Chapter 13

Q: How do you compute the expected return and standard deviation for an individual
asset? For a portfolio?

Expected Return and Standard Deviation for an Individual Asset:

Expected Return:

The expected return of an individual asset is calculated as the weighted average of the possible
returns, where each potential return is multiplied by its respective probability of occurrence.
Mathematically, it can be expressed as:

Expected Return=∑(Probability of Return×Possible Return)Expected

Return=∑(Probability of Return×Possible Return)

Standard Deviation:

The standard deviation measures the dispersion or variability of returns around the mean
expected return. It is a measure of the asset's risk. The formula to compute the standard
deviation is:

Standard Deviation=∑(Probability of Return×(Possible Return−Expected

Return)2)Standard Deviation=

∑(Probability of Return×(Possible Return−Expected Return)

Expected Return and Standard Deviation for a Portfolio:

Expected Return:

For a portfolio, the expected return is calculated similarly to an individual asset but considers
the weighted average of the expected returns of the assets within the portfolio, where the
weights are the proportions of each asset's investment in the portfolio.

Standard Deviation:

The standard deviation of a portfolio takes into account both the individual asset's volatility and
the correlation between the assets within the portfolio. The formula involves computing the
weighted sum of the squared standard deviations of the assets and their pairwise covariances,
considering their respective weights in the portfolio.

Q: What is the difference between systematic and unsystematic risk?

Systematic Risk:
Systematic risk, also known as market risk, is the risk that cannot be diversified away by holding
a diversified portfolio. It is related to factors affecting the entire market, such as changes in
interest rates, economic conditions, political events, etc. Systematic risk influences the overall
market and affects a broad range of assets.

Unsystematic Risk:

Unsystematic risk, also known as specific or diversifiable risk, is the risk that can be mitigated
through diversification. It is associated with factors specific to a particular company or industry,
such as management issues, competitive pressures, regulatory changes, etc. U nsystematic
risk can be reduced by holding a diversified portfolio of assets.

Q: What type of risk is relevant for determining the expected return?

The relevant risk for determining the expected return is primarily systematic risk. Investors are
compensated for bearing systematic risk because it cannot be diversified away. Therefore, the
expected return for an asset or a portfolio is primarily determined by its exposure to systematic
risk factors, such as beta in the Capital Asset Pricing Model (CAPM).

In summary, understanding how to compute expected return and standard deviation for assets
and portfolios is crucial in evaluating investment opportunities. Moreover, distinguishing
between systematic and unsystematic risk helps investors manage their portfolios effectively
by focusing on factors that impact returns and risk that cannot be diversified away. When
determining expected returns, it's the systematic risk that plays a pivotal role in setting the
required return for a given level of risk.

Concept Questions

13.2c Is there a simple relationship between the standard deviation on a portfolio and
the standard deviations of the assets in the portfolio?

The relationship shows that the portfolio standard deviation considers the weighted
contributions of the individual asset variances and covariances between assets within the
portfolio.

Understanding portfolio weights, calculating expected portfolio returns, and grasping the
relationship between portfolio standard deviation and asset standard deviations are
fundamental concepts in constructing and managing diversified investment portfolios.

13.5a What happens to the standard deviation of return for a portfolio if we increase
the number of securities in the portfolio?
13.5b What is the principle of diversification?

13.5c Why is some risk diversifiable? Why is some risk not diversifiable?

13.5d Why can’t systematic risk be diversified away?

13.5a - Impact of Increasing Securities on Portfolio Standard Deviation:

When we increase the number of securities in a portfolio, the standard deviation of the portfolio
tends to decrease. This phenomenon is known as the "Diversification Effect."

As more securities are added to a portfolio, their individual risks tend to offset each other due to
their imperfect correlations. By combining assets with less than perfect positive correlations (or
negative correlations), the unsystematic or idiosyncratic risk associated with individual
securities is mitigated. Consequently, the portfolio becomes less volatile overall, leading to a
reduction in the portfolio's standard deviation.

13.5b - Principle of Diversification:

The principle of diversification is a fundamental tenet in finance that suggests spreading

investment across various assets or securities to reduce overall risk. By holding a diversified
portfolio comprising assets with different risk profiles and correlations, investors can potentially
minimize unsystematic risk, also known as diversifiable risk.

13.5c - Diversifiable and Non-Diversifiable Risk:

● Diversifiable Risk: Also known as unsystematic risk, it is specific to a particular

company, industry, or asset. This risk can be mitigated or eliminated through
diversification. Examples include company-specific events, management changes, and
industry-related risks. Diversifiable risks can be reduced by holding a diversified portfolio
of assets whose returns are not perfectly correlated.

● Non-Diversifiable Risk: Also known as systematic risk, it is inherent in the entire market
or economy. It cannot be diversified away because it affects the overall market and is
beyond the control of individual investors. Factors such as interest rate fluctuations,
political events, economic conditions, and market volatility contribute to systematic risk.
This risk remains even in a well-diversified portfolio.

