Mgmt 497

Accounting, Finance & Other Interesting Stuff

Overview

This lecture will cover the most complicated accounting and finance questions from the Player’s Manual

Basic Strategies

High price, low share, best quality & features

Rolex

Low price, high market share, low unit cost

Timex

Mid-price pointSeiko

Basic Strategies

Choose your approachRolex, Timex, Seiko

Establish goals in writingMarket shareUnit costNet incomeROAROEStock price

Performance Measurement

Performance measures (Weighting Factors) should support strategies

Timex—UPC, market shareRolex—probably not UPC, or market shareFinancial leverage—ROE, not ROA

Basic Financial Statements

Income statementCash flow statementBalance sheet

Basic Financial Statements

Consolidated financial statements require

Elimination of intracompany sales and purchases (only sales and purchases between combined entities and the outside world matter)Elimination of intracompany payables and receivables

Basic Financial Statements

Consolidated financial statements require

Elimination of reciprocal investment accountsTranslation of foreign currency into $US (you can’t add apples and oranges)

Calculation of Consolidated Sales

See page 177 of Players ManualHome Area sales total (Intracompany and outside): $2,199Intracompany sales: $1,190M2 sales to outsiders: $755M3 sales to outsiders: $755N/P/S sales to outsiders: $806 (4841/6)

Calculation of Consolidated Sales

Consolidated sales total: $3,325($2,199-$1,190) + $755 + $755 + $806

Calculation of Consolidated Cost of Goods Sold

Beginning inventory total: $549 $271 +$118 + $118 + $42 (250/6)

Cost of goods manufactured: $1,494Intracompany purchases: $1,190

$397 + $397 + $396 (2,380/6)

Ending inventory total: $523 $287 + $86 + $86 + $64 (382/6)

Calculation of Consolidated Cost of Goods Sold

Total goods available for sale = Beginning inventory + Cost of goods manufactured + intracompany purchasesConsolidated goods available for sale = Beginning inventory + Cost of goods manufactured (does not include intracompany purchases)

Calculation of Consolidated Cost of Goods Sold

Consolidated cost of goods sold = Consolidated goods available for sale – consolidated ending inventoryConsolidated cost of goods sold: $1,520($549 + $1,494 - $523)

Cost Structure

TC = VC + FCIncreased volume reduces unit fixed costIncreased volume may increase unit variable costs (e.g., overtime)Adding FC:• Increases operating leverage• Increases operating risk• May reduce variable costs

Example: Fixed training reduces VC

Production Cost Analysis

Increased production volume reduces unit fixed costs (depreciation)Decreased production volume increases unit fixed costs (depreciation)See page 141 of Players Manual

Production Cost Analysis

Equipment depreciation for one quarter: $107,000Plant depreciation for one quarter: $26,000Six lines at 40 hours per week will produce 312,000 units per quarter (100 units/hour for 13 weeks per quarter)Six lines at 42 hours per week will produce 328,000 units (rounded)

Production Cost Analysis

Produce 312,000 unitsEquipment depreciation per unit: $ .343Plant depreciation per unit: $ .083Labor cost per unit: $2.880

Produce 328,000 unitsEquipment depreciation per unit: $ .326Plant depreciation per unit: $ .079Labor cost per unit: $2.950

Operating Leverage

Production worker training: $68,000 per quarter, indexed for inflation (fixed cost)Reduction in per unit labor (variable) costs (e.g. $.20 per unit)See page 136-137 of Players Manual

Production Layoffs and Deactivation

Production layoffs and deactivation lowers morale and output for several quartersA layoff or deactivation of second shift that is replaced by a new first shift has no impact on output

Tax Loss Carryforwards

If you lose money in a quarter, the business unit in question does not pay taxesLosses may be carried forward to offset future income and reduce future taxesNo loss carrybacks are allowedSee page 186

Tax Loss Carryforwards

If a subsidiary loses money in a quarter, it pays no taxes that quarter, and the loss reduces consolidated taxable income and taxes in the quarter of the loss (assumes parent’s total taxable income is positive)The subsidiary’s loss is carried forward to a future quarter when it makes income, reducing the subsidiary’s taxable income and taxes in that future quarter

