Corporate - Issuers - Chapter2 2

Bluewolf Formation 2022 13/09/2023
CORPORATE ISSUERS
Chapter 2: Business Models, Capital Investments & Working Capital
Eugene Brandon BALA, PhD
BlueWolf
Business Intelligence www.bluewolf.eu
Formation www.bluewell.fr
CFA Institute BOK - E. Bala 2023 1
1. INTRODUCTION
Bala Series
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1. INTRODUCTION
1. KEY FEATURES AND TYPES OF BUSINESS MODELS

A successful firm must provide a product or service, find customers, deliver the product or service, and make a profit.
The business model (it is not the financial plan) explains how a firm either does or proposes to do this.
A business model should:
- Identify the potential customers, how they are acquired (and what cost) and how it maintain customer satisfaction.
- Describe the product or service, how it meets a need for its potential customers, and what differentiates its products
- Explain how the firm will sell its product or service (e.g., online, physical location, direct mail, trade shows, sales
representatives); whether they will sell direct to the buyers (direct sales) or use intermediaries such as wholesalers, retailers,
agents, or franchisees; and how will they deliver their product or service.
The answers to these questions comprise a channel strategy (B2B -business to business firms vs B2C - business
to consumer firms).
- Describe the key assets (including intangibles, key personnel), and suppliers of the firm.
- Explain its pricing strategy and why buyers will pay that price for their product, given the competitive landscape
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Value-based pricing refers to setting prices based on the value received (or perceived) by the buyer.
Cost-based pricing refers to setting prices based on the costs of producing the good or service (plus a profit).
Price discrimination refers to setting different prices for different customers or identifiable groups of customers.
Eg: tiered pricing (based on volume of purchases), dynamic pricing (depending on the time of day or day of the week see
airlines), and auction pricing (e.g., eBay).
A value proposition refers to how customers will value the characteristics of the product or service, given the
competing products and their prices. How the firm executes its value proposition is referred to as its value chain.
-A value chain comprises the assets of the firm and how the organization of the firm will add value and exploit the
competitive advantage.
- A value chain should not be confused with a supply chain, which includes every step in producing and delivering
its products, even those that other firms perform.

Porter's Value Chain
(upstream and downstream) so the borders between these two

conceptually different notions are, actually, less obvious.
ting
products and their prices.
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Providers of both debt and equity capital are concerned with firm risk and firm growth.
- Lenders like to see less uncertainty about earnings, cash flow, operating margins, and the like.
- Equity holders like earnings growth over time, but are also concerned with earnings volatility.
Significant external factors that can affect business risk.

- Changes in economic conditions (e.g., economic growth, inflation and interest rates) typically affect all firms to some extent,
increasing firm risk.
- Changing demographics can affect the demand for some and products, either positively or negatively.
- Political, legal, and regulatory change .
Firm-specific (internal) factors:

- operating leverage (fixed vs variable costs)
- the stage of firm development: a start-up firm that requires large amounts of capital to grow has different financial needs
than a stable, mature firm.
- vulnerability to competition; more vulnerable firms have more business risk.
A business model can have significant effects on its financing needs.