13.5d - Inability to Diversify Systematic Risk:

Systematic risk, also referred to as market risk, cannot be diversified away because it affects
the entire market. It is associated with broad economic, political, and market factors that impact
the prices of all securities. Since systematic risk influences the overall market, it cannot be
reduced by holding a diversified portfolio because it is not specific to individual assets.
Investors are compensated for bearing systematic risk through the risk premium, as it cannot
be eliminated through diversification.

In summary, increasing the number of securities in a portfolio tends to reduce the portfolio's
standard deviation due to the diversification effect, as it helps offset individual securities' risks.
However, while diversification can significantly reduce unsystematic risk, systematic risk
persists and cannot be diversified away due to its market-wide nature.

13.7a What is the fundamental relationship between risk and return in well-functioning
markets?

13.7b What is the security market line? Why must all assets plot directly on the SML in
a well-functioning market?

13.7c What is the capital asset pricing model (CAPM)? What does it tell us about the
required return on a risky investment?

13.7a - Fundamental Relationship between Risk and Return:

In well-functioning markets, the fundamental relationship between risk and return is described
by the principle that investors require a higher expected return for bearing higher levels of risk.
This relationship is embodied in the concept of the risk-return tradeoff. Investors are generally
unwilling to accept greater risk without the potential for higher expected returns as
compensation.

13.7b - Security Market Line (SML) and Asset Plotting:

The Security Market Line (SML) is a graphical representation of the Capital Asset Pricing Model
(CAPM) that depicts the relationship between expected return and systematic risk (measured by
beta). In a well-functioning market, all assets must plot directly on the SML because the SML
represents the required return for assets given their systematic risk within the market.

Assets that plot above the SML are considered to offer returns higher than what their level of
risk justifies, implying they are underpriced. Conversely, assets that plot below the SML are
considered to offer returns lower than what their risk level justifies, indicating they are
overpriced.

13.7c - Capital Asset Pricing Model (CAPM) and Required Return:

The Capital Asset Pricing Model (CAPM) is a financial model used to determine the expected
return on an investment based on its risk (beta) and the risk-free rate of return, along with the
market risk premium. The CAPM equation is:

The CAPM tells us that the required return on a risky investment compensates investors for
bearing systematic risk. This model assumes that investors are rational and seek to maximize
their returns for a given level of risk, hence requiring compensation for taking on systematic risk
beyond the risk-free rate.

In summary, the fundamental relationship between risk and return suggests that higher levels of
risk should be accompanied by higher expected returns. The SML illustrates this relationship,
while the CAPM quantifies the required return on a risky investment based on its systematic risk
in relation to the market.
13.8a If an investment has a positive NPV, would it plot above or below the SML? Why?

13.8b What is meant by the term cost of capital?

Investment with Positive NPV and its Position relative to SML:

An investment with a positive Net Present Value (NPV) is considered attractive since it
generates returns higher than the initial investment's cost. Such an investment would typically
plot above the Security Market Line (SML) in a graph depicting risk-return relationships.

Reasoning:

● Positive NPV: An investment with a positive NPV signifies that its expected returns are
higher than the cost of the investment (the required return).

● Position above SML: The SML represents the required return for assets based on their
systematic risk (beta). An investment with positive NPV has higher expected returns
than the SML's required return for its level of risk. Therefore, it would plot above the SML,
indicating that it offers higher returns than what is justified by its systematic risk.

13.8b - Meaning of Cost of Capital:

The term "cost of capital" refers to the cost a company incurs to finance its operations and
investments. It represents the required rate of return that a company must generate on its
investments to satisfy its investors and creditors.

Components of Cost of Capital:

Cost of Equity: The return expected by shareholders given the risk of the company's equity
investments.

Cost of Debt: The interest rate paid by the company to borrow funds from debt holders.

Weighted Average Cost of Capital (WACC): The weighted average of the costs of equity and
debt, taking into account their proportional weights in the company's capital structure.

Importance:

● Investment Evaluation: Companies use the cost of capital as a benchmark to evaluate

potential investment projects. If an investment's expected return is lower than the cost
of capital, it may not be considered financially viable.

● Capital Budgeting Decisions: The cost of capital plays a crucial role in determining the
hurdle rate or minimum acceptable rate of return for investment projects.

Chap 14
 ● What are the two approaches for computing the cost of equity?

There are two primary approaches to compute the cost of equity:

Dividend Growth Model (Dividend Discount Model - DDM): This approach uses the Gordon
Growth Model or other variations like the Dividend Growth Model to estimate the cost of equity
based on expected dividends and growth rates.

Capital Asset Pricing Model (CAPM): CAPM calculates the cost of equity using the risk-free
rate, market risk premium, and beta of the stock to determine the expected return demanded by
investors for bearing systematic risk.

● How do you compute the cost of debt and the after-tax cost of debt?

Cost of Debt: The cost of debt is typically computed as the yield to maturity (YTM) on the
company's existing debt or by considering the current market interest rates for similar debt
instruments.

After-Tax Cost of Debt: To calculate the after-tax cost of debt, the cost of debt is adjusted by
subtracting the tax savings resulting from the tax-deductibility of interest expenses. The
formula is: After-Tax Cost of Debt = Cost of Debt × (1 - Tax Rate)

● How do you compute the capital structure weights required for the WACC?

