Financial Management

Cumulative and non-cumulative preferred stock

Is there any difference in value between cumulative and non-cumulative preferred stock? Why, or why not?

While the difference is minimal in financially healthy companies, there is a significant difference in companies in financial distress. A company with outstanding cumulative preferred stock cannot pay dividends on its common stock unless all past dividends on the preferred issue have been fully paid. Financially healthy companies routinely pay all preferred dividends; to the preferred shareholders of these firms, the cumulative feature adds little value to the issue because it is highly unlikely that it will ever be invoked. However, companies in financial distress often are cash poor and elect to suspend preferred dividends in order to conserve their cash. To the preferred shareholders of these firms, the cumulative feature is critical to maintaining any value to the preferred shares at all.

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Why do companies issue warrants?

Companies issue warrants for at least three reasons:

(1) as the mechanism for conveying preemptive rights to their shareholders (“stock subscription warrants”),
(2) as incentive compensation for employees (“employee stock options”), and
(3) as extra compensation for lenders and preferred stockholders (“sweeteners,” “kickers”).

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Why do companies issue convertible bonds?

Companies issue convertible bonds for at least four reasons:
(1) to minimize the interest rate on their debt since the conversion feature forms part of the lenders’ value,
(2) to raise funds in a poor stock market that will eventually become equity at a much better share price,
(3) to create financial leverage for a period of time which then disappears upon the bonds’ conversion, and
(4) to use and then automatically free up debt capacity.

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Warrant and a convertible bond

What is the relationship of a warrant and a convertible bond to a call option?

Both a warrant and a convertible bond contain a call option. A warrant is a call option. The holder of the warrant can force the company to deliver a specified number of shares of its stock to be paid for with cash. Warrants differ from other call options only in that they are issued by the company whose stock can be called. A convertible bond is the combination of a bond and a call option. The bond’s owner can force the company to deliver a specified number of shares of its stock to be paid for with the bond. And, like a warrant, the option is granted by the company whose stock can be called.

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Conversion of a convertible bond

Under what circumstances can a company successfully force conversion of a convertible bond? Under what circumstances will the company fail?

Since holders of convertible bonds generally have no reason ever to convert the bonds to stock, companies often use a call feature to force conversion. Bondholders will convert their bonds in response to a call if the value of the stock to be received upon conversion exceeds the proceeds from the call. This will be the case if the stock has risen sufficiently since the bond was issued. On the other hand, if the company’s stock price has not increased very much so that the value to be received upon conversion is less than the proceeds from the call, bondholders will simply submit to the call and the company will find itself paying out cash instead of issuing new stock.

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Utilitarianism Consequentialism

Introduction
Utilitarianism (Thrift Edition)   — Kotchian values consequences (protection of jobs and investment in company) over
     potential violation of duty (responsibilities of government officials to uphold the law)
   — Moral dilemma:  Consequences (teleological theory) vs. Duty (deontological theory)
   — Utilitarianism focuses more on the consequences of an action
  ∙  Two Types of Ethical Theories
   — Utilitarianism vs. Kantian ethics (duty) vs. Virtue (i.e., Aristotle – not covered in the
       reading)
   — Teleological:  ends over means (judged by maximum balance of good over bad)
       ∙∙ Strengths:  in accord with most moral reasoning (makes sense), precise and
         objective method
       ∙∙ Weaknesses:  ignores promises and duties, does not take into consideration rights,
          justice, and obligations (i.e., free speech might do more harm, yet is a basic right)
   — Deontological:  actions are analyzed according to moral rules (duties)
       ∙∙ Strengths:  good when consequences are irrelevant (e.g., contracts, family
          obligations), examines motives (e.g., giving to charity for tax reasons or for
          compassion)      
       ∙∙ Weaknesses: rules seem arbitrary at times and potentially ethnocentric, no clear-
          cut priority among rules
∙  Classic Utilitarianism
   — Jeremy Bentham and John Stuart Mill –> created practical guide in English reform
      movement
Utilitarianism and Other Essays  — Bentham: “hedonistic calculation” means the sum of pleasure minus pain for all
     individuals affected by an action (> 0 = good, < 0 = evil) – critics argue is pleasure a
     sufficient measure of human happiness?
 — Mill:  injects overall happiness into calculation rather than just pleasure (quality
    besides quantity)

∙  The Forms of Utilitarianism
   — Classic (Act) Utilitarianism:  AN ACTION IS RIGHT IF AND ONLY IF IT
      PRODUCES THE GREATEST BALANCE OF PLEASURE OVER PAIN FOR
      EVERYBODY
      Key Features:  consequentialism (consequences), hedonism (pleasure), maximalism
      (greatest net balance between pleasure and pain), universalism (everybody included in the
     calculation)
  — Act Utilitarianism:  AN ACTION IS RIGHT IF AND ONLY IF IT PRODUCES THE
     GREATEST BALANCE OF PLEASURE OVER PAIN FOR EVERYBODY
vs.
  — Rule Utilitarianism: AN ACTION IS RIGHT IF AND ONLY IF IT CONFORMS TO A
     SET OF RULES THE GENERAL ACCEPTANCE OF WHICH WOULD PRODUCE
    THE GREATEST BALANCE OF PLEASURE OVER PAIN FOR EVERYONE
Cost Benefit Analysis: Concepts and Practice (3rd Edition)∙  Problems with Calculating Utility
  
