Capital Budgeting Self Study Tasks 1, 2 & 3 Week 1 1-4 budgeting, Investments and... · basis. The...

Capital Budgeting 1-4

Self Study Tasks 1, 2 & 3 Week 1

IB 1.4 – Capital Budgeting, Investments and Accounting Literature summary by Boris Nissen of 1

Problems Task 1: 1. What are the different legal statuses of a company? 2. How does a firm decide upon which legal status to take up? 3. How are the different forms organized and called in the Netherlands (article)? à table 2 in reader article

- NV: public limited company – differs from BV in respect that it can issue publicly tradable shares - BV: private limited c. – most widely used business form (as NV incorporated, separate legal entity) - others are: general partnership, simple partnership, limited partnership, co-operative association, mutual

guarantee association, associations, foundations, sole proprietorship Problems Task 2: 1. What are the roles of a CFO and a controller? 2. What’s the interest of the company to serve either stockholders or stakeholders? What’s the principle agent

conflict? - shareholder wealth rests on companies building long-term relationships with suppliers, customers,

employers…, one of the most important assets of a company is its good name and thus stockholder and stakeholder interests are matched by the invisible hand (theoretically)

- principle-agent conflict: potential conflict arises when management and ownership are separated, managers cannot be expected to act in shareholder’s best interest à agency costs; solution: incentives

3. Is profit maximization consistent with the long-term viability of a firm? Yes, because the viability of the firm depends heavily on long-term cash flow out of the company being larger than the one into the company, the value created has to be more than the cost. The important thing to recognize is also that the sock-holders should be satisfied at first because the firm needs a sound financial basis. The cash flow from sales has to be bigger than the cash flow of the costs.

Problems Task 3: 1. What is the difference between a bond- and a stockholder and how are bonds and stocks correlated? 2. What is a leverage buyout?

An LBO is the acquisition by a small group of equity investors of a public or private company primarily financed with debt. The equityholders service the heavy interest and principal payment with cash from operations and/or asset sales. Usually the shareholders hope to reverse the LBO within a couple of years by a public offering, hoping the company is more attractive to them at that point.

Corporate Finance – Chapter 1 (Overview) 1.1 Corporate Finance: • balance sheet: amount of cash invested in assets must be matched by an equal amount of cash raised by

financing (total value of assets <-> total value of the firm to investors) - fixed assets: long lasting assets, such as buildings (tangible & intangible) - current assets: short lived assets, such as inventory - long-term debt: debt that does not have to be repaid after one year - current liability: short term debt to be repaid within one year - equity shares: stock certificates; difference between value of assets and the debt

• 3 basic concerns of corporate finance: 1. What long-term investment strategy should a company take on? à capital budgeting (capital expenditures),

process of making and managing expenditures on long-lived assets (left hand of balance sheet) 2. How can cash be raised for the required investments? à financing decision or capital structure, proportion

of the firm’s financing from current and long-term debt and equity 3. How much short term cash flow does a company need to pay its bills? à short-term management of cash

flow is associated with a firm’s net working capital (= current assets – current liabilities) • Capital Structure – financing arrangements determine how the value of the firm is sliced up:

- creditors: persons or institutions that buy debt from the firm (B value of debt) - shareholders: holders of equity shares (S value of equity) - value of the firm: V = B + S (can be though of as a pie, B and S deciding how the pie is sliced, its size

being the value of the firm in the financial markets; the way the pie is sliced can affect its value) • CFO’s (Chief Financial Officer) most important job is to create value from the firm’s capital budgeting,

financing and liquidity activities (by creating more cash flow than it uses) – reporting to him are: - treasurer: responsible for handling cash flows, making capital-expenditures decisions and making

financial plans - controller: handles accounting function (taxes, costs and financial accounting and information systems)




- 3 reasons why value creation is difficult: - identification of cash flows: not easy to observe cash flows directly, they have to be extracted from

accounting statements, but those do already include expected payments that are not relevant to the corporate finance view à value creation depends on the actual payment

- timing of cash flows: most important assumption of finance is that individuals prefer to receive cash flows earlier rather than later

- risk of cash flows: cash flows are not known with certainty; most investors are risk averse 1.2 Corporate Securities as Contingent Claims on Total Firm Value - debt: promise by the borrowing firm to repay a fixed amount by a certain date – contractual obligations to

repay corporate borrowing (debtholders have a claim to X (value of the firm) or F (the promised amount), whichever is smaller)

- equity: noncontractual claims to the residual cash flow of the firm - stockholders’ claim on the firm value at the end of the period is what remains after debtholders are paid (X – F if X > F or 0 if X ≤ F)

à debt and equity securities are contingent claims on the total firm value (debtholders’ claim + stockholders’ claim = value of the firm at the end of a period) 1.3 The corporate firm àà 3 basic legal forms of organizing firms (see also table on page 13) • sole proprietorship: business owned by one person, who has unlimited liability and equity capital only being

personal wealth but all profits of the business are only taxed as individual income à cheapest business form • partnership: 2 or more persons join and the income is taxed as personal income of the partners – difficulties

are: unlimited liability, limited life of the enterprise and difficulty of transferring ownership à difficult to raise cash - general partnership: all parties provide fraction of the work, cash and share profits and losses (general

partner has unlimited liability and the control of the partnership resides with the general partner(s)) - limited partnership: liability of some of the partners is limited to the amount of cash he has contributed

(limited partners can sell their interest, but do not have control) • corporation: distinct legal entity having a name and enjoying many of the legal powers of natural persons –

advantages: ease of ownership transfer, unlimited life, limited liability - simplest form comprises 3 sets of distinct interests: shareholders (owners), directors and corporation

officers (top management) 1.4 Goals of the corporate firm • set-of-contracts perspective: corporate firm will attempt to maximize shareholders’ wealth by taking actions

that increase the share of existing stock of the firm (equity contract is a principal-agent relationship (agent = management; principal = shareholders) - agency costs: costs of resolving conflicts of interest between managers and shareholders – defined as

sum of monitoring costs and costs of implementing control devices - residual losses: lost wealth of shareholders due to divergent behavior of the managers

• managerial goals: differ from those of shareholders in that the basic financial objective is maximization of corporate wealth (wealth over which management has effective control – linked to corporate growth and corporate size) à 2 basic motives that influence managers: survival; independence & self-sufficiency (managers do not like to issue new stock, but try to rely on internally generated cash flow)

• diffuse ownership of firms raises question who controls the firm à several control devices used by shareholders bond management to the self interest of shareholders: - determine membership of the board, management can be paid in stock option, performance shares (shares of stock given on basis

of performance as measure), threat of a takeover, competition in labor market 1.5 Financial Markets • money markets: markets for debt securities that will pay of in the short term (less than one year), they are

dealer markets (the dealer is a principal in most transactions) • capital markets: markets for long-term debt (maturity over a year) and for equity shares, they are usually

auction markets where stockbrokers act as agents for a customer • primary market: used for initial sales of government of corporate securities (public offering: usually a

underwriting syndicate buys new securities from a firm at it’s own account and resells them at a higher price; private placements are sold on basis of private negotiations and do not have to be registered)

• secondary market: where equity and debt securities are traded - auction markets: most equity securities are traded in auction markets (only some are traded in the OTC

market – over-the-counter); they differ in respect to dealer markets that they take place at a single site on the floor and are immediately communicated to the public

- dealer markets: most debt securities are traded in dealer markets




Additions form “Corporate Finance and Investment” – Pike & Neale - shareholder value: manager should maximize shareholder wealth which is distinct from profit maximization

(measures can be earnings per share (EPS), profit retentions, borrowing levels, profitability, etc.)

Financial Accounting – Chapter 1 (The Role of Accounting) 1.1 What is accounting? - Accounting: The function of accounting is to provide quantitative information, primarily financial in nature,

about economic entities that is intended to be useful in making economic decisions (to facilitate economic decision making) – in making reasoned choices among alternative courses of action. (accounting information about individuals, business enterprises, non-business organizations, social programs, government units, etc is needed for various uses)

- though accounting information can improve decisions, it is only one part of the information needed 1.2 Focus on financial accounting - Financial accounting: Financial accounting provides a continual history quantified in money terms of

economic resources and obligations of a business enterprise and of economic activities that change those resources and obligations.

- External users of information: External users of information concerning an accounting entity are those interested parties whose decisions relate to the entity, but who are not employed by the entity to direct its activities or utilize its resources. (e.g. investors, customers, suppliers, tax authorities)

- Accounting entity: An accounting entity is any individual or organization that (1) uses economic resources to achieve a purpose, (2) has an identity of its own, and (3) is interest to one or more individuals for decision-making purposes.

1.3 Decision making - members of society must continually make decisions to resolve conflict between unlimited wants and needs

and limited resources à land or natural resources, labor, capital and entrepreneurial ability - Decision making: process of choosing from among alternative courses of action using criteria adopted by

the decision maker - accounting provides information for use in the decision making process (need felt à problem identified à

information about alternatives à alternative evaluated à conclusion or action selected à action taken if appropriate à outcome reviewed, new need felt)

- Statement of objectives: expression of the decision maker’s preference in terms of the consequences of potential courses of action

- Uncertainty: Condition of not knowing at the time of decision precisely what the outcomes of relevant future events will be; that is not knowing precisely the consequences of alternatives courses of action.

- Information: Information is data that improves the decision maker’s understanding and predictions of the outcomes of uncertain future events.

- Decision relevance: Information is relevant with respect to a specific decision situation if it will improve predictions regarding future events related to the decision. (Information is costly!)

- Information specialist: An information specialist is an individual who devotes resources to producing decision-relevant information for use by other (cheaper if large number of individuals need information on similar courses of action

1.4 The business enterprise - entrepreneurs have to take the roles of organizing and risk taking - Business enterprise: A business enterprise is an organization comprised of one or more individuals, capital

goods, and other resources, whose purpose is to produce specific products or services for sale. à a business organization provides a means of breaking down a large opportunity for profit into a number of smaller individual opportunities

- Money capital: Money capital is the cash or cash equivalent of other resources committed to a business enterprise to enable it to procure and meet its obligations to pay for capital goods, labor, material and other factors of production.

- 3 traditional kinds of business enterprises: proprietorships, partnerships and corporations; they all are recognized by accountants as economic units or entities with an existence separate form that of their owners, but have different legal statuses (see table on page 7 or Woods Chapter 1)




1.5 Decisions related to the business enterprise - Internal users of information: Those individuals who are employed to direct the activities of the enterprise

(managers) or to utilize its resources to achieve the goals of the enterprise (other employees) à managerial accounting supplies the information (financial accounting - external users)

- book focuses on perspective of external decision makers - 2 classes of external decisions:

- Investment decisions: Individual’s investment decision involves an exchange of present resources for rights to resources in the future. – both present and prospective investors need the information to make decisions

- Distribution of enterprise benefits: Owners are concerned with the future benefits to be received from ownership they are the residual beneficiaries: - Residual beneficiaries: Parties whose rights and claims remain after all existing statutory and

contractual rights and claims have been satisfied.


Self Study Tasks 4, 5 Week 1


Problem 4: 1. What is an intertemporal choice? 2. What’s the role of banks and financial markets according to intertemporal choice? 3. How do financial markets influence decision making? Problem 5: 1. What’s an annuity formula?

2. What do these terms mean: income statement, discount rate, cash flow, earnings? 2. Link between an annuity formula and the table? 3. Should the investment project be carried out?

- NPV of investment = -900 + (640 – 400) * ( 1/0.1 – 1/(0.1*(1.1)5)) = 9,789 à The investment should be carried out. (the 640 – 400 is the difference between the cash flows before and after the investment

- cash flow: profit after tax + depreciation 4. What’s the difference between cash flows and earnings and which one should be used for calculations? - in the perspective of finance, the value of the firm is its ability to generate financial cash flow, thus when

evaluating an investment, one should take a look at the cash flows 5. What is a balance sheet / an income statement?

Corporate Finance – Chapter 2 (Accounting Statements and Cash Flow) 2.1 The balance sheet - balance sheet: snapshot of the firm’s accounting value on a particular date à assets left (sorted by length of

time required to convert them to cash), liabilities and stockholders’ equity right (reflect the types and proportions of financing) à Assets = Liabilities + Stockholders’ equity

- 3 concerns when analyzing the balance sheet: - accounting liquidity: refers to the ease and quickness with which assets can be converted to cash à

probability of a firm to avoid financial distress can be linked to its liquidity, but to the extent the firm invests in liquid assets, it sacrifices an opportunity to invest in more profitable investments - accounts receivable: amounts not yet collected form customers for goods or services sold

- debt versus equity: - debt service liabilities require payout within a stipulated time period (bondholder: investor in the

firm’s debt – firm gives them first claim on its cash flow) - stockholders’ equity: claim against the firm’s assets that is residual and not fixed (increases when

retained earnings are added) - value versus cost:

- carrying value or book value: accounting value of a firm’s assets – naming misleading as under the GAAP1, the assets are carried at cost (not a the market value: what goods are traded for) à when looking at the balance sheet, you know something about the cost, not the true value of the firm

2.2 The income statement: - income statement: measures performance over a specific period of time à Income = Revenue – Expenses

- operations section: repots revenues and expenses from principal operations - second section reports amount of taxes levied on income - last item is the bottom line net income

- 3 things to keep in mind when analyzing the income statement - GAAP: revenue is recognized on an income statement when the earnings process is virtually completed

and an exchange of goods or services has occurred à unrealized appreciation in owning property is not recognized as income; GAAP also dictates that revenues be matched with expenses à income is reported when it is earned, even when no cash flow has occurred, e.g. when goods are sold for credit

- noncash items: items that are expenses against revenues, but that do not (directly) affect cash flow - depreciation: accountant’s estimate of the cost of equipment used up in the production process

(from financial perspective, cost of the asset is the actual negative cash flow incurred when it is acquired) – can affect cash flow indirectly through taxes

- deferred taxes: result form differences between accounting income and true taxable income, these taxes are not paid today, but will have to be paid in the future à liability for the firm and included in the balance sheet until they are actually paid (not a cash outflow from cash flow perspective)

- time and costs: accountants do not distinguish between variable and fixed costs, but make a distinction between product and period costs - product costs: variable and fixed costs of production

1 GAAP: generally accepted accounting principle s




- period costs: costs allocated to a time period as selling, general and administrative expenses 2.3 Net working capital: - change in net working capital: difference between the net working capital in 2 consecutive years 2.4 Financial cash flow: - statement of cash flows: explains the change in accounting cash and equivalents à in the perspective of

finance, the value of the firm is its ability to generate financial cash flow - cash flow equality: CF(A) = CF(B) + CF(S) (CF from operating activities = CF to creditors + CF to equity

investors) - Total cash flow of the firm: (add all 3; can be frequently negative in times of growth)

- operating cash flow: earnings before interest and depreciation – taxes (CF generated by business activities, reflecting tax payments, but not financing, capital spending or changes in net working capital)

- capital spending = acquisitions of fixed assets – sales of fixed assets - additions to net working capital: CF to investments in net working capital

- Cash flow to investors in the firm: - debt =debt service (interest payments + repayment of principal (or retirement of debt)) – proceeds from

long-term debt sales - equity = dividends + repurchase of equity – new equity financing

- net income is not cash flow! Appendix 2A: (only short summary) – show how to rearrange information form financial statements into financial ratios providing information about 5 areas of financial performance: 1. short -term solvency – ability of the firm to meet its short -run obligations

- current ratio = total current assets / total current liabilities - quick ratio = quick assets / total current liabilities

- quick assets = total current assets – inventories (as they are the least liquid assets) 2. activity – the ability of the firm to control its investment in assets

- total asset turnover = total operating revenues / total assets (average) ; (average: (beginning + end)/ 2) - receivables turnover = total operating revenues / receivables (average) - average collection period = days in period / receivables turnover - inventory turnover = costs of goods sold / inventory (average) - days in inventory = days in period / inventory turnover

3. financial leverage – the extent to which a firm relies on debt financing - debt ratio = total debt / total assets - debt-to-equity ratio = total debt / total equity - equity multiplier = total assets / total equity - interest coverage = earnings before interest and taxes / interest expense

4. profitability – extent to which a firm is profitable - net profit margin = net income / total operating revenue - gross profit margin = earnings before interest and taxes / total operating revenues - net returns on assets (net ROA) = net income / average total assets (can be increased by increasing margins or turnover) - gross returns on assets (gross ROA) = earnings before interest and taxes / average total assets - return on equity (ROE) = net income / average stockholders’ equity - payout ratio = cash dividends / net income - retention ratio = retained earnings / net income - retained earnings = net income – dividends - sustainable growth rate = ROE * retention ratio (maximum rate of growth without increasing financial leverage and using internal

equity only) 5. value – value of the firm

- market price of a share: price of a share of common stock that is established by trading - price-to-earnings (P/E) ratio = market price / earnings per share of last year - dividend yield = dividend per share / market price per share - market -to-book value ratio = market price per share / book value per share - Tobin’S Q = (market value of firm’s debit + equity) / replacement value of firm’s assets

Appendix 2B: - 3 components of an official statement of cash flows:

- cash flow from operating activities - cash flow from investing activities - cash flow from financing activities

- difference between cash flow from financing activities and total cash flow of the firm is interest expense