The capital structure weights required for calculating the Weighted Average Cost of Capital
(WACC) are determined by dividing the market value of each component of the capital structure
(debt, equity, preferred stock) by the total market value of the firm.

● What is the WACC?

WACC represents the average cost of funds employed by a company, calculated as the
weighted average of the cost of equity, cost of debt, and cost of preferred stock, weighted by
their respective proportions in the capital structure.

● Formula: WACC = (Weight of Equity × Cost of Equity) + (Weight of Debt × Cost of Debt) +
(Weight of Preferred Stock × Cost of Preferred Stock).

● What happens if we use the WACC for the discount rate for
all projects?

If WACC is used as the discount rate for all projects, it assumes that the projects have the same
risk as the company's overall operations. This approach might be appropriate for projects with
similar risk profiles as the company.

● What are two methods that can be used to compute the appropriate discount rate
when WACC isn’t appropriate?

Two methods to compute appropriate discount rates when WACC isn't appropriate include:
 Adjusted Present Value (APV): Incorporates the specific financing and risks associated
with individual projects.

Risk-Adjusted Discount Rate: Uses different discount rates based on the risk level of
each project or investment.

● How should we factor flotation costs into our analysis?

Flotation costs (costs associated with issuing new securities) can be factored into analysis by
adjusting the cost of new equity or debt to reflect these costs. Adjustments are made by
incorporating the flotation costs into the cost of equity or debt.
Chapter 16
•Explain the effect of leverage on EPS and ROE.

Effect of Leverage on EPS and ROE:

EPS (Earnings Per Share):

● Leverage magnifies the impact of operating income on EPS. With debt financing,
interest payments are fixed, leading to higher EPS as net income increases.
However, excessive leverage can lead to higher interest expenses, reducing EPS
if operating income declines.
ROE (Return on Equity):
● Leverage amplifies ROE as it allows a company to generate higher returns on
equity capital than it would without leverage. However, increased financial risk
due to higher debt levels may result in higher variability in ROE.

•What is the break-even EBIT, and how do we compute it?

● Break-even EBIT (Earnings Before Interest and Taxes) is the level of EBIT at which a
company's earnings are just sufficient to cover its fixed costs and result in zero
operating income (neither profit nor loss).

● The formula to compute Break-even EBIT is: Break-even EBIT = Fixed Costs / (1 - Tax
Rate).

•How do we determine the optimal capital structure?

● The optimal capital structure is achieved when the cost of capital is minimized, resulting
in maximizing the firm's value.
● It involves finding the mix of debt, equity, and other securities that minimizes the
Weighted Average Cost of Capital (WACC).

•What is the optimal capital structure in the three cases that were discussed in this
chapter?
1. No Taxes: In this case, the optimal capital structure is 100% equity as there are no tax
benefits from debt.

2. Corporate Taxes: The optimal capital structure involves a mix of debt and equity where the
tax benefits of debt outweigh the costs of financial distress.

3. Corporate Taxes and Financial Distress Costs: The optimal capital structure balances the tax
advantages of debt with the costs of potential financial distress due to excessive leverage.

•What is the difference between liquidation and reorganization?

 ● Liquidation: Involves winding up a company's operations, selling its assets, and
distributing the proceeds to creditors and shareholders according to a predetermined
order of priority. It typically occurs when a company is unable to meet its financial
obligations and ceases operations permanently.
● Reorganization: Refers to a process where a financially distressed company seeks to
restructure its operations, debts, or ownership to regain financial stability and continue
operating. It often involves negotiating with creditors, restructuring debts, and
implementing changes to improve the company's financial health.

Q: Suppose managers of a firm know that the company is approaching financial

distress. Should the managers borrow from creditors and issue a large one-time
dividend to shareholders? How might creditors control this potential transfer of wealth?

In the scenario where managers are aware of the company approaching financial distress, the
decision to borrow from creditors and issue a large one-time dividend to shareholders can be
controversial and may raise ethical and fiduciary duty concerns.

Borrowing and Issuing Large Dividends:

Managerial Considerations:
Ethical and Fiduciary Responsibilities: Managers have a fiduciary duty to act in the best
interests of the company and its stakeholders. Borrowing funds with the intention of
issuing a large dividend, especially when the company is on the brink of financial
distress, could be seen as prioritizing shareholders over creditors.
Risk of Aggravating Financial Distress: Taking on additional debt to pay a substantial
dividend might worsen the financial condition of the company. It could exacerbate
financial distress by increasing interest obligations, impacting the company's ability to
meet future debt payments, and worsening its creditworthiness.
Potential Legal Implications: Depending on the circumstances, such actions might be
perceived as fraudulent conveyance if creditors believe it was intended to hinder their
ability to recover debts in the event of insolvency.