Types of business and financial risks for a company
Macro risk refers to the risk (to operating profit) arising from economic, political, changes in exchange rates and legal risk
factors, as well as other risks that affect all businesses within a country or region or globally over time.
- Cyclical companies, vs
- Non-cyclical (defensive) such as utilities and health care providers
Business risk refers to the variability of operating income (EBIT) that arises from both firm-specific risk factors and industry risk
factors.
Industry risk factors include:
- Revenue and earnings cyclicality.
- Industry structure: Low concentration (many smaller firms) is associated with high competitive intensity.
- Competitive intensity: Higher competitive intensity in the industry typically reduces profitability.
- Competitive dynamics within the value chain: Profits are affected by actions of buyers, suppliers, and actual and
potential competitors.
- Long-term growth and demand expectations: An industry with increasing demand and high long-term growth
prospects is more attractive to investors, but may also attract more competition.
- Other industry risks are regulatory risks and other relevant external risks.
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Firm-specific risk factors include:
Competitive risks such as the erosion of an existing competitive advantage over time or the introduction of innovative
business models that disrupt the industry; also, execution risk failure to implement plans.
Product market risk: over time, consumer preferences may change, products may become obsolescent, and patents may
expire. Firms with many products typically face less product risk.
Capital investment risk refers to investing firm assets in opportunities that do not produce returns above the cost of
capital. Many acquisitions turn out to be quite ill-advised.
ESG risk measures often focus on corporate governance risk, but the risk of running afoul of current expectations for
environmentally and socially progressive company policies can damage a reputation and bottom line (or not,
e.g., Volkswagen).
Business risk is increased by higher operating leverage that results from higher percentages of fixed costs, relative to
variable costs, in a cost structure. The effect of sales variability on operating income is magnified by higher operating
leverage.
Financial risk refers to the increase in the variability of net income and cash flows that results from using debt in a
capital structure, which increases financial leverage. Financial leverage magnifies the effects of business risk on profits.
2. CAPITAL INVESTMENTS
Capital budgeting is the allocation of funds to long-lived capital projects
the capital allocation process.
A capital project is a long-term investment in tangible assets.
The principles and tools of the capital budgeting are applied in many different aspects of a business
decision making and in security valuation and portfolio management.
A capital budgeting process and prowess are important in valuing a company.
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CLASSIFYING PROJECTS
3. BASIC PRINCIPLES OF CAPITAL BUDGETING
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COSTS: INCLUDE OR EXCLUDE?

A sunk cost is a cost that has already occurred, so it cannot be part of the incremental cash flows of a capital
budgeting analysis.
An opportunity cost is what would be earned on the next-best use of the assets.
An incremental cash flow is the difference in a cash flows with and without the project.
An externality is an effect that the investment project has on something else, whether inside or outside of the
company.
Cannibalization is an externality in which the investment reduces cash flows elsewhere in the company (e.g.,
takes sales from an existing company project).
INDEPENDENT VS. MUTUALLY

EXCLUSIVE PROJECTS
When evaluating more than one project at a time, it is important to identify whether the projects are independent or
mutually exclusive
This makes a difference when selecting the tools to evaluate the projects.
Independent projects are projects in which the acceptance of one project does not preclude the acceptance of
the other(s).
Mutually exclusive projects are projects in which the acceptance of one project precludes the acceptance of
another or others.
Capital projects may be sequenced, which means a project contains an option to invest in another project.
Projects often have real options associated with them; so the company can choose to expand or abandon the
project, for example, after reviewing the performance of the initial capital project (hereafter)
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CAPITAL RATIONING
Capital rationing is when the amount of expenditure for capital projects in a given period is limited.
If the company has so many profitable projects that the initial expenditures in total would exceed the budget for
capital projects for the period, the management must determine which of the projects to select.
The objective is to maximize wealth, subject to the constraint on the capital budget.
Capital rationing may result in the rejection of profitable projects.
4. INVESTMENT DECISION CRITERIA
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NET PRESENT VALUE

The net present value is the present value of all incremental cash flows, discounted to the present, less the initial
outlay:
(2-1)
Or, reflecting the outlay as CF0,
(2-2)
where
CFt = After-tax cash flow at time t
r = Required rate of return for the investment
Outlay = Investment cash flow at time zero
If NPV > 0:
Invest: Capital project adds value
If NPV < 0:
Do not invest: Capital project destroys value
NET PRESENT VALUE
Example: A firm is considering a project with an initial

investment of $3,000,000. The project's cost of capital
is 12% and the expected cash flows are as follows:
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EXAMPLE: NPV
Consider the Hoofdstad Project, which requires an investment of $1 billion initially, with subsequent cash flows of
$200 million, $300 million, $400 million, and $500 million. We can characterize the project with the following end-
of-year cash flows:
Cash Flow
Period (millions)
0 $1,000
1 200
2 300
3 400
4 500
What is the net present value of the Hoofdstad Project if the required rate of return of this project is 5%?
EXAMPLE: NPV
Time Line
0 1 2 3 4
| | | | |
| | | | |
$1,000 $200 $300 $400 $500
Solving for the NPV:
NPV = $219.47 million
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INTERNAL RATE OF RETURN

