
· Staggered Boards - ⅓ of Board up for election each yr. (3 yr. terms)

- provides continuity, but also entrenchment
· Functions/Responsibilities fully informed basis

· duty of care good faith must act
due diligence
· duty of loyalty – interests of shareholders
· guides/approves strategic direction
· appoints CEO
· monitors/reviews performance
· ensures effectiveness of audit procedures
· reviews all major M&A
Pg-6
- Board Committees/ - review
a) Audit Committee – supervises internal audit system, appoints
external auditor (external directors only/mostly)
b) Governance Committee – ensures good governance procedures
c) Remuneration/Compensation Committee
d) Nominations Committee – for the Board
e) Risk Committee - determine risk profile/appetite of the company
f) Investment Committee – reviews material investment
opportunities proposed by mgmt.
⇒ Factors Affecting Relationships/

· Market Factors (capital market related)
1) Shareholder engagement – build support for mgmt. position
2) Shareholder activism – attempts to compel mgmt. to act in
a desired manner
i.e. shareholder derivative lawsuits
73
⇒ Factors Affecting Relationships/ Pg-7

- review
· Market Factors (capital market related)
3) Competition & Takeovers proxy contest
tender offer
· Non-Market Factors/ hostile takeover
1) Legal Environment – offers protection of the interests

of stakeholders
2) Media/Social Media – shape public opinion
3) Corporate Governance Industry – external governance services
⇒ Risks of poor governance ⇒ Benefits of good governance

a) operational efficiency
a) weak control systems b) improved control
b) ineffective decision making c) better operating/financial performance
c) legal, regulatory or
reputational risks d) lower default risk and cost of debt
d) default & bankruptcy risk
Pg-8
⇒ Analyst Considerations/
- review
· economic ownership & voting control
voting
· dual class structure?
non-voting/restricted
· BoD representation
- independence, expertise, experience, tenure, diversity
· Remuneration & Company Performance

base salary + short-term bonus + multiyear incentive plan
- should align interests with shareholders
cross shareholders
· Investors in the Company sizeable affiliated shareholder
activist investors
· Strength of Shareholder Rights
⇒ Environmental & Social Factors/

· SI/RI – sustainable/responsible investing
· impact investing (targeted ESG objectives)
· universal owners (exposed to costs globally from env. factors)
74
Pg-9
⇒ Environmental & Social Factors/
- review
· stranded assets – e.g. - coal (assets no longer economically
viable)
· Social ⇒ human rights, workplace welfare, community impact
- ESG implementation methods/
· negative screening – excluding sectors that violate certain

accepted standards (human rights)
· positive screening & best-in-class – positive ESG aspects

energy efficiency
· thematic investing – single factor
climate change
75
Capital Budgeting
NPV & IRR Pg-1

- based on cash flow analysis Payback/Discounted Payback - review
Profitability Index
maintain capacity
⇒ Categories/ · Replacement Projects improve operations
· Expansion Projects
· new products/services
often mandatory
· Regulatory, safety, environmental
may result in exit
· Lease/buy; make/outsource
⇒ Terminology/ · sunk costs - costs that cannot be recovered
· opportunity cost - value forgone by doing one thing
over another
· incremental cash flow - additional cash realized as a
result of a decision
· externality – other effects
- Conventional cash flows - initial outflow, followed by a series of Pg-2

inflows (i.e. one sign change) - review
- Unconventional cash flows – varying series of inflows & outflows

(i.e. multiple sign changes)
$ $ $ $ $ $ $
vs.
| | | | | | | | | |
-$ -$ -$ - problem for
IRR
- Basic Principles/
· Decisions are based on actual incremental cash flows only
· Timing of CF is crucial (TVM)
· CFs are based on opportunity costs
· financing costs are ignored - reflected in the discount rate
· CFs are on an after-tax basis
· accounting net income is not used
76
· Independent Projects - CFs are independent of each other Pg-3

