FUNDAMENTALS OF FINANCIAL MANAGEMENT VAN HORNE PDF
Fundamentals of “ a useful text either as preparation for a second year course, or as a text for a ﬁrst year ﬁnancial Fundamentals of Financial Management. Trove: Find and get Australian resources. Books, images, historic newspapers, maps, archives and more. Instructor's Manual Fundamentals of Financial Management twelfth edition James C. Van Horne John M. Wachowicz JR. ISBN 0 7.
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Fundamentals of financial management / James C. Van Horne, John M. .. PowerPoint slides plus PDF's of all figures and tables from the book. Shepherding_a_Childs_Heart_-_Tripp,cittadelmonte.info Shepherding a Child\'s Heart Fundamentals of Financial Management (Van Horne 13th edition). Instructor's Manual Fundamentals of Financial Management twelfth edition James C. Van Horne John M. Wachowicz JR. ISBN 0 7 Pearson.
Maintaining its dedication to the financial decision-making process and the analysis of value creation, this new 13th edition develops a more international scope and introduces new topics into the debate. Current discussions on corporate governance, ethical dilemmas, globalization of finance, strategic alliances and the growth of outsourcing have been added with examples and boxed features to aid understanding and provide a more global perspective of financial management. This book is particularly well-suited to introductory courses in financial management, for a professional qualification and as a reference for practitioners. Your source for management ideas and insights, delivered to your inbox. Skip to main content.
The ownership is not liquid when it comes Van Horne and Wachowicz: Fundamentals of Financial Management, 12e to planning for 13 Decision making can be cumbersome. Accelerated depreciation is used up to the point it is advantageous to switch to straight line depreciation. A one-half year convention is followed in the first year, which reduces the cost recovery in that year from what would otherwise be the case.
Additionally, a one-half year convention is followed in the year following the asset class. This pushes out the depreciation schedule, which is disadvantageous from a present value standpoint.
The double declining balance method is used for the first four asset classes, 3, 5, 7 and 10 years. The asset category determines the project's depreciable life.
The immunity from each other's taxing power dates back to the early part of the 19th century. It used to apply to salaries of government employees as well. Personal tax rates are progressive up to a point, then become regressive. Fundamentals of Financial Management, 12e 14 The Business, Tax, and Financial Environments 8.
These include low dividend common stocks, common stocks in general, discount bonds, real estate, and other investments of this sort. Depreciation changes the timing of tax payments. The longer these payments can be delayed, the better off the business is. One advantage to Subchapter S occurs when investors have outside income against which to use losses by the company. Even with no outside income, stockholders still may find Subchapter S to be advantageous.
If dividends are paid, the stockholder under Subchapter S is subject only to taxation on the profits earned by the company. Under the corporate method, the company pays taxes on its profits and then the owners pay personal income taxes on the dividends paid to them. Tax incentives are the result influencing legislators. Some of these incentives benefit society as a whole; others benefit only a few at the expense of the rest of society.
It is hard to imagine all individuals interest of the whole above their own interests. Further, some incentives can be used to benefit large groups of people. Fundamentals of Financial Management, 12e 15 The Business, Tax, and Financial Environments While if a company has steady losses it does not benefit from this provision, the marginal company with profit swings does.
Financial markets allow for efficient allocation in the flow of savings in an economy to ultimate users. In a macro sense, savings originate from savings-surplus economic units whose savings exceed their investment in real assets. The ultimate users of these savings are savings-deficit economic units whose investments in real assets exceed their savings. Since the savings-surplus and savings-deficit units are usually different entities, markets serve to channel these funds at the least cost and inconvenience to both.
As specialization develops, efficiency Loan brokers, secondary markets, and investment bankers all serve to expedite this flow from savers to users. Financial intermediaries provide an indirect channel for the flow of funds from savers to ultimate users. These institutions include commercial banks, savings and loan associations, life insurance companies, pension and profit-sharing funds and savings banks.
Their primary function is the transformation of funds into more attractive packages for savers. Services and economies of scale Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 16 Pooling of funds, diversifica- tion of risk, transformation of maturities and investment expertise are desirable functions that financial intermediaries perform.
Differences in maturity, default risk, marketability, taxability, and option features affect yields on financial instruments. In general, the longer the maturity, the greater the default risk, the lower the marketability and the more the return is subject to ordinary income taxation as opposed to capital gains taxation or no taxation, the higher the yield on the instrument.
If the investor receives an option e. Conversely, if the firm issuing the security receives an option, such as a call feature, the investor must be compensated with a higher yield. Another factor -- one not taken up in this chapter -- is the coupon rate.
The lower the coupon rate, the greater the price volatility of a bond, all other things the same, and generally the higher the yield. The market becomes more intermediation is difference interest receives in and efficient reduced. Also, inconvenience to one or both parties is an indirect cost. The market becomes more complete when special types of financial instruments and financial processes are offered Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 17 For example, the new product might be a zero-coupon bond and the new process, automatic teller machines.
These exchanges serve as secondary markets wherein the buyer and seller meet to exchange shares of companies that are listed on the exchange. These markets have provided economies of time and scale in the past and have facilitated exchange among interested parties. If there are no disparities in savings pattern, the effect would fall on all financial markets. Disequilibrium would likely continue to occur until the rate of inflation reduced to a reasonable level.