Corporate Finance – Chapter 3 (Financial Markets and Net Present Value) - financial markets: special markets dealing with cash flows over time, exist because people want to adjust

consumption over time




3.1. The financial market economy - financial markets facilitate borrowing (from) and lending (to) between individuals - financial instruments: e.g. bonds or IOUs that are traded on the financial market - principal repayment: original amount that has to be paid back - interest payment: interest that has to be paid - bearer instruments (or IOU): financial instruments that entitle whoever possesses them to receive payment - financial intermediaries: institutions that match borrowers and lenders or traders (anonymous market) - market clearing: total amount people wish to lend has to equal total amount people wish to borrow - equilibrium interest rate: interest rate at which the market clears 3.2 Making consumption choices over time - individuals and firms can smooth consumption over time - the intertemporal consumption opportunities graph shows the possible consumption of 2 consecutive years,

the area beneath the constraint line contains all feasible solutions - the constraint line has a slope of – (1+r) and is straight because an individual has no effect on the interest

rate - a patient person wishes to lend money, a impatient person wishes to borrow money, but what a person does

actually depends on the interest rate he faces 3.3 The competitive market - perfectly competitive financial market (or perfect market): all individuals are price takers – they have no

influence on the rates and prices - conditions that lead to a perfect market:

- trading is costless and access to the financial market is free - information about borrowing and lending opportunities is available - there are many traders and no single trader can have a significant impact on market prices

- as soon as different interest rates are offered for essentially the same risk-free loans, arbitrageurs will take advantage of the situation, borrowing at the low and lending at the high rate à gap closes quickly and there is only one rate available in the market

- arbitrage: process of striking a deal in one market and an offsetting deal in another simultaneously and at more favorable terms

3.4 The basic principle First principle of investment decision making: The financial markets provide a benchmark against which proposed investments can be compared, with the interest rate being the basis for a test that any proposed investment must pass. (Assumption that people can always lend or borrow at the financial market). For an investment to be undertaken it has to be at least as desirable as what is available in the financial market. 3.5 Practicing the principle - financial markets can be used as a standard of comparison and as a tool to actually help the individual

undertake and investment - separation theorem: The value of an investment to an individual is not dependent on consumption

preferences, however do these preferences dictate whether he borrows or lends. - Net present value (of a transaction) = present value –original investment à Answers the question of how

much cash an investor would need to have today as a substitute for making the investment. - Present value (PV) = future value (FV) / (1+r) - Net present value rule: An investment is worth making if it has a positive NPV. If an investment’s NPV is

negative, it should be rejected. 3.6 Corporate investment decision making - differs by the fact that the firm has no consumption endowment, thus in the one-period diagram, the firm

starts at the origin - when a company takes on a positive NPV investment, shares increase in value today by the value of the

NPV à all shareholders in a company are better off, no matter what their levels of patience or impatience are, managers just need to follow the NPV rule

à Thanks to the separation theorem, we can use the NPV rule for companies as well as for investors (based on the assumption of competitive markets), it also applies for risky cash flows that extend beyond one period




Corporate Finance – Chapter 4 (Net present value) - time-value-of-money concept: relationship between a dollar today and a (possibly uncertain) dollar in the

future 4.1 The One-Period Case - future-value = compound value: value of a sum after investing over one or more periods (Ex: future value

of $10.000 at 12% interest rate is $11.200) - present value = C1 / (1 + r) ß C1 being the cash flow at date 1 and r the interest rate (or discount rate) - future value analysis and present value analysis lead to the same decisions - discount rate = what rate of return used for present value calculations is also called - net present value = – Cost + PV (present value of future cash flows minus the present value of the cost of

the investment) à determines exact cost or benefit of a decision to buy this year and sell next year - when including risk in a present value calculation, the appropriate interest rate cannot simply determined by

checking with a few banks à quite difficult, will be done later 4.2 The multiperiod case - compounding: leaving money in the capital market and lending it for another year - simple interest: the interest received is not reinvested in consecutive year - compound interest: each interest payment is reinvested à the longer-lasting the loan, the more important

the interest on interest (r²) gets - future value (of an investment): C0 * (1 + r)T ; C0 is cash to be invested at date 0, T the number of periods - compound interest after the period being twice as long is the square of the compound interest of the original

period (e.g. at 10.71%, $1 after 71 years: $1370.95, after 141 years: $1370.95²) - discounting: process of calculating the present value of a future cash flow - present value (of an investment) = CT / (1 + r)T ; CT is cash flow at date T - present value factor = 1 / (1 + r)T à factor used to calculate the present value of a future cash flow - someone is equally inclined towards receiving the present value of a future cash flow today or the full

amount in the future - the present value of a set of cash flows is simply the sum of the present values of the individual cash flows - NPV for a T-period project = – C0 + ∑∑ (Ci /(1 + r) i) ; i: 1…T 4.3 Compounding periods - compounding an investment m times a year provides end-of-year wealth of: C0 * (1 + r/m)m - stated annual interest rate (SAIR) (or annual percentage rate): interest rate without consideration of

compounding à meaningful without a compounding interval stated - effective annual interest rate (EAIR) (or effective annual yield): (1 + r/m)m – 1 ; due to compounding it is

higher than the stated annual interest rate à only meaningful when compounding interval given - future value with compounding: C0 * (1 + r/m)mT - continuous compounding: limiting case where amount is every infinitesimal instant compounded à value

at the end of T years is expressed as: C0 * emT - continuous compounding has both the smoothest curve and the highest ending value 4.4 Simplifications Perpetuity: constant stream of cash flows without end (example: British bonds called consols) - present value of a perpetuity: PV = C / (1+r) + C / (1+r)²… = C / r ; finite sum of the infinite number of

items of this geometric series - value of the perpetuity rises with a drop in the interest rate Growing perpetuity: stream of cash flows that rise at a fixed rate per year - PV = C / (r – g) ; g: rate of growth per period, r: appropriate discount rate - 3 important point on the formula:

- numerator: C is the cash flow one period hence (thus the annuity is sometimes called annuity in arrears), not at date 0 (thus when asked about e.g. the price of a stock that just issues a dividend is growing perp. PV + imminent dividend)

- interest and growth rate: r must be greater than g for the formula to work - timing assumption: formula can only be applied when a regular and discrete pattern of cash flow is

assumed - annotation on terminology of time: some others treat cash flows as being received on exact dates (Date0 is

now), others refer to cash flows that occur at the end of a year or period (end-of-the-year convention à End of year 0 is now) à authors believe that date convention reduces ambiguity




Annuity: level stream of regular payments that lasts for a fixed number of periods - present value of having cash flows for T years is the present value of a consol with its first payment at date 1

minus the present value of a consol with its first payment at date T - PV of Annuity = C * [1/r – 1/(r*(1+r)T)] ß in [] is the annuity factor - annuity factor: AT

r (sometimes used instead the term in brackets) - 4 different tricks with annuity formulas:

- a delayed annuity: an annuity or perpetuity that begins at a date many periods in the future à first calculate the present value of the annuity at the date before the first payment, then discount the present value of the annuity back to date 0

- annuity in advance: the formula refers to annuities in arrears if the first payment is occurring at date 0, then we have to calculate the annuity for T-1 years and add an extra payment - annuity in advance: annuity with an immediate initial payment - annuity in arrears: annuity with first payment a year from now

- the infrequent annuity: if annuity is payable only once every several years, we calculate the interest rate over the time period of the gap between payments and then calculate an annuity with T equal to the number of payments and r equal to the calculated interest rate

- equating present value of 2 annuities: calculate the present value of both annuities and set them equal then you get e.g. the amount you have to save to meet annuity expenses in the future periods

- growing annuity: finite number of cash flows that grow with a fixed percentage: - PV: C * [1/(r-g) – 1/(r-g)*((1+g)/(1+r))T] ; C being the payment to occur at the end of the first period

4.5 What is a firm worth? - the present value of a firm depends upon its future cash flows - when deciding upon an investment, we have to calculate the NPV and decide


Self Study Tasks 6, 7, 8 Week 2


Problems Task 6: 1. Explain terms: S&P rating, maturity date, coupon rate & yield. 2. Calculate the price for the Newland Bank bond. à 108,717 ;See calculations on paper! 3. Which of the 3 is the best investment? à as the price takes account of the differences and makes them

basically equal with regard to the return and the risk, you can be indifferent; but as a student is about to choose she is probably risk averse and I would recommend the triple A rated bond

Problems Task 7: 1. Calculate whether the investment project is profitable. à No! See calculations on paper Problems Task 8: 1. What are the other criteria for investment selection: internal rate of return (IRR), pay-back period? 2. What are the advantages / disadvantages of both? 3. Choose between A and B, C and D. à Choose B and D.

Corporate Finance – Chapter 5 (How to value Bonds and Stocks) - r has to be seen as required return! 5.1 Definition of a bond - bond: certificate showing that a borrower owes a specified sum and who has agreed to make interest and

principal payments on designated dates - maturity date (or just maturity): date when the issuer of the bond makes the last payment; it expires then - face value (or principal, or denomination): the specified sum, referred to with letter ‘F’ 5.2 How to value bonds - pure discount bond: promises a single payment at a future date (if that payment is 1 year from now it is

called a one-year discount bond, 2 years from now it is called a two-year discount bond…) à also called zero-coupon bonds, terms zero, bullet and discount can be used interchangeably for bonds that pay no coupons - value of a pure discount bond: PV = F/(1+r)T

- level-coupon bonds: bonds offering cash payments not just at maturity, but also at regular times in between - coupons: payments of a bond other than the repayment of the principal, usually paid semiannually

((F*cupon rate)/2 is what you get) - value of a level-coupon bond: PV= C * AT

r + F / (1 + r)T - consols: bonds that never stop paying a coupon and have no final maturity date – can be calculated by the

perpetuity formula - preferred stock: important example of a consol, which provides the holders with a fixed dividend in

perpetuity 5.3 Bond concepts - bonds sell:

- at face value, if coupon rate is equal to marketwide interest rate - at a discount, if coupon rate is below marketwide interest rate - at a premium, if coupon rate is above marketwide interest rate

- yield to maturity: the discount rate that equates the price of the bond with the discounted value of the coupons and face value à a bond with a 10% coupon is priced to yield 8% at $1035.67

- almost all corporate bonds are traded by institutional investors and are traded on the OTC market - current yield: current coupon / current price Appendix: The term structure of interest rates, spot rates and yield to maturity - spot-interest rate: interest rate fixed today on a loan that is made today – differs for loans that differ in

length - interest rate is not constant over all future periods, mainly because inflation rates are expected to differ - yield to maturity (y): is the time-weighted average of the different spot rates that are used in the calculation

of the PV (interest for the different payments at different times varies!) - 2 bonds with same maturity will usually have different yields if the coupons differ Term Structure and explanations: - term structure: describes the relationship of sport rates with different maturities à exists only for a moment

in time




- forward rate: hypothetical interest rate needed to give an investor investing in 2 one-year discount bonds after another the same amount as when he invested in a two-year discount bond; they can also be calculated over later years as well:

- fn = (1 + rn )n / (1 + rn-1 ) n–1 – 1 ; fn is the forward rate over the n-th year, rn the n-year spot rate, and rn-1 the sport rate for n-1 years

- all forward rates are calculated from the spot rates à they are all known at date 0 - spot rate over year 2: the spot rate from date 1 to date 2, it is not known at date 0, so also the price at which

a 2 year bond sells at date 1 is not known (only the forward rate is known) - amount that a two-year bond is expected to sell for at date 1: Payment at maturity / (1 + sport rate

expected over year 2) à as individuals have different expectations it will differ - expectations hypothesis: forward rate for year 2 = spot rate expected for year two à investors will set

interest rates such that the forward rate over the second year is equal to the one-year spot rate expected over the second year (if f2 is less than the spot rate expected, individuals desiring to invest for one year would always buy a one-year bond)

- liquidity preference: forward rate for year 2 > spot rate expected over year 2; as investors are assumed to be risk-averse, the expectations hypothesis is not practical as they have to be induced to hold the riskier 2 year bonds so their forward rate has to be higher than the expected spot rate

à see also page 132!

Additions from “Investments” Chapter 2 pages 30-45 2.1 The money market – short-term debt securities that are highly marketable - treasury bills: issued by the government that pays the holder the equivalent of the face value of the bill at

maturity (face value usually $1000) - can be bought by competitive (only the highest accepted) or noncompetitive bid (all accepted and

average price charged) or through intermediaries - bank discount yield: approach by which the yield of T-bills is stated à rBD = (F – P)/F * 360/n ; P is

asked price à compared with the effective annual yield, the bank discount yield is lower - bond equivalent yield: rBY = (F-P)/F * 365/n à but states annual percentage rate (simple interest)

- certificate of deposit (CD): time deposit with a bank, which pays interest and principal to depositor at the end of the fixed term

- commercial paper: when companies issue their own short-term unsecured debt notes - bankers’ acceptances: order to a bank by a bank’s customer to pay a sum of money at a future date, when

the bank accepts the order, it assumes responsibility for ultimate payment (often used in foreign trade) - eurodollars: dollar-denominated deposits at foreign banks or foreign branches of US bank - repurchase agreements (repos): dealer sells government securities to an investor on an overnight basis with

an agreement to buy back those securities the next day at a slightly higher price (term repro: longer than 30 days) (reverse repro: mirror image of a repro)

- federal funds: funds of the commercial banks at the Fed, banks with excess federal funds lend to those with shortage

- LIBOR market (London Interbank Offered Rate): rate at which large banks in London are willing to lend money among themselves

à money market securities are low risk, but not risk free (except treasury bills) 2.2 The fixed income capital market – longer-term borrowing instruments (‘fixed income’ derives from the promise of most of a stream of income) - treasury notes & treasury bills: long term debts sold by the government that make semiannual coupon

payments (T-bonds may be callable during a given period) - yield to maturity: quoted on an annual percentage rate (APR)

- federal agency debt: securities issued by government agencies, usually formed to channel credit to a particular sector

- municipal bonds: bonds issued by state or local governments that are exempt from federal income taxation and from state and local taxation in the issuing state à investors have to compare after-tax returns on each bond (normal or municipal) - equivalent taxable yield of a tax-exempt bond: r = rm/(1– t) ; t is the tax-bracket of the investor - the cutoff tax bracket: tax bracket at which after-tax yields are equal: t = 1 – rm/ r

- corporate bonds: bonds issued by private firms; also pay semiannual coupons over their lives and return the face value to the holder at maturity; differ from treasury bonds in terms of risk (secured bonds are backed for the case of bankruptcy, debentures are unsecured bonds and subordinated debentures have a lower priority claim to the firm’s assets in event of bankruptcy) - callable bonds: give the firm the option to repurchase the bond from the holder at a stipulated price




- convertible bonds: give the bondholder the option to convert it into a stipulated number of shares of stock

- mortgage-backed securities: ownership claim in a pool of mortgages or an obligation that is secured by such a pool à mortgage lenders originate loans and then sell packages of them in the secondary market, later passing the payments of interest and principal through to the buyers of the packages (usually guarantee payment of interest and principal, but not the rate of return)

Chapter 6 – Some Alternative Investment Rules 6.1 Why use net present value? - accepting positive NPV projects always benefits the stockholders - key to NPV is its 3 attributes:

- NPV uses cash flows – by contrast earnings are an artificial construct and should not be used as they do not represent cash

- NPV uses all the cash flows of a project – beware, others ignore cash flows beyond particular dates - NPV discounts the cash flows properly – beware, others might ignore the time value of money

6.2 The payback period rule - payback period rule: one of the most popular alternative to NPV à a particular cutoff time is selected and

all investment projects that have payback periods this cutoff time or less are accepted, the others are rejected - payback period: number of periods it takes to recover the investment just by means of adding up the cash

flows without discounting them àà 3 problems:

- timing of cash flows within the payback period: timing is not considered, so it is inferior to NPV which discounts the cash flows properly

- payments after the payback period: are ignored and thus an artificial short-term orientation is enforced which may lead to decisions not in the shareholder’s best interests (not with NPV)

- arbitrary standard for payback period: with NPV firm can go to the capital market to get the discount rate, but there is no comparable guide for choosing payback period à choice to some extent arbitrary

- why is it used then? - for small decisions frequently used because of its ease in use, especially when decisions are numerous - has desirable features for management control: after the payback period you know whether decision was

correct or not - firms with very good investment opportunities but limited cash may choose it as it may enhance

reinvestment possibilities - as decision grows in importance, NPV becomes more important in evaluation 6.3 The discounted payback rule - discounted payback rule: we first discount the cash flows and then ask how long it takes for the discounted

cash flows to equal the initial investment - discounted payback period: payback period for the discounted cash flows (as long as cash flows are

positive, it will never be smaller than the payback period) - though it takes account of discounting, it still ignores all of the cash flows after the arbitrary cutoff date 6.4 The average accounting return - average accounting return (AAR): average project earnings after taxes and depreciation, divided by the

average book value of the investment during its life (fatally flawed, but frequently used in real world) - steps in calculation:

- determine average net income: net income = cash flow – depreciation – taxes - determine average investment: add up all the values after depreciation and divide them by n+1 (because

you have to add not n, but n+1 terms, you have to include the beginning and the ending value) - determine the AAR: gives a percentage value which has to be compared with a target value