- can select both - review
· Mutually exclusive – either/or
· Project sequencing - staged investments with go/no-go options
· Capital rationing - vs. unlimited funds (requires ranking projects)
after-tax CF
𝐍 invest if
NPV/ 𝐂𝐅𝐭
𝐍𝐏𝐕 = ( − 𝐎𝐮𝐭𝐥𝐚𝐲 NPV > 0
(𝟏 + 𝐫)𝐭 investment
𝐭#𝟏
16 16 16 16 20 𝟏𝟔 𝟏𝟔 𝟏𝟔 𝟏𝟔 𝟐𝟎
𝐍𝐏𝐕 = 8 + + + + ; − 𝟓𝟎
-
(𝟏. 𝟏) (𝟏. 𝟏)𝟐 (𝟏. 𝟏)𝟑 (𝟏. 𝟏)𝟒 (𝟏. 𝟏)𝟓

-50
r = 10%
IRR/ 𝐍
𝐂𝐅𝐭 𝟏𝟔 𝟏𝟔 𝟏𝟔 𝟏𝟔 𝟐𝟎
> = 𝐎𝐮𝐭𝐥𝐚𝐲 + + + + = 𝟓𝟎
(𝟏 + 𝐈𝐑𝐑)𝐭 (𝟏 + 𝐈𝐑𝐑) (𝟏 + 𝐈𝐑𝐑)𝟐 (𝟏 + 𝐈𝐑𝐑)𝟑 (𝟏 + 𝐈𝐑𝐑)𝟒 (𝟏 + 𝐈𝐑𝐑)𝟓
𝐭)𝟏
· unconventional CFs · invest if IRR > WACC

may give multiple IRRs
- no problem for NPV
Payback Period/ number of years required to recover initial investment

Pg-4
· ignores TVM
16 16 16 16 20 - review
· ignores CFs after payback period
-
-50
cumulative
-50 -34 -18 -2 +14
payback period = 3 1/8 yrs.
2/16 or 1/8th of a year
Discounted Payback
-50 14.545 13.223 12.021 10.928 12.418
cumulative Payback
-50 -33.455 -22.232 -10.211 0.717 Period = 3.934 yrs.
Profitability Index
10.211/10.928 = .934
𝐍𝐏𝐕 e.g.
𝐏𝐈 = 𝟏 + 𝟏𝟑. 𝟏𝟑𝟔
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝟏+ = 𝟏. 𝟐𝟔 ⇒ the value received for
𝟓𝟎
or one unit of currency
𝐏𝐕 invested
𝐏𝐈 =
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
77
NPV Pg-5
+ · for a single conventional - review
NPV Profile:
project, NPV & IRR will agree
if NPV > 0
0
then IRR > r
-
r
-
-
IRR
- when NPV & IRR rank mutually exclusive projects differently

– choose the one with the higher NPV
- Value of company should increase by the amount of NPV
- the higher the discount rate, the more important the timing of the CFs
- size of the project can cause a conflict between

NPV vs. IRR NPV IRR
A -100 50 50 50 50 58.49 34.9%
e.g.
B -400 170 170 170 170 138.88 25.21%
Multiple IRR
NO IRR 0 1 2
0 1 2 100 -300 250
-$1000 5000 -6000
no solution
0 0
for IRR
78
Cost of Capital
Debt Pg-1
Capital common - each component has its own cost
Equity - Review
preferred
- cost of capital reflects the cost of ‘new’ capital