The internal rate of return is the rate of return on a project.
The internal rate of return is the rate of return that results in NPV = 0.
=0 (2-3)
Or, reflecting the outlay as CF0,
(2-4)
If IRR > r (required rate of return):

Invest: Capital project adds value
If IRR < r:
Do not invest: Capital project destroys value
INTERNAL RATE OF RETURN
Example:
A firm is considering a project with an initial investment
of $3,000,000. The firm's required return is 10% and
the expected cash flows are as follows:
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EXAMPLE: IRR
Consider the Hoofdstad Project that we used to demonstrate the NPV calculation:
Cash Flow
Period (millions)
0 $1,000
1 200
2 300
3 400
4 500
The IRR is the rate that solves the following:
A NOTE ON SOLVING FOR IRR

The IRR is the rate that causes the NPV to be equal to zero.
The problem is that we cannot solve directly for IRR, but rather must either iterate (trying different values of IRR
until the NPV is zero) or use a financial calculator or spreadsheet program to solve for IRR.
In this example, IRR = 12.826%:
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NET PRESENT VALUE PROFILE

The net present value profile is the graphical illustration of the NPV of a project at different required rates of return.
The NPV profile intersects the

vertical axis at the sum of the
cash flows (i.e., 0% required
rate of return).
Net The NPV profile crosses the
Present
Value internal rate of return.
Required Rate of Return
RANKING CONFLICTS: NPV VS. IRR

The NPV and IRR methods may rank projects differently.
If projects are independent, accept if NPV > 0 produces the same result as when IRR > r.
If projects are mutually exclusive, accept if NPV > 0 may produce a different result than when IRR > r.
The source of the problem is different reinvestment rate assumptions

Net present value: Reinvest cash flows at the required rate of return
Internal rate of return: Reinvest cash flows at the internal rate of return
The problem is evident when there are different patterns of cash flows or different scales of cash flows.
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EXAMPLE: RANKING CONFLICTS

Consider two mutually exclusive projects, Project P and Project Q:
End of Year Cash Flows
Year Project P Project Q

0 100 100
1 0 33
2 0 33
3 0 33
4 142 33
Which project is preferred and why?

Hint:
DECISION AT VARIOUS REQUIRED

RATES OF RETURN
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THE MULTIPLE IRR PROBLEM

If cash flows change sign more than once during the life of the project (aka there may be
more than one rate that can force the present value of the cash flows to be equal to zero.
In other words, there is no unique IRR if the cash flows are nonconventional.
Example:
Consider the fluctuating capital project with the following end
of year cash flows, in millions - what is the IRR of this project?
POPULARITY AND USAGE OF CAPITAL

BUDGETING METHODS
(Best measure)
(Alternative periods of cash)
(Inflows and outflows)
(Gives and idea of value creating) (The size of the project matters, ie IRR 50% over how
much?)
(More agressive assumptions)
Note: For independent projects NPV and IRR will and should produce the same conclusions!
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RELATIONSHIP AMONG NPV, COMPANY VALUE, AND

SHARE PRICE
The return on invested capital (ROIC) is one measure of the profitability (in the aggregate) of a company
relative to the amount of capital invested by the equity and debtholders.
- ROIC reflects how effectively a management is able to convert capital into profits. The ratio is calculated by
dividing the after-tax net profit by the average book value of invested capital (common, preferred, and debt).
ou
The ROIC measure is often compared with the associated cost of capital, the required return used in the NPV
calculation and the associated cost of funds.
- If the ROIC measure is higher than the cost of capital, the company is generating a higher return for investors compared with
the required return, thereby increasing the value for shareholders.
- The inverse is true if the if the ROIC is lower.
RELATIONSHIP AMONG NPV,

