Financial Management

Three components of a firm’s credit policy

The three primary components of a firm’s credit policy are credit standards, payment date, and price changes.

  • Credit standards are the rules the company uses to determine which customers are acceptable credit risks. This is generally done by performing a credit analysis of the potential customer to get a sense of its financial health and whether it rigorously pays its obligations.
  • Payment date is the date on which the customer is asked to pay, often a set number of days from receipt of the product or the invoice.
  • Price changes are often used to motivate prompt payment. The traditional way to change prices is through a discount for early payment, although today, many companies charge a fee (effectively interest) instead for each month payment is late.

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Costs and benefits of maintaining inventories

What are the costs and benefits of maintaining inventories? What does this tell you about the movement toward just-in-time systems?

The costs of maintaining inventories include the cost of the capital used to purchase them; the cost of ordering them purchasing, transportation, receiving, inspection, and accounting; and the cost of storing them including warehousing, handling and data management, insurance, and shrinkage.

A merchandising company generally requires inventory so it has something to sell when a customer comes into the store or places an order. In a manufacturing company, the traditional benefit of carrying inventories is to decouple the purchasing, manufacturing, and sales processes, so each can run at its own optimal pace. Today many manufacturing companies are discovering another category of cost to maintaining inventories, inefficiencies in production processes that are masked by the ability to put defective inventory aside and rework it later.

These costs can be so great compared to the other costs of maintaining inventories, that they have led to a rethinking of optimal inventory policy. Today, many companies have adopted some form of just-in-time manufacturing, in which raw materials inventory arrives immediately before entering production, work-in-process is kept to an absolute minimum, and finished goods are shipped as soon as they come off the line. Companies are establishing customer-supplier alignments, often with a single supplier for each item, to insure the quality and on-time delivery of raw materials. They are re engineering their production processes to remove defects and build inspection in to every step on the line.

Many companies no longer produce to a plan, but only to customer orders to minimize finished goods. These companies, where the traditional benefits of inventories are no longer needed or even wanted, see no benefits any more to paying the costs.

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In what way is business leverage similar to physical leverage?

Both types of leverage involve magnification. In both, we carefully construct our system to produce the magnified result. The differences are in what is magnified income vs. physical force, and what serves as the lever fixed costs vs. a mechanical device.

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Distinguish between operating leverage and financial leverage

Both operating and financial leverage result in the magnification of changes to earnings due to the presence of fixed costs in a company’s cost structure. The difference is only the part of the income statement we are looking at. Operating leverage is the magnification on the top half of the income statement¾how EBIT changes in response to changes in sales; the relevant fixed cost is the fixed cost of operating the business. Financial leverage is the magnification on the bottom half of the income statement¾how earnings per share changes in response to changes in EBIT; the relevant fixed cost is the fixed cost of financing, in particular interest.

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How much choice does a firm have over its operating leverage? Over its financial leverage?

Choice over operating leverage depends on the technologies available to a company. Some companies have little control over their operating leverage. For example, airlines which have no substitute for airplanes and their associated support systems can only operate with a large investment in fixed assets that create fixed costs. Other companies have a significant degree of control over their operating leverage. Many manufacturing companies, for example, can choose to produce using automated equipment or piecework labor. By contrast, most firms have total control over their financial leverage through their choice of financing (the exception is small firms that have limited access to financial markets, hence limited financing alternatives). A company can increase its financial leverage by using debt financing and can avoid financial leverage through financing with equity.

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Describe the way in which earnings per share responds to changing EBIT in a firm with

a. No fixed financing costs. A firm with no fixed financing costs has no financial leverage. In such a firm, earnings per share will rise and fall with EBIT by the same percentage. For example, a 15% increase in EBIT will result in a 15% increase in EPS; a 9% decrease in EBIT will result in a 9% decrease in EPS.

b. Some fixed financing costs. A firm with some fixed financing costs does have financial leverage. In such a firm, earnings per share will rise and fall with EBIT by a greater percentage. For example, a 15% increase in EBIT will result in a more-than-15% increase in EPS; a 9% decrease in EBIT will result in a more-than-9% decrease in EPS.