Fundamentals of Financial Management, 12e 18 Answers to this question will differ depending on the financial intermediary that is chosen. Their presence improves the efficiency of financial markets in allocating savings to the most productive investment opportunities. Money markets serve the short-term liquidity needs of investors. The usual line of demarkation is one year; money markets include instruments with maturities of less than a year while capital markets involve securities with maturities of more than one year.
However, both markets are financial markets with the same economic purpose so the distinction of maturity is somewhat arbitrary. Money markets involve instruments that are impersonal; funds flow on the basis of risk and return.
A bank loan, for example, is not a money-market instrument even though it might be short term. Transaction costs impede the efficiency of financial markets. Financial institutions and brokers perform an economic service for which they must be compensated.
The means of compensation is If there is competition among them, transaction costs will be reduced to justifiable levels. Fundamentals of Financial Management, 12e 19 Financial brokers, such as investment bankers in particular as well as mortgage bankers, facilitate the matching of borrowers in need of funds with savers having funds to lend.
For this matching and servicing, the broker earns a fee that is determined by competitive forces. In addition, security exchanges and the over-the-counter market improve the secondary market and hence the efficiency of the primary market where securities are sold originally. If sued, they could lose up to their full combined net worths.
Fundamentals of Financial Management, 12e 10, In contrast, the borrower suffers in having to pay a higher real return than expected.
In other words, the loan is repaid with more expensive dollars than anticipated. No specific solution is recommended. The student should consider default risk, maturity, marketability, and any tax effects. Fundamentals of Financial Management, 12e 21 Henry is responsible for all liabilities, book as well as contingent.
He still could lose all his net assets because Kobayashi's net worth is insufficient to make a major dent in the lawsuit: As the two partners have substantially different net worths, they do not share equally in the risk.
Henry has much more to lose. Under the corporate form, he could lose the business, but that is all. Fundamentals of Financial Management, 12e 22 The Business, Tax, and Financial Environments 2. In addition, market conditions dictate that 3 percent is the floor for the deposit rate, while 7 percent is the ceiling for the mortgage rate.
Suppose that Wallopalooza wished to increase the current deposit rate and lower the current mortgage rate by equal amounts while earning a before-tax return spread of 1 percent. It would then offer a deposit rate of 3. Of course, other answers are possible, depending on your profit assumptions. Fundamentals of Financial Management, 12e 23 The Business, Tax, and Financial Environments 4. The premium attributable to maturity is 7. In this case, default risk is held constant and marketability, for the most part, is also held constant.
Fundamentals of Financial Management, 12e 24 Fundamentals of Financial Management, 12e 25 Chapter 3: Simple interest is interest that is paid earned on only the original amount, or principal, borrowed lent. With compound principal and interest, both then interest earn Hence interest is compounded.
The greater the number of periods and the more times a period interest is paid, the greater the compounding and future value. The answer here will vary according to the individual. Common answers include a savings account and a mortgage loan. An annuity is a series of cash receipts of the same amount over a period of time.
It is worth less than a lump sum equal to the sum of the annuities to be received because of the time value of money. Interest compounded continuously. It will result in the highest terminal value possible for a given nominal rate of interest. In calculating the future terminal value, we need to know the beginning amount, the interest rate, and the number of periods.
In calculating the present value, we need to know the future value or cash flow, the interest or discount rate, and the number of periods. Thus, there is only a switch of two of the four variables. Fundamentals of Financial Management, 12e 26 The Time Value of Money 7.
Otherwise, it is necessary to raise 1 plus the discount rate to the nth power and divide. Prior to electronic calculators, the latter was quite laborious.
With the advent of calculators, it is much easier and the advantage of present-value tables is lessened. Interest compounded as few times as possible during the five years. Realistically, it is likely to be at least annually. Compounding more times will result in a lower present value.
For interest rates likely to be encountered in normal business situations the "Rule of 72" is a pretty accurate money doubling rule. Since it is easy to remember and involves a calculation that can be done in your head, it has proven useful.
Decreases at a decreasing rate. The denominator of the present value equation increases at an increasing rate with n.
Therefore, present value decreases at a decreasing rate. Fundamentals of Financial Management, 12e 27 The Time Value of Money A lot. This translates into a weight of about pounds at age Fundamentals of Financial Management, 12e 28 It is particularly important when the interest rate is high, as evidenced by the difference in solutions between Parts 1. Fundamentals of Financial Management, 12e 29 The comparison illustrates the desirability of early cash flows.
Fundamentals of Financial Management, 12e 30 The Time Value of Money 4. Therefore, the note has an implied interest rate of almost 7 percent. Fundamentals of Financial Management, 12e 31 The Time Value of Money 9. Therefore, the implicit interest rate is slightly more than 7 percent. Fundamentals of Financial Management, 12e 32 Fundamentals of Financial Management, 12e 33 Fundamentals of Financial Management, 12e 34 Fundamentals of Financial Management, 12e 35 Thus, it will take approximately 9 years of payments before the loan is retired.
Fundamentals of Financial Management, 12e 36 So, we need to then subtract three future values from our "trial" ending balance: After collecting terms, we get the following: There are many ways to solve this problem correctly. Here are two: Cash withdrawals at the END of year Fundamentals of Financial Management, 12e 37 Answers to Alt.