COMPANY VALUE & SHARE PRICE
If a company invests in a positive NPV project, the expectation is that shareholder wealth will be increased as well
as the stock value.
The market value of the company would be expected to increase by the NPV amount. The stock price would also
be expected to increase by the NPV per share, i.e., the NPV divided by the number of shares outstanding.
The effect of a NPV is, however, more complicated than this:
- if an analyst learns that a company intends to undertake an investment, the impact of the investment on the stock
price will depend on whether or not the profitability is more or less than expected. For example, a
project may have a positive NPV, but if the profitability is less than analysts expect it to be, then the stock
price might fall.
- It is also possible that news of a project having a positive NPV sends a positive signal to the markets, causing market
players to expect that other profitable projects may be underway. This may serve to increase the stock price.
capital budgeting processes may indicate the extent to which management embraces the goal of
shareholder wealth maximization and its effectiveness in pursuing that goal. This is extremely important to both
shareholders and analysts and may influence company valuation and share price.
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SHARE PRICE
Although the capital allocation model accommodates the effects of inflation, inflation complicates the capital
allocation process (and the operations of a business, in general).
Inflation does not affect all revenues and costs uniformly.
Companies may choose to do the analysis in either nominal or real terms (more often nominal)
The cash flows and discount rate used by the company should both be nominal (or both be real)
Inflation reduces the value of depreciation tax savings to the company (unless the tax system adjusts depreciation
for inflation), effectively increasing its real taxes.
The effect of expected inflation is captured in the discounted cash flow analysis:
- If inflation is higher than expected, the profitability of the investment is correspondingly lower than expected, inflation
essentially shifting wealth from the taxpayer (i.e., company) to the government.
- Conversely, lower-than-expected inflation reduces real taxes for the company (the depreciation tax shelters are more
valuable than expected) and results in higher-than-expected profitability of the investment and a corresponding wealth
increase for the company.

SHARE PRICE
Example
-tax cash flows is
and it
is independent of other expectations about the company.
Solution:
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REAL OPTIONS
Real options are options that allow companies to make decisions in the future that alter the value of capital
investment decisions made today, and are an important piece of the value in many capital investments.
Timing Options: Project sequencing options allow the company to defer the decision to invest in a future investment until
the outcome of some or all of a current investment is known.
Sizing Options: If after investing the company can abandon the investment if the financial results are disappointing, it has an
abandonment option or, conversely, if the company can make additional investments when future financial results are strong,
the company has a growth option or an expansion option.
- When estimating the cash flows from an expansion, the analyst must also be wary of cannibalization.
Flexibility Options: Once an investment is made, operational flexibilities besides abandonment or expansion may be
available. For example, suppose demand exceeds capacity, management may be able to exercise a price-setting option.
By increasing prices, the company could benefit from the excess demand, which it cannot do by increasing production.
what is forecast. - There are also production-flexibility options, which offer the operational flexibility to alter production when
demand varies from
Fundamental Options: in other cases, the whole investment is essentially an option, the payoffs from the investment are
contingent on an underlying asset, just like most financial options.
For example, the value of an oil well or refinery investment is contingent on the price of oil. If oil prices were low, you likely
would not choose to drill a well. If oil prices were high, you would go ahead and drill.
- Many R&D (research and development) projects also look like options.
REAL OPTIONS
Management can take the following common sense approaches to real option analysis:
1 Use DCF (discounted cash flow) analysis without considering options.
If the NPV is positive without considering real options and the project has real options that would simply add more value, it is
unnecessary to evaluate the options. Management should simply undertake the investment.
2 Consider the Project NPV = NPV (based on DCF alone) Cost of options + Value of options.
Calculate the NPV based on expected cash flows. Then simply add the value associated with real options less their
incremental cost.
3 Use decision trees.

Although they are not as conceptually sound as option pricing models, decision trees can capture the essence of many
sequential decision-making problems for companies.
4 Use option pricing models.