Creditor Control over Wealth Transfer:

Creditors have several mechanisms to control potential wealth transfers from borrowing and
dividend payouts:

Covenants in Loan Agreements: Creditors often include restrictive covenants in loan

agreements that limit the company's ability to take actions like paying large dividends
without the creditors' consent.
Monitoring and Credit Ratings: Creditors closely monitor a company's financial health. If
they observe signs of financial distress or actions that jeopardize their interests, they
might react by downgrading the company's credit rating or demanding immediate
repayment of debts.
Legal Remedies: Creditors can take legal action if they perceive actions taken by the
company's management as detrimental to their interests. They may challenge dividend
payments made while the company was insolvent or close to insolvency.
Conclusion:

In situations where a company is on the verge of financial distress, borrowing to pay large
dividends might not be advisable due to the potential negative implications for the company's
financial health, stakeholder trust, and legal obligations. Managers should act prudently,
considering the broader implications on the company and its various stakeholders, including
creditors, to avoid exacerbating financial difficulties and potential legal repercussions.
Chapter 17
What are the different types of dividends, and how is a dividend paid?

What is the clientele effect, and how does it affect dividend policy relevance?

What is the information content of dividend changes?

What are stock dividends, and how do they differ from cash dividends?

How are share repurchases an alternative to dividends, and why might investors prefer
them?

Types of Dividends and Dividend Payment:

Cash Dividends: These are payments made by a company to its shareholders in the form of
cash from the company's profits or reserves.
Stock Dividends: Companies distribute additional shares of their own stock to shareholders,
usually in proportion to their existing holdings.

Dividend Payment Process:

● Dividends are typically declared by a company's board of directors, announced to

shareholders as a set amount per share or a percentage of share value.
● After declaration, there's a record date (shareholders registered by this date receive
dividends) and a payment date when dividends are distributed to eligible shareholders.

Clientele Effect and Dividend Policy Relevance:

● The clientele effect refers to the tendency of investors to prefer certain dividend policies
based on their own income needs, tax situations, and risk preferences.
● For example, investors in high tax brackets might prefer low or no dividend payments to
avoid immediate taxation. In contrast, investors seeking regular income might prefer
higher dividend-paying stocks.
● The clientele effect influences the relevance of dividend policy as companies often
adjust dividend policies to attract and retain specific types of shareholders.

Information Content of Dividend Changes:

● Changes in dividend policy often convey information to the market about a company's
future prospects and financial health.
● Positive Signal: A dividend increase might signal confidence in future earnings, financial
stability, and positive growth prospects.
 ● Negative Signal: Conversely, a dividend cut or omission might indicate financial
difficulties or uncertainty about future earnings.

Stock Dividends vs. Cash Dividends:

● Stock Dividends: Involve distributing additional shares to existing shareholders, often

expressed as a percentage of existing shares held. They do not result in cash outflows.
● Cash Dividends: Involves the distribution of cash from the company's profits or reserves
to shareholders. Shareholders receive a set amount per share in cash.

Share Repurchases as an Alternative to Dividends:

● Share repurchases involve a company buying back its own shares from the open market
or directly from shareholders.
● Advantages: Share repurchases offer flexibility, tax advantages for shareholders, and the
ability to signal confidence while avoiding commitments associated with regular
dividend payments.
● Investor Preference: Investors might prefer share repurchases as they can increase
earnings per share (EPS) by reducing the number of outstanding shares, potentially
leading to capital gains for shareholders.

In summary, dividends come in different forms (cash and stock), and their payment involves a
formal process. The clientele effect influences dividend policy relevance, while changes in
dividends convey information to the market. Share repurchases are an alternative to dividends
and offer flexibility and potential benefits for both companies and investors.
Chapter 18
•How do you compute the operating cycle and the cash cycle?
•What are the differences between a flexible short-term financing policy and a restrictive
one? What are the pros and cons of each?
•What are the key components of a cash budget?
•What are the major forms of short-term borrowing?

Answer

Computing Operating Cycle and Cash Cycle:

● Operating Cycle: The operating cycle is the duration required to convert inventory into
cash through sales. It's calculated as the sum of the days inventory outstanding (DIO)
and days sales outstanding (DSO).
● Operating Cycle = DIO + DSO
● Cash Cycle: The cash cycle represents the time it takes for a company to convert its
investments in inventory into cash receipts from customers. It's calculated as the
operating cycle minus the days payable outstanding (DPO).
● Cash Cycle = Operating Cycle - DPO

Differences Between Flexible and Restrictive Short-Term Financing Policies:

● Flexible Short-Term Financing Policy: Involves maintaining higher liquidity with greater
access to short-term financing. Pros include greater flexibility, ability to seize profitable
opportunities, and lower risk of cash shortages. However, it might result in higher costs
due to interest expenses.
● Restrictive Short-Term Financing Policy: Involves maintaining lower liquidity and
limiting reliance on short-term financing. Pros include lower interest expenses and
reduced risk of over-borrowing. However, it might lead to missed growth opportunities
and increased risk during unexpected cash needs.