𝐖𝐀𝐂𝐂 = 𝐰𝐝 𝐫𝐝 (𝟏 − 𝐭) + 𝐰𝐩 𝐫𝐩 + 𝐰𝐞 𝐫𝐞
w- weightings
d - debt
interest is tax dividends are r - cost of
p - preferred
deductible not e - equity
∴ higher tax regimes will have a lower cost of debt
⇒ Capital Structure - the mix of debt & equity a firm uses to finance its
assets (based on market values)
⇒ Target Capital Structure - a capital structure a company wants to
achieve/maintain
- can be estimated by assuming the current structure at market value
weights
- if the company is private, we can use the average weights of
comparables
Pg-2
r MCC - marginal cost of capital
- Review
Cost - increases with additional capital
or
Return
IOS - investment opportunity schedule
- decreases with additional
$ new Capital investments
optimal capital
budget
- increases in interest rates shift MCC up & IOS down = lower optimal capital
budget
• for average-risk projects - use WACC as the discount rate
(assumes constant capital structure over life of project)
• for above/below average-risk projects - up/down adjustments to WACC
are needed
⇒ Cost of Debt/ yield-to-maturity approach
e.g./ 10 yr. - 5% semi @ 102.50 rd ≠ 5%
rd = YTM = 4.684%
79
⇒ Cost of Debt/ Debt rating approach - when a market price Pg-3

is not available (use comparable credit quality YTM) - Review
⇒ Cost of Preferred/ 𝐃
𝐫𝐩 = 𝐩Q𝐏
𝟎 ⇒ non-convertible, non-callable
↓ rp ↑ rp
⇒ Cost of Equity relative to a market-index
➀ CAPM 𝐄(𝐑 𝐢 ) = 𝐑 𝐟 + 𝛃[𝐄(𝐑 𝐦 ) − 𝐑 𝐟 ]
forward ERp
looking - should be guided by the duration of the project
• estimating E (Rm - Rf) - historical equity risk premium
- sensitive to time period chosen
- level of risk of the index can change over time
- geometric or arithmetic
- dividend discount model 𝐃 𝐃
𝐏𝟎 = 𝟏M𝐫𝐞 − 𝐠 𝐫𝐞 = 𝟏M𝐏 + 𝐠
𝟎
- survey approach - ask a panel of experts
⇒ Cost of Equity Pg-4

2) DDM 𝐃𝟏 let V0 = P0 - Review
𝐕𝟎 = 𝐃
𝐫𝐞 − 𝐠 𝐫𝐞 = 𝟏M𝐏 + 𝐠 and g = RR × ROE
𝟎
forward annual sustainable

div. yield growth rate
3) Bond Yield + Risk Premium
re = rd + Risk Premium - typically estimated from historical spreads
⇒ Estimating β/ Regression/
a 𝐑𝐦
𝐑 𝐢𝐭 = 𝐚_ + 𝐛 𝐭
sensitive to length of time,
estimate of β
periodicity, and selection of Rm
elasticity of demand
cyclicality Sales
industry structure risk
Business
β financial level of
risk
risk Debt
FC vs. VC Operating risk unlevering β
2 components
removes this
80
⇒ Estimating β/ similar business risk Pg-5

• Pure Play Method - use a comparable publicly-traded company - Review
and adjust for leverage differences

Bus. risk
- unlever comparable β, then re-lever
𝜷𝒂 = 𝜷𝒅 𝑾 𝒅 + 𝜷𝒆 𝑾 𝒆 a - asset
d - debt βL βU
𝐃 𝐄
e- equity
𝐃+𝐄 𝐃+𝐄 D
levered β (comp’s) A
E
𝟏
- since βd = 0 βa = βe d e - Hamada equation
𝟏 + (𝟏 − 𝐭) 𝐃M𝐄
& rd is after tax
unlevered β (βU) comp’s capital structure ➀
βa
comp’s tax rate ➂
re βL
re-lever 𝛃𝐋 = 𝛃𝐔 g𝟏 + (𝟏 − 𝐭) 𝐃M𝐄h
➁
βU
premium for
project’s cap. structure
project β βa from Rf business risk
projects’s tax rate
above
𝐃H
𝐄
premium for financial
risk
⇒ Country Risk/ re = rf + β (ERP +CRP) Pg-6