- flaws: 1) uses net income figures (not actual cash flows); 2) does not take account of timing (does not discount); 3) offers no guidance on what the right target rate of return should be

6.5 The internal rate of return - internal rate of return (IIR): tries to find a single number that summarizes the merits of a project and does

not depend on the interest rate (the number then is intrinsic to the project and does only depend on the cash flows) à it is the interest rate at which the NPV of a project equals zero

- basic IRR rule: Accept the project if IRR is greater than the discount rate; reject it if IFF is less than the discount rate




- thus for basic examples the IRR and the NPV rule coincide, but unfortunately there are several problems with the IRR in more complicated situations

6.6 Problems with the IRR approach - independent project: one whose acceptance or rejection is independent of the acceptance or rejection of

other projects - mutually exclusive investments: you can accept A or B, or reject both, but you cannot accept them both • 2 general problems affecting independent and mutually exclusive projects:

- investing or financing: - the basic IRR rule only holds for real investments (NPV is negatively related to the discount rate;

first negative, then positive cash flow) - if the project is of financing-type (NPV is positively related to the discount rate; first positive, then

negative cash flow), the rule has to be reversed to à accept project when IRR is less than discount rate, reject if it is greater

à problem , unless it is understood properly - multiple rates of return: à see also table on page 147

- when a project’s cash flows exhibit more than one change of sign (or flip-flops) the project may have more than one IFF (with M changes it can have up to M IRRs) à thus the IRR cannot be used

- real life examples are e.g. lease arrangements that bring substantial tax advantages à only when there is only one change of sign we are safe from multiple IRRs

• 2 problems dealing with the application of the IRR approach to mutually exclusive projects: it is not necessary to determine which problem occurs as they in real life are quite likely to occur together and the same methods are used to get rid of them - scale problem: the IRR does not take scaling into account, means we cannot directly compare 2 projects

with different initial investments as the IRR would be misleading à you can handle the comparison of 2 mutually exclusive projects in 3 ways: - compare the NPVs of the 2 choices (as they take scaling into account) - compare the incremental NPV from making the larger investment and the smaller investment - compare the incremental IRR to the discount rate - (when calculating incremental flows, you should subtract the smaller project’s cash flows from the

bigger project’s cash flows) - timing problem: occurs when the cash flows of the project occur at different times and thus one of the

NPVs declines more rapidly than the other à you can handle the comparison again with 3 approaches: - compare NPVs of the 2 projects - compare incremental IRR to discount rate (subtract the cash flows from one project of the other so

that the first cash flow is negative in order to be able to apply the basic IRR rule à then if discount rate is below the calculated incremental IRR chose the project from which you subtracted)

- calculate NPV on incremental cash flows (if NPV negative choose the project you subtracted) - IRR survives because it fills the need of a summarizing number that the NPV does not give 6.7 The profitability index - profitability index: ratio of the present value of future expected cash flows after initial investment divided

by amount of initial investment - 3 possibilities to consider:

- independent projects: PI decision rule à Accept an independent project if PI > 1, reject if PI < 1. - mutually exclusive projects: like the IRR the PI ignores differences of scale for mutually exclusive

projects which can be corrected using incremental analysis. If the profitability index on the incremental cash flow is greater than 1 the bigger investment should be accepted

- capital rationing: when a firm does not have enough capital to fund all possible NPV projects, the projects should be ranked according toe the ratio of present value to initial investment (PI rule) à does only work if funds are only limited in the initial time period

6.8 The practice of capital budgeting - not all firms use capital budgeting procedures based on discounted cash flow - in large corporations most frequently used are IRR or NPV - payback is rarely used as a primary method, but most frequently as secondary method - in some businesses (e.g. movies) the estimation of cash flows is virtually impossible and thus also the NPV

analysis




Chapter 7 – Net present value and capital budgeting 7.4 Investments of unequal lives: The equivalent annual cost method - when a firm must choose between 2 machines with unequal lives that do the same job, but have different

operating costs calculation of the NPV is misleading as it can lead to the wrong decision à such projects have to be evaluated on an equal-life basis (with methods that take into account all future replacement decisions)

- Replacement chain: there are 2 methods to adjust for the difference in useful life:

1. matching cycles: - we simply calculate the present value of costs of both machines for a period of time that is the smallest

mutual multiple of their useful lives à after that period we have used up the different machines and when calculating the present value we take also the replacement costs into account (e.g. is the machine with the shorter useful life more often included in the period and thus has to be bought more often)

- drawback of this approach: if the number of cycles needed is high it demands an excessive amount of calculations

2. equivalent annual cost (EAC): - we simply equate the present value of both machines at date 0 with the corresponding annuities of their

respective lives à we get the equivalent annual cost of the machines that would have to be made for an infinite period into the future when using repeated cycles

- we chose the one with the lowest equivalent annual cost à both approaches are simply different ways of presenting the same information, so they give the same result - Assumptions in replacement chains:

- Analysis of replacement chain applies only if one anticipates replacement - Strictly speaking the 2 approaches only make sense when the time horizon is a multiple of the smallest

mutual multiple; however, if the time horizon is long but not known precisely, these approaches should still be satisfactory

• General decision to replace: most typically firms must decide when to replace an existing machine with a new one à see pages 178/9 1. calculate EAC for the new equipment 2. calculate the yearly cost for the old equipment, as it occurs at the end of each year (as costs also are

assumed to occur at the end of the year à calculate present value of keeping the machine one more year and then make a future value out of it by multiplying with the appropriate compounded interest rate - the PV of keeping the old machine one more year is the opportunity cost + additional maintenance

– salvage value 3. check where the cost of the old machine exceed the costs of the new machine (but beware, perhaps the

old machine’s maintenance is high in the first year but drops after that)




Problem 9: 1. Do the calculations and mind the exact inventory and accounts receivable! (discount rate: 15%+5%=20%) Problem 10: 1. Calculate NPVs with oil-prices $9 an $13. 2. Should you go ahead with the research project?

Chapter 7 – Net present value and capital budgeting 7.1 Incremental cash flows - difference between corporate finance and financial accounting: uses cash flows opposed to earnings - incremental cash flows: when calculating the NPV of a project, only cash flows that occur as a direct

consequence of accepting it should be used - sunk cost: cost that has already occurred and consequently cannot be changed by the decision to accept or

reject the project à should be ignored and are no incremental cash outflow - opportunity costs: lost potential revenues from an asset that is used in a new project (firm foregoes

opportunities for using the assets in an other way) - erosion: side effect of an investment that occurs when (part of) the cash flow of new project is transferred

from sales of other products of the firm à has to be included in the determination of NPV 7.2 Baldwin Company: An example - net working capital: difference between current assets and current liabilities needed, but mostly assumed to

be recovered at the end of the project (common assumption) à increases in working capital must be funded by cash generated elsewhere in the firm = viewed as cash outflows, decrease = viewed as cash inflows - needed for 1) raw materials and other inventory purchased prior to sale of finished goods; 2) credit

sales; 3) cash kept in project as a buffer against unexpected expenditures - net working capital = accounts receivable – accounts payable + inventory + cash - typically net working capital is treated as a whole and the individual components do not generally

appear on the worksheets (but remember that it is based on assumptions!) - capital gain: difference between ending market value and adjusted basis of the machine à is taxed! - cash flow of the project: cash flow from operations (sales – operating costs – taxes) + total cash flow of the

investment - though net income is not directly needed, it needed for the calculations of the taxes - firms generally keep 2 sets of books (for determining the cash flows we used the IRS rules)

- tax books: for the IRS according to its rules - stockholders’ books: follows the rules of the Financial Accounting Standards Board (FASB)

- though debt financing can be used, firms typically calculate a project’s cash flows under the assumption that the project is financed only with equity à adjustments for debt financing are reflected in the discount rate not in the cash flows

7.3 Inflation and capital budgeting - inflation is an important fact in economic life and has to be considered in capital budgeting - nominal interest rate or simple the interest rate - real interest rate = (1+ nominal interest rate) / (1 + inflation rate) –1 (approximation, only valid for small

values: real = nominal – inflation) - the nominal rate of interest usually exhibits more variability form year to year than does the real rate - nominal cash flow: reflects the actual dollars to be received in the future (to determine the real cash flow we

have to divide by the cumulated inflation rate) - real cash flow: cash flow expressed in purchasing power of date 0 - depreciation: is a nominal quantity as it gives the amount of money that is the actual tax deduction over

each of the following years à it does not matter which approach (real or nominal rate) one uses when discounting, only consistency

between cash flows and discount rates has to be maintained (nominal cash flows must be discounted at the nominal rate, real cash flows must be discounted at the real rate)

à NPV for an investment is the same when cash flows are expressed either in real or in nominal quantities à for expenditure at date 0, nominal and real value are equal




Chapter 8 – Strategy and Analysis in using NPV 8.1 Corporate strategy and positive NPV - corporate strategy analysis: process of asking about the sources of positive NPV in capital budgeting - intuition behind discounted cash flow analysis: project must generate higher rate of return than one that can

be earned in the capital market (only if this is true the NPV is positive) - assumption that positive NPV projects are hard to find à ways to create positive NPV:

- introduce a new product - develop core technology - create barriers to entry - introduce variations on existing products - create product differentiation - utilize organizational innovation

- positive NPV projects are harder to find in a competitive than in a noncompetitive industry Corporate strategy and the stock market - connection between stock market and capital budgeting: if company engages in positive NPV project, the

stock price should go up - research found that the stock market encourages managers to make long-term strategic investment decisions

in order to maximize shareholders’ value (some argue in contrast for short-sightedness of US stock market) 8.2 Decision Trees - fundamental problem in NPV analysis is the uncertainty of future outcomes and also, there is usually a

sequence of decisions in NPV project analysis - decision tree: used for identifying the sequential decisions in NPV analysis and calculating the NPV - the decisions are actually made in reverse order with decision trees:

- 1) you calculate the expected payoff at the lowest decision level - 2) go back until you reach the highest decision level, always keeping discounting in mind

- warnings: discount rates may actually differ for the different decisions that have to be made + a decision tree cannot capture all of the managerial options in changing environments

8.3 Sensitivity analysis, scenario analysis and break-even-analysis - though NPV analysis is a superior capital budgeting analysis, and it is hard to find any theoretical fault with

it, some managers complain that despite the usually quite impressive documentation for capital budgeting proposals, the projected cash flow often goes unmet in practice

Sensitivity Analysis and scenario analysis: - sensitivity analysis (a.k.a. what-if analysis and bop (best, optimistic, pessimistic) analysis): examines how

sensitive a particular NPV calculation is to changes in underlying assumptions - besides the normal expectations, the firm’s analysts prepare both optimistic and pessimistic forecasts for

the different variables for purpose of comparison - standard sensitivity analysis now calls for NPV calculation for all 3 possibilities of a single variable,

along with the expected forecast for all others - purpose:

- resulting table can indicate whether NPV analysis should be trusted (are most negative / positive?) - sensitivity analysis also shows where more information is needed (e.g. when effect of incorrect

estimates on revenues is much greater than the effect of incorrect estimates on costs) - drawbacks:

- it may as well increase the false sense of security (loss is still possible if all values are positive (to solve this some companies do not make optimistic/pessimistic forecasts but deduct/add a certain percentage à drawbacks: ignores the fact that some variables are easier to forecast than others)

- each variable is treated in isolation, in reality they might be linked (solution: scenario analysis) - scenario analysis: variant of sensitivity analysis; it examines a number of different likely scenarios, where

each scenario involves a confluence of factors Break-even analysis: - break-even analysis: another approach to examine variability in forecasts, it determines the sales needed to

bread even à sheds light on the severity of incorrect forecasts - calculated for accounting profit:

- contribution margin: the after-tax difference per unit that contributes to after-tax profit - accounting profit break-even point: (fixed costs + depreciation)*(1 – Tc) / Sales price – Variable

costs)*(1 – Tc)




- calculated for present value: (as we are usually not interested in net profits) - first we have to express the initial investment as a x-year equivalent annual cost (EAC) - present value break-even point: (EAC + fixed costs * (1 – Tc) – depreciation * Tc) / (Sales price –

Variable costs)*(1 – Tc) - the present value break-even point is different form the accounting break-even point, because in the

accounting profit break-even approach the economic opportunity costs of the initial investment are disregarded

- depreciation understates the true costs of recovering the initial investment à companies may break even, but basically are really losing money

8.4 Options - the analysis presented so far is static, in fact standard NPV analysis is somewhat static, but corporations

have to make decisions in a dynamic environment and thus have options that should be considered in project evaluation: - option to expand: most important option is to expand when economic prospects are good, itself has

value - option to abandon: it also has value; a firm will exercise its option of abandoning, rather than keeping a

money-losing product on the market - discounted cash flows and options:

- the market value of a project (M) is the sum of the NPV of the project without options to expand or contract and the value of the managerial options (Opt): M = NPV + Opt

- valuation approaches that ignore these managerial options are likely to substantially underestimate the value of the project à there are both qualitative and quantitative approaches to adjusting for option value in capital budgeting decisions, with quantitative approaches gaining acceptance




Problem 11: 1. Definitions: foreign stocks, investment bonds, foreign bonds…? 2. Definitions: options, futures, forwards, swaps? 3. How can she reduce the risk of her portfolio and the amount of tax payable? 4. What are the factors that cause the emergence of financial innovations? à demand, taxation and regulation 5. What are the consequences of these instruments for investors, companies and regulatory bodies? 6. Be able to explain the table. Problem 12: 1. What is the discounted cash flow formula? 2. What does it mean when stocks are undervalued by the market? 3. How can future dividends be determined? – by educated guesses 4. What does a historical trend tell us about the future? – not too much 5. How can the value of a stock be determined? – by present value calculation of all future dividends

Chapter 5 (5.4-5.9) – How to value bonds and stocks 5.4 Present value of common stocks - value of common stocks: dependent on the future cash flows à PV equals the discounted present value of

the sum of the next period’s dividend plus next period’s stock price, or which is the same, the discounted present value of all future dividends à P0 = ∑ (Divi /(1 + r) i)

- valuation of a stock with a constant dividend: perpetuity formula à P0 = Div / r - valuation of a stock with growing dividends: P0 = Div / (r – g) ; Div is the dividend at the end of the first

period, r the required rate of interest (or the marketwide interest for this risk class) - valuation of a stock with differential growth:à see block with formulas 5.5 Estimates of parameters in the dividend-discount model - where g does come form:

- business earnings and thus dividends can only grow if a net investment is made - net investment: total investment – depreciation à will only occur when some of the earnings are not

paid out = when some earnings are retained - the increase in earnings in the following year(s) is a function of the retained earnings and the return on

retained earnings - retention ratio = ratio of retained earnings to earnings - return on equity (ROE): return on the cumulation of all the firm’s past projects - g = retention ration * return on retained earning (as usually unknown ROE is used as an estimation)

- where does r come form: - solving the formula for the growing perpetuity for r: r = Div / P0 + g - dividend yield: Div/P0 - payout ratio = 1 – retention ratio (gives the ratio of dividends/earnings)

- calculations of g and r have to be seen with skepticism, as g can only be approximated and r is heavily dependent on it (just think of what happens to the value when there is no dividend payment or during a period when g is higher than r (this can’t last forever and we thus can’t use the annuity))

5.6 Growth opportunities - earnings per share (EPS) - value of a share of stock when firm acts as a cash cow (EPS = Div): PV = EPS/r = Div/r ; r being the

discount rate on the firm’s stock - stock price after firm commits to a new project: PV = EPS/r + NPVO - net present value of the growth opportunity (NPVO) - in order to increase value à 1) earnings must be retained so that projects can be funded; 2) projects must

have a positive net present value - but, dividends grow, whether projects with positive or negative NPVs are selected à policy of investing in

projects with negative NPVs leads to growth in dividends and earnings, but will reduce value - in application, always the dividends are discounted (not the earnings) as they one of the 2 things the investor

gets out of the stock - though the formulas suggest that no-dividend firms would trade at 0, they actually do trade at positive

prices, as the investors expect dividends to be paid at some point (firms with high growth rates are likely to pay lower dividends) (opposed are utilities as a group as they have few growth opportunities and thus pay out most of their earnings)




5.7 The dividend-growth model and the NPVGO model (advanced) - value of a stock with steady growing dividends (resulting from a continual investment in growth

opportunities) can be derived using the ‘dividend-growth model’ or the ‘NPVGO model’, giving the same results: - dividend-growth model: the price of the stock is the value of the growing perpetuity (Div / (r – g)) - NPVGO model: price of a share of stock is the sum of its price as a cash cow plus the per-share value

of its growth opportunities à more difficult to calculate when there is a steady growth: - 1) calculate the value per share of a single growth opportunity - 2) calculate the value per share of all opportunities (using a simple growth perpetuity with the value

of the first single growth opportunity - 3) calculate the value per share if the firm acts as a cash cow (Div/r)

5.8 Price-earnings ratio - financial analysts frequently relate earnings and price per share à P/E ratio - under the assumption that a company acts as a cash cow (EPS = Div) we get from the NPVGO model

divided by EPS: P/E = 1/r + NPVGO/EPS à the P/E ratio is a function of 3 different factors. A company’s ratio or multiple is likely to be high if