Pros and Cons of Flexible vs. Restrictive Short-Term Financing:

● Pros of Flexible Financing: Improved liquidity, ability to capitalize on opportunities,

reduced risk of cash shortages.
● Cons of Flexible Financing: Higher interest costs, potential for over-borrowing and
increased risk.
● Pros of Restrictive Financing: Lower interest expenses, reduced risk of over-borrowing
and default.
● Cons of Restrictive Financing: Missed growth opportunities, potential inability to meet
unexpected cash needs.

Key Components of a Cash Budget:

A cash budget typically includes:

Cash Receipts: Expected cash inflows from sales, investments, loans, etc.
Cash Disbursements: Anticipated cash outflows including expenses, payments to suppliers,
taxes, etc.
Beginning Cash Balance: Initial cash on hand.
Ending Cash Balance: Calculated by adding beginning cash balance, cash receipts, and
subtracting cash disbursements.

Major Forms of Short-Term Borrowing:

Bank Loans: Traditional loans from banks with specified repayment terms and interest
rates.
Lines of Credit: Prearranged credit limits allowing companies to borrow as needed.
Commercial Paper: Short-term unsecured promissory notes issued by corporations to raise
funds.
Trade Credit: Extending payment periods with suppliers.

Understanding the operating cycle, cash cycle, financing policies, cash budget components, and
forms of short-term borrowing are crucial aspects of managing a company's working capital
and short-term financial needs.

18.1a What is the difference between net working capital and cash?
18.1b Will net working capital always increase when cash increases?
18.1c List five potential sources of cash.
18.1d List five potential uses of cash.
18.2a Describe the operating cycle and the cash cycle. What are the differences?
18.2b What does it mean to say that a firm has an inventory turnover ratio of 4?
18.2c Explain the connection between a firm’s accounting-based profitability and its
cash cycle.
18.3a What keeps the real world from being an ideal one in which net working capital
could always be zero?
18.3b What considerations determine the optimal size of the firm’s investment in
current assets?
18.3c What considerations determine the optimal compromise between flexible and
restrictive net working capital policies?
Give an example of an action that will increase cash.
What type of lending relies on a control agent to supervise inventory on behalf of a
lender

18.1a - Difference Between Net Working Capital and Cash:

● Net Working Capital: It represents the difference between a company's current assets
and current liabilities. It reflects a company's short-term liquidity position. Formula: NWC
= Current Assets - Current Liabilities.
 ● Cash: Refers to the actual currency and cash equivalents held by a company, including
physical cash, cash in bank accounts, and highly liquid investments.

18.1b - Net Working Capital and Cash Increase Relationship:

● Net Working Capital Increase with Cash Increase: Not necessarily. While an increase in
cash could lead to an increase in net working capital if it's held as a current asset, an
increase in cash might also occur without a corresponding increase in net working
capital if the cash is acquired through long-term financing or equity issuance.

18.1c - Five Potential Sources of Cash:

Operating Cash Inflows (e.g., sales revenue).

Proceeds from Debt Issuance (e.g., bank loans, bonds).
Equity Financing (e.g., issuing new shares).
Asset Sales (e.g., selling machinery, property).
Investment Income (e.g., dividends, interest).

18.1d - Five Potential Uses of Cash:

Operating Expenses (e.g., salaries, utilities).

Debt Repayment (e.g., interest payments, loan repayments).
Investments in Capital Expenditures (e.g., purchasing equipment, infrastructure).
Dividend Payments to Shareholders.
Working Capital Investments (e.g., inventory, accounts receivable).

18.2a - Operating Cycle vs. Cash Cycle:

● Operating Cycle: Represents the time it takes for a company to convert inventory into
cash through sales. It includes inventory holding period and accounts receivable
collection period.
● Cash Cycle: Reflects the time it takes for a company to convert resources into cash flow.
It involves the operating cycle minus the accounts payable payment period.

18.2b - Inventory Turnover Ratio of 4:

● An inventory turnover ratio of 4 implies that a company sells and replaces its inventory
four times within a specific period (usually a year). It indicates the efficiency of inventory
management, higher ratios often signify better inventory management.

18.2c - Connection Between Accounting-Based Profitability and Cash Cycle:

● A firm's accounting-based profitability metrics (such as return on assets - ROA) may not
necessarily correlate directly with its cash cycle. While higher profitability might suggest
efficient use of assets, the cash cycle provides insights into the efficiency of converting
those assets into cash.

18.3a - Factors Preventing Zero Net Working Capital:

 ● Varied Cash Needs: The real-world operating environment demands varying levels of
cash for operations, and immediate payments often result in a constant need for
working capital.

18.3b - Determinants of Optimal Investment in Current Assets:

● Factors include the company's sales volume, operating cycle, cash cycle, industry norms,
and growth expectations. Striking a balance between liquidity and profitability influences
the optimal level of investment in current assets.

18.3c - Determinants of Optimal Net Working Capital Policy:

● Considerations include the company's risk tolerance, industry volatility, market

conditions, and growth objectives. A flexible policy offers greater liquidity but higher
costs, while a restrictive policy minimizes costs but may limit growth opportunities.

Action to Increase Cash:

● One example is reducing non-essential expenses or selling underutilized assets to

generate immediate cash inflows.

