At the end of this module, you should be able to:
explain and apply the concepts of cash flow and working capital management
discuss how capital structures are determined using a simplified structure of debt, equity and preference shares
calculate the cost of debt, ordinary shares (equity) and preference shares and explain the capital asset pricing model (CAPM)
calculate and use the before- and after-tax weighted average cost of capital (WACC).
Part A: Cash flow management
Which of the following is considered to be a cost associated with maintaining liquidity?
Interest earned on invested surplus cash
Finance facility costs for unused financing facilities
Margin costs on borrowings due to poor credit rating
A.1. Liquidity risk
Not being able to:
meet obligations as and when they fall due
convert assets into cash quickly without material price reduction
How do you measure liquidity
current ratios = current assets / current liabilities (1.5 - 2)
quick ratio = current assets - inventory) / current liabilities (1 - 1.5)
A.2. Cash management
forecasting and planning
cash procedures
inter-company transactions
investing surplus funds
monitoring and measuring performance
A.3. Cash disbursement
timely and accurate payments
policies and infrastructure
authorization
segregation of duties
record-keeping
independent check
A.4. Free cash flow
underlying cash generated by their business:
operating cash flow
less capital invested
after-tax cash flows available to capital providers
[net income + depreciation and amortization - changes in net working capital - capital expenditure]
net income: accrual basis, after tax
depreciation and amortization: non-cash item, relates to prior period outflows
changes in net working capital: reflects the growth of the organization
capital expenditure: no longer available to external providers
Example A.4.1
net income + depreciation and amortization - changes in NWC - CapEx
50,000 + 20,000 - 25,000 - 20,000 = 25,000
A.5. Stress testing
Part B: Working capital management
B.1. Strategies to manage working capital
B.2. Measuring working capital requirements
B.3. Funding risk and credit risk assessment
need to consider the "cash effects"
assets
liabilities
tax effects (e.g. interest/ depreciation / amortization)
Example B
Delicious chocolate supplies boxes of chocolates to a supermarket:
purchases on credit, payable within 30 days from supplier invoice date
inventories sold after 50 days
sales are on credit, payable 60 days from invoice date
Days between outflow of cash and inflow of cash: 50 + 60 - 30 = 80 days
Working capital drivers
inventory cycle
receivable cycle
payable cycle
Cash cycle & Operating cycle
Pre-webinar activity
What is the 20X6 cash conversion cycle:
CCC = Days of Sales Outstanding (DSO) + Days of Inventory Outstanding (DIO) - Days of Payables Outstanding (DPO).
DSO = [(BegAR + EndAR) / 2] / (Revenue / 365)
= $25,000 / ($250,000 / 365) = 36.5 days
DIO = [(BegInv + EndInv / 2)] / (COGS / 365)
= $4,000 / ($100,000 / 365) = 14.6 days
Operating Cycle = DSO + DIO
= 36.5 + 14.6 = 51.1 days
how many days it takes for something to go from first being in inventory to receiving the cash after the sale. You want this number to be low meaning that merchandise isn’t sitting on shelves too long and customers are paying relatively quickly. https://blogs.cfainstitute.org/insideinvesting/2013/05/21/a-look-at-the-cash-conversion-cycle/
DPO = [(BegAP+EndAP) / 2] / (COGS / 365)
= $8,000 / ($100,000 / 365) = 29.2 days
how many days the company takes to pay its suppliers. Unlike the other two numbers that make up the Operating Cycle, the company wants to stretch out how long it takes to pay for its inventory.
Cash conversion cycle = 51.1 - 29.2 = 21.9 days
What advice can you give?
ask suppliers to increase the terms of engagement or the credit days (to extend payable days)
ask or force customers to pay early (to reduce receivable days)
there's a risk that the organization could lose some customers or critical suppliers
Part C: Cost of capital and capital structure
e.g. Blendle
Pay-per-article journalism start up:
initial high investment in infrastructure and running costs
costs associated with ramping up agreements with publishers
low initial income, and hard to forecast income/growth
e.g. NAB
Listed multi-national financial institution:
Significant capital and IT infrastructure in place
Operating costs have a long history
Funding costs can fluctuate based on international markets
Income largely based on margins/spreads and fees (reliant on number of clients/transactions)
Capital structure
C.1.Qualitative factors
Underlying asset structure - generating 'predictable cash flows'
Earnings stability
Flexibility required (debt is more flexible)
Management control (equity)
Risk profile
Cost (deb cost is lower)
Imposed constraints (e.g. debt covenant)
Quantitative factors
Cost of debt
Cost of equity
Cost of preference shares
Weighted average cost of capital (sum of everything above)
Quiz C
Crafty Metal issues a one-year bond with a face value of $200,000 and a coupon rate of 7%.