- it has many growth opportunities (NPVGO is bigger, most important) - it has low risk (r required is smaller making the first term bigger) - it is accounted for in a conservative manner (using LIFO instead of FIFO in inventory accounting)

- a significant portion of the academic community belies that the market sees through virtually all accounting differences (hypothesis of efficient markets)

5.9 Stock market reporting - Hi/Lo 52 weeks: reports the high and low share prices over the last 52 weeks - Div = Dividend - YLD = dividend yield = current annual dividend / current closing price - PE = Price earnings ratio - Vol = trading volume on the particular day - Hi/Lo/Close = high, low and closing price of the share on this day - Net chg = change in closing price compared to the previous day

Additions from “Investments” Chapter 1 (1.1-1.4) 1.1 Real assets versus financial assets - real assets: land, buildings, machines, knowledge à the productive capacity of an economy is function of

them - financial assets: stocks, bonds à do not represent a society’s wealth, but contribute to the productive

capacity of the economy indirectly, as they allow for a separation of ownership and management; they are claims to the income generated by real assets or claims on income from the government

- on the balance sheet real assets only appear on the debit side, financial assets appear on both sides 1.2 Financial markets and the economy - financial assets allow us to make the most of the economy’s real assets:

- consumption timing: they allow us to separate decisions concerning current consumption from constraints imposed by current earnings

- allocation of risk: all real assets involve some risk, with the diverse financial instruments it is possible to allocate the risk that is inherent to all investments to be borne by the investors most willing to bear it and each security can be sold at the best possible price à facilitates process of building economy’s stock of real assets

- separation of ownership and management: financial assets and the ability to buy and sell those make this possible; the goal of management should be to pursue strategies that enhance the value of the shares

1.3 Clients of the financial system - by looking at the needs of the clients, we gain insight into why organizations and institutions evolved as they

did - household sector: mainly concerned with how to invest money à households demand for a variety of

financial assets, depending on their economic situation, the tax brackets they are in and differences in risk tolerance à myriad of risk-specific assets are demanded and created by agents




- corporate sector: mainly concerned with how to raise money à 2 ways: - borrowing: from banks or from households by issuing bonds - issuing stock à objectives: get the best possible price for the securities at the lowest cost of issue à

fairly simple securities are issued, which mismatch the demand of the households of diverse investment opportunities (middlemen specialized in transforming simple into complex securities arise)

- government sector: are restricted to borrowing to raise funds, special advantage is their taxing power that makes them very creditworthy

1.4 The environment responds to clientele demands Financial intermediation: - financial intermediaries: banks, investment companies, insurance companies bring the two sectors

(households and companies) together by selling their own liabilities to raise funds that are used to purchase liabilities of other corporations à lenders and borrowers do not need to contact each other directly

- spread between rates paid and rates charged is the source of profit - advantages: 1) pool resources of many small investors and thus are able to lend considerable sums to large

borrowers; 2) by lending to many borrowers they reach significant diversification and thus lower risk; 3) gain experience through volume of business

- investment companies: pool together and manage money of many investors or design portfolios specially for small groups of large investors with particular goals

- mutual funds: pool limited funds of small investors into large amo unts - economies of scale also explain the proliferation of analytic services available to investors Investment banking: - investment bankers: advise issuing firms on the prices it can chare for securities, market conditions,

appropriate interest rates & also handles the marketing of the security issue to the public (advantage is also that their reputation provides a certification role to security issuers)

Financial Innovation and derivatives: - investment diversity desired by households is greater than most businesses have a desire to satisfy à profit

opportunity for innovative security designed packed by the financial intermediaries - most new securities are created by dismantling and rebundling more basic securities - prime security: offers returns based only on the status of the issuer - derivative securities: yield returns that depend on additional factors pertaining to the prices of other assets

- options: give buyers the right, but not the obligation, to buy or sell an asset at a present price over a specific period (often interest-rate options are used as caps and floors by companies to control financing costs)

- forward-type contracts (forwards, futures, swaps): commit the buyer and the seller to trade a given asset a set price on a future date (often settled in cash rather than by exchanging the asset) (often used to protect against fluctuations in currency or commodity prices)

- one of the uses of derivatives is to hedge risks, the other is to take highly speculative positions Response to taxation and regulation: - many financial innovations are direct responses to government attempts to regulate or to tax investments of

various sorts (e.g. are in the US capital gains taxed lower than dividends) - regulatory pressures thus often lead to unanticipated financial innovations

Additions from “Investments” Chapter 2 (2.3-2.5) 2.3 Equity securities - common stock (or equity security or equity): ownership shares in a corporation à entitles its owner to vote

on any matters of corporate governance put to a vote at the corporation’s annual meeting and to a share in the financial benefits of ownership - characteristics: 1) stocks are a residual claim on the assets and the income of the corporation and 2)

have a limited liability (the investor can only loose his investment) - preferred stock: has features similar to both equity and debt

- similar to bond: promises to pay to its holder a fixed amount of income each year in perpetuity and has no voting right

- similar to equity: no contractual obligation to make the dividend payment, but unpaid dividends cumulate and must be paid in full before any dividends may be paid to holders of common stock; claim on the assets is also only a residual claim




- return is taxed as dividend, but corporations may exclude 70% of dividends received from domestic corporations in computation of taxes à preferred stock is interesting for businesses

2.4 Stock and bond market indexes: - price-weighted average: money invested in each company represented in the portfolio is proportional to that

company’s share price à are affected by stock splits! - market-weighted average: money invested in each company is proportional to its market value - equally weighted indexes: places equal dollar values on each stock - Dow Jones Industrial average: is a price-weighted average of 30 American blue-chip companies - Standard & Poor’s Composite 500: broadly based, market-value-weighted index of 500 firms - Value line index: equally weighted geometric average of the performance of 1700 firms (downward biased) à stock and bond market indexes provide guidance concerning the performance of the overall stock market / various categories of bonds 2.5 Derivative markets – futures, options and related derivatives derive their value from or are contingent on the values of other assets

and thus are also called ‘derivative assets’ or ‘contingent claims’ Options: - call option: gives the holder the right to purchase an asset for a specified price (the ‘exercise’ or ‘strike’

price) on or before a specified expiration date - put option: gives the holder the right to sell an asset for a specified exercise price on or before a specified

expiration date - each option contract is for 100 shares, however quotations are made on a per-share basis à profits on call options increase when the asset increases in value, profits on put options increase when the

asset value falls Futures contracts: - futures contract: calls for delivery of an asset (or in some cases its cash value) at a specified delivery or

maturity date for an agreed-upon price to be paid at contract maturity - long position: held by the trader who commits to purchase the commodity at delivery date - short position: held by the trader who commits to deliver at maturity date

- trader holding the long position profits from price increases - opposed to options a futures contract is an obligation, so the holder of a call option has a better position than

does the holder of a long position on a futures contract with a futures price equal to the option’s exercise price à this advantage comes at a price, the purchase price of the option, futures contracts may be entered without costs (similar is relationship put option, short futures position)

- premium: purchase price of the option, represents compensation the holder must pay for the ability to exercise the option only when it is profitable to do so




Problem 13: 1. What’s the portfolio theory of Markowitz? What’s the correlation coefficient and what does the standard

deviation tell us? 2. Apply Markowitz theory to the task! Problem 14: 1. What’s insider trading and is Renate involved in it and if, is it correct form an economic/ethic/legal point of

view? 2. What’s the Model code (probably not in the literature)?

Corporate Finance – Chapter 9 (Capital Market Theory: An overview) 9.1 Dollar returns • return on an investment in stocks comes in form of dividends and capital gains (capital losses)

- total return = dividend income + capital gain - capital gain is part of the return as is the dividend, even if you do not decide to realize it you should

count it as return • percentage returns:

- it is more convenient to summarize the information about returns in percentages - dividend yield (percentage) = dividend paid / stock price at beginning of year - capital gain (percentage) = change in price of the stock / initial price - (assumption that dividends are paid at the end of the year; if not the case, the return that comes from

reinvesting the dividend in the stock has to be included) à percentage return = (Dividends paid at end of period + Change in market value over period) /

Beginning market value 9.2 Holding-Period returns - holding-period return: rate of return over a given period (with reinvestment) - in diagrams, using a logarithmic scale, equal distances measure the same number of percentage change - largest return in last 72 years could be made with small-company stocks (but very volatile) - treasury bills show very little fluctuation and always gave a positive return 9.3 Return statistics - average return: mean of the return distribution (gives best estimate of return that an investor could have

realized in a particular year 9.4 Average stock returns and risk-free returns - risk-free return (over a short time): interest the government pays on short term liabilities - excess return on the risky asset: difference between risky returns and risk-free returns - risk premium: excess return on the risky asset that is the difference between expected return on risk assets

and the return on risk-free assets - there is a long-run excess of the stock return over the risk-free return, but that does not mean that it never

pays to invest in T-bills – this is due to the variability of the various types of investment: - while common stock frequently yields negative returns, T-bills always produce positive returns

9.5 Risk statistics - there is no universally agreed-upon definition of risk – one way is in terms of how spread-out the frequency

distribution is à the standard deviation (and it square the variance) is the standard statistical measure of the spread of a sample and it will be the measure we use most of the time

- normal distribution: - for large samples it is a symmetric, bell-shaped curve - probability of having a return that is within one (two) standard deviation(s) of the mean of the

distribution is approximately 0.68 (0.95) - a sampling error exists in any individual sample à the distribution of the sample only approximates the

true distribution




Corporate Finance – Chapter 10 (Return and Risk: The Capital-Asset-Pricing Model CAPM) 10.1 Characteristics of individual securities - expected return: return that an individual expects a stock to earn over the next period - variance and standard deviation: measures of volatility - covariance and correlation: covariance is a statistic measuring the interrelationship between two securities,

alternatively this relationship can be restated in terms of correlation 10.2 Expected return, variance and covariance - expected return and variance:

- when calculating the variance using past data, we have to use the divisor N-1, but in the case of possible outcomes, the divisor N is used

- Var(r) = Expected value of (R – R²) - SD(r) = sqrt(Var(r))

- covariance and correlation à measure the interrelation between 2 random securities - Cov(Ra,Rb) = Expected value of [(Ra – Ra)*(Rb – Rb)] (multiplication of the deviation form the

expected returns) - if the 2 returns are positively (negatively) related to each other, they will have a positive (negative)

covariance; if they are unrelated the covariance should be zero - Corr(Ra,Rb) = (Cov(Ra,Rb))/ (Sda * SDb) - the sign of the correlation is the same as of the covariance its value is always between +1 and –1

10.3 The return and risk for portfolios - portfolio: combination of securities à for the investor the portfolio should give a high expected return and a

low standard deviation of return - expected return on a portfolio: is the simple weighted average of the expected return on the individual

securities - variance and standard deviation of a portfolio: (see formulas!)

- the variance of a portfolio depends on both the variances of the individual securities and the covariance between them

- a positive covariance increases the variance of the entire portfolio, a negative decreases it - diversification effect: when comparing the standard deviation of the portfolio with the weighted average of

the standard deviations of the individual securities, one notices that it is lower à - As long as p<1 (correlation < 1) (between pairs of securities), the standard deviation of a portfolio of

two (or more) securities is less than the weighted average of the standard deviations of the individual securities.

- though the standard deviation of most individual securities in an index is usually higher than that of the index, it can nevertheless be that it is lower in some cases

10.4 The efficient set for 2 assets - when graphing ‘expected return of portfolio’ against ‘standard deviation of portfolio’s return’, the result will

be, except when the correlation is 1, a opportunity curve (if p=1, then it is a line between the 2 individual points)

- the diversification effect is illustrated by the figure since the curved line is always to the left of the straight line

- minimum variance portfolio (MV): point on the curve with the lowest possible variance (and standard variation)

- opportunity set (or feasible set): the set of choices an individual has - when the curve is backwards bending, the one stock serves as a hedge to a portfolio only composed of the

other (backward bending always occurs if p <= 0, and may or may not when p > 0) - efficient set (or efficient frontier): no investor would want to hold a portfolio with an expected return below

that of the minimum variance portfolio so this backwards bending part is excluded from the efficient set - the lower the correlation, the more bend there is in the curve - an efficient set can also be generated where the 2 individual assets are portfolios themselves à the

diversification benefits form combining 2 different portfolios can more than offset the introduction of a riskier set of stocks into one’s holdings

- but one should always be aware, that using only past data to calculate future returns yields only an estimate




10.5 The efficient set for many securities - with more than 2 securities, the opportunity set becomes an area giving all possible combinations of

expected return and standard deviation for a portfolio - but no one would choose an expected return below that one given by the upper edge of the area above the

MV Variance and standard deviation in a portfolio of many assets: - the variance can be calculated using a matrix with N*N fields, where the diagonal terms in the matrix

contain the variances of the different stocks, the off-diagonal terms the covariances - as the number of off-diagonal terms rises much faster than the number of diagonal terms, the variance of the

return on a portfolio with many securities is more dependent on the covariances between the individual securities than on the variances of the individual securities

- variance of portfolio = Number of diagonal terms * each diagonal term + Number of off-diagonal terms * each off diagonal term

10.6 Diversification: An example - in a portfolio with N securities, that have all the same variance, each pair has the same covariance and all

securities are equally weighted, the variance of the portfolio (increasing N to infinity), reaches the covariance (also applies when variances and covariances are not equal)

à with diversification, the variances of the individual securities are diversified away, but covariance terms cannot be diversified away

- the variance of the portfolio drops with every security added, so one can never achieve too much diversification in theory, but in reality there are costs related to diversification

- a portfolio of about 30 stocks is needed to achieve optimal diversification - total risk of individual security = portfolio risk + unsystematic or diversifiable risk - total risk: risk that one bears by holding onto one security only - portfolio risk (or systematic / market risk): risk that one still bears after achieving full diversification (this is

the contribution to the risk of the entire portfolio) - diversifiable risk (or unique / unsystematic risk): risk that can be diversified away in a large portfolio - the average investor is risk averse, so he opts for diversification to reduce the risk 10.7 Riskless borrowing and lending - by definition, the risk-free asset has no variability - the relationship between risk and expected return for one risky and one riskless asset is represented on a

straight line between the risk free rate and a pure investment in the risky asset - when borrowing is considered, the line can even be extended using its original slope, only if the borrowing

rate is higher than the lending rate, the extension’s slope is smaller The optimal portfolio - in reality an investor is likely to combine an investment in the riskless asset with a portfolio of risky assets - capital market line: tangent to the efficient set through the risk-free rate point à can be viewed as efficient

set of all assets, both risky and riskless and does not depend on any personal characteristics à separation principle: with riskless borrowing and lending, the portfolio of risky assets held by any investor is

always the point of tangency of the capital market line which he combines with the riskless assets (this is the only point where personal characteristics come into play)

10.8 Market equilibrium - homogeneous expectations: assumption that all investors have the same beliefs concerning returns, variances

and covariances (but not necessarily the same aversion to risk) à In a world with homogeneous expectations, all investors would hold the portfolio of risky assets represented

by the point of tangency (A). - market portfolio: the portfolio the investors choose (based on assumption of homogeneous expectations) à

it is a market-valued weighted portfolio of all existing securities - broad based indexes (such as S&P500) are good proxies for the highly diversified portfolios of many

investors Definition of risk when investors hold the market portfolio - beta: measures the responsiveness of a security to movements in the market portfolio - characteristic line of a security: plots the return on a security over the return on the market, beta is the slope




- a security with a beta above the market average (1) contributes more to the risk; a security with a negative beta can bees seen as a hedge or insurance

The formula for beta: - beta = covariance between the return on the asset and the return on the market portfolio / variance of the

market - the average beta across all securities, when weighted by the proportion of each security’s market value to

that of the market portfolio, is 1 à we measure risk as the contribution of an individual security to the variance of the market portfolio; though

many investors do not hold the market portfolio exactly, they are close enough so that the beta of a security is likely to be a reasonable measure of its risk

10.9 Relationship between risk and expected return (CAPM) Expected return on market: - Rm = Rf + risk premium à the expected return on the market is the sum of the risk-free rate plus some

compensation for the risk inherent in the market portfolio - best estimate for the risk premium in the future is the average risk premium in the past Expected return on individual security: - capital-asset-pricing model (CAPM): Expected return on a security = Risk-free rate + beta * difference

between expected return on market and risk-free rate à expected return on a security is linearly related to its beta - if β=0, then expected return = risk-free rate - if β=1, expected return = expected return on market

- security market line (SML): graphical representation of the linear relationship (the risk-free rate is the intercept, Rm – Rf the slope)

- SML is upward sloping (as market portfolio as a risky asset is expected to return more than the risk-free rate)

- 3 additional points on the CAPM: - lineariy: in equilibrium, all securities would be held only when prices changed, so that the SML became

straight (if securities lie above the SML, they are underpriced; if they lie below, they are overpriced) - portfolios as well as securities: the CAPM also holds for portfolios – the beta of the portfolio is simply

a weighted average of the securities it consists of - a potential confusion: capital market line and capital market line are 2 different concepts!




Task 15: 1. What are the differences between financial and management accounting? 2. What’s the difference between a treasurer and a controller? 3. What are the costs involved with management accounting? Task 16: 1. Be able to explain financial statements and the underlying principles. Task 17: 1. What’s the differences between the accrual approach and the operating cash flow approach? 2. Apply both methods to the task? Why is he confused?

