B2 Summary

M1 - Capital Structure (CS)

debt vs equity, how company funds itself

WACC - Weighted Average Cost of Capital

  • LOWEST WACC = BEST Value for firm & best CS

  • WACC Formula: (A)* (B) *(C)

        A. [((Cost of Stock %) / Proportion of CS that is Stock ) x Market Return Rate for Stock ]

        B. [((Cost of Preferred Stock%) / Proportion of CS that is Preferred Stock ) x Market Return Rate for Preferred Stock ]

        C. [((Cost of Debt %) / Proportion of CS that is Debt) x Market Return Rate for Debt]

Cost of Retained Earnings

  • How much a firm should grow to keep stockholders happy (otherwise stockholders = mad and take money away)

  • Market risk premium = market return rate - risk free rate

Methods to know cost of RE:

  1. CAPM - Capital asset pricing model

    • Risk-free rate + [Beta x Market Risk Premium]

  2. DCF - Discounted Cash Flow

    • [Dividend per share / Market value price per stock] x Growth Rate

  3. BYRP - Bond Yield plus Risk Premium

    • Market Risk Premium + Pretax cost of long term debt.

Analyzing Capital Structure

  • Loan covenant - requirements from lenders to secure debt. Positive debt covenants ensure you maintain certain levels or ratios. Negative debt covenants restrict you from doing things.

  • Retention - Increase in RE / Net Income. AKA- portion of income not paid out in dividends.

  • Growth Rate - (Return on Assets x Retention) / [1 - (Return on Assets x Retention)]

  • High Financial leverage - when there’s less owners so existing owners get more profits → less equity + more debt CS = more EBIT to cover interest

  • Operating Leverage - when company has less variable costs → higher contribution margin.

  • Levered firm - company that has debt in its CS. unlevered = all equity no debt. levered firm can deduct interest on debt from taxes = good.

M2 - Working Capital Management

How businesses use cash, collect cash, and manage payments to get the most return on capital.

AR Management

  • Factoring - a company gives you a % of your AR now in exchange for a fee and interest payments. You get benefit of money now instead of waiting and less administrative work. Con = expensive.

Inventory Management

  • Reorder point = safety stock + (sales during lead time)

  • Economic Order Quantity = SQUARE ROOT of [(2 * Annual Sales * Cost to place each order)/ Annual carrying cost per unit]

    • Make sure that the time measure (like annual/quarterly/weekly all match up).

  • SCOR - Supply Chain Operations Reference Model. Plan, Source, Make, Deliver.

  • 3 types of Inventory Management Issues:

    1. Just in time - order gets placed → manufacture starts → gets to customer = less lag & more efficient

    2. Kanban - “hit me over the head with a can” → OOPS we ran out = order more.

    3. Computerized - computer tells when to order more when stock is running low.

AP Management

  • Annual Cost of NOT taking a cash payment discount =

    • Effective Interest on Missed Discount Rate x Cycles of days of delayed payment per year

      • another way to look at it is…

    • [Forgone discount % / (100% - Foregone Discount %)] x [360 / (Pay period - Discount period)]

  • Short-term financing - debt that matures <1 yr

    • Pros: faster conversion of operating cycle, lower interest rates.

    • Cons: higher interest rate risk from fluctuating market/economy, credit worthiness can be affected impacting future funding for capital.

  • Long-term financing - debt that matures >1 yr. pros and cons are opposite of short term financing.

M3 - Financial Valuation Methods

Security Valuation

Absolute Value Models

  • Assigns an intrinsic value to an investment by calculating the PV of the cash flow.

Types of absolute value calculations:

  1. Annuities - same cash flow each period. Annuity Due = beginning of period. Ordinary annuity = end of period.

  1. Perpetuities (aka Zero Growth Stock) - same cash flow forever = like a dividend.

  • Present value of a perpetuity = the stock price.

  • Stock price = Dividends / Required Rate of Return %

  1. Constant (Gordon) Growth Dividend Discount Model (DDM) -

  • Present value or price at specified period = A/B

    • A. [ Dividend 1 yr after specified period x (1 + Sustainable Growth Rate)]

    • B. (Required rate of return % - Sustainable Growth Rate)

      • Get the required rate of return from the CAPM

  • Discounted Cash Flow Analysis:

    1. Dividend discount model (DDM) - expected dividends = basis for PV of future CF

    2. Free cash flow model (FCFF) - available cash after covering working capital needs = basis for PV of future CF

Relative Valuation Models

  • Uses price multiples, to determine if the stock is undervalued, fairly valued, or overvalued.

  1. Price Earnings (P/E) Ratio = Stock Price / Earnings per Share expected for 1 Fiscal Year

    • PE Ratio x Earnings for 1 year = Current stock price

      • Forward vs Trailing P/E Ratio:

        • Forward = future earnings & future EPS.

        • Trailing = past earnings & past EPS

  2. PEG Ratio

  3. Price-to-Sales Ratio

  4. Price-to-Cash-Flow Ratio

  5. Price-to-Book Ratio

Options

  • Option:

    • Put -

    • Call -

  • The Black-Scholes Model

  • Binomial Model

Valuing Debt Instruments

  1. Cost Method

  2. Market Value Method

  3. Appraisal Method

  4. Liquidation Value

Accounting Estimates & Fair Value Measurement

  • Methods to prepare accounting estimates:

  • Fair value terminology:

    1. Orderly Transaction

    2. Market Participants

    3. Principal Market

    4. Most advantageous market

  • Hierarchy of inputs:

    1. Level 1

    2. Level 2

Valuing Tangible & Intangible Assets

  1. Market Approach

  2. Income Approach

  3. Cost Approach