You are faced with determining the present value of an annuity due. For approximate answers, we can make use of the "Rule of 72" as follows: Fundamentals of Financial Management, 12e 39 Future terminal value of each cash flow and total future value of each stream are as follows using Table I in the end-of-book Appendix: More specifically, the book goes on to investigate current asset and liability decisions and then moves on to consider longer-term assets and financing.
A good deal of emphasis is placed on working capital management. This is because we have found that people tend to face problems here when going into entry-level business positions to a greater extent than they do to other asset and financing area problems.
Nonetheless, capital budgeting, capital structure decisions, and long-term financing are very important, particularly considering the theoretical advances in finance in recent years.
These areas have not been slighted. Many of the newer frontiers of finance are explored in the book. By design, this exposure is mainly verbal with only limited use of mathematics. The last section of the book deals with the more specialized topics of: While the book may be used without any formal prerequisites, often the student would have had an introductory course in accounting and economics and perhaps a course in statistics.
Completion of these courses allows the instructor to proceed more rapidly over financial analysis, capital budgeting, and certain other topics. While we feel that all of the appendices are relevant for a thorough understanding of financial management, the instructor can choose those most appropriate to his or her course. If the book is used in its entirety, the appropriate time frame is a semester or, perhaps, two quarters.
For the one-quarter basic finance course, we have found it necessary to omit coverage of certain chapters. For the one-quarter course, the following sequencing has proven manageable:. In a one-quarter course, few if any of the appendices are assigned. While chapter substitutions can be made, we think that 19 or 20 chapters are about all that one should try to cover in a quarter.
This works out to an average of two chapters a week. For working capital management and longer-term financing, it is possible to cover more than two chapters a week.
For the time value of money and capital budgeting, the going is typically slower. Depending on the situation, the pace can be slowed or quickened to suit the circumstances. The semester course allows one to spend more time on the material. In addition, one can take up most of the chapters omitted in a one-quarter course. Two quarters devoted to finance obviously permits an even fuller and more penetrating exploration of the topics covered in the book.
Here the entire book, including many of the appendices, can be assigned together with a special project or two.
Fundamentals of Financial Management (13th edition)
The coverage suggested above is designed to give students a broad perspective of the role of financial management. This perspective embraces not only the important managerial considerations but certain valuation and conceptual considerations as well. It gives a suitably wide understanding of finance for the non-major while simultaneously laying the groundwork for more advanced courses in finance for the student who wants to take additional finance courses.
For the one-quarter required course, the usual pedagogy is the lecture coupled perhaps with discussion sections. In the latter it is possible to cover cases and some computer exercises. The semester course or the two-quarter sequence permits the use of more cases and other assignments. Our website provides links to hundreds of financial management websites grouped to correspond with the major topic headings in the text e.
The Pearson Education Website - http: Kuhlemeyer, Carroll College. This supplement is available as a custom computerized test bank for Windows through your Prentice-Hall sales representative. In addition, Professor Kuhlemeyer has done a wonderful job in preparing an extensive collection of Microsoft PowerPoint slides as outlines with examples to go along with the text. The PowerPoint presentation graphics are available for downloading through the following Pearson Education Website:.
All text figures and tables are available as transparency masters through the same web site listed above. Finally, computer application software that can be used in conjunction with specially identified end-of-chapter problems is available in Microsoft Excel format on the same web site.
We thank you for choosing our textbook and welcome your comments and suggestions please E-mail: With an objective of maximizing shareholder wealth, capital will tend to be allocated to the most productive investment opportunities on a risk-adjusted return basis. Other decisions will also be made to maximize efficiency. If all firms do this, productivity will be heightened and the economy will realize higher real growth. There will be a greater level of overall economic want satisfaction.
Presumably people overall will benefit, but this depends in part on the redistribution of income and wealth via taxation and social programs. In other words, the economic pie will grow larger and everybody should be better off if there is no reslicing. With reslicing, it is possible some people will be worse off, but that is the result of a governmental change in redistribution. It is not due to the objective function of corporations.
Earnings is a time vector. Unless one time vector of earnings clearly dominates all other time vectors, it is impossible to select the vector that will maximize earnings. Each time vector of earning possesses a risk characteristic. Maximizing expected earnings ignores the risk parameter. Earnings can be increased by selling stock and buying treasury bills. Earnings will continue to increase since stock does not require out-of-pocket costs. The impact of dividend policies is ignored.
If all earnings are retained, future earnings are increased. However, stock prices may decrease as a result of adverse reaction to the absence of dividends. Maximizing wealth takes into account earnings, the timing and risk of these earnings, and the dividend policy of the firm. Financial management is concerned with the acquisition, financing, and management of assets with some overall goal in mind.
Thus, the function of financial management can be broken down into three major decision areas: Yes, zero accounting profit while the firm establishes market position is consistent with the maximization of wealth objective.
Other investments where short-run profits are sacrificed for the long-run also are possible. The goal of the firm gives the financial manager an objective function to maximize.
The financial manager is involved in the acquisition, financing, and management of assets. These three functional areas are all interrelated e. If managers have sizable stock positions in the company, they will have a greater understanding for the valuation of the company.
Moreover, they may have a greater incentive to maximize shareholder wealth than they would in the absence of stock holdings. However, to the extent persons have not only human capital but also most of their financial. If the company deteriorates because a risky decision proves bad, they stand to lose not only their jobs but have a drop in the value of their assets.