Management Accounting – Chapter 1 (managerial accounting & the business organization) Accounting and decision making - accounting information allows for more informed and better decisions - users of accounting information: 1) internal managers for short-term planning; 2) internal managers for non-

routine decisions; 3) External parties - management accounting: process of identifying and measuring, accumulating, analyzing, preparing,

interpreting and communicating information that helps managers fulfill organizational objectives - financial accounting: field of accounting that develops information for external decision makers such as

stockholders, suppliers, banks and government regulatory agencies - good accounting helps organizations achieve their goals and objectives by giving answers on 3 types of

questions: - scorekeeping: accumulation and classification of data (am I doing well or poor?) - attention directing: reporting and interpreting information helps managers to focus on operating

problems, imperfections, inefficiencies and opportunities - problem-solving: aspect of accounting that quantifies the likely results of possible courses of action and

often recommends the best course of action to follow - for differences on management and financial accounting à see exhibit 1-1 on page 6 Accounting systems: - accounting system: a formal mechanism for gathering, organizing and communicating information about an

organization’s activities (using one for both financial and management purposes, can create problems, as financial accounting usually has to obey set standards)

- generally accepted accounting principles (GAAP): broad concepts or guidelines and detailed practices, including all conventions, rules and procedures that together make up accepted accounting practice at a given time

Effects of government regulation: - foreign corrupt practices act: US law forbidding bribery and other corrupt practices, and requiring that

accounting records be maintained in reasonable detail and accuracy and that an appropriate system of internal accounting controls be maintained. (applies to all publicly held companies – thus also internal accounting systems are affected by government regulation)

- management audit: a review to determine whether the policies and procedures specified b top management have been implemented

Management accounting in service and nonprofit organizations - characteristics of service organizations: 1) labor is intensive; 2) output is usually difficult to define; 3)

major inputs and outputs cannot be stored - besides simplicity, 2 ideas have to be kept in mind when designing an accounting system:

- cost-benefit balance: weighing estimated costs against probable benefits, the primary consideration in choosing among accounting systems and methods

- behavioral implications: the accounting system’s effect on the behavior of managers (if managers do not use accounting reports, the reports create no benefits)

à even more than financial accounting, management accounting spills over into related disciplines, such as economics, decision sciences and behavioral sciences.




The management process and accounting - decision making: the purposeful choice form among a set of alternative courses of action designed to

achieve some objective - the management process is a series of activities in a cycle of planning and controlling (planning determines

action, action generates feedback and feedback influences further planning) - budget: a quantitative expression of a plan of action and an aid to coordinating and implementing the plan

(budgets are forecasts of costs for the projected level of production activity and must predict costs in lights of trends, price changes, etc.)

- performance reports: feedback provided by comparing results with plans and by highlighting variances - variances: deviations form plans - performance reports are used to judge decisions and the productivity of organizational units and managers - management by exception: concentrating on areas that deviate form the plan and ignoring areas that are

presumed to be running smoothly à though budgets aid planning and performance reports aid control, it is not accountants but other managers

who evaluate accounting reports and actually plan and control operations Planning and control for product life cycles and the value chain - product life cycle: the various stages through which a product passes, from conception and development

through introduction into the market through maturation and finally withdrawal form the market à at each stage managers face different costs and potential returns, comparisons between planned and actual costs and revenues reveal not only the current profitability but also the current life-cycle stage

The value chain - value chain: the set of business functions that add value to the products or services à Research and

development, designs of products, services or processes, production, marketing, distribution, customer service

- accountants play a key role in all value chain functions; especially in the development and design stages can estimations of revenue and cost data enable managers and engineers to reduce the life-cycle costs of products or services more than in any other value-chain function

- customer focus is in the center of the value chain Accounting’s position in the organization Line and staff authority - line authority: authority exerted downward over subordinates

- line departments: subunits of an organization that are directly responsible for conducting basic activities - staff authority: authority to advise but not command; it may be exerted downward, laterally or upward

- staff departments (or service departments): their principal task is to support or service the line departments; every department not directly concerned with producing or selling

- controller (comptroller): the top accounting officer of an organization; the term comptroller is used primarily in government organizations – the controller fills a staff role (sales and production executives fill line roles), his job is to provide other managers with specialized services

The controller - controller position varies from company to company, usually they have growing roles as internal consultants - they are generally empowered to approve, install and oversee the organization’s accounting system (in theory

the president has to approve proposes for systems and methods, but in practice the controllers directly specify how production records should be kept and time records should be completed)

à in theory they have no line authority, but by reporting and interpreting relevant data, they do exert a force of influence leading to logical decisions

Controllership Treasurership 1. Planning for control 2. Reporting and interpreting 3. Evaluating and consulting 4. Tax administration 5. Government reporting 6. Protection of assets 7. Economic appraisal

1. Provision of capital 2. Investor relations 3. Short-term financing 4. Banking and custody 5. Credits and collections 6. Investments 7. Risk management (insurance)

Management accounting is the primary means of implementing the first 3 functions of controllership – a controller measures and reports operating performance

The treasurer is concerned mainly with the company’s financial matters.




Career opportunities in management accounting - certified public accountant (CPA): in the US an accountant earns this designation by a comb ination of

education, qualifying experience and the passing of a 2 day written national examination - certified management accountant (CMA): the management accountant’s counterpart to the CPA - institute of management accountants (IMA): largest US professional organization of accountants whose

major interest is management accounting - accounting can also prepare for other high levels of management, because general management skills and a

broad overview are acquired - Current trends à 1) shift from manufacturing-based to service-based economy; 2) increased global

competition, 3) advances in technology - just-in-time (JIT) philosophy: philosophy to eliminate waste by reducing the time products spend in the

production process and eliminating the time products spend on activities that do not add value - computer-integrated manufacturing (CIM) systems: systems that use computer-aided design (CAD) and

computer-aided manufacturing (CAM), together with robots and computer-controlled machines Importance of ethical conduct - both external and internal accountants are expected to adhere to standards of ethical conduct - standards of ethical conduct for management accountants: codes of conduct developed by the institute of

management accountants which include competence, confidentiality, integrity and objectivity

Financial Accounting – Chapter 3 (Basic concepts and income determination) Information for making investment decisions - the concept of net present value as a decision model needs the prediction of all the future cash flows, whether you are a (possible)

investor (owner or creditor) à what type of information is required by the investor - forecasts are difficult to make and the management of the firm is very unlikely to disclose the information necessary (or their

predictions) as competitors could use the information to determine their strategy, management could disclose biased figures… - one possibility for the investor is to use past and present cash flows, assuming continuity of events and activities Cash basis: - on obvious way of assessing a firm’s performance is to determine cash in- and outflows over a given time

period and using that figure for predicting the enterprise’s future performance - cash basis: cash basis of accounting reports the entity’s cash receipts and cash disbursements during a

specific time period - net operating cash flow: the excess of total cash received by the enterprise during a period of time over total

cash disbursed during the same period of time, excluding dividends or withdrawals paid to owners, repayment of long-term debt or cash receipts from owners or long-term creditors (basically the cash flows associated with providing goods and services) - advantages: 1) cash receipts and disbursements include factual data; 2) is similar to the future-period

cash flow information of interest to investors - disadvantage: may seriously misrepresent long-run cash-generating ability (there is not necessarily an

association between the measure of effort and the measure of accomplishment) à a better financial measure of performance measure is needed that associates the positive and negative

aspects of operations with the appropriate time period Accrual basis - accrual basis: accrual accounting records the financial effects on an enterprise of transactions and other

events and circumstances that have cash consequences for the enterprise in the periods in which the transactions occur rather than only in the periods in which cash is received or paid by the enterprise à financial effects of transactions are recognized in the period in which they occur

Measuring periodic accomplishments - revenue: revenues are actual or expected cash inflows during a period from delivering or producing goods,

rendering services, or other activities that represent the entity’s business purpose (= selling price of all products sold and services provided whether for cash or on credit) - does not include payments received for products and services rendered in an earlier period




- realization: Revenue has been realized when goods or services are exchanged for cash or claims to cash. This usually occurs when the prices to be received for products and services become reasonably certain and have been earned by the enterprise. - process of deciding when to include revenue in the current period’s performance is handled by the

realization principle - recognition: recognition is the process of recording or including the financial measurement of a transaction,

event, or circumstance in the entity’s measure of current period performance (income is recognized if it is realized)

Measuring periodic effort or sacrifice - expense: expenses are the outflows or costs of resources during a period used to deliver or produce goods,

render services, or carrying out other activities that represent the entity’s business purpose (actual or expected cash outflows that occurred or will occur in order to produce the current period’s revenue)

- matching concept: matching is the process of including the expenses incurred to produce and sell a product or service in the same time period as the revenues they generated - the matching process associates the efforts expended with the revenues earned to measure performance

during a time period - income = revenue earned – expenses incurred (determining the revenues realized precedes identifying the

expenses to be recognized when calculating profit) Product and Period Expenses - product expenses: costs that can be associated with a specific product or service – are recognized in the

period the product is sold - period expenses: costs of a resource that is consumed during a specific period and bears no discernible

relation to a specific present or future product or service Income - matching procedure allows to associate revenues with expenses yielding income which represents the

increase of wealth over that period - income measurement represents essential information to enable the investor to predict future returns form

being creditor or owner - gains and losses: inflows or outflows of resources from transactions and other events and circumstances

which affect the entity during a period but are incidentally related to the entity’s business purpose (arise from events not generally associated with the primary business)

- extraordinary gains and losses: inflows or outflows of resources due to clearly abnormal events or transactions; such events are not a normal part of the operations of the business in the long run and they occur very infrequently

- income form continuing operations: the difference between revenues form operations and related expenses, plus or minus gains or losses for a given period of time - extraordinary gains or losses are not included in that number, but are added / subtracted to determine net

income - net income: income or loss form continuing operations plus or minus extraordinary gains or losses

Financial Accounting – Chapter 4 (Basic concepts and balance sheet measures) - income statement: tells the results form managing and operating the business - balance sheet: tells what resources management has available to operate the business during the year &

where it comes form Financial position The elements defined - assets: assets are probable future economic benefits embodies in resources are owned by an entity as a result

of past transactions or events (e.g. outright purchase or receipt of a gift) - ‘probable future economic benefits’ – the asset will contribute to the firm’s profitability

- liabilities: Future sacrifices of economic benefits which arise from present obligation of the entity to provide assets or services to other parties in the future as the result of past transactions or events - are one source of money management can use to purchase assets




- owners’ equity: Interest in the assets of an entity that remains after deducting its liabilities. In this sense it is the residual or the assets which remain after liabilities have been paid. In a business enterprise, the residual assets represent the ownership interest. à has 2 components: - paid-in capital: Equals the resources contributed by the owners to the entity in exchange for ownership

interests. It is the portion of owner’s equity represented by the assets contributed by investors to become owners of the entity.

- retained earnings: Equals the cumulative excess of net income over net losses and dividend distributions to or withdrawals by owners since the inception of the business. It is the portion of owners’ equity represented by the cumulative profitability of the entity which has not been given to owners as a return on their investment. - retained earnings do not represent a legal claim which the owners have against the entity

Measurement of the balance sheet elements - cost principle: the amount sacrificed to acquire use of a resource is measured as the price paid; all assets are

recorded at the amount that was paid, regardless of changes in their prices and market values in future periods (assets, liabilities and owners’ equity are stated at their historical cost) - the cost principle is actually not consistent with the definition of assets (future economic benefits), but measuring them at market

value needs predictions about unknown cash flows Financial position - balance sheet: a balance sheet depicts the financial position of the enterprise, or its financial status,

consisting of the monetary amounts assigned to its assets, liabilities, and owners’ equity as of a point in time - accounting equation: since the measurement of owners’ equity derives from the amounts assigned to assets

and liabilities, the following equality must always hold: Assets = Liabilities + Owners’ equity Recognizing events External transaction (arising from outside events) - external transactions: exchange transactions between the enterprise and other economic entities - prepayments represent an asset, because upon payment the enterprise get the right to something that

contributes to the net income in the future - financial position worksheet: schedule with a column for each of the specific elements (accounts) which

constitutes the entity’s financial position (each transaction is recorded in a separate event line; at all times the accounting equation must be satisfied)

Income measurement within the financial position framework - revenue is recognized as an increase in owner’s equity (the retained earnings part) in the same period that we

recognize increase in cash and promises to pay from sales to customers; expenses are recognized as a decrease in owner’s equity in the same period that we recognize decrease in assets

Internal adjustments - internal adjustments: changes in the enterprise’s financial position that are evidenced by observation of

events within the entity, many have to do with a physical sacrifice of resources for the revenue recognized à they are made at the end of an accounting period

- accumulated depreciation account: stated on the asset side and is always negative! Balance sheet - the ending financial position of one period is the beginning financial position of the next period, it carries

forward information about resources available for future performance - conveys information to external investors about the ongoing ability to generate cash - the 2 sides are presented separately, first assets, then liabilities and owners’ equity Income statement - net income is the recognized net increase in the ownership interests of the enterprise that results from its

productive activities and any extraordinary gains or losses - while net income for a period may be large, it may not be readily distributable (e.g. in form of receivables,

etc.) à the income statement is a descriptive statement of how and to what extent recognized accomplishments

(revenues) and efforts (expenses) of the enterprise altered the ownership interest in the business during a period of time.




Problem 18: 1. Make the balance sheets for January 2nd and 31st! Problem 19: 1. What is a cash flow statement and what are the 2 ways to prepare it? 2. Prepare the cash flow statement according to the direct method. 3. What information do they convey? 4. What are the advantages of cash flow statements? Problem 20: 1. What are the influences of the sources in the Netherlands? 2. What are the sources of influence on US financial reporting? 3. Why do people oppose financial reporting requirements?

Financial Accounting – Chapter 5 (Statement of Cash Flows) The need for cash flow information - primary purpose is to provide information about firm’s cash receipts and disbursements during a period

(assess ability to generate positive future net cash flows, meet obligations (short-run cash-generating ability), the reasons for differences between net income and associated cash receipts and payments, effects on the enterprise’s financial position)

- is required à equal importance as income statement and balance sheet - income statement alone just presents net change in an account, not the causes of the change in the change in

the firm’s cash position - 2 ways to determine it:

- direct method: each income statement account is adjusted to the cash basis - indirect method: effect of accruals and deferrals are removed from net income

Cash flows from operating, investing and financing activities - objective of the statement of cash flow is to explain change in the cash account according to the managerial

activities that cause them: - operating activities: transactions directly related to the regular production and delivery of

goods/services - investment activities: transactions and events relating to the acquisition and dis posal of assets –

resources that provide capacity over time to carry out the operations of the business - financing activities: acquiring funds from and making payments to creditors and owners

- effects of operations, investing and financing activities arise from the management of a business over its natural operating cycle (operating pans in conjunction with financing and investment considerations determine a desired level of investment in various assets)

- all changes in cash can be viewed as the result of wither operating, investing or financial activities Preparing the statement of cash flows - beginning and end-of-period balance sheets are used in conjunction with income statement an other relevant

information to prepare the statement of cash flows à 3 steps: 1) analyze balance sheet accounts; 2) use analysis to calculate cash flows; 3) prepare the statement of cash flows

Analyzing the balance sheet accounts: - 1. change in cash: determine the change in cash during the period (net change is the focus of our analysis) - 2. change in noncash accounts: analyze the change in each noncash account together with any additional

information available to explain the cause of each change and categorize them into the 3 categories - all changes are interpreted as having an effect on cash during the period - depreciation is categorized as related to operations - special attention must be given to the sale of fixed assets à statement of cash flows reflects source of

cash equal to the total proceeds received from the sale of an asset - even when transactions do not directly affect cash, they are included in the statement of cash flows as if

they were a source or use for cash – done to provide information about all the investing and financing activities since they will likely affect future cash flows

- net change in retained earnings for the period must be divided into the in(de-)crease due to net income (loss) and the decrease form dividends

Cash flow from operating activities: à general approach is to adjust each income statement item to obtain the real cash flow à adjust the income statement to the cash basis




- cash receipts from customers = revenue +/- decrease/increase in accounts receivable - cash payments for merchandise à need to adjust cost of sales to cash payments for merchandise

- cost of sales = +/- increase/decrease in inventory +/- decrease/increase in accounts payable - cash payments for operating expenses = operating expenses +/- increase/decrease in prepaid expenses +/-

decrease/increase in accrued liabilities – depreciation - depreciation is included in the cost of sales as part of operating expenses, but it has to be removed for

the cash basis as it is an item that does not requires the use of cash during the period, but when it is bought (investment)

- knowing specifically the transactions related to operations responsible for the change in cash during the period may help investors predict future cash flows from operations

Preparing the statement of cash flows - last step is to arrange the information into a formal statement showing separately the 3 categories of cash

flows along with appropriate information regarding the cause of the net change à fully explains the net increase/decrease in cash during the period

- interpretation of the results is as important as the preparation

Financial Accounting – Chapter 12 (Policy making) Market economy - economy: system for allocating available resources to various uses, by political choice, they are organized

differently Capital formation in a market economy - the material standard of living depends on the level of output; without increasing the hours of labor needed

to, an increase in living standard is only possible when labor productivity rises for which physical, technical or human capital is needed

- in order for a high standard of living to be sustained a high level of capital must be built up and maintained - consumption postponement: prerequisite to capital formation is a sacrifice of current consumption

- direct savings: when individuals do not spend all the funds they currently receive - indirect savings: when business enterprises retain earnings

- demand for capital: excess savings can lead to unemployment, excess spending leads to inflation - transfer of funds between economic units: a systematic way is needed

- capital market: The capital market consists of all the individuals and institutions that together accomplish the transfer of funds from savers to economic units that wish to spend additional funds on capital goods and services.