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How does a firm’s financial leverage affect: Financial leverage changes a firm’s returns and risk.

a. Its profitability? Financial leverage changes a firm’s earnings per share. To the left of the indifference point (lower EBIT) between financing alternatives financial leverage reduces EPS. To the right of the indifference point (greater EBIT) EPS is increased as the firm takes on financial leverage. This observation indicates the importance of knowing the indifference point and where a company’s level of EBIT is relative to it.

b. Its level of risk? Financial leverage increases the volatility of a firm’s earnings per share. As a firm increases its financial leverage, its EPS will rise and fall by magnified amounts in response to changes in EBIT. This makes the EPS stream riskier for investors. Also, the possibility that EPS could be lower than if there were less financial leverage (if EBIT is left of the indifference point) and the power over the firm given to creditors should the firm have difficulty paying its debts create additional risks for shareholders.

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EBIT levels

A firm is considering two alternative capital structures, and has calculated its profitability at various EBIT levels under each structure. What should the firm do if its projected EBIT is:

a. Below the indifference point? In this case, choose the capital structure with the lower degree of financial leverage. If EBIT is below (to the left of) the financing indifference point, higher financial leverage would decrease EPS (lower return) as it increases the volatility of the EPS stream (higher risk). However, lower financial leverage would increase EPS (higher return) and decrease the volatility of the EPS stream (lower risk), the combination preferred by risk-averse investors.

b. Above the indifference point? In this case, the choice of capital structure is not obvious, since there is a tradeoff between the effects of financial leverage on risk and return. If EBIT is above (to the right of) the indifference point, higher financial leverage would increase EPS (higher return) but also increase the volatility of the EPS stream (higher risk). Lower financial leverage would decrease EPS (lower return) and decrease the volatility of the EPS stream (lower risk). Further analysis is required to identify which capital structure provides investors with the best risk-return combination.

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Net income approach

Compare and contrast the “net income approach,” “net operating income approach,” and “traditional approach” to the optimal debt-equity mix. Which assumptions do you find reasonable? Unreasonable?

The net income approach, net operating income approach, and traditional approach are three theoretical frameworks for how a company should set its debt-equity mix. All three examine how a company’s cost of capital changes with the debt-equity mix and search for the lowest value of the cost of capital, hence the maximum value of the firm, to identify the best mix. They reach different conclusions because they make different assumptions about creditors’ and investors’ reactions to increasing debt. Each of us will have our own feelings about the reasonableness of the assumptions. Without going into the Modigliani-Miller mathematics, the assumptions of the traditional approach usually seem most reasonable to most people.

(1) The net income approach makes the simplest assumptions, that neither creditors nor investors increase their required rates of return as a company takes on debt. The cost of capital declines as higher-cost equity is replaced with lower-cost debt. This approach concludes that the optimal financing mix is all debt.

(2) The net operating income approach assumes that creditors do not increase their required rate of return as a company takes on debt, but investors do. Further, the rate at which investors increase their required rate of return as the financing mix is shifted toward debt exactly offsets the weighting away from the more expensive equity and toward the cheaper debt. The result is that the cost of capital remains constant regardless of the financing mix. This approach concludes that there is no optimal financing mix¾any mix is as good as any other.

(3) The traditional approach assumes that both creditors and investors increase their required rates of return as a company takes on debt. At first this increase is small, and the weighting toward lower-cost debt pushes the cost of capital down. Eventually, the rate at which creditors and investors increase their required rates of return accelerates and dominates the weighting toward debt, pushing the cost of capital back upward. The result is that the cost of capital declines with debt and reaches a minimum point before rising again. This approach concludes that there is a optimal financing mix consisting of some debt and some equity.

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Describe “homemade leverage.”

Homemade leverage is investors’ method of substituting their own borrowing or lending for corporate borrowing. Investors who want more leverage than a company has taken on can buy the company’s stock on margin that is, borrow money from a broker and use the borrowed funds to pay for a portion of the stock in order to add to the corporate borrowing. Investors who want less leverage than the company has taken on can invest a portion of their funds in a risk-free investment to offset some of the corporate borrowing. MM argued that homemade leverage was a perfect substitute for corporate borrowing, given their assumptions. As a result, investors do not care how much debt any firm has since they can use homemade leverage to adjust their overall debt exposure to precisely reproduce the effect of any level of corporate debt on their returns and risk.

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