country risk premium - Review
CRP = sovereign yield 𝛔𝐞
b c
spread 𝛔𝐝 in terms of developed markets currency
USD Arg.
𝐠𝐨𝐯 < 𝐭. 𝐓– 𝐛𝐨𝐧𝐝
− in developed country
𝐲𝐢𝐞𝐥𝐝 𝐲𝐢𝐞𝐥𝐝
ddfcurrency, issued by developing country
denominated in developed market’s
⇒ MCC Schedule r
marginal
cost of capital break points - points at which WACC changes
e.g./ rd Amount of new Capital
3% ≤ $3M re 6% up to $10M
3.4% $3M - $5M 6.4% $10M - $15M
4.2% > $5M 6.6 % > &15M
81
• YTM Pure Play • historical Pg-7

𝐃𝐩 DDM - Review
• Debt Rating Q𝐏 •
𝟎
CAPM = rf + β[rm -rf] • survey
WACC = wdrd (1-t) + wprp + were DDM V𝐃𝟏M + 𝐠X
𝐏𝟎
estimating capital structure • prepublished

- assume existing Bond yield
- comparables + premium • Y𝟏 − 𝐃M𝐄𝐏𝐒\𝐑𝐎𝐄
⇒ Floatation Costs/
a) include in cost of capital b) adjust cash flows for F
𝐃𝟏
no t
𝐫𝐞 = +𝐠
(𝐏𝟎 − $𝐅) le
or e s irab
𝐃𝟏 d
𝐫𝐞 = +𝐠 Initial Investment
𝑷𝟎 (𝟏 − %𝑭)
+ F (1-t)
proper way
82
Measures of Leverage
- Operating leverage - mix of FC vs. VC Pg-1

- use of FC in company’s cost structure - review
- financial leverage - level of debt - use of debt in company’s
capital structure
- both increase the volatility of earnings & cash flow
𝐅𝐂 𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭
𝐁𝐄𝐏 = →
𝐂𝐌/𝐔 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐌𝐚𝐫𝐠𝐢𝐧/𝐮𝐧𝐢𝐭
- operating BEP = 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐅𝐂 - removes effect of financial
𝑪𝑴/𝑼
leverage
$ -
- NI = -FC + (CM/U × Q)
cup
-
graph Q if Q = 0
- NI = -FC
-
-
Business Risk Sales Risk p - industry

Pg-2
(not much X elasticity of demand - review
discretion) Q - cyclicality
Operating Risk - FC - higher FC, higher
(discretionary to vs. operating risk, higher
some extent) VC business risk
Debt
Financial Risk - level of debt - fixed financing charges
Preferred
(far more discretionary)
% 𝚫𝐎𝐩. 𝐏𝐫. - the % 𝚫𝐎𝐩. 𝐏𝐫. for a
⇒ Degree of Leverage/ 𝐃𝐎𝐋 =
% 𝚫𝐐 given % 𝚫𝐐 (typically a 1% 𝚫𝐐)
- calculated at a
particular Q
% 𝚫𝐎𝐩. 𝐏𝐫. = 𝐃𝐎𝐋 × % 𝚫𝐐 → 1%
e.g./ if DOL = 1.9
then % 𝚫𝐎𝐩. 𝐏𝐫. : 𝐠𝐢𝐯𝐞𝐧 𝐚 𝟏% 𝚫 𝐐
𝑪𝑴 𝑸 × 𝑪𝑴/𝑼
= 1.9% =
% 𝚫𝐎𝐩. 𝐏𝐫. : 𝐠𝐢𝐯𝐞𝐧 𝐚 𝟓% 𝚫 𝐐
𝑶𝒑. 𝑷𝒓. (𝑸 × 𝑪𝑴M𝑼) − 𝑭𝑪
= 9.5%
83
→ DOL drops as Q ↑ Pg-3