Type of Lending with Control Agent Supervision:

● Asset-Based Lending: This type of lending relies on a control agent (often a bank or
financial institution) to supervise inventory on behalf of the lender to secure the loan
with assets such as inventory or accounts receivable.
Chap 19

Q: What is BAT model and its implication for business enterprise

Business Risk-Adjusted Return On Capital (RAROC):

● RAROC is a measure that considers both the return generated and the risk
associated with a particular business or project.

● It involves adjusting the return on capital based on the level of risk undertaken.
Higher-risk activities or projects require higher returns to compensate for the
increased risk.

Economic Value Added (EVA):

● EVA is a financial performance metric that assesses a company's ability to

generate value above its cost of capital.

● It subtracts the company's cost of capital from its net operating profit after tax
(NOPAT), adjusted for the economic use of capital.

Implications for Business Enterprises:

Performance Evaluation:

● The BAT model allows businesses to evaluate their performance by considering

the relationship between risk and return. It emphasizes the importance of
generating returns that adequately compensate for the risks taken.

Risk Management:

● It encourages businesses to assess and manage risks effectively. By

incorporating risk-adjusted returns, companies can make informed decisions
about resource allocation and project selection, considering the risk-return
tradeoff.

Capital Allocation:

● The model aids in optimizing capital allocation by identifying projects or

activities that contribute positively to economic value creation. It helps in
prioritizing investments that generate returns exceeding the cost of capital while
considering the associated risks.

Incentivizing Value Creation:

 ● By focusing on economic value added, the BAT model incentivizes management
to prioritize initiatives that add value to the business. It aligns managerial
incentives with the creation of shareholder wealth.

Shareholder Value Enhancement:

● Ultimately, the BAT model aims to enhance shareholder value by aligning

strategic decisions with the goal of maximizing economic value creation relative
to the cost of capital and risk undertaken.

In summary, the BAT model (Business Risk-Adjusted Return On Capital and Economic Value
Added) offers a comprehensive framework for evaluating business performance, integrating
risk management with financial metrics to drive value creation and strategic decision-making
within a business enterprise.

19.1a What is the transaction motive, and how does it lead firms to hold cash?

19.1b What is the cost to the firm of holding excess cash?

19.2a Which would a firm be most interested in reducing, collection or disbursement

float? Why?

19.2b How is daily average float calculated?

19.2c What is the benefit from reducing or eliminating float?

19.4a Is maximizing disbursement float a sound business practice?

19.4b What is a zero-balance account? What is the advantage of such an account?

19.5a What are some reasons why firms find themselves with idle cash?

19.5b What are some types of money market securities?

19.5c Why are money market preferred stocks an attractive short-term investment?

A firm probably has the most control over what components of collection float?

What is the primary purpose of a lockbox?

19.1a - Transaction Motive and Cash Holding:

● Transaction Motive: It refers to the need for cash to facilitate day-to-day transactions
and operational activities such as paying suppliers, meeting payroll, and managing
routine expenses.
 ● Reason for Holding Cash: Firms hold cash to ensure smooth and timely transactions,
avoiding delays in payments and taking advantage of potential discounts for prompt
payments.

19.1b - Cost of Holding Excess Cash:

● Opportunity Cost: The primary cost of holding excess cash is the missed opportunity for
investing that cash in income-generating assets or opportunities.
● Risk of Inflation: Holding excess cash might result in loss of purchasing power due to
inflation eroding the value of idle cash over time.

19.2a - Interest in Reducing Float:

● Firm's Interest: Generally, firms would be more interested in reducing collection float as
it involves the time delay between receiving checks and depositing them, impacting cash
availability and fund utilization.

19.2b - Calculation of Daily Average Float:

● Daily Average Float: Calculated as the sum of all checks in the process of collection or
disbursement divided by the number of days.

19.2c - Benefit of Reducing Float:

● Reducing or Eliminating Float: This accelerates the availability of funds, reducing the
time between receiving and utilizing funds. It enhances cash availability for investment
or operational needs.

19.4a - Maximizing Disbursement Float Practice:

● Maximizing Disbursement Float: It's not generally considered a sound practice as it can
inconvenience payees by delaying payments and can negatively affect relationships with
suppliers or service providers.

19.4b - Zero-Balance Account (ZBA) and Advantage:

● Zero-Balance Account: It's a cash management tool where funds are transferred
automatically from a master account to subsidiary accounts, maintaining a zero balance
in subsidiary accounts.
● Advantage: It allows firms to minimize idle cash balances in subsidiary accounts while
ensuring sufficient funds for payments.

19.5a - Reasons for Idle Cash:

● Seasonal Variations: Periods of low activity or cyclical downturns might result in idle
cash.
● Delay in Investment Opportunities: Time gaps between identifying profitable investment
opportunities can result in temporarily idle cash.
19.5b - Types of Money Market Securities:

● Examples include Treasury bills, commercial paper, certificates of deposit (CDs), and
repurchase agreements (repos).

19.5c - Attractiveness of Money Market Preferred Stocks:

● Money market preferred stocks are appealing short-term investments due to their
liquidity, stability, and relatively higher yields compared to other money market
instruments.