Tax Loss CarryforwardsThe consolidated net income is not reduced in the future quarter, since the loss was deducted from consolidated net income in the prior quarterIn summary, the loss reduces consolidated net income and taxes in the quarter of the loss, leaves consolidated net income and taxes unchanged in the carryforward year, and reduces subsidiary income and taxes in the carryforward year

Foreign Currency Gain or Loss

N/P/S revenues and expenses in a quarter are translated into $US at the current exchange rate for that quarterThe Home Area uses the Equity Method of Accounting for its investment in subsidiaries, including N/P/SEquity in Subsidiaries on the Balance Sheet will equal the sum of the Capital Stock and Retained Earnings for each subsidiary (see page 201)

Foreign Currency Gain or Loss

If the exchange rate rises (falls), Equity in Subsidiaries will decrease (increase), creating a loss (gain) in comprehensive incomeSee page 187 of Players Manual

Foreign Currency Gain or Loss

N/P/S beginning Capital Stock: 4573N/P/S beginning Retained Earnings:1128 (assumed)Beginning Equity in N/P/S: 6701Beginning exchange rate: 6.0Ending exchange rate: 6.3 (Rate rises)Foreign currency loss: $6 (see page 188)

Cash Flow Statement

Net Operating Cash FlowsNet Investment Cash Flows (Home Area)Net Financing Cash Flows (Home Area)See page 192

Cash Flow Statement

A good company has Operating Net Cash Flow ≥ Operating Net IncomeIf Operating Net Cash Flow ≤ Operating Net Income, there is usually a build up in Accounts Receivable and InventoriesA good company has Operating Cash Flow ≥ Investing Cash Outflows, requiring no additional financing

Cash Flow Statement

Initially, your net operating cash flow may not be sufficient to cover your investments, and some financing may be requiredHopefully, you will have excess operating cash flow at a later date

Investing Excess Cash

“Investments”CDsRepayment of debtRepurchase of stock

Need for liquidity

Operating Cash Inflows

All sales are on creditFor Merica: 50% collected current

quarter; 50% next quarterFor N/P/S: 40% collected current

quarter; 60% next quarter (See page 189)

Net sales to affiliates and purchases from affiliates result in zero cash flow from a consolidated point of view

Operating Cash Outflows

All operating expenses except depreciation, are paid in cashTaxes are paid the following quarter, creating a taxes payable liability (pg. 193)Two thirds of operating and cash production costs are paid in current quarter; one third are paid in the following quarter (pg. 191-193)

Investing and Financing Cash Flows

Subsidiary Dividends Received and Dividends Paid to Parent result in zero net cash flow from a consolidated point of viewSubsidiary Stock Purchased and Stock Sold to Parent result in zero net cash flow from a consolidated point of view

Balance Sheet

The income statement and cash flow statements should be prepared first, and the balance sheet will followThe year end balance sheet, is the Q4 balance sheet, not the sum of quarterly balance sheets

Balance Sheet

The N/P/S asset and liability accounts on the balance sheet are translated using the “current quarter exchange rate” as of the balance sheet dateThe N/P/S Capital Stock account is translated using the historical rate in effect at the time the stock was sold

Balance Sheet

The N/P/S Accumulated Earnings account is translated using historical exchange rates in effect when the earnings were earnedThe inconsistent use of current and historical exchange rates necessitates the use of an Accumulated Foreign Currency Adjustment (see pages 199 and 204)

Accumulated Foreign Currency Adjustment

Consolidated Total Assets minus Consolidated Total Liabilities equals Consolidated Total Equity $12,370 ($14,370-2000)Consolidated Capital Stock and Accumulated Earnings equal $12,373 ($9,500 + 2873), requiring an adjustment of -$3 (plug figure)

Equity in Subsidiaries

The Home Area uses the “Equity Method” to account for its investment in subsidiariesThe formula for Equity in Subsidiaries is: Beginning Equity in Subsidiaries + Net Income of Subsidiaries – Dividends paid by Subsidiaries = Ending Equity in Subsidiaries