Excessive risk aversion can work to the detriment of maximizing shareholder wealth as can excessive risk seeking, if the manager is particularly risk prone. Regulations imposed by the government constitute constraints against which shareholder wealth can still be maximized. It is important that wealth maximization remain the principal goal of firms if economic efficiency is to be achieved in society and people are to have increasing real standards of living.
The benefits of regulations to society must be evaluated relative to the costs imposed on economic efficiency. Where benefits are small relative to the costs, businesses need to make this known through the political process so that the regulations can be modified.
Presently there is considerable attention being given in Washington to deregulation. Some things have been done to make regulations less onerous and to allow competitive markets to work.
As in other things, there is a competitive market for good managers. A company must pay them their opportunity cost, and indeed this is in the interest of stockholders. To the extent managers are paid in excess of their economic contribution, the returns available to investors will be less.
However, stockholders can sell their stock and invest elsewhere. In competitive and efficient markets, greater rewards can be obtained only with greater risk. The financial manager is constantly involved in decisions involving a trade-off between the two.
For the company, it is important that it do well what it knows best. There is little reason to believe that if it gets into a new area in which it has no expertise that the rewards will be commensurate with the risk that is involved.
The risk-reward trade-off will become increasingly apparent to the student as this book unfolds. Corporate governance refers to the system by which corporations are managed and controlled. These relationships provide the framework within which corporate objectives are set and performance is monitored. The Board reviews and approves strategy, significant investments, and acquisitions. Cost accounting, as well as budgets and forecasts, would be for internal consumption.
Corporation, n. An ingenious device for obtaining individual profit without individual responsibility. The principal advantage of the corporate form of business organization is that the corporation has limited liability. The owner of a small family restaurant might be required to personally guarantee corporate borrowings or purchases anyway, so much of this advantage might be eliminated.
The wealthy individual has more at stake and unlimited liability might cause, one failing business to bring down the other healthy businesses. The liability is limited to the amount of the investment in both the limited partnership and in the corporation. However, the limited partner generally does not have a role in selecting the management or in influencing the direction of the enterprise.
On a pro rata basis, stockholders are able to select management and affect the direction of the enterprise. Also, partnership income is taxable to the limited partners as personal income whereas corporate income is not taxed unless distributed to the stockholders as dividends.
Increasingly, as the debt maturity is shortened, smaller and smaller adverse deviations from the expected cash flow can send the firm into technical insolvency. The reduced safety margin against adverse net cash flow fluctuations results in an increased risk level for the firm.
Second, if no amortization payments are required i. The firm faces the risk of not being able to refinance the maturing debt and the risk of being forced to pay higher interest payments on any refinancing available.
Increasing the firm's liquidity increases the safety margin against adverse cash flow fluctuations increases the probability of interest and principal repayment and thus reduces all the risks outlined above.
Too large an investment in working capital lowers the firm's profitability without a corresponding reduction in risk. In fact, risk might actually increase - - see answer to Question 8. Too small a level of working capital could also lower profitability due to stockouts and too few credit sales because of an overly strict credit policy. A margin of safety to offset uncertainty can be provided by increasing the level of current assets of the firm, by increasing the maturity schedule of its debt, or by some combination of the two.
In all cases the increased safety comes at a cost of lower profitability. One can visualize situations where sales are lost as a result of stockouts and costs may increase as more lost time in production is caused by shortages of materials. Finance fixed assets with common stock and retained earnings. Finance the temporary working capital with short- term debt. Alternative 1 is lowest in cost because the company borrows at a lower rate, 12 percent versus There is a risk consideration in that if things turn bad the company is dependent on its bank for continuing support.
There is risk of loan renewal and of interest rates changing. Alternative 2 involves borrowing the expected increase in permanent funds requirements on a term basis. As a result, only the expected seasonal component of total needs would be financed with short-term debt. Alternative 3, the most conservative financing plan of the three, involves financing on a term basis more than the expected build-up in permanent funds requirements. In all three cases, there is the risk that actual total funds requirements will differ from those that are expected.
Also, more lenient credit terms may lead to increased sales and profits. A hidden cost is that part of the debt capacity of the firm is used up by virtue of financing increased levels of current assets with debt. Cash management involves the efficient collection and disbursement of cash and any temporary investment of cash while it resides with the firm. The general idea is that the firm will benefit by "speeding up" cash receipts and "slowing down" cash payouts.
Concentration banking involves the movement of cash from lock-box or field banks into the firm's central cash pool residing in a concentration bank. This process is needed to: The lock-box system may improve the efficiency of cash management by reducing the float. The funds made available by this reduction in float may be invested to produce additional profit. The most important criterion for asset selection is safety of principal. Since the funds invested represent only temporary funds which will be needed in the short run, the ability to convert the investments into cash is more important than the expected return to be earned.
Lock-box banking provides the financial manager an opportunity to contribute to the objective of maximizing wealth by reducing the Van Horne and Wachowicz: Reducing the funds in the collection "pipeline" will not affect the risk characteristics of the firm as these funds are reinvested in productive assets. Corporate cash balances should be reduced as a result of the lock-box banking.
In the "ready cash segment," a major requirement is instant liquidity. These securities may need to be liquidated on very short notice. Safety is also of high concern. Treasury bills, because they are the safest and most marketable of all money-market instruments, would be the best choice.