DOL - review
+
lowest value of DOL = 1

% 𝚫𝐐 = 𝟏% 𝚫𝐎𝐩. 𝐏𝐫.
-
operating BEP
- no operating leverage
- low operating leverage companies
- defensive
- high operating leverage companies
-
- cyclical
- Degree of Financial Leverage/ DFL
%∆𝐍𝐈 %∆ 𝐍𝐈 = 𝐃𝐅𝐋 × % 𝚫𝐎𝐩𝐏𝐫
𝐃𝐅𝐋 =
%∆𝐎𝐩. 𝐏𝐫.
𝐂𝐌 − 𝐅𝐂 C - fixed
- calculated at a particular
(𝐂𝐌 − 𝐅𝐂) − 𝐂 financing
level of Op.Pr.
costs
𝐎𝐩. 𝐏𝐫.
𝐄𝐁𝐓
- if DFL = 1.5 & Op.Pr. ↑ 20%, % NI = 30%
· if 𝐭𝐚𝐧𝐠𝐢𝐛𝐥𝐞 𝐚𝐬𝐬𝐞𝐭𝐬 is high, capacity for higher DFC Pg-4

𝐭𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬 (assets to back debt) - review
· if revenues have below average business cycle sensitivity,
capacity for higher DFC
%𝚫𝐎𝐩. 𝐏𝐫. %𝚫𝐍𝐈 %𝚫𝐍𝐈
𝐓𝐨𝐭𝐚𝐥 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = × =
%𝚫𝐐 %𝚫𝐎𝐩. 𝐏𝐫. %𝚫𝐐
𝐃𝐎𝐋 × 𝐃𝐅𝐋 TL
𝐂𝐌 𝐂𝐌 − 𝐅𝐂
×
𝐂𝐌 − 𝐅𝐂 𝐂𝐌 − 𝐅𝐂 − 𝐂
DOL
𝑪𝑴
𝑻𝑳 =
𝑪𝑴 − 𝑭𝑪 − 𝑪
𝐂𝐌 DFL
= Q
𝐄𝐁𝐓
84
Working Capital Management
- working capital ⇒ current assets used in operations (WC) Pg-1

- net working capital ⇒ CA – CL (NWC) - review
- net operating working capital ⇒ operating CA – operating CL
(NOWC) (cash, AR, Inv.) (payables, accruals)
- Liquidity - extent to which company can meet short-term obligations
using assets that can be readily transformed to cash
Sources/ • ready cash balances
• short-term funds – trade credit, bank LOCs, securities
• cash-flow management – CCC mgmt., centralized
collections/payments
- Secondary Sources/
• Debt contracts
• liquidate assets
• bankruptcy protection
- Cash Conversion Cycle - Day AR Outstanding Pg-2

- review
+ Days Inventory on Hand – Days Payables
Outstanding
- Operating Cycle ⇒ time needed to convert raw materials into
cash from sale
CCC
(# of days Inv. + # of days AR) = cash
- Net Operating Cycle ⇒ Op. Cycle - # of days AP
- why hold cash? transactions – day-to-day

precautionary – unexpected requirements
speculative - opportunities
Liquidity Measures/• Current Ratio

• Quick Ratio
• AR Turnover – 𝐜𝐫𝐞𝐝𝐢𝐭 𝐬𝐚𝐥𝐞𝐬M𝐚𝐯𝐠. 𝐀𝐑 or 𝐒𝐚𝐥𝐞𝐬M𝐚𝐯𝐠. 𝐀𝐑
𝐀𝐯𝐠. 𝐀𝐑
• # days AR – Q𝐜𝐫𝐞𝐝𝐢𝐭 𝐬𝐚𝐥𝐞𝐬 or 𝐒𝐚𝐥𝐞𝐬M𝟑𝟔𝟓
M𝟑𝟔𝟓
85
Liquidity Measures/ Pg-3

