Higgins 5 factor model

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Financial Management

Review Exercise

Sample essay questions

1. List and briefly describe the three basic questions addressed by a financial manager. a. What long-term investments should the firm take on? (Capital budgeting) b. Where will we get the long-term financing to pay for the investment? (Capital

structure) c. How will we manage the everyday financial activities of the firm? (Working

capital) 2. Compare IRR and NPV.

NPV: Net Present Value: - Two cash flow streams with the same present value can be transformed into each other. - It is the present value of the future cash flows minus the initial investment. - NPV measures the amount of value creation (If NPV is + we accept the project) IRR: Internal Rate of return: discount rate that make the NPV=0

- the IRR can be regarded as the rate of return associated with cash flows ( If IRR > required return, we accept the project ) NPV vs. IRR

- NPV and IRR will generally give us the same decision - Exceptions:

a. Non-conventional cash flows – cash flow signs change more than once

b. Mutually exclusive projects i. Initial investments are substantially different

ii. Timing of cash flows is substantially different

3. Briefly explain the use of Du Pont identity in financial statement analysis.

ROE= PM * TAT * EM

- Profit Margin is a measure of the firm’s operating efficiency – how well does the control costs

- Total Asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets

- Equity multiplier is a measure of the firm’s financial leverage

4. Briefly describe Higgins 5-factor model.

Uses 5 ways in which company financing can affect operating income:

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– Distress costs(E): imposed by various parties when concerns arise about a company’s ability to honor its financial obligations

– Financial flexibility(E): the possibility that high debt levels will limit future financing options

– Market signaling(D): the information managers convey when they opt for one form of financing over another

– Tax benefits(D): due to the tax deductibility of interest

– Management incentives(D): the increased pressure to generate cash flows to meet high debt service obligations

• Emphasizes that the financing decision involves a careful assessment of each factor in light of the company’s specific circumstances.

• fast growing businesses = maintain conservative capital structures, while slow growth firms may want to consider the opposite strategy.

Sample problem solving / mini-case

1. (Ratio Analysis) Know the definition of the financial ratios covered in class. Know how to evaluate a company’s performance based on ratio analysis. Three determinants of ROE:

1. Profit Margin = Net Income / Sales 2. Asset Turnover= Sales / Assets 3. Financial Leverage = Assets / Shareholder’s Equity

2. (Managing growth) Biosite, Inc. is a developer manufacturer, and marketer of medical diagnostic products in San Diego, California. If you wanted to test for parasites, drug abuse, or congestive heart failure, you would be wise to contact Biosite. Following are selected financial data for the company for the period 2010-2014.

2010 2011 2012 2013 2014

Profit margin (%) 11.2 10.3 12.7 14.3 16.9

Retention ratio (%) 100.0 100.0 100.0 100.0 100.0

Asset turnover(X) 0.66 0.64 0.80 0.89 0.86

Assets (end of year, millions)

$83.0 102.7 131.3 194.6 283.5

Equity (end of year, millions)

72.9 90.9 107.9 152.9 220.3

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a. Calculate Biosite’s sustainable growth rate in each year.

G*2011=PRAT(cap)=10.3%*100%*0.64*(102.7/72.9)=9.28%

G*2012=14.68%

G*2013=22.95%

G*2014=26.95%

b. Comparing the company’s sustainable growth rate with its actual growth rate in sales, what growth problems did Biosite face over this period? The actual growth rates were consistently higher than the sustainable growth rates. The firm was growing too fast.

c. How did the company cope with these problems?

Raise the price - Accumulate company with excess cash

Lower expansion goal - Prune away slow turning customer

3. (Valuation of stocks; CAPM) What is the value of a stock that just paid $2 dividend and expected to increase dividends by 3% per year since next year? The required return is 15%. Assume the company’s 15% required return resulted from a risk-free rate of 9%, a market return of 13%, and a beta of 1.50. Now imagine that the financial manager makes a decision that, without changing expected dividends, causes the firm’s beta to increase to 1.75. Assume the risk free rate and market return remain the same. Based on CAPM model, how would the change in beta affect the stock value? By how much? P=D1/(R-g)=$2(1+3%)/(15%-3%)=2.06/12%=$17.17

CAPM: 9%+1.75*(13%-9%)=9%+1.75*4%=16%

P’=$2*(1+3%)/(16%-3%)=$15.85

4. (WACC calculation) Assume that ABC Corporation has the following market values for its capital

Bonds outstanding $5 million Preferred stock 1 million Common stock 14 million

ABC Corporation wishes to maintain these proportions as it raises new funds. Its before- tax cost of debt is 8 percent, its cost of preferred stock is 10 percent, and its cost of equity is 15 percent. If the company’s marginal tax rate is 40 percent, what is ABC’s weighted average cost of capital?

WACC=8%*(5/20)*(1-40%)+10%*(1/20)+15%*(14/20)=12.2%

Growth rate in sales (%) 25.8 19.4 60.3 64.8 41.3

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5. (Asset beta vs. equity beta) An analyst gathered the following information about a private company and its publicly-traded competitor: Comparable Companies Debt/Equity Equity Beta

Private company 1.00 N.A.

Public company 0.90 1.75

Using the pure-play method and ignore taxes, what is your estimated equity beta for the private company? Be: business risk & financial risk Ba: business risk (same for companies in the same industry) Un-lever: Convert BeàBa: Ba=(E/V)*Be=(1/1.9)*1.75 D/E=.9, If E=1, then D=0.9àE/V=1/1.9 Or: D=0.9E, E/V=E/(0.9E+E)=1/1.9 Re-lever: Convert BaàBe: Be=Ba*(V/E) D/E=1, IF E=1, D=1, V/E=2 Be=(1/1.9)*1.75*2=1.84

6. (Capital budgeting; investment appraisal) Phone Home, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $4.2 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $3,100,000 in annual sales, with costs of $990,000. The tax rate is 35 percent.

(1) What is the Operating Cash Flow for this project?

OCF=EBIT-taxes+depreciation

EBIT=$3.1m-$0.99m-($4.2m/3)=$0.71m

OCF=$0.71m*(1-35%)+$4.2m/3=$1.8615m

(2) Suppose the required return on the project is 12 percent. What is the project's NPV?

0 1 2 3 OCFs $1.8615m $1.8615m $1.8615m NCS -$4.2M

NPV=$1.8615/(1+12%) + $1.8615/(1+12%)2 + $1.8615/(1+12%)3- $4.2m= $ 0.27m

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(3) Suppose the project requires an initial investment in net working capital of $300,000, and the fixed asset will have a market value of $210,000 at the end of the project. What is the project's year 0 net cash flow? Year 1? Year 2? Year 3? What is the new NPV?

0 1 2 3 OCFs $1.8615m $1.8615m $1.8615m NCS -$4.2m $0.21m-($0.21-

0)*35% Investment in NWC

-$0.3m $0.3m

FCFs -$4.5m $1.8615m $1.8615m $2.298m

NPV=$1.8615/(1+12%) + $1.8615/(1+12%)2 + $2.298/(1+12%)3- $4.5m= $ 0.28m