Commercial paper, while relatively safe, is generally held to maturity and has poor marketability. Compensating balances are a requirement imposed by a bank. Usually, the requirement is expressed in terms of an average collected balance. Its purpose is to compensate the bank for the activity in the account checks cleared, deposits accepted, transfers, etc.
These things cost the bank money to administer and the bank hopes to earn enough on the balances maintained to offset its costs. Because the activity in an account varies by company, so too will the compensating balance requirement. Net float is the dollar difference between the balance shown in a firm's checkbook balance and the balance on the bank's books. Until a check is collected at the bank, it is not deducted on the bank's books.
A company can "play the float" by anticipating the Van Horne and Wachowicz: Marketable securities serve as a temporary investment for funds which later will be needed for transaction purposes.
They also serve as a liquidity buffer for unforeseen cash drains. This buffer can be quickly converted into cash. In this sense, marketable securities serve as precautionary balances. Cash inflows would need to be perfectly synchronized with cash outflows and there would need to be complete certainty. In the real world, these conditions seldom, if ever, would be met. The three motives for holding cash are: Treasury bills are the most liquid securities available; they have tremendous marketability.
Moreover, they are risk free with respect to default. For these reasons they provide the lowest return of the money-market instruments. Bankers' acceptances are marketable, though less so than Treasury bills. They have a degree of default risk in that banks can fail. As a result, they yield more than bills. Both instruments serve the liquidity needs of the Van Horne and Wachowicz: Electronic commerce EC is the exchange of business information in an electronic non-paper format.
EDI involves the transfer of business information e. The distinguishing feature of EFT is that a transfer of value money occurs in which depository institutions primarily banks send and receive electronic payments. FEDI involves the exchange of electronic business information non value transfer between a firm and its bank or between banks.
Examples include lockbox remittance information and bank balance information. Outsourcing consists of subcontracting a certain business operation to an outside firm, instead of doing it "in-house. Cash management is an essential, but generally non- core business activity.
Therefore, all the major areas of cash management -- collections, disbursements, and marketable-securities investment -- are ripe for outsourcing consideration. Other popular reasons for outsourcing include improving company focus and gaining access to world-class capabilities.
If the company were certain of the pattern shown, it would wish to have the following deposits in its payroll account in order to cover the checks that were cashed: The greater the uncertainty, the greater the buffer that will be needed. The transfers are not large enough to offset the fixed cost.
No specific solution recommended. Commercial paper is less attractive than Treasury bills because of the state income tax from which Treasury bills are exempt. In states with no income taxes, the after-tax yield on commercial paper would be higher. Preferred stock may not be the most attractive investment when risk is taken into account.
There is the danger that interest rates will rise above the ceiling and the market value will fall. There also is default risk with respect to dividend payment, whereas Treasury bills have no default risk. All others must pay cash. Only if the added profitability of the additional sales to the "deadbeats" less bad debt loss and other costs does not exceed the required return on the additional and prolonged investment in accounts receivable should the firm cease sales to these customers.
Some firms such as jewelry or audio equipment dealers are very happy to sell to almost any "deadbeat" because their margins are very high. This policy suggests that the firm has a poor collection policy. Accounts that are collectable are being written off too quickly. Thus, the turnover is maintained at the expense of increased bad-debt losses. This policy suggests a lax collection policy or ineffective screening of poor credit risks.
The final profitability position depends upon the profitability and costs of servicing the past-due accounts. Credit standards are probably too strict. Customers accepting credit are not of uniform high quality. Customers accepting credit are of uniform high quality. Liberalizing credit terms may stimulate sales. The incre- mental profit may be greater than the required return on the investment necessary to finance added accounts receivable.
To analyze a credit applicant, one might turn to financial state- ments provided by the applicant, credit ratings and reports, a check with the applicant's bank particularly if a loan is involved , a check with trade suppliers, and a review of your own credit experience if the applicant has done business with you in the past.
Each step involves a cost and the value of additional information must be balanced against the profitability of the order and the cost of the information. The quality of account accepted, the credit period, the discount, and the discount period.
The level of sales, the level of investment in receivables, and the percent of bad-debt losses. Beyond a certain point, increased expenditures will yield no results as those accounts will default regardless of the pressure brought upon them to pay.
A line of credit establishes the maximum amount of credit that an account can have outstanding at one time. The advantage of this arrangement is that it is automatic. An order can be filled as long as it does not bring the total owed above the line.
This facilitates order taking and reduces delays. However, the line must be reevaluated periodically in order to keep abreast of developments in the account. Aging accounts receivable represents an effort to determine the age composition of receivables.
A similar approach for inventory could involve determining the inventory turnover in days ITD of product lines and of individual products. For example, General Electric may evaluate inventory policy by comparing the trend in inventory turnover in days of home appliances.
Within the home appliance category, the inventory turnover in days of refriger- ators, for example, may yield an insight into inventory policy. The greater the ordering costs, the more inventory that will be maintained, all other things the same, and the greater the funds that will be tied up in inventory.
The greater the storage costs and cost of capital, the less inventory that will be maintained. Efficient inventory management implies the elimination of redundant inventory and selecting a level of inventory that provides the risk-profitability trade-off desired by investors.
Eliminating redundant inventory does not involve increasing risk. The profit- ability will increase, but since the inventory was redundant, the risk will not increase. In fact, there could be a situation where risk decreases since the risk of obsolescence is reduced.