- capital market intermediaries: needed to efficiently collect and lend mo ney - sources of funds for business enterprises – the corporate securities market: this is for the our focus of

interest, where business enterprises raise funds to acquire capital goods and services Social demands on the corporate securities market - public interest demands the following characteristics: 1) matching of supply and demands of funds; 2) all

markets must be operationally efficient & must be reasonably fair à principle motivation for the public interest in corporate financial reporting

- matching supply and demand for funds in the corporate securities market: - size and time need to be matched – usually businesses are interested in large, long-term contracts, savers

are interested in small amounts and great flexibility à intermediaries balance this - individuals who do not save through intermediaries have to opportunity to adjust the time problem in

the secondary market - primary corporate securities market: The primary corporate securities market consists of all transactions in

which the money capital of business enterprises is expanded through the issue of new securities or reduced through the redemption, retirement, or liquidation of previously outstanding securities.

- secondary corporate securities market: The secondary corporate securities market consists of all trades of corporate securities not involving the business enterprise whose securities are bought or sold. (this market makes the securities a lot more attractive)

- operational efficiency of the securities markets: A securities market is operationally efficient when all the intermediaries and others who participate in the transfer of funds from savers to users earn no more than is necessary to induce them to provide their services. à higher than necessary fees of intermediaries inhibit the flow of funds and thus the formation of capital à social interest is to regulate or supervise the activities and fee structures of corporate securities market intermediaries




Role of financial accounting in corporate securities markets - financial accounting information is the link between savers and users of financial capital Principal-Agent relationship established - managers = agents; investors = principals à principals need reliable information to make decisions - the agents have legal and ethical duties to render faithfully periodic reports about their activities Fairness of markets & public interest in financial reporting - when market is perceived to be unfair, flow of new money capital shrinks and the prices drop - high-quality financial reporting contributes to fairness in financial markets and thus is a public interest - market manipulation creates excessive investment risk Standard setting for financial accounting - Securities act of 1933 (US): 2 major objectives à 1) requires adequate and accurate disclosure of material

data concerning securities to be sold on the primary market; 2) outlaws fraud in the sale of securities whether or not newly issued

- Securities act of 1934: The SEC (Securities and Exchange Commission) is given the authority to regulate trading in securities and also gives it power over the accounting practices of business enterprises (mainly directed at the secondary corporate securities market)

Setting financial accounting standards - SEC has full veto power on any accounting standard, but development and pronouncement of standards is

left to private-sector efforts à Financial Accounting Standards Board (FASB), Financial Accounting Foundation (FAF)

- GAAP (Generally accepted accounting principles) are the sum total of all financial accounting standards, rules and regulations which must be observed in the preparation of financial reports acceptable to the SEC (the FASB statements are the major component)

Governmental accounting and reporting - governmental agencies have some difficulty in defining their products à absence of profit measurability in

governmental accounting creates 3 critical problems. 1) managerial performance is difficult to determine; 2) no measure of comparison is there; 3) economic costs have little motivating power in terms of public interest

- one solution was that money is appropriated to programs à accountability breaks down into 3 categories: 1) fiscal accountability (spending in a lawful way); 2) process accountability (policies and programs are carried out in intended ways; 3) program accountability (results are intended)

- GASB (governmental accounting standards board) is very similar to the FASB, but differs in that governmental accounting is more divers and in that it lack an active enforcement mechanism

Accounting as a social factor - as accounting is an abstract concept, there is no unanimity as to the best alternative, what is the optimum is

decided by the political mechanisms - the result can be thought of as a social contract between all interested parties - the choice for the ‘historical costs’ as measure is one of the social choices - one element of the social choice approach is that there is ‘flexibility within defined boundary lines’

regarding e.g. inventory and depreciation methods International accounting - neither social nor economic activities are strictly domestic à global interdependence à 5 critical issues of

international accounting: - different national accounting practices - MNC Accounting à MNCs have to integrate all their national accounting systems - International corporate securities market - Technical international accounting problems à e.g. foreign currency translation - International financial accounting standards à most effective has been the IFAC (international

federation of accountants), but the progress is very slow

Financial Accounting – Chapter 13 (Financial reporting and analysis) Financial reporting




- financial statements are the direct product of a large number of integrated accounting processes (periodic income, financial position and cash flow), they are a formal representation of an entity’s financial activities and events during a specified period of time

- financial reporting is broader than financial statement preparation, they also contain other descriptions, explanations and analyses

- user groups who heavily rely on financial reports: 1) economic policy makers; 2) government regulators; 3) parties making economic decisions affecting their own relationships with an entity (e.g. investors); 4) entities seeking funds from others

Types of financial reports - annual corporate reports: extensive, annual report for shareholders (generally available to the public on

request) according to strict regulations and responsibility of management for integrity and objectivity à usually consists of (1. Reports of management; 2. Report of independent accountants; 3. Primary financial statements; 4. Management discussion and analysis of results of operations and financial condition; 5. Secondary financial statements; 6. Notes of financial statements; 7. 10 year comparison of selected data; 8. Se lected quarterly data; 9. Supplemental financial information) à information filed with the SEC is fully compatible with information provided in annual reports

- summary annual reports: companies with publicly traded securities also might issue condensed reports, as long as the full reports are filed to the SEC and are available to stockholders upon request

- quarterly financial reports: when information is desired more frequently so called ‘interim financial reports’ can be issued (required for companies listed on major stock exchanges) that are less elaborated and formal

- SEC reporting: all corporations subject to its jurisdiction file audited annual reports with the commission (the 10-K reports) – these reports are public records, as well as (only for some comp anies required) unaudited quarterly financial reports (10-Q)

- news announcements: at intervals throughout the year released financial information through financial press, for securities listed on national exchanges required – usually available 30 days before the release of annual or interim reports

Financial analysis - making investment decisions is a challenge, as with the task of specifying future cash flows the risk

associated needs to be assessed à ultimate objective of forecasting-analysis is the selection of a portfolio of investments with the optimum ratio of return to risk

- the decision model has 2 major elements: 1) expected return; 2) expected risk Estimating investment decision factors form financial report information - use of information form corporate financial reports to estimate expected return and risk is based on the

assumption, that data on the immediate past is relevant for future possibilities - 2 important requirements for interpretation of financial statistics:

- scaling: process of relating one number to another based upon a presumably important relationship - time and industry standards: an investor is interested in the relationship between numbers (ratios) and

some standard à time standards and industry standards (present accounting policy calls for inclusion of data from the preceding period)

Statistical measures – Indicators of return (indicators often have implications for both decision factors) - earnings per share (EPS) = net income accruing to common stock / total shares of common stock

outstanding - when a company has outstanding convertible securities, this has to be regarded in the EPS calculations:

- primary earnings per share: if the convertible security is classified as ‘common stock equivalent’ its number has to be added to the common stock outstanding à upper bound on earnings

- fully diluted earnings per share: all outstanding convertible securities are assumed to be converted into common stock à lower bound on earnings per share

- earnings yield = Adjusted EPS (EPS – Cash dividends) / Average annual share price - return on assets = (net income + interest expense) / average total assets à gives percentage return

regardless of the source of investment - return on owners’ equity = net income / average owners’ equity à reflects scaled return accruing to

shareholders on contributed capital - leverage effect: return on owner’s equity is larger than the return on assets, as return on total assets is

larger than the cost of all the liabilities - net income to sales = net income / sales (revenues) à indicates the amount of profit generated form each

dollar of sales - return on owner’s equity = net income / average owners’ equity (or net income to sales * investment

turnover) à slow turnover demands for a higher return on each dollar of revenue




Indicators of risk - current ratio = current assets / current liabilities à short-term solvency - acid-test ratio (or quick ratio) = quick assets / current liabilities - debt to assets ratio = total liabilities / total assets à relationship between funds provided by creditors and

owners - long-term capitalization à percentage of owner’s equity in total liabilities (the larger the amount of funds

supplied by creditors, the potentially larger the return that might accrue to the owners due to the leverage effect)

- times interest earned = (before-tax income + interest expense) / interest expense à (measures extent to which interest requirements are covered by net income)

à when evaluating the statistical measures, one always has to keep in mind, that the interpretation of any single

statistic is based upon the assumption that all other measures remain constant (also the concept of historical cost may not be really desirable in the ratios)

The comparability question - comparability over time à needs consistency in accounting principles - comparability between firms à difficult, because of the use of different accounting methods, but flexibility

in choosing accounting policies is wanted due to measurement problems - enhancing comparability between firms à financial analysts can make adjustments to the data as large

amounts of supplemental information are required to be published, but as long as there is flexibility in the choice of accounting methods, audits will be necessary

European Financial Accounting: The Netherlands - NIRVA (Dutch institute of registered accountants): introduces statutory rules concerning the accounting

profession and certifies RA’s (chartered / certified public accountants) - in the Netherlands, limited companies (except small companies) must be audited by an appropriately

qualified auditor, who must conclude that the financial statement gives a true and fair view - advice and recommendations for generally acceptable accounting principles are given by the Council for

Annual Reporting - current value concept is used in the Netherlands instead of the historical cost principle - complaints about financial statements can be filed with the Enterprise Chamber - financial statements for tax purposes are based on tax law and try to minimize or postpone the taxes payable,

even when the same methods are used as for financial reporting, differences in income may arise




Problem 21: 1. What different financial ratios are there and what do they tell us? 2. Why do financial ratios have to be interpreted carefully? Problem 22: 1. What are the 3 major categories of manufacturing costs? 2. Why is it becoming more difficult to trace costs to products? 3. What are the advantages and disadvantages of the old and the new way to allocate costs? 4. Do the calculations for the task in the old and the new way. Problem 23: 1. What are the different ways to allocate control and service department costs to the production departments? 2. Why is it necessary to know the full product costs?

Management Accounting – Chapter 4 (Cost management systems and activity-based costing) - managers rely on accountants to design a reliable cost accounting system that measures the cost of goods

and services the company produces in order to make intelligent decisions - cost accounting typically includes 2 processes:

- cost accumulation: collecting costs by some natural classification such as materials or labor - cost allocation: tracing and reassigning costs to one or more cost objectives such as activities,

departments, customers or products - cost accounting: that part of the accounting system that measures costs for the purposes of management

decision making and financial reporting Classification of costs - cost: a sacrifice or giving up of resources for a particular purpose, frequently measured by the monetary

units that must be paid for goods and services - cost objective (cost object): anything for which a separate measurement of cost is desired (examples include

departments, products, activities and territories) - direct costs: costs that can be identified specifically and exclusively with a given cost objective in an

economically feasible way - indirect costs: costs that cannot be identified specifically and exclusively with a given cost objective in an

economically feasible way - whenever something is ‘economically feasible’, managers prefer to classify costs as direct; the key

factor that influences whether a cost is direct or indirect is the particular cost objective - when a department is the cost objective rather than a service or a product, many more costs are direct - when managers want to know both cost of running departments and products, costs are inevitably

located to more than one cost objective and can simultaneously be direct and indirect Categories of manufacturing costs: - direct-material cots: the acquisition costs of all materials that are physically identified as a part of the

manufactured goods and that may be traced to the manufactured goods in an economically feasible way (often minor items such as tacks or glue are not included, but are classified as part of the factory overhead)

- direct-labor costs: the wages of all labor that can be traced specifically and exclusively to the manufactured goods in an economically feasible way (indirect labor is classified as part of factory overhead)

- indirect manufacturing costs (factory overhead, factory burden, manufacturing overhead): all costs other than direct material or direct labor that are associated with the manufacturing process

à the more overhead costs can be traced directly to products, the more accurate the product cost Prime costs, conversion cots and direct-labor costs - prime costs: direct labor costs + direct materials cost à the resulting 2 fold categorization is used in many automated manufacturing companies

- conversion cost: direct labor costs + factory overhead - costs associated with other value-chain functions are accumulated by departments and are often called

selling and administrative costs, most firm’s financial statements do not allocate these to the physical units produced, while management reports often do




Activity-based costing - traditional system: portion of total overhead allocated to a product depends on the proportion of total direct-

labor hours consumed in making the product - activity-based costing (ABC): a system that first accumulates overhead costs for each of the activities of an

organization and then assigns the costs of activities to the products, services or other cost objects that caused that activity à significant overhead activities are identified and the costs of overhead resources used to perform these activities are traced to the activities using the most appropriate cost drivers (output measures) - 4 steps involved in the design and implementation of an ABC system:

- determine cost objectives, key activities, resources and relevant cost drivers(cost drivers being based on the criteria of reasonable cause-effect relationships and availability of data)

- develop a process-based map representing the flow of activities, resources and their relationships (costs are not considered until step 3, but the key interrelationships of the business need to be understood)

- collect relevant data concerning costs and the physical flow of the cost-driver units among resources and activities

- calculate and interpret the new activity-based information - high volume cost objects with simple process are usually overcosted when only one volume-based cost

driver is used - ABC systems are not necessarily better, a cost-benefit balance must be assessed on a case-by-case basis à Activity-based accounting systems can turn many indirect manufacturing overhead costs into direct costs and thus managers have greater confidence in the accuracy of the costs of products and services reported. - reasons why ABC is used more and more: competitive pressure, increased business complexity, new

production techniques increase the proportion of indirect costs, rapid technological change shortens life-cycles (no time for cost-adjustments), computer technology reduced the costs of an ABC, inaccurate cost determination can be very costly

Management Accounting – Chapter 12 (Cost allocation and activity-based costing) - cost accounting systems: the techniques used to determine the cost of a product, service, or other cost

objective by collecting and classifying costs and assigning them to cost objectives Cost allocation in general - cost-allocation base: a cost driver when it is used for allocating costs - cost pool: a group of individual costs that is allocated to cost objectives using a single cost driver (individual

items are not important enough to justify being allocated individually) 4 purposes of allocation: 1. to predict the economic effects of planning and control decisions à managers should be aware of the

consequences of their decisions 2. to obtain desired behavior à cost allocations may promote goal congruence 3. to compute income and asset valuations: costs are allocated to products and projects to measure inventory

costs and costs of goods sold (or for planning and performance evaluation) 4. to justify costs or obtain reimbursement (especially important in government contracts) - first 2 specify planning and control uses for allocation, last 2 show how cost allocations may differ for

inventory costing - often inventory-costing purposes dominate by default, because they are externally imposed - often the added benefit of using separate allocations for planning and control and inventory-costing purposes

is much greater than the added cost 3 types of allocations 1. allocation of costs to the appropriate organizational unit: direct costs are physically traced to he unit, costs

used jointly are allocated based on cost-driver activity 2. reallocation of costs form one organizational unit to another: when one unit provides product or services to

another, costs as well as products/services are transferred 3. allocation of costs of a particular organizational unit or activity to products or services: includes those

allocated to the organizational unit in allocation types 1 and 2 - service department: unit that exists only to support other departments (all its costs are totally reallocated)




General guidelines for allocating service department costs: 1. evaluate performance using budgets (by comparing actual costs with budget, regardless how costs are

allocated) 2. allocate variable- and fixed-cost pools separately; a service department can also contain multiple cost pools

if more than one cost driver causes the department’s costs, the variable- and fixed-cost pools are the minimum

3. establish part of all of the details regarding cost allocation in advance (so that all departments can plan appropriately)

Variable-cost pool - cause-effect relationship: the heavier the usage, the higher the total costs - budgeted costs are used for allocating variable costs of service departments to protect departments short-run

price fluctuations and inefficiencies of the service department à (allocation of actual costs would hold department managers responsible beyond their control and provide less incentive for service department to be efficient)

Fixed-cost pool - predetermined lump-sum approach: charging the departments with budgeted fixed costs based on the

capacity available à short-run allocations to user departments are not affected by the actual usage of other user departments

- problem using lump sums: if allocated on the basis of long-range plans, tendency on the part of consumers to underestimate planned usage à solutions: penalties for underpredictions; bonuses for accurate predictions

Allocation of central costs - allocation of central costs is nether necessary form an accounting viewpoint, nor useful as management

information à in the book they are not considered part of the value chain - but there is a widespread belief that all costs must be fully allocated to revenue-producing parts of the

organization à whenever possible the preferred cost driver for central services is usage (actual or estimated) Usage of budgeted sales for allocation - if costs of central services are to be allocated based on sales, even though costs do not vary in proportion to

sales, the use of budgeted sales is preferable to the use of actual sales à making costs to individual departments independent form usage of others

Reciprocal services - service departments often support other service departments in addition to producing departments à 2

popular methods for allocating service department costs in such cases (assuming all costs in a given service department being caused by a single cost driver): - direct method: method for allocating service department costs that ignores other service departments

when any given service department’s costs are allocated to the revenue-producing (operating) departments