- review
• Inv. Turnover - 𝐂𝐎𝐆𝐒M𝐀𝐯𝐠. 𝐈𝐧𝐯. • AP Turnover - 𝐏𝐮𝐫𝐜𝐡𝐚𝐬𝐞𝐬M𝐀𝐯𝐠. 𝐀𝐏
• # days Inv. - 𝐈𝐧𝐯.Q • # of days payables
V𝐂𝐎𝐆𝐒M𝟑𝟔𝟓X
- Net Daily Cash Position/ - forecasting cash balances

Inflows
· Receipts
daily (s.t.)
· maturing investments s.t. to med. term
· Debt Proceeds
med. term – long term
· Interest Income
· Payments
s.t. - daily
minimum · transfers from subsidiaries
cash s.t. to med. term · Investments made
balance Outflows · Debt Repayments
$0
med-term to · Interest Exp.
long-term
• short-term liquid investments ➞ give up yield on longer-dated Pg-4

securities - review
• T-bills, agency debt, Bank CD’s,
BA, CP, MMF etc.…
• short-term borrowings ➞ may be cheaper to borrow long-term
• bank overdraft, CP, LOCs
𝟏𝟎𝟎 − 𝐏𝐕 𝟑𝟔𝟎
• Comparable Yields MMY = b c ×
𝐏𝐕 𝐝𝐚𝐲𝐬
(bond equiv.)
BEY = b𝟏𝟎𝟎 − 𝐏𝐕c × 𝟑𝟔𝟓 gY√𝐄𝐀𝐘 − 𝟏\ × 𝟐h
(dis. basis) 𝐏𝐕 𝐝𝐚𝐲𝐬
𝟏𝟎𝟎 − 𝐏𝐕 𝟑𝟔𝟎
DBY = b c ×
⇒ Short-term investment policy/
• passive
matching – match timing of cash outflows
86 maturities
with investment
• active
Prepared exclusively for susana (self-liquidating approach)
serna ,tuti_ese@hotmail.com Transaction: 0079224436,
Pg-5
⇒ Short-term investment policy/ Mkt. Sec. - review
STD
* active – mis-matching
OWC
Temp. N STD OWC STD
Temp. N
permanent NOWC LTD Perm. NOWC

Perm. NOWC LTD LTD
+
+ +
Fixed Assets Equity Fixed Assets Fixed Assets
Equity Equity
Matching Aggressive Conservative
intentional mis-matching of outflows & maturities

• laddering strategy not needed?
-
-
-
or
purpose
• Cash Mgmt. IPS outflow
authority
limitations/constraints
credit mgmt. (lost sales vs. Bad Debts) Pg-6

• mgmt. of AR/ •
𝐀𝐯𝐠. 𝐝𝐚𝐢𝐥𝐲 𝐟𝐥𝐨𝐚𝐭 - review
• receipts mgmt. (𝐟𝐥𝐨𝐚𝐭 𝐟𝐚𝐜𝐭𝐨𝐫 = M𝐀𝐯𝐠. 𝐝𝐚𝐢𝐥𝐲 𝐝𝐞𝐩.)
- payment rec. to cash available
• collection mgmt. (overdue accts.)
- sale to payment
improve average collection period by:

• changing credit terms, using discounts, use electronic pmts., lock box
• again schedules current %
1-30d past. d. %
30-60d past. d. %
etc.… %
current days X W
• weighted–average collection period
1-30d p.d. days X W
• mgmt. of Inv./ · availability w/o excess

- avoid shortages - storage costs
- obsolescence
87
• mgmt. of Inv./ · Economic Order Quantity Pg-7

- review
𝟐𝑺𝑶 S – usage in units/period
𝑬𝑶𝑸 = ˆ
𝑪 0 – order cost/order
C – carrying cost/unit
- min. total order & holding costs
Total costs
C · Reorder Point:
Daily usage × lead time
O
Optimal order size
- mgmt. of Payables/ - pay too early – loss of int. income