After the redundant inventory is eliminated, any further reduction of inventory will increase the risk as well as the profitability. Efficient inventory management means selecting that combination of inventory that possesses the combination of profitability and risk desired by investors.
The firm could lower its investment in inventories by: Increased costs include: With no variation in product demand, the firm would be able to minimize costs by maintaining a level production schedule and eliminating inventory safety stocks. With seasonal demand, however, the firm is unable to pursue such a policy. Unless production is tied exactly to sales, production decisions will influence inventory levels. For example, a level production schedule with seasonal demand results in counter-seasonal inventory movement.
Likewise, with seasonal demand a constant inventory level requires a seasonal production schedule. This inter- dependence of demand, production, and inventory considerably complicates any optimal solution. From the standpoint of dollars committed, the two are the same.
However, inventories change rapidly over time whereas fixed assets do not. Therefore, one is concerned with the level of investment in inventories, as opposed to the investment in a specific asset as would be the case with fixed asset. Usually a company will use the same required rate of return for both. However, if one type of inventory was significantly more risky than the other, one might wish to apply a higher required rate of return. This might occur if the raw materials had a ready market with little price fluctuation whereas the finished products were subject to considerable uncertainty.
Incremental profitability1 , , , 60, c. New receivable turnover2 8 6 4 2. Additional investment4 , , , , f. Opportunity cost5 94, 81, 81, 64, g. Opportunity cost from Ans. Incremental profitability from Ans. It is the only one where incremental profitability exceeds opportunity costs plus bad-debt losses. Percent default 1. Any more liberal credit policy beyond this point would only result in more incremental costs than benefits. If the opportunity cost is 10 percent, however, the program is not worthwhile as shown in the last column.
Positive factors: Negative factors: Short-term debt and trade credit from suppliers have increased faster than total liabilities and net worth while inventory and receivable turnovers have slowed.
The nature of academics suggests that sales would occur at the beginning of each term. Beyond that point incremental costs are larger than incremental benefits. As the bad-debt loss ratio for the high-risk category exceeds the profit margin of 22 percent, it would be desirable to reject orders from this risk class if such orders could be identified. Therefore, the company should not undertake credit analysis of new orders.
An example can better illustrate the solution. The following would then hold: Therefore, it should not undertake the credit analysis of new orders. This is a case where the size of order is too small to justify credit analysis. After a new order is accepted, the company will gain experience and can reject subsequent orders if its experience is bad. The lower the carrying cost, the more important ordering costs become relatively, and the larger the optimal order size. Therefore, the new production plan should not be undertaken.
Trade credit from suppliers is spontaneous because there is no formal negotiation for the funds. By merely purchasing merchandise on credit, funds are acquired. The reasons trade credit from suppliers is used to finance temporary working capital are as follows: Stretching payables creates problems for suppliers since their ability to forecast cash flows is substantially impaired. The more uncertain the cash projections, the higher the level of protective liquidity a firm must hold.
Also, investors may perceive a higher degree of risk for the supplier, thus increasing the supplier's cost of capital. The firm could expect its liquidity to be improved. The cost to the firm's customers of not taking cash discounts has risen drastically from 9.
Thus, customers will tend to borrow money from banks and other sources in order to receive the cash discount. This will tend to increase the selling firm's turnover, and decrease the firm's investment in accounts receivable, thereby increasing the firm's liquidity. Of course the customer's position is exactly reversed.
There is far less ability to change the amount of financing provided by accrued expenses than there is with trade credit. The amount largely depends on the amount of wages and profits. The rate on commercial paper is lower than the prime rate since the high quality borrower, who is able to issue commercial paper, can get the prime rate at the bank. Lenders can buy treasury bills; therefore, to induce lenders to buy commercial paper, a higher rate must be paid.
To induce borrowers to issue commercial paper, a rate lower than prime, but more than the T-bill rate, must be available. The commercial paper market is not available to all firms. Also, the market is very impersonal compared to a bank.
For the most part, commercial paper is restricted to large, high quality industrial companies, finance companies, and utilities. Whereas the purpose originally was to support seasonal borrowings, Van Horne and Wachowicz: It is simply rolled over at maturity. While both represent money-market, short-term instruments, a bankers' acceptance has a viable secondary market whereas commercial paper does not. Bankers' acceptances are associated with a specific shipment of goods or storage of goods.
With this instrument, the acceptance of the draft by a bank substitutes the bank's credit for that of the parties involved. Similarly, if commercial paper is "bank supported," a bank provides a letter of credit guaranteeing the obligation.
With "stand alone" commercial paper, the company often must have backup lines of credit from banks. Both instruments are rated as to quality by independent rating agencies. A line of credit is an informal lending arrangement, usually for one year, where the bank expresses a willingness to lend up to some specified amount of funds at an interest rate related to the prime rate or to the bank's cost of funds.
A revolving credit agreement is a legal commitment to extend credit up to some maximum amount anytime a company wishes to borrow. Usually the commitment is for multiple years, often three. Also, the company must satisfy certain restrictions called protective covenants specified in the agreement. If satisfied, however, the loan cannot be denied whereas it can be legally denied under a line of credit should the company evolve itself into financial difficulty.