- step-down method: method for allocating service department costs that recognizes that some service departments support the activities in other service departments as well as those in production departments - a sequence of allocations is chosen, usually by starting with the service department that renders the

greatest service to the greatest number of other service departments- once a department’s costs are allocated to other departments, no subsequent service department costs are allocated back to it

- comparison of the methods: generally the step-down method is better as it recognizes the effects of the most significant support provided by service departments to other service departments, but the direct method is a lot simpler

Costs not related to cost drivers - identify additional cost drivers à divide costs into 2 or more pools and use a different cost driver to allocate the costs in each pool - divide costs into variable and fixed costs and only allocate the variable costs - use the old cost driver, assuming a long-term relationship Allocation of costs to final cost objects - cost application (or cost attribution): the allocation of total departmental costs to the revenue-producing

products or services (or customers in banking, health care, education) à usage: inventory valuation, decision purposes, cost-reimbursement purposes Traditional approach to allocate costs to products, services or customers




1. Allocate production related costs to the operating, production or revenue-producing departments 2. Select one ore more cost drivers in each production department 3. Allocate the total costs accumulated in step1 to products or services that are the outputs of the operating

departments using the cost drivers specified in step 2 (with one cost driver use variable and fixed costs; fixed costs should either remain unallocated or be allocated on basis of budget cost-driver activity)

Activity-based costing (ABC) - traditional allocation focuses on accumulating costs into organizational units - ABC systems focus on accumulating costs into key activities (first focus on activities required to produce

the product/service, then accumulate all resource costs based on their use in performing these activities) - Usually better when it is inappropriate to allocate all costs based on measures of volume - 3 steps: 1) identify significant overhead activities; 2) allocate costs of overhead resources used to

perform these activities to the activities using cost drivers; 3) allocate the pooled costs of each activity to products using cost drivers

- simply said, the large overhead cost pool is broken down into several pools - resource cost pool: determined according to the guidelines mentioned for the traditional allocation; all

elements should have the same cost behavior with respect to the chosen cost driver - cost drivers: factors that affect costs; they are a measure of the activity level and the amounts of resources

used by the processing activity - consumption rates: give the rates at which resources are used in response to the changes in processing

activity - costs of fixed-cost resources do not change automatically when cost drivers change, this involves a

management decision - 4 steps involved in the design and implementation of an ABC system (repetition):

- determine cost objectives, key activities, resources and relevant cost drivers - develop a process-based map representing the flow of activities, resources and their relationships - collect relevant data concerning costs and the physical flow of the cost-driver units among resources and

activities using the process map as a guide - calculate and interpret the new activity-based information (many companies today use more than 20

different cost drivers, but the benefit-cost criteria must be regarded) - the new cost drivers often measure number of transactions rather than volume




Problem 24: 1. How do you determine the costs of an auditing engagement/a service engagement? 2. What are the kind of products in manufacturing that are like audit engagement services and that can be

costed similarly? à job costing, process costing Problem 25: 1. What are committed- and what are discretionary fixed costs? 2. What is the intensity-of-use in this context? 3. What is a cost function? 4. What is the cost function related to the cleaning department? Problem 26: 1. What is break-even analysis? 2. Do the calculations!

Management Accounting – Chapter 2 (Introduction to cost behavior and cost-volume relationships) - one of the main goals of management accounting is controlling (and reducing) costs – companies do have

more control over their costs than over their revenues - cost behavior: how costs are related to and affected by the activities of an organization Activities, Costs and cost drivers - associating cost behavior with products helps little to control costs on a day-to-day basis - cost drivers: output measures of resources and activities à enable us to associate costs with activites Comparison of variable and fixed costs - variable cost: a cost that changes in direct proportion to changes in the cost driver - fixed cost: a cost that is not immediately affected by changes in the cost driver à the ‘variable’ and ‘fixed’ characteristic of a cost relates to its total dollar amount and not to its per-unit

amount - relevant range: the limit of cost-driver activity within which a specific relationship between costs and the

cost driver is valid (idea applies to fixed, but also to variable costs) - more costs are vixed and fewer are variable when decisions involve very short time spans and very small

changes in activity level - for now we assume costs to be classifiable as either variable or fixed, and that they only have one volume-

related cost-driver and a linear relationship Cost-volume-profit analysis - cost-volume-proft (CVP) analysis: the study of the effects of output volume on revenue (sales), expenses

(costs) and net income (profit) - it is a useful starting point in the decision process, though many factors in addition to volume will affect

costs - the major simplification in the CVP analysis is to classify costs as either variable or fixed with respect to a

single measure of the volume of output activity Creak-even point – Contribution margin and equation techniques - break-even point: the level of slaes at which revenue equals expenses and net income is zero (the most basic

CVP analysis) - margin of safety = planned unit sales – break even unit sales ; shows how far sales can fall below the

planned level before losses occur - contribution margin (marginal income): sales price – variable costs per unit

- when contribution margin * items equals total fixed costs, the break-even point is reached - contribution margin ratio: 1 – (variable-expense ratio) - equation technique: calculating the break-even point for the equation: 0 = sales – variable expenses – fixed

expenses - general shortcut formulas:

- break-even volume in units = fixed expenses / contribution margin per unit - break-even volume in dollars = fixed expenses / contribution-margin ratio (to sales)

- the break-even point can be shifted by either reducing the total fixed or the variable costs




Cost-Volume-Profit graph - when presenting the break-even point in a graph, it is the crossing of the total expenses line and the sales

line; the vertical axis is dollars of cost and revenue and the horizontal axis is the sales volume - besides the vertical distance between the 2 lines is the net income/loss - concept of relevant range also applies to the entire graph - assumptions: constant efficiency, sales mix and inventory levels - sales mix: the relative proportions or combinations of quantities of products that constitute total sales Target net profit and an incremental approach - CPV analysis can also be used to determine total sales in units and dollars needed to reach a target profit - target sales volume in units = (fixed expenses + target net income)/(contribution margin per unit) - target sales volume in dollars = (fixed expenses + target net income)/(contribution-margin ratio) - incremental effect: the change in total results (revenues, expenses or income) under a new condition in

comparison with some given or unknown condition à in the target sales volume approach, we can use the break-even volume as a starting point

Multiple changes in key factors - e.g. a change in units results in a change in sales, and variable as well as fixed costs - using an incremental approach is much more simple in such a situation CPV Analysis in the computer age - computers make it possible to omit some of the simplifications made, but their use is a cost-benefit issue and

the reliability of the models always depends on the accuracy of the underlying assumptions Additional uses of cost-volume analysis - when the contribution margin as a percentage of sales is low, great increases in volume are necessary before

significant increases in net profits can occur – a high contribution-margin percentage increases profit faster than does a small one

à companies with high contribution-margin percentages spend more on advertising - operating leverage: a firm’s ratio of fixed to variable costs à in highly leverages companies (high fixed

costs and low variable costs) small changes in sales volume result in large changes in net income à higher leveraged alternatives are more risky Contribution margin and gross margin: - variable-cost ratio (variable-cost percentage): all variable costs divided by sales - gross margin: the excess of sales over the total costs of goods sold - cost of goods sold: the cost of the merchandise that is acquired or manufactured and resold

Management Accounting – Chapter 3 (Management of cost behavior) - management of cost behavior: understanding and quantifying how activities of an organization affects

levels of cost (measurement, evaluation, influence) Cost drivers and cost behavior - linear-cost behavior: activity that can be graphed with a straight line because costs are assumed to be either

fixed or variable (the relevant rage specifies the limits) - besides the true volume-driven costs there are others that are not directly related to volume and have

multiple cost drivers, but in practice many organizations use a linear relationship with one single cost driver as the added benefit of understanding the ‘true’ cost behavior does not outweigh the cost

Step- and mixed-cost behavior patterns - step costs: costs that change abruptly at intervals of activity because the resources and their costs come in

indivisible chunks (when the chunks are large and apply to a specific, broad range of activity, the cost is considered fixed over that range of activity; if the chunks are relatively small, they can be described as variable)

- mixed costs: costs that contain elements of both fixed- and variable-cost behavior (the fixed element is determined by the planned range of activity level, the variable element is a purely variable cost)




Management influence on cost behavior - managers can influence cost behavior through decisions about such factors as product or service attributes,

capacity, technology and policies to create incentives to control costs - capacity costs: fixed costs of being able to achieve a desired level of production or to provide a desired level

of service while maintaining product or service attributes such as quality - committed fixed costs: costs arising from the possession of facilities, equipment and a basic organization:

large, indivisible chunks of costs that the organization is obligated to incur or usually would not consider avoiding (only major changes in philosophy, scale or scope of operations could change them in future periods)

- discretionary fixed costs: costs determined by management as part of the periodic planning process in order to meet the organization’s goals (e.g advertising – fixed until the next period, in extreme cases they can also be altered within a period) – they are essential in the long-run, but can vary broadly in the short run

- distinguishing committed and discretionary fixed costs is the first step in identifying costs reduction possibilities

- choice of technology positions the organization to meet its current goals and to respond to changes in the environment – technology may have great impact on costs of products/services

- incentive to control costs are another way to reduce costs Cost functions - steps in estimating or predicting costs

1. cost measurement: estimating or predicting costs as a function of appropriate cost drivers 2. use the cost measures to estimate future costs at expected future levels of cost-driver activity

- cost function: an algebraic equation used by managers to describe the relationship between a cost and its cost driver - linear-cost function: a straight line with the fixed costs being the intercept and the variable costs per

unit the slope - criteria for choosing functions: plausibility & reliability

- a cause-and-effect relationship is desirable for them to be accurate and useful - reliability can be assessed in term of ‘goodness of fit’ – how well it explains past cost behavior

Choice of cost drivers: Activity analysis - activity analysis: the process of identifying appropriate cost drivers and their effects on the costs of making

a product or providing a service (especially important when cost drivers are not obvious) - it examines various potential cost drives for plausibility and reliability - identifying the appropriate cost drivers is the most critical aspect of measuring cost behavior

- cost prediction: the application of cost measures to expected future activity levels to forecast future costs - in the past, the only cost driver used was labor, but things have changed… Methods of measuring cost functions - once the most plausible cost drivers are determined, there are various methods of approximating cost

functions, which are not mutually exclusive but can all be applied simultaneously: - relying on logical analysis: engineering analysis; account analysis à both subjective - also involve analysis of past costs: high-low analysis; visual fit analysis; simple least-squares

regression; multiple least-squares regression - engineering analysis: the systematic review of materials, supplies, labor, support services and facilities

needed for products and services; measuring cost behavior according to what costs should be, not by what costs have been - measures can be based on information form personnel, experiments, engineering literature, experience

from competitors, advice from management consultants, etc.) - disadvantage: costly & take time

- account analysis: selecting a volume-related cost driver and classifying each account as a variable cost or as a fixed cost - uses available information from the accounting system - fixed costs are added up to get the total fixed costs per month; the total variable costs are divided by the

number of units of cost-driver activity to get the variable costs per cost driver unit High-Low, visual-fit and least-squares methods - when enough data is available, historical data can be used to measure the cost function mathematically - all 3 methods are more objective than engineering analysis because they are based on hard evidence, and

also more objective than account analysis because they use more than one period’s costs




- disadvantages: historical data might hide past inefficiencies; by the time data are collected it is already obsolete

- high-low method: a simple method for measuring a linear-cost function from past cost data, focusing on the highest-activity and lowest-activity points and fitting a line through these 2 points - a graph of all points is used to check for error ors nonrepresentativeness - advantages: easy to use, not many data needed - disadvantages: choice of high/low points is subjective; does not use all available data; method may not

be reliable - visual-fit method: a method in which the cost analyst visually fits a straight line through a plot of all the

available data, not just between the high point and the low point, making it more reliable than the high-low method à highly subjective

- least-squares regression (regression analysis): measuring a cost function objectively by using statistics to fit a cost function to all the data (one cost driver: simple regression; multiple cost drivers: multiple regression) - coefficient of determination (R²): a measurement of how much of the fluctuation of a cost is explained

by the changes in the cost driver - advantages: is more reliable and yields statistical information about the reliability of the estimates

Management Accounting – Chapter 13 (Job-costing systems) - product costs are needed for both decision-making and financial reporting Distinction between job costing and process costing - job-order costing (job costing): the method of allocating costs to products that are readily identified by

individual units or batches, each of which requires varying degrees of attention and skill - process costing: the method of allocating costs to products by averaging costs over large numbers of nearly

identical products - basic distinction between both is the breadth of the denominator (job-order costing à small (1 to 100);

process costing à large) Illustration of job costing - job-cost record (job-cost sheet, job order): a document that shows all costs for a particular product, service

or batch of products; it summarizes information contained on source documents such as: - materials requisitions: records of materials issued to particular jobs - labor time tickets (time cards): the record of the time a particular direct laborer spent on each job

- on the job-cost record 3 classes of costs are accumulated: direct-material costs, direct-labor costs, budgeted overhead rates

Accounting for factory overhead - ideally all costs need to be known when decisions are made, unfortunately actual overhead costs are not

available when managers need them à budgeted overhead rates are used to apply overhead to jobs as they are completed

- steps to follow when accounting for factory overhead: 1. select the cost driver that is the best measure of the cause-and-effect relationship 2. prepare a factory-overhead budget for the planning period à budgeted overhead + budgeted volume of

the cost driver 3. compute the budgeted factory-overhead rate(s): the budgeted total overhead for each cost pool divided

by the budgeted cost-driver level 4. obtain actual cost-driver data 5. apply budgeted overhead to the jobs 6. at end of the year account for any differences between overhead incurred and applied

- budgeted overhead application rate = total budgeted factory overhead / total budgeted amount of cost driver - overhead rates are estimates!!! Choice of cost drivers - no one cost drivers is right for all situations, the cause-effect relationship must hold - the 80-20 rule can be used in situations with many different cost drivers, 80% of the overhead costs are

incurred by 20% of the cost drivers, the one(s) selected should be the one(s) that cause most of the overhead costs




Problems of overhead application - normal costing system: the cost system in which overhead is applied on an average or normalized basis, in

order to get representative or normal inventory valuations - the variance between incurred and applied costs is due to: e.g. operations at a different level of volume, poor

forecasting, calendar variations, etc. - normal costing is more useful than actual costing, because it does not distort cost by month-to-month

fluctuations in production volume and the erratic behavior of many overhead costs Disposition of underapplied or overapplied overhead - overapplied overhead: the excess of overhead applied to products over actual overhead incurred - underapplied overhead: the excess of actual overhead over the overhead applied to products - at year-end the difference is disposed through either a write-off or through proration - immediate write-off: the overapplied/underapplied overhead is regarded as a increase/reduction in current

income by subtracting/adding it to the cost of goods sold à most commonly used method - proration among inventories: to assign underapplied overhead or overapplied overhead in proportion to the

sizes of the ending account balances à dividing the variance between WIP (work in progress), finished goods and inventory); only done when inventory valuations would be materially affected

The use of variable and fixed application rates - most companies do not make a distinction between variable- and fixed-cost behavior in the design of their

accounting systems, but some do and distinguish between variable overhead and fixed overhead for product costing as well as control purposes - budgeted variable-overhead application rate = budgeted total variable overhead / budgeted amount of cost driver - budgeted fixed-overhead application rate = budgeted total fixed overhead / budgeted amount of cost driver

Activity-based costing/Management in a job-costing environment - activity based costing is used to determine the indirect costs that have to be budgeted to each line of business

and finally each individual job - budgeted overhead application rate = total ABC allocations / total budgeted units Product costing in service and nonprofit organizations - here the focus shifts form the costs of products to the costs of services; instead of a ‘job’ these may be called

a ‘program’ or a ‘class of service’ - in many service organizations, job orders are used not only for product costing, but also for planning and

control purposes; e.g. when a fixed fee is quoted, the profitability of an engagement depends on whether it can be accomplished within the budgeted time limits or not

- many professional service firms have refined their data processing systems and adopted activity-based costing à generally ABC shifts costs from being classified as overhead to being classified as direct costs




Problem 27: 1. What’s the integral cost price? (integral = ganz, vollständig) 2. Are the calculations correct? – calculations yes, reasonings no 3. Contribution method? 4. What are absorption? Problem 28: 1. What is budgeting? – budgeting in business, comment on the statements Problem 29: 1. What’s a variance analysis? 2. What is efficiency variance? 3. Do the calculations – variance analysis! 4. Who can be held responsible for the variance?