Component of Collection Float Firms Control Most:

● Firms typically have the most control over mail and processing time in the collection
float component.

Purpose of a Lockbox:

● Primary Purpose: A lockbox is a service provided by banks that enables companies to

expedite the collection process by having customer payments sent directly to a
designated post office box. The primary purpose is to accelerate the deposit of
customer checks and reduce collection float time.

What are the major reasons for holding cash?

What is the difference between disbursement float and collection float?

How does a lockbox system work?

What are the major characteristics of short-term securities?

Major Reasons for Holding Cash:

Transaction Needs: To facilitate day-to-day operations, pay routine expenses, and manage
working capital requirements.
Precautionary Motive: To have a financial buffer for unexpected expenses, emergencies, or
uncertain future needs.
Speculative Motive: To take advantage of investment opportunities that may arise due to
market fluctuations or favorable conditions.
Transaction Costs: Holding cash can be more cost-effective than frequent borrowing or
selling securities for short-term needs.
Avoiding Financial Constraints: To ensure liquidity and flexibility in funding, preventing
potential financial constraints.

Difference Between Disbursement Float and Collection Float:

 ● Disbursement Float: It refers to the delay between the time a company writes a check
and the time the funds are actually debited from the company's account.
● Collection Float: It represents the time lag between when a company receives a payment
and when the funds are available in its account.

How a Lockbox System Works:

● Operation: A lockbox system is a service provided by banks where customer payments

are directed to a designated post office box. The bank collects the payments, processes
them, and deposits them directly into the company's account, reducing the time it takes
for funds to become available.
● Benefits: It accelerates the collection process, shortening the collection float period, and
enhances cash availability for the firm.

Major Characteristics of Short-Term Securities:

Maturity Period: Short-term securities have relatively short maturity periods, typically
ranging from a few days to one year.
Liquidity: They are highly liquid and easily tradable in the market, allowing investors to
convert them into cash quickly.
Low Risk: Generally considered low-risk investments due to short maturities and often
issued by creditworthy entities (e.g., government securities, high-grade corporate
bonds).
Interest Rates: Offer lower interest rates compared to long-term securities due to shorter
durations and lower risk.
Diversification: Investors often use short-term securities for portfolio diversification due to
their stability and low-risk nature.

Some corporations routinely pay late or take discounts that they do not qualify for.

How does this impact the supplier?

Does this action have any negative impact on the company itself?

This hurts the suppliers that the company does business with and may ultimately hurt the company
through a loss of reputation or credit. Ethical behavior can be summed up in the following rule of thumb
proposed by a top executive at a financial management seminar. When asked about a practice similar to
the one described above, he responded that he followed the “mother rule” when faced with a decision
with ethical consequences – “If you would be comfortable telling your mother what you did, it’s probably
ethical.” Of course, this doesn’t work for everyone, but it does hit home with a lot of students.

Impact of Corporations Paying Late or Taking Ineligible Discounts on Suppliers:

 ● Supplier Impact: Late payments or taking unqualified discounts can strain the cash flow
of suppliers. It affects their working capital and may force them to seek alternative
financing, impacting their operations and financial health.
● Relationship Strain: Repeated late payments can strain the supplier-buyer relationship,
potentially leading to a loss of goodwill and bargaining power for the buyer.

Negative Impact on the Company Itself:

● Supplier Relations: Continual late payments or taking unmerited discounts can damage
the company's reputation and relationships with suppliers. This might lead to strained
relations, reduced supplier cooperation, or even discontinued supply.
● Penalties and Interest: Late payments might result in penalties, interest charges, or
damaged credit terms, increasing the cost of goods sold or disrupting the supply chain.

Conclusion:

Regularly paying late or taking discounts for which a company doesn’t qualify may adversely
affect both the supplier and the company itself. It can strain supplier cash flow, damage
relationships, and potentially disrupt operations. Simultaneously, it can tarnish the company's
reputation, lead to penalties, and escalate costs. Maintaining ethical and responsible payment
practices is crucial to fostering healthy supplier relationships and sustaining a smooth
operational environment.
Chapter 20
What are the key issues associated with credit management?

What are the cash flows from granting credit?

How would you analyze a change in credit policy?

How would you analyze whether to grant credit to a new customer?

What is ABC inventory management?

How do you use the EOQ model to determine optimal inventory levels?
20.3a What are the important effects to consider in a decision to offer credit?
20.3b Explain how to estimate the NPV of a credit policy switch.
20.4a What are the carrying costs of granting credit?
20.4b What are the opportunity costs of not granting credit?
20.4c What is a captive finance company?
20.6a What tools can a manager use to monitor receivables?
20.6b What is an aging schedule?

Key Issues Associated with Credit Management:

Credit Policy: Establishing appropriate credit terms, credit standards, and procedures for
evaluating creditworthiness.
Risk Assessment: Evaluating the credit risk associated with extending credit to customers.
Collection Procedures: Implementing effective strategies for timely collection of accounts
receivable.
Cash Flow Impact: Managing the balance between credit sales and cash flow
requirements.