In carrying out capital allocation, management must consider
(1)a variety of real options that investments may possess and
(2) a decision about how to reasonably value these options.
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REAL OPTIONS
Production-Flexibility Option
Auvergne AquaFarms has estimated the NPV of the expected cash flows from a new processing plant to be
coal, natural gas, and oil as energy sources.

The original plant relied only on coal. The option to switch to cheaper sources of energy when they are available has an
What is the value of the new processing plant including this real option to use alternative energy sources?
Solution:
The NPV, including the real option, should be
Project NPV = NPV (based on DCF alone) Cost of options + Value of options.
Project NPV = 0.40 million
Without the flexibility offered by the real option, the plant is unprofitable. The real option to adapt to cheaper energy sources
adds enough to the value of this investment to give it a positive NPV. The company should undertake the investment, which
would add to its value.
COMMON CAPITAL ALLOCATION PITFALLS

Not incorporating economic responses into the investment analysis.
Misusing capital allocation templates
Pushing pet projects
Basing investment decisions on EPS, net income, or ROE:
Paying too much attention to ST accounting numbers can result in choosing investments that are not in the LT interests of its
shareholders.
Using IRR to make investment decisions for investment opportunities that are mutually exclusive
Incorrectly accounting for cash flows
Over- or underestimating overhead costs:
-The cost of an investment may include the overhead it generates for items hard to estimate such as as management time, information
technology support, financial systems, and other support. .
Not using the appropriate risk-adjusted discount rate:
- The required rate of return for an investment should be based on its risk. If the company is financing an investment specifically with
debt (or with equity), the required rate of return - not the cost of debt (or cost of equity) - should still be used.
- Similarly, a high-risk investment being considered should be discounted not at the overall cost of capital but at the
required rate of return.
Overspending and underspending the capital allocation:
Incorrectly handling sunk costs and opportunity costs
- Not identifying the economic alternatives (real and financial) that are the opportunity costs is probably the biggest failure by
companies in their analyses.
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CORPORATE ISSUERS
Working Capital & Liquidity
Eugene Brandon BALA, PhD
BlueWolf
Business Intelligence www.bluewolf.eu
Formation www.bluewell.fr
1. INTRODUCTION
Companies have multiple short-term and long-term financing choices.
Short-term funds without explicit interest rates, such as accounts payable, are part of working capital management,
which is the management of short-term assets and liabilities.
-The goal of effective working capital management is to ensure that a company has adequate, ready access to the funds necessary
for day-to-day operations, while at the same time making sure that the assets are invested in the most productive way
Other debt and equity obligations used to finance the business longer term are considered part of the capital
structure.
- The goal of capital structure management is to balance the risks and costs of the long-term finances. In this reading, we
examine a variety of debt and equity claims that companies rely on for their sources of capital.
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2. CORPORATE FINANCING OPTIONS
INTERNAL FINANCING
Operating Cash Flows:
can be used to invest in assets and are equal to net income plus depreciation charges minus dividend payments.
Accounts Payable (A/P):
they arise from trade credit and will differ among industries and might involve a delay of payment and a discount from the
purchase price if payment is received within a specified number of days; otherwise, the full amount is due.
- For example, the terms 2/10, net 30 indicate that a 2% discount is available if the account is paid within 10 days;
otherwise, the full amount is due by the 30th day.
Accounts Receivable (A/R):
The sooner a company can collect what it is owed, the lesser its need to finance its operations in some other way.
Marketable Securities:
can be quickly sold and converted to cash within a year, such as ST debt that matures within a year, LT debt and common
stocks
- Companies often invest in marketable securities to earn a rate of return that is greater than what they would earn by
holding cash.
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MANAGING SHORT-TERM FINANCING

The objective of a short-term financing strategy is to ensure that the company has sufficient funds, but at a cost
(including risk) that is appropriate.
Sources of financing
WHICH SHORT-TERM FINANCING?