The current market price for the bond is $198,148.
What is the cost of debt?
cost of debt = [(coupon payment + face value) / market price] - 1
[( 200,000 + 14,000) / 198,148] - 1
( 200,000 x 1.07 ) / 198,148] - 1 = 8%
Market price of debt security
coupon payments: the amount you'll be getting over the period of the bond, as interest on that bond
every bond will have a certain percentage so if it's a fixed interest security it might say 4% on the face value and you'll always get that
PV of the face value repayment: at the end of the term of the bond that amount has to be refunded back or paid back - to whoever has invested in the bond
P0: present value
C: coupon payment
kd: market yield
Fn: face value
A 3-year bond with a face value of $100,000 and market yield of 4% carries a coupon of 6% per annum paid annually
P0 of coupon payments = [($6,000/0/04)(1-1/(1+0.04)^3] = $16,650.55
P0 of face value repayments = [$100,000/(1+0.04)^3] = $88,899.64
P= $105,550.19
A 3-year bond with a face value of $100,000 and market yield of 4% carries a coupon of 6% per annum paid semi-annually
P0 of coupon payments = [($3,000/0/02)(1-1/(1+0.02)^6] = $16,804.29
P0 of face value repayments = [$100,000/(1+0.02)^6] = $88,797,14
P= $105,601.43
market price is how much you could be able to sell this bond
Cost of debt
coupon rates are not the cost of debt (although they can be the same in some situations)
if coupon rate < cost of debt, then market price < face value (vice versa)
E.g.
coupon rate: 4%
cost of debt: 6%
meaning, you are stuck with this 4% fixed history Interest security, whereas in a market you could have gotten 6%. Therefore, the market price of that bond will be less than its face value.
Cost of equity
= shareholders
unsystematic risk = very inherent to that company
assumed to be removed through diversification of a portfolio
Does the capital asset pricing model use systematic risk or unsystematic risk?
systematic risk, because the CAPM assumes that you have a well diversified portfolio
CAPM specifies the relationship between a security's systematic risk and its required return
Risk-free interest rate: equivalent to government Treasury bond - risk of default is really low
Expected return on market portfolio: you will tend to expect a higher return than a risk-free interest rate
Expected market risk premium: difference between the expected return and the risk-free rate
Beta: systemic risk that cannot be diversified away (inherent in the market)
Assume the cost of equity for ZYX is 16.5%
1. If the risk-free interest rate is 3% and the market risk premium is 9%, what is the beta for ZYX?
ke = rf + market risk premium x β
16.5% = 3% + [9%] x β
13.5%/ 9% = β
β = 1.5
2. What would be the cost of equity for ZYX if its beta was 2 and the relevant risk free interest rate increased to 4%?
ke = rf + [expected return - rf] x β
ke = 4% + [12-4%] x 2 = 20%
The current risk-free rate is 5% and the expected market risk premium is 7%. CBF Ltd has a beta of 1.1.
Using the CAPM, what is CBF's cost of equity?
ke = rf + [expected return - rf] x β
ke = 5% + [7%] x 1.1 =12.7%
Cost of preference shares
P = Dp / kp (for non-redeemable preference shares, the cash flows are a perpetuity)
kp = Dp /P (rearranged for kp)
If annual dividends are $2 and the current preference share price is $35.
kp = $2/ $35 = 5.72%
If annual dividends are 10% of the $8 preference share issue price, and the current preference share price is $20:
kp = (10% x $8)/ $20 = 4%
C.2. Weighted average cost of capital
weighted average cost of capital
FRM Week 3 - Pre webinar activity
ZYX Ltd is financed by debt, preference shares and equity.
The book values and market values of each, and their respective market coats, are provided below.
What is ZYX Ltd's weighted average cost of capital?
weighted cost
debt: (2.4/8.8) * 4.5% = 1.23%
preference shares: (1.2/8.8) * 7.5% = 1.02%
equity: (5.2/8.8) * 16.5% = 9.75%
WACC = 12%
C.3. Weighted average cost of capital with taxes
maintain consistency both over time and between investments
align with cash flows (pre-tax v post-tax)
cost of debt is generally provided before tax
cost of preference share is generally provided after tax
cost of equity is generally provided after tax
convert to before tax: divide by (1 - tax rate)
convert to after tax: multiply by (1 - tax rate)
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