Cash Flows from Granting Credit:

● Positive Cash Flow: Credit sales generate revenue, contributing to cash inflows, albeit
deferred. However, they also lead to increased accounts receivable.
● Negative Cash Flow: Delay in receiving cash payments affects the timing of cash
inflows.

Analyzing a Change in Credit Policy:

 ● Assess the impact on sales volume, collection period, bad debts, and associated costs.
Use metrics like accounts receivable turnover, average collection period, and bad debt
expense to evaluate the effect.

Analyzing Whether to Grant Credit to a New Customer:

● Evaluate the customer's creditworthiness by examining financial statements, credit

reports, payment history, and references.
● Consider credit scoring models or credit risk assessment tools to assess the risk
associated with extending credit.

ABC Inventory Management:

● ABC inventory management categorizes inventory items based on their value and
contribution to overall inventory cost.
● "A" items are high-value, critical items. "B" items are moderately priced, and "C" items
are low-value, high-volume items.

EOQ Model for Optimal Inventory Levels:

● The Economic Order Quantity (EOQ) model determines the optimal order quantity that
minimizes total inventory costs.
● EOQ formula:

Important Effects in Offering Credit:

● Sales Increase vs. Bad Debt Risk: Offering credit can boost sales but carries the risk of
bad debts.
● Impact on Cash Flow: Credit sales delay cash inflows, affecting liquidity.
● Customer Relationships: Credit policy can influence customer loyalty and relationships.

Estimating NPV of Credit Policy Switch:

● Estimate initial and ongoing costs and benefits associated with changing the credit
policy.
● Calculate the present value of cash flows related to increased sales, reduced bad debts,
collection costs, etc., to determine the net present value (NPV).

Carrying Costs of Granting Credit:

● Carrying costs include the expenses incurred in maintaining accounts receivable such as
financing costs, administrative costs, and bad debt expenses.

Opportunity Costs of Not Granting Credit:

● Opportunity costs are the potential revenues or profits forgone by not extending credit,
potentially losing sales and market share.

Captive Finance Company:

 ● A captive finance company is a subsidiary established by a firm to provide financing to
its customers, often to facilitate sales of its products.

Tools for Monitoring Receivables:

● Aging Schedule: It's a report categorizing accounts receivable by the length of time
they have been outstanding.

Act like an excellent student in Corporate Finance course using FUNDAMENTALS OF

CORPORATE FINANCE 12th edition by Stephen A. Ross, answers the question.
20.7a What are the different types of inventory?
20.7b What are three things to remember when examining inventory types?
20.7c What is the basic goal of inventory management?
20.8a What does the EOQ model determine for the firm?
20.8b Which cost component of the EOQ model does the JIT inventory system
minimize?
What is the difference between the accounts receivable period and the cash collection
period?
Marsha can purchase goods for her store on credit terms of 2/10, net 25. What is the
effective annual rate that Marsha will pay if she forgoes the discount on a purchase of
$8,700?
If Rosie’s Formal Attire has too low an inventory, the firm is most
apt to ___________.

20.7a - Different Types of Inventory:

Raw Materials: Basic materials used in manufacturing before being converted into finished
goods.
Work-in-Progress (WIP): Goods in various stages of completion within the production
process.
Finished Goods: Completed items ready for sale or distribution.

20.7b - Three Aspects to Consider in Examining Inventory Types:

Costs: Different inventory types have varying carrying costs, storage costs, and
obsolescence risks.
Demand and Lead Time: Each type may have different demand patterns and lead times,
impacting inventory management strategies.
Value Addition: Consider the value addition at each stage of inventory - raw materials, work-
in-progress, and finished goods - and their contribution to the overall value chain.
20.7c - Basic Goal of Inventory Management:

● The fundamental goal is to strike a balance between minimizing inventory holding costs
(carrying costs) while ensuring adequate stock availability to meet demand and prevent
stockouts.

20.8a - Determination by the EOQ Model:

● The Economic Order Quantity (EOQ) model determines the optimal order quantity that
minimizes total inventory costs.

20.8b - Cost Minimized by JIT Inventory System:

● Just-in-Time (JIT) inventory system aims to minimize holding or carrying costs

associated with inventory by synchronizing production with demand, reducing excess
inventory levels.

Difference Between Accounts Receivable Period and Cash Collection Period:

● Accounts Receivable Period: It represents the average time it takes to collect payments
from customers after sales on credit.
● Cash Collection Period: Indicates the actual time taken to convert credit sales into cash
receipt.

Effective Annual Rate if Discount is Forgone:

Formula for Effective Annual Rate (EAR):

● \text{EAR} = \left(1 + \frac{{\text{Discount %}}}{{100 - \text{Discount %}}}\right)^{365/T} -

1
● Using the given terms (2/10, net 25) and purchase of $8,700, the calculation
would yield the effective annual rate.

Impact of Too Low Inventory for Rosie’s Formal Attire:

● If Rosie's Formal Attire maintains too low inventory levels, the firm is more likely to face
stockouts, which can result in lost sales opportunities and potentially harm customer
satisfaction due to insufficient product availability.