Because interest is subtracted from the amount advanced, a discount note has a higher effective rate of interest than a note where interest is collected at the end everything else being equal. Therefore, a borrower will prefer a collect note and the lender a discount note, all other things the same. The quality of the borrower and its cash flow ability to service debt largely determine whether a lender is willing to make an unsecured loan. If the lender does not have a very high degree of confidence in the ability of the borrower to repay, it will insist on some type of secured lending arrangement.
The percentage advanced depends on the marketability of the collateral, the synchronization of its life with that of the loan, and the basic riskiness of the collateral. With respect to the latter, the lender is concerned with fluctuations in market price. The analysis should be on the basis of costs and benefits. Typically, the factoring arrangement will be more costly as a method of financing.
However, the sale of receivables eliminates clerical and credit costs the company would otherwise have to bear. For the small company, these can be significant on a relative basis and more than offset the difference in financing costs. Also, because of economies of scale, the factor may be able to do a better job of credit analysis and record keeping.
No answer suggested. Eurodollar loans may be an attractive source for such companies. In determining an appropriate composition of short-term financing, such things as the relative cost of funds, the availability of different types of financing, whether or not the type of financing requires security, the timing of the borrowing in the money market or from a private lender, and the flexibility associated with the various types of potential financing should be considered.
All of these things can change over time with changing financial market conditions. Blunder is confusing the percentage cost of using funds for five days with the cost of using funds for a year. These costs are clearly not comparable. One must be converted to the time scale of the other. In this case, payment 30 days after purchases are received rather than 15 would reduce the annual interest cost to Declining interest costs, rising commitment fees, and declining useable funds combine to produce this result.
Factoring costs monthly: Interest cost savings: Quarter Inventories Inventories x 1. As the savings exceed the increased costs, the company should utilize the trust receipt financing arrangement. Annualized costs are as follows: Trade credit: Bank financing: Commercial paper: Bank loan: Tax depreciation is a noncash charge against operating income that lowers taxable income.
So we need to deduct it as we determine the incremental effect that the project has on taxable income. However, we ultimately add it back to the net change in income after taxes so as not to understate the project's effect on cash flow. Sunk costs must be ignored because they do not affect incremental cash flows. With capital budgeting, one is concerned with the net cash flows that occur presently and in the future.
Van Horne: Fundamentals of Financial Management (13th Edition) by by Jeff Warner - PDF Drive
The occurrence of past costs should not enter into the decision process. If the required return is the cost of capital where the expectation of investors includes an increment for protection of purchasing power, then the benefits to be generated by a project should include the higher price of the product over time as a result of inflation.
Otherwise, a bias would be introduced into the decision-making process. Implied is that a project is regarded as more important, the larger it is.
As a result, increasing levels of approval are necessary and more information frequently is required as well. This pro- cedure is used by many companies under the implicit assumption that management time is valuable and must be rationed. Consequently, smaller projects frequently are approved at a low level with little scrutiny.
Whether this is appropriate or not depends on the situation. There is a trade-off between the efficiency of reviewing projects and the economic gains of more sophisticated, and time consuming, analysis. The product expansion project will produce new future cash revenues but will also involve higher future cash operating costs. An equipment replacement project usually involves only a reduction in costs. Both projects require an investment.
Relevant cash flows: Depreciation, new 19, 26, 8, 4, 0 ———————— ———————— ———————— ———————— ———————— d. Profit change before tax b - c 2 6, 11, 15, 20, e. Profit change after tax d - e 1 4, 6, 9, 12, g. Profit change before tax b - c 2 5, 13, 19, 25, e. Profit change after tax d - e 1 3, 8, 12, 15, g. Net cash flow for terminal year b. Initial cash b. Incremental cash inflows: Depreciation, new 19, 26, 8, 4, c.
Depreciation, old 4, 0 0 0 ————————— ————————— ———————— ————————— d. Incremental depreciation b - c 15, 26, 8, 4, e. Profit change before tax a - d 3, 14, 3, 7, f. Profit change after tax e - f 2, 8, 1, 4, h. Depreciation, new 20, 27, 9, 4, c. Depreciation, old 4, 0 0 0 ————————— ————————— ———————— ———————— — d. Incremental depreciation b - c 16, 27, 9, 4, e.
Profit change before tax a - d 4, 15, 2, 7, f. Profit change after tax e - f 2, 9, 1, 4, h. Depreciation, new 96, , 92, 55, 3. Depreciation, old 34, 34, 17, 0 ———————— ———————— ———————— ——————— 4. Incremental depreciation 2 - 3 61, , 74, 55, 5. Profit change before tax 1 - 4 38, 19, 25, 44, 6. Profit change after tax 5 - 6 23, 11, 15, 26, 8. Salvage value x 1 -. Depreciation, new 55, 27, 0 0 3.
Depreciation, old 0 0 0 0 ———————— ———————— ———————— ——————— 4. Incremental depreciation 2 - 3 55, 27, 0 0 5. Profit change before tax 1 - 4 44, 72, , , 6. Profit change after tax 5 - 6 26, 43, 60, 60, 8. Incremental maintenance 6, 6, 6, 6, 3.
Depreciation , , 74, 37, ————————— ————————— ———————— ————————— 4. Profit change before tax 1 - 2 - 3 22, 78, 69, , 5. Profit change after tax 4 - 5 13, 46, 41, 64, 7.
If it is a purely arbitrary one, it may be impossible for us to solve it. If, on the other hand, it is systematic, I have no doubt that we shall yet get to the bottom of it. The time value of money refers to the fact that money has an opportunity cost, i.