Characteristics that determine the choice of financing:
Size of borrower
Creditworthiness of borrower
Access to different forms of financing
Flexibility of borrowing options
Asset-based loans are loans secured by an asset
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FINANCIAL INTERMEDIARIES
Uncommitted lines of credit - are the least reliable form of bank borrowing, a bank reserves the right to refuse to honor
any request for use of such line. They do not require any compensation other than interest but cannot be shown as a financial
reserve in a footnote to the financial statements.
Committed (regular) lines of credit - are more reliable because of the formal commitment and can be footnoted
in the annual report. They are in effect for 364 days, less than a full year.
- are unsecured and are pre-payable without any penalties.
- The most common interest rates are negotiated at the prime rate or at a money market rate plus a spread. The
spread varies depending on the creditworthiness.
- Regular lines, unlike uncommitted lines, require compensation, usually in the form of a commitment fee to the lender
(typically a fractional percent -e.g., 0.50% - on the full amount of the unused amount of the line, depending on bank
company negotiations.
Revolving credit agreements - also referred to as are the most reliable form of unsecured short-term bank
borrowing. Revolvers differ in that they are in effect for multiple years (e.g., three to five years) and can have optional medium-
term loan features.
-often used for much larger amounts than a regular line, these larger amounts are spread out among more than one bank.
-borrowers draw down and pay back amounts periodically.
FINANCIAL INTERMEDIARIES
Secured -based loans
are loans in which the lender requires the company to provide collateral in the form of an asset, such as a fixed asset that the
company owns or high-quality receivables and inventory
- Companies that lack sufficient credit quality to qualify for unsecured loans might arrange for secured loans.
For example, a company can cash flow through the assignment of accounts receivable, which is the use of these
receivables as collateral for a loan. The company remains responsible for the collection of the accounts
- A company can also sell its accounts receivable to a lender (called a factor), typically at a substantial discount. In a
factoring arrangement, the company shifts the credit granting and collection process to the lender or factor.
- The cost of this credit (i.e., the amount of the discount) depends on the credit quality of the accounts and the costs of
collection.
- Similarly, inventory can be used in different ways as collateral for a loan.
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CAPITAL MARKETS
Commercial Paper
- is a short-term, unsecured instrument typically issued by large and well-rated companies that can be sold directly to
investors or through dealers, with maturities ranging from a few days up to 270 days to avoid registration costs with regulatory
agencies
- although a significant amount of asset-backed commercial paper exists, most commercial paper is unsecured, with no
specific collateral but the Issuers are often required to have a backup line of credit.
overall a low-risk investment for investors.
Web-based lenders & non-bank lenders

are not typically used by larger companies, operate primarily on the internet, only offering loans in relatively small amounts,
typically to small businesses in need of cash.
Both bank and non-bank lenders often charge additional commissions and fees beyond the quoted interest rate.
changes in work in
capital generates cash
flows
CAPITAL MARKETS
Long-Term Debt
- because of their longer (than 1 year) maturities, bonds are riskier - interest (price) and credit risk - than money market
instruments.
- bond covenants are contracts specifying the rights of the lender and restrictions on the borrower (company) such as the use
and disposition of assets, its ability to pay dividends, and ability to issue additional debt that might dilute the value of a bond.
- public debt is negotiable on open markets (i.e. whereas private debt does not trade on a market and is
more difficult for the holder to sell.
- while some private debt instruments are not negotiable, such as government savings bonds and certificates of deposit, private
debt issued by businesses can usually be sold by one party to another.
Common equity, or common shares