Management Accounting – Chapter 4 (Cost management Systems) Cost accounting for financial reporting - product costs: costs identified with goods produced or purchased for resale - period costs: costs that are deducted as expenses during the current period without going through an

inventory stage - in both merchandising and manufacturing accounting, selling and general administrative costs are period

costs; manufacturing overhead is traditionally regarded as a product cost Balance sheet & Income statement presentation - only essential difference between manufacturer’s and retailer’s balance sheet is the division of inventory for

the manufacturer in ‘direct materials inventory’, ‘work-in-process inventory’ and ‘finished-goods inventory’ - difference on income statement: manufacturer’s cost of goods sold is split in 3 categories: direct materials,

direct labor and indirect manufacturing - expenses: all costs deducted from revenue - costs: describes both an asset (cost of inventory) and an expense Cost behavior and income statements - absorption approach: a costing approach that considers all factory overhead (both variable and fixed) to be

product (inventoriable) costs that become an expense in the form of manufacturing cost of goods sold only as sales occur à used by most companies

- contribution approach: a method of internal (management accounting) reporting that emphasizes the distinction between variable and fixed costs for the purpose of better decision making - contribution margin: revenue – all variable costs à makes it easier to understand the impact of

changes in sales demand on operating income - role of fixed costs in net income is stressed - difference between gross margin and contribution margin is striking especially in manufacturing

companies, as the (high) fixed manufacturing costs do not reduce the contribution margin Cost management systems - cost-management system: identifies how management’s decisions affect costs, by first measuring the

resources used in performing the organization’s activities and then assessing the effects on costs of changes in those activities

Activity-based management - activity-based management (ABM): using an activity-based costing system to improve the operations of an

organization (ABC helps, because managers’ day-to-day focus is on activities not costs) - aim is to improve value received by customers & profits by providing this value

- ABC can be used to spot expensive non-value-added costs that can be reduced or even eliminated: - value-added cost: the necessary cost of an activity that cannot be eliminated without affecting a

product’s value to the customer (activity has to be performed efficiently) - non-value-added costs: costs that can be eliminated without affecting a product’s value to the customer




JIT systems - just-in-time (JIT) production system: a system in which an organization purchases materials and parts and

produces components just when they are needed in the production process, the goal being to have zero inventory, because holding inventory is a non-value-added activity (whose cost can thus be eliminated)

- factors crucial to the success of JIT systems: - focus on quality; TQC (total quality control) is used to minimize non-value added activities - short production cycle times are needed to timely respond to orders

- production cycle time: the time from initiating production to delivering the goods to the customer - smooth flow of production: JIT companies often simplify the production process; develop close

relationships with suppliers & perform routine maintenance to avoid breakdowns - cellular manufacturing: a production system in which machines are organized in cells according to

the specific requirements of a product family - flexible production operations: cross-trained employees and facilities flexibility

à Accounting for JIT systems is often simpler, because in true JIT systems, material, labor and overhead costs can be charged directly to costs of goods sold, because inventories are small enough to be ignored

Management accounting – Chapter 5 (Relevant Information & decision making: Marketing decisions) The concept of relevance - relevance of information depends on the decision being made - accountants are technical expert on financial analysis, helping mangers to focus on relevant information

leading to the best decision - relevant information: the predicted future costs and revenues that will differ among alternative courses of

action - decisions affect the future à relevant information is a prediction of the future (past data can have an

indirect bearing by helping in the prediction) - any item remaining the same regardless of the alternative selected is irrelevant

- decision model: any method for making a choice, sometimes requiring elaborate quantitative procedures - steps: historical & other information à prediction method à decision model à implementation and

evaluation - accountants are forced to trade off relevance versus accuracy – precise but irrelevant information is

worthless, imprecise but relevant information can be useful; the degree to which information is relevant or precise often depends on the degree to which it is qualitative or quantitative (qualitative aspects may easily carry more weight than quantitative ones)

The special sales order - key question: what are the differences between the alternatives? - usually the contribution approach’s distinction between variable- and fixed-cost behavior patterns aid the

necessary cost analysis in this case (when fixed costs are irrelevant) - while we only focus on relevant data, there are occasions when irrelevant data is included in the

accountant’s presentation of analysis to suit the preferences of managers who will use the information - avoid the assumption that unit costs may be used indiscriminately as a basis for predicting how total costs

will behave, unit costs are useful for predicting variable costs, but misleading when used to predict fixed c. - with the special order it is assumed that the fixed costs will not rise as total output is within the relevant

range - more and more firms identify significant activities and related cost drivers (use ABC) to produce more

detailed relevant information to predict the effects of special orders more accurately Deletion or addition of products, services, or departments - decisions are made by examining all the relevant cost and revenue information à purpose in deciding

whether to add/drop new products, services, departments is to obtain the greatest contribution possible to pay unavoidable costs (the key is picking the alternative that will contribute the most toward paying the unavoidable costs off)

- avoidable costs: costs that will not continue if an ongoing operation is changed or deleted - unavoidable costs: costs that continue even if an operation is halted - common costs: those costs of facilities and services that are shared by users (part of unavoidable costs) à relevant costs are not always variable, the key to decision making is not relying on a hard and fast rule!




Optimal use of limited resources - when decide upon the optimal use of limited resources, the contribution approach applies, the product to be

emphasized or the order to be accepted is the one that makes the biggest total profit contribution per unit of the limiting factor (however, the product that is most profitable when one particular factor limits sales may be the least profitable if a different factor restricts sales)

- limiting factor (scarce resource): the item that restricts or constrains the production or sale of a product or service

- in general, retail companies seek faster inventory turnover to maximize the total profit contribution per unit of the limiting factor

- inventory turnover: the number of times the average inventory is sold per year Pricing decisions Concept of pricing à pricing decisions depend on the characteristics of the market - perfect competition: a market in which a firm can sell as much of a product as it can produce, all at a single market price - imperfect competition: a market in which the price a firm charges for a unit will influence the quantity of units it sells - marginal cost: the additional cost resulting from producing and selling one additional unit - marginal revenue - marginal revenue: the additional revenue resulting form the sale of an additional unit (curve horizontal in perfect competition, half of

the demand curve in imperfect competition) - in managerial accounting marginal cost is essentially the variable cost – the difference is that variable costs

are assumed to be constant within the relevant range, whereas marginal cost may change with each unit produced, but variable costs can be a reasonable approximation in many situations

Pricing and accounting - accountants seldom use marginal revenue and m. cost curves, but instead use estimated to predict effects of

additional production; in addition they examine selected volumes, not the whole range of possible volumes - comparing the total contributions is essentially the same as computing the additional revenues and costs General influences on pricing in practice - legal requirements à both are not allowed:

- predatory pricing: establishing prices so low that competitors are driven out of the market; the predatory pricer then has no significant competition and can raise prices dramatically

- discriminatory pricing: charging different prices to different customers for the same product or service - competitors react to price changes à their predicted reaction has to be incorporated in the decision Role of costs in pricing decisions - exact role costs play in pricing decisions depends on market conditions and company’s approach to pricing - cost-plus pricing: computing an average and adding a desired markup - markup: amount by which price exceeds costs (different markups can be used for different categories) - prices are most directly related to costs in industries where revenues is based on cost reimbursement - ultimately the market sets prices; in the long-run it must be high enough to cover all costs - minimum price: usually the variable costs - maximum price: not related to costs, but to expectations Cost bases for cost-plus pricing - cost plus is often basis for target prices, size of the plus depends on desired operating incomes à many

ways to arrive at one target price: 4 popular markup formu las for pricing: (always: (revenue – costs)/costs) - percentage of variable manufacturing costs - percentage of total variable costs - percentage of full costs (total of manufacturing costs +ü total of all selling and administrative costs) - percentage of absorption costs

Advantages of contribution approach / of absorption-cost or full-cost in cost-plus pricing - because the contribution approach is sensitive to cost-volume-profit relationships, it is a helpful basis for

developing pricing formulas; in contrast target pricing with absorption costing or full costing presumes a given volume level

- managers may perceive a pronounced danger of underpricing when variable-cost data are revealed à there is no single method of pricing that is always best; companies often use both full-cost and variable-cost

information à there are numerous ways to compute selling prices; managers should understand their options and the effects

on profits if they know their cots




Target costing - cost-plus pricing is used when management actions can influence the market price, but when management

cannot influence the price and desired profits are to be achieved, focus on cots is needed - target costing: a cost management tool for making cost a key focus throughout the life of a product

- target cost is set and managers have to try to reduce and control costs, most effective is target costing at reducing costs during the product design phase

- one of the key characteristics of successful target costing is strong emphasis on understanding customer demands

- ABC is important to provide accurate costing information and eliminate non-value-added activities - value engineering: a cost-reduction technique, used primarily during design, that uses information about all

value-chain functions to satisfy customer needs while reducing costs - kaizen costing: the Japanese word for continuous improvement (lower costs) during manufacturing - it becomes increasingly popular, because companies are more and more limited in influencing market prices

Management Accounting – Chapter 7 (The master budget) Budgets and the organization - business organizations use budgets to focus attention on company operations and finances, not just to limit

spending - budgets are formal business plans and are especially important in uncertain environments - 3 major benefits of budgeting:

1. Formalization of planning: - budgeting makes planning an explicit management responsibility - to prepare a budget goals/objectives are set which are destination points, the budget being the road map 2. Framework for judging performance (benchmarking): - budgeted goals and performance are a better basis for judging performance than past performance,

because inefficiencies may be concealed 3. Communication and coordination: - budgets tell employees what is expected à good budgeting communicates both from top down and

bottom up - budgetary process forces managers to visualize the relationship of their department’s activities to other

departments and the company as a whole Types of budgets - strategic plan: a plan that sets the overall goals and objectives of the organization (most forward looking,

does not produce financial statements) - long-range planning: producing forecasted financial statements for 5 to 10 year periods - capital budget: a budget that details the planned expenditures for facilities, equipment, new products, and

other long-term investments à managers have to find a balance of focus on long-range and day-to-day operations - master budget (pro forma statement): a budget that summarizes the planned activities of all subunits of an

organization - extensive analysis of the first year of the long-range plan - the master budget is a periodic business plan that includes a coordinated set of detailed operating

schedules and financial statements - continuous budget (rolling budget): a common form of master budget that adds a month in the future as the

month just ended is dropped à budgeting becomes an ongoing process (when a new month is added, the others can also be updated)

Components of master budget - terms used vary from organization to organization, but all have common elements à master budget for a

nonmanufacturing company: A. Operating budget

1. Sales budget (and other cost-driver budgets as necessary) 2. Purchases budget 3. Cost-of-goods-sold budget 4. Operating expenses budget 5. Budgeted income statement




B. Financial budget 1. Capital budget 2. Cash budget 3. Budgeted balance sheet

- manufacturing companies also need to budget physical product inventories and might also add budgets for each type of resource activity

- operating budget (profit plan): a major part of a master budget that focuses on the income statement and its supporting schedules

- financial budget: the part of a master budget that focuses on the effects that the operating budget and other plans (such as capital budgets and repayments of debt) will have on cash

Preparing the master budget - the sales budget is the starting point for budgeting because inventory levels, purchases and operating

expenses are geared to the rate of sales activities (if no revenues are generated, a desired level of service is predetermined)

- cash budget: a statement of planned cash receipts and disbursements (heavily affected by level of operations summarized in budgeted income statement à has following major sections: - total cash available before financing - cash disbursements - minimum cash balance desired - financing requirements (total cash available compared with total cash needed) - ending cash balance à financing has either a positive (borrowing) or a negative (repayment) effect

à cash budgets help management to avoid having unnecessary idle cash or unnecessary cash deficits - when the master budget is formulated, management can consider all major financial statements as a basis for

changing the course of events - the budgeted income statement is prepared form the supporting schedules: sales budget, cash collections,

purchases budget, cash disbursements for purchases, operating expenses, disbursements for expenses - Difficulties of sales forecasting - accuracy of estimated purchases budgets, production schedules and costs depends on the detail and accuracy

of the budgeted sales - sales forecast: a prediction of sales under a given set of conditions (not necessarily identical with sales

budget) - sales budget: the result of decisions to create conditions that will generate a desired level of sales - important factors considered by sales forecasters: past patterns of sales; estimates made by the sales force;

general economic conditions; competitors’ actions; changes in the firm’s prices; changes in product mix; market research studies; advertising and sales promotion plans

Getting employees to accept the budget - if budgets are to benefit an organization, they need the support of all the firm’s employees – often difficult

when employees only see the aspect of checking their performance - participative budgeting: budgets formulated with the active participation of all affected employees Financial planning models - a well-made budget considers all aspects of a company à effective model for decision making - financial planning models: mathematical models of the master budget that can react to any set of

assumptions about sales, costs or product mix à allows managers to assess the predicted impacts of various alternatives before final decisions are selected (these models are only as good as are the assumptions and inputs)

Management Accounting – Chapter 8 (Flexible budgets and variance analysis) Flexible budgets: bridge between static budgets and actual results Static budgets - all master budgets are static, as they assume fixed levels of activity - a helpful performance report includes variances that direct management’s attention to significant deviations à allowing for management by exception

- master budget variance (static budget variance): the variance of actual results from the master budget à not useful for management by exception




- unfavorable expense variance: a variance that occurs when actual expenses are more than budgeted expenses

- favorable expense variance: a variance that occurs when actual expenses are less than budgeted Flexible budgets - flexible budget (variable budget): a budget that adjusts for changes in sales volume and other cost-driver

activities à in format identical to the master budget, but can be prepared for any level of activity à for performance evaluation, it is prepared at the actual levels of activity achieved

- companies using a traditional, volume-based costing system use a single cost driver in the flexible budget approach, while companies that use ABC need a more detailed approach

- activity-based flexible budget: a budget based on budgeted costs for each activity and related cost driver (should be used when a significant proportion of the costs vary with cost drivers other than units of production)

Evaluation of financial performance using flexible budgets - the difference between actual results and the master budget has 2 components: sales-activity variance and

flexible-budget variance - flexible-budget variances: the variances between the flexible budget and the actual results (due to

departures of actual costs or revenues from flexible-budget formulas) - activity-level variances: the differences between the master budget amounts and the amounts in the

flexible budget - it is useful to separate these effects because different people may be responsible Isolating the causes of variances - when evaluating performance it is useful to distinguish between:

- effectiveness: the degree to which a goal, objective, or target is met - efficiency: the degree to which inputs are used in relation to a given level of outputs (measured by the

flexible-budget variances) - flexible-budget variances indicate whether operations were efficient, but one should not automatically

conclude that favorable flexible-budget variances are good an unfavorable bad à variances should be seen as signals and any costs that differs significantly form the flexible budget should be scrutinized

- sales-activity variances: variances that measure how effective managers have been in meeting the planned sales objective calculated: total sales-activity variance = (actual sales units – master budgeted sales units) * (budgeted contribution margin per unit) à most able to explain variances are the marketing managers

Expectations, standard costs, and standard cost systems - expected cost: the cost most likely to be attained - standard cost: a carefully determined cost per unit that should be attained - standard cost systems: accounting systems that value products according to standard costs only - in the flexible budgets we use the expected costs (may also be called standard costs but this dos not imply

that a company needs a standard cost system to make budgets) Current attainability: Most widely used standard à what standard of expected performance should be used? - perfection standards (ideal standards): expressions of the most efficient performance possible under the best

conceivable conditions, using existing specifications and equipment à constantly reminds personnel of need for improvement, but has adverse effects on motivation

- currently attainable standards: levels of performance that can be achieved by realistic levels of effort, either with standards set just tight enough to let employees regard attainment as highly probable (adv.: same cost can be used for financial budgeting, inventory & motivation) or by setting standards tight but at an achievable level employees accept

Other points to notice: - because of the many interdependencies among activities, an unfavorable or favorable label should not lead

managers to jump to conclusions – they just direct manager’s attention - variances are unlikely to be exactly zero, thus there should be a range of ‘normal’ variances - some organizations compare the most recent budget period’s actual results with last years results for the

same period, but this is not very useful, as many changes will have occurred in the organization and the environment




Flexible-budget variances in detail - the flexible budget gives the standard costs allowed = units of good output achieved * input allowed per unit

of output * standard unit price of input - flexible-budget variances can be attributed to (19 using more or less of the resource than planned for the

actual level of output achieved and (2) paying more or less for the resource than planned - price variance: the difference between actual input prices and expected input prices multiplied by the actual

quantity of inputs used - when calculating the price variance, hold use of inputs constant at the actual level of usage

- usage variance (quantity variance, efficiency variance): the difference between the quantity of inputs actually used and the quantity of inputs that should have been used to achieve the actual quantity of output multiplied by the expected price of the input - when calculating usage variance, hold price constant at the standard price

- when feasible, the variances subject to a manager’s direct influence should be separated form those that are not à provides better feedback

- the sum of the price and usage variances equals the total flexible budget variance (no inventories!) Effects of inventories - till now inventories (finished goods & raw materials) have been discarded - if production does not equal sales: sales-activity variance is the difference between the static budget and the

flexible budget for the number of units sold; the flexible cost variance on the other hand compare actual costs with flexible-budgeted costs for the number of units produced

- generally managers want quick feedback à material price variance is based on quantity purchased (at time of purchase); material usage variance remains based on quantity used

Overhead variances - overhead variances are often not subdivided beyond the flexible-budget variances, but sometimes they are,

especially when considering variable overhead à related to control of the cost driver and the control of overhead spending itself

- variable-overhead efficiency variance: an overhead variance caused by actual cost-driver activity differing from the standard amount allowed for the actual output achieved

- variable-overhead spending variance: the difference between the actual variable overhead and the amount of variable overhead budgeted for the actual level of cost-driver activity

General approach - when a variety of units are added together in a budget approach, a common denominator for measuring total

output volume has to be found à standard hours allowed is a measure of actual output achieved! - price variance = actual cost incurred – (actual inputs * expected prices) - usage variance = (actual inputs * expected prices) – (inputs allowed for actual outputs achieved * expected

prices)

Capital Budgeting Self Study Tasks 1, 2 & 3 Week 1 1-4 budgeting, Investments and... · basis. The...

Documents

Transcript of Capital Budgeting Self Study Tasks 1, 2 & 3 Week 1 1-4 budgeting, Investments and... · basis. The...