- pay too late – forgone discounts
𝟑𝟔𝟓9
𝐈𝐦𝐩𝐥𝐢𝐜𝐢𝐭 𝐑𝐚𝐭𝐞 = b𝟏 + c −𝟏
# of days
beyond discount
period
Pg-8
- Short-term funding sources/ - review
· Banks · Money Market · Asset-based loans
· LOCs (CP) (AR/inv. as collateral)
· notes
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 + 𝐂𝐨𝐦𝐦𝐢𝐭𝐦𝐞𝐧𝐭 𝐅𝐞𝐞

𝐋𝐨𝐚𝐧 𝐀𝐦𝐭.
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 + 𝐃𝐞𝐚𝐥𝐞𝐫 < 𝐬 𝐂𝐨𝐦𝐦. +𝐁𝐚𝐜𝐤𝐮𝐩 𝐋𝐢𝐧𝐞 𝐂𝐨𝐬𝐭
𝐁𝐀 = 𝐂𝐏 =
𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬
88

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Level I - Corporate Finance

Introduction to Corporate Governance and Other ESG Considerations 2

Working Capital Management 53

© markmeldrum.com. All rights reserved.

Introduction to Corporate Governance

a. describe corporate governance;

b. describe a company’s stakeholder groups and compare interests of

c. describe principal – agent and other relationships in corporate governance

d. describe stakeholder management;

e. describe mechanisms to manage stakeholder relationships and mitigate

f. describe functions and responsibilities of a company’s board of directors and

g. describe market and non-market factors that can affect stakeholder

h. identify potential risks of poor corporate governance and stakeholder

i. describe factors relevant to the analysis of corporate governance and

j. describe environmental and social considerations in investment analysis;

k. describe how environmental, social, and governance factors may be used in

- the arrangement of checks, balances, and incentives a

Shareholder Theory – the most important responsibility of

Stakeholder Theory – broadens focus to also include customers,

⇒ Shareholders/ interests focused on growth in LOS b

Controlling shareholders – hold a %’age of shares that gives

⇒ Creditors/ bondholders & banks (typically)

⇒ Managers & Employees/ senior exec. ➝ motivated to maximize

⇒ Managers & Employees/ lower level employees LOS b

⇒ Board of Directors/ elected to protect shareholder interests,

one-tier – single BOD of executive & non-executive directors

two-tier – 2 separate boards ➀ supervisory board

⇒ Customers/ product satisfaction for value paid LOS b

⇒ Suppliers/ primary interest ➝ get paid in a timely manner

⇒ Governments/Regulators – seek to protect interests of the

- created when a principal hires an agent LOS c

· Shareholder vs. Manager/Director

· risk tolerance – mgmt. may be more risk averse

- related-party transactions – controlling shareholder has

- dual class shares – voting vs. non-voting

· Manager & BOD/ · relies on information

· Shareholder vs. Creditor/ - prefer stable LOS c

· Other Stakeholder Conflicts/

· Customers vs. Suppliers – lenient credit terms to

· Shareholders vs. governments/regulators

· prioritize · active engagement

· legal infrastructure – rights established

· organizational infrastructure – internal

Mechanisms of Stakeholder Mgmt.

⇒ General Meetings/ companies must hold an LOS e

· Proxy voting – allows another to vote on your behalf

⇒ Board of Directors/ elected by shareholders to provide broad

⇒ Reporting & Transparency/ regulatory disclosures & investor relations

⇒ Policies on Related-Party Transactions/

⇒ Remuneration Policies/ LOS e

⇒ Say on Pay – Shareholders vote on executive pay

⇒ Contractual Agreements with Creditors/

⇒ Employee Laws & Contracts/ LOS e

⇒ Contractual Agreements with customers & suppliers/

⇒ Laws & Regulations

· Publicly traded companies are generally required to

BOD & Committees