- are a more permanent source of capital that represents ownership in a company.
- shareholders have claims on profits, receive dividends and are entitled to the residual value of the assets if the company
goes bankrupt (ie « residual claimants »).
- private equity is not registered with the security regulatory agency and is not traded in the public equity markets (often
times family owned and small business although large organizations can also fall in this category)
- specialized private equity firms provide private equity financing to companies and invest in VC firms, LBO funds and
portfolio of publicly and non-publicly traded companies.
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CAPITAL MARKETS
Preferred Equity
are hybrid securities that have characteristics of both bonds and common equity: dividends on preferred shares are often fixed
- but can be variable (e.g. preferred shares pay dividends based on a profitability).
- the company must pay any skipped (cumulative) preferred dividend payments before it can make any dividend payments on
common equity.
- in case of business failure, bondholders have seniority over preferred shareholders on assets or cash flows, and preferred
shareholders have similar seniority over common shareholders.
Hybrid Securities
Convertible debt and convertible preferred are hybrid securities issued by companies and are convertible into a fixed number of
the common shares.
- Other: MBS & ABS securities but in their case the assets pledged against the debt instruments issued are isolated from the
company in a SPV or SPE form an economic point of view it is equivalent to assets to a third party.
Leasing Obligations
In a leasing arrangement, the purchase of an asset and its financing are bundled instead of being separate transactions.
(check the Financial Statement Analysis)
MANAGING AND MEASURING LIQUIDITY

Working capital management is the management of the short-term investment and financing of a company.
Goals:
Adequate cash flow for operations
Most productive use of resources
Internal and External Factors that Affect Working Capital Needs

Internal Factors External Factors
Company size and growth rates Banking services
Organizational structure Interest rates
Sophistication of working capital New technologies and new products
management The economy
Borrowing and investing Competitors
positions/activities/capacities
Bottom line:
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MANAGING AND MEASURING LIQUIDITY

Liquidity is the ability of the company to satisfy its short-term obligations using assets that are readily converted
into cash.
Liquidity management is the ability of the company to generate cash when and where needed.
Liquidity management requires addressing drags and pulls on liquidity.
Drags on liquidity are forces that delay the collection of cash, such as slow payments by customers and obsolete
inventory.
Pulls on liquidity are decisions that result in paying cash too soon, such as paying trade credit early or a bank reducing a
line of credit.
SOURCES OF LIQUIDITY
Primary sources of liquidity
Ready cash balances (cash and cash equivalents)
Short-term funds (short-term financing, such as trade credit and bank loans)
Cash flow management (for example, getting payments deposited quickly)
Secondary sources of liquidity

Renegotiating debt contracts
Selling assets
Filing for bankruptcy protection and reorganizing.
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MEASURING LIQUIDITY
Operating Cycle
needs.
RATIOS USED FOR ASSESSING COMPANY LIQUIDITY
Ability to satisfy current liabilities

using current assets
Ability to satisfy current liabilities

using liquid current assets
Ability to satisfy current liabilities using

the most liquid of current assets
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RATIOS USED FOR ASSESSING COMPANY LIQUIDITY
EXAMPLE: LIQUIDITY AND OPERATING CYCLES
Compare the liquidity and liquidity needs for Company A and Company B for Fiscal Year 2
Company A Company B
FY2 FY1 FY2 FY1
Cash and cash equivalents
Inventory
Receivables
Accounts payable
Revenues
Cost of goods sold
1. How do these companies compare in terms of liquidity?

2. How do these companies compare in terms of their need for liquidity, based on their operating cycles?
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EXAMPLE: LIQUIDITY AND OPERATING CYCLES

Company A Company B
FY2 FY2
Current ratio 3.3 times 3.5 times
Quick ratio 2.0 times 2.0 times
Number of days of inventory 73.0 days 63.2 days

Number of days of receivables 73.0 days 60.8 days
Number of days of payables 57.3 days 42.1 days
Operating cycle 146.0 days 124.0 days

Cash conversion cycle 88.7 days 81.9 days
1. Company B has slightly more liquidity than Company A (same quick ratio, but slightly higher current ratio, which means that
Company B has a slightly greater proportion of inventory in its current assets compared with Company A).
2. Company A has a longer operating cycle (by 22 days) and cash conversion cycle ( by 7 days).
Company B has a quicker turnover of inventory and receivables than Company A (that is, more efficient use).
Company B pays its trade creditors quicker than does Company A.
MANAGING THE CASH POSITION