Given a positive interest rate, a dollar invested today will yield more that one dollar in the future. Thus, capital budgeting systems such as payback, which equate the bird in the hand with one in the bush rather than more than one do not accurately reflect either the investment opportunities of society, or a shareholder preference for current, rather than future, consumption.
As such, they are nonoptimal. If the payback period is used as the criterion for assigning priorities to investment projects, the highest priority will be assigned to projects with the shortest payback period.
Funds available for investment may be unavailable for long-term projects if short-term projects are acquired first. It is often the case that larger projects will provide greater absolute dollar increases in the value of the firm than smaller projects simply because of the scale of the projects.
This is not a problem for ranking projects unless the firm may be faced with a capital rationing constraint. For example, when faced with a single-period constraint, profitability index rankings will prove more useful in project selection. The internal rate of return IRR is the discount rate that makes the present value of the benefits generated by a project equal to the investment. The net present value NPV is the difference between the present value of the benefits discounted at the required return or cost of capital and the investment.
One essential difference between the two approaches is the implied rate of return on the reinvestment of the cash flows. Under conditions of capital rationing, or mutually exclusive projects, and of sharply rising cost of capital, this difference is very important since only one assumption is correct.
In addition, problems in rankings can occur because of differences in the scale of investment and project life. The payback period is unsound because the time value of money is ignored. Also, the cash flows after payback are ignored.
Finally, the payback period of, say, three years may or may not be adequate to satisfy a cost of capital of, say, 10 percent. It is a popular profitability measure because of its simplicity and practicality. In a limited sense, the payback is a measure of risk. It emphasizes short-term cash flows that are important for small growing concerns.
It emphasizes those cash flows that can be predicted with greatest accuracy. When used in conjunction with the NPV method, the payback can improve the decision-making process. A project is mutually exclusive with another if acceptance of one rules out acceptance of the other.
Van Horne: Fundamentals of Financial Management (13th Edition) by
A dependent or contingent project depends on the acceptance of another project before it can be accepted. If the use of capital budgeting techniques is widespread, capital will be allocated to the most efficient uses in society. Savings in the economy will be channeled to the most promising investment opportunities. As a result, economic growth and want satisfaction will be maximized. All of this depends on the accurate measurement of the benefits to be realized from an investment.
Capital rationing is done to facilitate the approval process. A division may be given an annual budget for smaller projects, with larger projects having to be approved on a project-by-project basis. In other words, capital rationing may not apply to all projects, but only to smaller ones.
Beyond the desire to facilitate the administration of capital budgeting, many companies ration capital because they do not want to go to the external market for financing. While this is suboptimal if projects are available that provide returns in excess of those required, we should recognize that this reason for capital rationing frequently prevails.
Problems may result if the reinvestment rate available to the company differs sharply from the internal rate of return usually Van Horne and Wachowicz: For example, we should not be overly concerned with a three- year project where the IRR is 16 percent but the reinvestment rate is only 13 percent. However, we should be concerned if the IRR of a year project is 32 percent but the reinvestment rate is only 13 percent. Yes, it should bother you.
For a conventional project i. The projects NPV would, in fact, be equal to the present value of all cash flows occurring after the projects discounted payback period. If we reject this independent project, we would not be maximizing the value of the firm. Thus, if a firm not subject to capital rationing sets a single maximum discounted payback period as a cutoff for all independent projects, it runs the real risk of rejecting long-lived, but still positive-NPV projects.
The discounted payback period method overcomes one shortcoming of the traditional payback period method. It accounts for the time value of money and risk by discounting cash flows at the cost of capital. However, it fails to consider cash flows occurring after the expiration of the discounted payback period; consequently, we cannot regard it as a measure of profitability.
In addition, the maximum acceptable discounted payback period, which serves as the cutoff standard, is a purely subjective choice. For example, the NPV method considers all cash flows for a project, reveals the absolute dollar value added to the firm by project acceptance, and handles correctly even unconventional cash-flow patterns. Payback period PBP: Profitability index: The payback method 1 ignores cash flows occurring after the expiration of the payback period, 2 ignores the time value of money, and 3 makes use of a crude acceptance criterion, namely, a subjectively determined cutoff point.
The IRR for project B is Below about 28 percent, B dominates; at about 28 percent and above, A dominates. We are assuming that the required rate of return is the same for each project and that there is no capital rationing. Cash Flows: The project is not acceptable. This assumes the discount rate is the same as before, 15 percent, and does not vary with inflation. The resort should accept all projects with a positive NPV. If capital is not available to finance them at the discount rate used, a higher discount rate should be used that more adequately reflects the costs of financing.
The Rockbuilt bid should be accepted as the lower maintenance and rebuilding expenses more than offset its higher cost. With a higher discount rate, more distant cash outflows become less important relative to the initial outlay. But, the lower maintenance and rebuilding expenses related to the Rockbuilt bid continue to more than offset its higher cost.
As the net present value is negative, the project is unacceptable. The internal rate of return is If the trial- and-error method were used, we would have the following: To approximate the actual rate, we interpolate between 13 and 14 percent as follows: As the internal rate of return is less than the required rate of return, the project would not be acceptable.
The project would be acceptable. Risk is our business. Investment projects with different risks can affect the valuation of the firm by suppliers of capital.
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