— Difficulty in calculating how much, in identifying alternative courses, and
       accounting for differing preferences among different people
  — Lockheed did not account for the pain of other companies and might have been
      wrong under the utilitarian calculation
  — Cost-Benefit Analysis (used to select means and ends) vs. Cost Effective Analysis
    
(predetermined ends with least costly means)
  — Problems with CBA: difficult to put monetary value on non-market items, often
     understates value (ignores opportunity costs)
  — One advantage of utilitarianism is its transparency since any ethics theory is value-
     laden

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Activity Based Costing

Activity-based Cost Management: An Executive's GuideGoal of ABC: to establish a better cause-effect relationship between products and overhead costs
Traditional Costing:
§  Costs are divvied up based on the allocation base, e.g. Direct Labor Hours
§  Cost pools are typically departments, e.g. R&D, marketing, sales, finance, human resources
§  Divide cost pool by allocation base gives the allocation rate
§  Homogeneity of cost pool is not very strong
ABC Costing:
§  Costs are divvied up based cost drivers, e.g. number of customers, machine hours, etc
§  Cost pools are typically activities, e.g. design products, set up molding machine, distribute, etc
§  Divide cost pool by the cost driver gives the allocation rate
§  Homogeneity of cost pool is strong
Cost hierarchy:
§  Unit – costs that change with the level of units produced                      
§  Batch – costs that change with the number of batches produced
§  Product – costs that change with the number of products supplied
§  Facility – costs that do not change much with the change in volume     

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Standard Costing – Alternative Costing Systems

Updating Standard Cost SystemsStandard costing:
Based on standard (budgeted) values rather than on actual results. 
Static budget:
Used for standard costing.  Created in an income statement format that summarizes the expected performance at the beginning of the budgeting period.  The volume that is used is the expected production (or sales) volume.
Flexible budget:
The flexible budget is the budget that is created at the end of the year that represents the actual volume produced (or sold) during the specified period.
Flexible Budget Variance:
Difference between the static budget and the flexible budget.  To determine what the reasons are for the variance, the following variances are calculated by changing one variable at a time:
Volume Variance:
This variance estimates the impact on profits of changes in sales volume
Volume Variance = (Actual volume – Budgeted volume) x Budgeted contribution margin
Efficiency Variance:
This variance estimates the impact of changes in efficiency use of inputs
Efficiency variance = (Budgeted quantity – Actual quantity) x Budgeted price of inputs
Sales Price Variance:
This variance estimates the impact on profits of changes in mix of sales
Sales price variance = (Actual price – Budgeted price) x Actual volume

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Cost Accounting – Review

Schaum's Outline of Cost Accounting, 3rd, Including 185 Solved ProblemsProduct costs:
– Costs that can be attributed to the generation and delivery of individual products
– Also called “inventoriable” costs and are capitalized in the WIP accounts
Period costs:
– Costs that are attributable to time periods
– Period costs are not capitalized in inventory accounts and go directly to the income statement
– Only appear on income statement as COGS when the product is sold
Direct costs:
– Costs that can be directly related to a cost object
– Includes both variable (varies with volume) and fixed costs (doesn’t vary in specified time span)
– Direct materials: materials that are used in production that end up as part of the finished product
– Direct labor: wages for the workers who are directly involved in the production process
Direct fixed costs: Example: machines à how to estimate cost per unit of fixed costs is an issue
Direct variable costs: Example: material, labor
Indirect costs (Overhead costs):
– Costs that cannot be directly related to a cost object à how to estimate cost per unit is an issue
– Includes both variable (varies with volume) and fixed costs (doesn’t vary in specified time span)
– Examples: spare parts for machines, electric power, supervisor’s salary
– Indirect materials: materials used in production that do not end up as part of finished product
            – Example: supplies and spare parts for machines
– Indirect labor: costs of workers who work in the factory but not directly on the mfg process
            – Example: the factory foreman
Indirect fixed costs: Examples: finance staff, a machine that is used by more than product
Indirect variable costs: Examples: sales force
Relevant costs: used for decision making
– Depends on decision under consideration, no universal method for classifying relevant costs
– Usually variable costs are relevant and fixed costs are not but it depends on the situation
Contribution Margin:
Relevant costs are frequently equal to variable costs
Contribution margin = Price – variable costs (direct, indirect, manufacturing, and SG&A)
Profit = Contribution margin – fixed costs/volume
Breakeven volume (where profit = 0) = fixed costs / contribution margin
Note:
When determining which product to produce you should select the product with the highest contribution margin per unit volume on the capacity constraint assuming that fixed costs do not change.

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Financing a Business expansion

Enterprise and Venture Capital: A Business Builder's and Investor's Handbook

1.  Reserves

Are profits, which are ploughed back into the business to create growth? This form of finance is suitable for organic growth as the pace of the expansion can be matched to the funds available. Are used to finance the purchase of new buildings or equipment. They have no direct cost for a company but take along time to build up.

2.  Share Capital

Referred to as the equity of the company. This is money imputed into the firm by the individual shareholders. As the firm makes money, the shareholders receive a % dividend on their investment. However if the firm’s profits are low, the individual dividend will be low.

3.  Loan Capital

Is the long-term finance provided by financial institutions? Long-term loans are called debentures. When applying for a loan to finance expansion, a company has to supply the bank with accounts showing the present state of the business. Also needed are cash flow forecasts, costings, and research.

Information needed before any loan is granted includes:

Creditworthiness of borrower
Purpose of loan
Capacity to repay
Amount of loan
Security offered
Duration of loan

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