Management of the cash position of a company has a goal of maintaining positive cash balances throughout the day.
Forecasting short-term cash flows is difficult because of outside, unpredictable influences (e.g., the general economy).
Companies tend to maintain a minimum balance of cash (a target cash balance) to protect against a negative cash balance.
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MANAGING CASH
Managers use cash forecasting systems to estimate the flow (amount and timing) of receipts and disbursements.
Managers monitor cash uses and levels.
They keep track of cash balances and flows at different locations.
Investment of cash in excess of day-to-day needs and

Short-term sources of borrowing.
Other influences on cash flows:
Capital expenditures
Mergers and acquisitions
Disposition of assets
INVESTING SHORT-TERM FUNDS

Short-term investments are temporary stores of funds.
Examples include U.S. Treasury Bills, eurodollar time deposits, repurchase agreements, commercial paper, and money
market mutual funds.
Considerations:
Liquidity
Maturity
Credit risk
Yield
Requirement of collateral
The major objectives of a short-term borrowing strategy include the following:

- Ensuring that sufficient capacity exists to handle peak cash needs
- Maintaining sufficient sources of credit to be able to fund ongoing cash needs
- Ensuring that rates obtained are cost-effective and do not substantially exceed market averages
30

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Bluewolf Formation 2022 13/09/2023

Eugene Brandon BALA, PhD

CFA Institute BOK - E. Bala 2023 2

CFA Institute BOK - E. Bala 2023 3

1. KEY FEATURES AND TYPES OF BUSINESS MODELS

CFA Institute BOK - E. Bala 2023 4

1. KEY FEATURES AND TYPES OF BUSINESS MODELS

CFA Institute BOK - E. Bala 2023 5

1. KEY FEATURES AND TYPES OF BUSINESS MODELS

(upstream and downstream) so the borders between these two

CFA Institute BOK - E. Bala 2023 6

1. KEY FEATURES AND TYPES OF BUSINESS MODELS

Significant external factors that can affect business risk.

Firm-specific (internal) factors:

A business model can have significant effects on its financing needs.

CFA Institute BOK - E. Bala 2023 7

1. KEY FEATURES AND TYPES OF BUSINESS MODELS

CFA Institute BOK - E. Bala 2023 8

1. KEY FEATURES AND TYPES OF BUSINESS MODELS

CFA Institute BOK - E. Bala 2023 9

CFA Institute BOK - E. Bala 2023 10

CFA Institute BOK - E. Bala 2023 11

3. BASIC PRINCIPLES OF CAPITAL BUDGETING

CFA Institute BOK - E. Bala 2023 12

COSTS: INCLUDE OR EXCLUDE?

CFA Institute BOK - E. Bala 2023 13

INDEPENDENT VS. MUTUALLY

CFA Institute BOK - E. Bala 2023 14

CFA Institute BOK - E. Bala 2023 15

4. INVESTMENT DECISION CRITERIA

CFA Institute BOK - E. Bala 2023 16

NET PRESENT VALUE

Or, reflecting the outlay as CF0,

CFA Institute BOK - E. Bala 2023 17

NET PRESENT VALUE

Example: A firm is considering a project with an initial

CFA Institute BOK - E. Bala 2023 18

CFA Institute BOK - E. Bala 2023 19

$1,000 $200 $300 $400 $500

Solving for the NPV:

NPV = $219.47 million

CFA Institute BOK - E. Bala 2023 20

INTERNAL RATE OF RETURN

Or, reflecting the outlay as CF0,

If IRR > r (required rate of return):

CFA Institute BOK - E. Bala 2023 21

INTERNAL RATE OF RETURN

CFA Institute BOK - E. Bala 2023 22

The IRR is the rate that solves the following:

CFA Institute BOK - E. Bala 2023 23

A NOTE ON SOLVING FOR IRR

CFA Institute BOK - E. Bala 2023 24

NET PRESENT VALUE PROFILE

The NPV profile intersects the

Required Rate of Return

CFA Institute BOK - E. Bala 2023 25

RANKING CONFLICTS: NPV VS. IRR

The source of the problem is different reinvestment rate assumptions

CFA Institute BOK - E. Bala 2023 26

EXAMPLE: RANKING CONFLICTS

End of Year Cash Flows

Year Project P Project Q