Equity in Subsidiaries

In the consolidation process, the assets and liabilities of M2, M3, and N/P/S are added to the Home Area’s assets and liabilitiesIn the consolidation process, the subsidiaries are treated as wholly owned “departments” of the Home Area, with no common stock outstanding

Equity in Subsidiaries

The Home Area’s Capital Stock account includes the value of its original investment in the capital stock of the subsidiariesSince the Home Area is using the Equity Method of Accounting, the net income (Accumulated Earnings) of the subsidiaries has been added to Home Area’s net income (Accumulated Earnings)

Equity in Subsidiaries

Moreover, the Equity in Subsidiaries account includes the original value of the subsidiaries capital stock and the subsidiaries’accumulated earningsTo avoid “double counting” from a consolidated point of view, the Equity in Subsidiaries is eliminated against the capital stock and accumulated earnings accounts of the subsidiaries in the process of consolidation

Consolidated Retained Earnings

The formula for Consolidated Retained Earnings is: Beginning Consolidated Retained Earnings + Home Area’s Net Income from its own operations + Subsidiaries’ Net Income from their own operations – Dividends paid to outside shareholders (excluding intercompany dividends)

Consolidated Retained Earnings

Example: See page 204Home Area NI: $122M2 NI: $ 35M3 NI: $ 35N/P/S NI: $ 63 (374/6)Total NI: $255Total Sub NI: $ 133

Consolidated Retained Earnings

Intercompany dividends:M2: $ 35 (100% payout)M3: $ 35 (100% payout)N/P/S: $ 50 ((316/6)x.8) (80% payout)Total: $ 115Subsidiary Earnings Retained: $ 18“Outside” dividends: $ 209

Consolidated Retained Earnings

Beginning RE: $ 2,685+ Home Area NI: +122+M2 NI: + 35+M3 NI: + 35+N/P/S NI: + 63 (374/6)- Outside Dividends: -209Ending RE: $ 2,731

Repurchase of Stock

Stock repurchases are accounted for using the “par value,” not the cost methodEven though the stock has no “par value,” treat the “book value” as if it were the par value

Repurchase of Stock

Upon repurchase, the repurchase price is subtracted from cashThe book value of the repurchased shares is subtracted from Capital StockThe excess of the repurchase price over book value is subtracted from retained earnings

Capital Structure

Debt vs. Equity FinancingROA• Profit Margin (NI/Sales) x Asset Turnover

(Sales/Assets) = ROA (NI/Assets)

ROE • ROA x Financial Leverage (Assets/Owners

Equity) = ROE (NI/OE)

Financial leverage• Financing assets with debt

External Financing Sources

Emergency loans Bank loansBondsStock

Bank Loans

Emergency loansVery expensive• 1st time r + 5%• 2nd time r + 15%• 3rd time r + 30%• After 3 r + 45%

Generally due to poor planningHurts credit rating, causes sales force resignations, and decline in demand

Bank Loans

For 1 QuarterAutomatic repayment of P + IMaximum: 50% of (AR + Inventory), or$2.5 millionClean out 1 in 4 Qtrs

Bonds

10 year, callableInterest rate determined on day of issueIssued in multiples of $1 million Maximum = Lesser of (50% equity or 75% fixed assets)

Bonds

Redeemed in multiples of $100,000 Max redemption = $500,000 per Qtr5% call premium

Stock Issue

Issued in multiples of 100,000 shares Min value of issue = $1 million

Issue price = (shs outstanding x current market price)

(shs outstanding + new shs issued)

Issuing New Stock

Current market price $ 10.00 $ 10.00 Current shares outstanding 6,000 6,000 New issue 100 1,000

Price of new issue $ 9.84 $ 8.57

Avg price per share after issue $ 9.997 $ 9.796

• Credit rating 1 yields 10% premium• Credit rating 3 requires 10% discount

Current Stock Price

Conditions in the stock marketConsistent earnings growthConsistent dividend payout

Dividend policy

Riskiness of stockBased on credit rating

Investor ROI  n-8 n

r = Pn – P8 + Dt - 1 t=9

 

Pn – P8 = increase in stock price since Q8

n

Dt = dividends paid after Q8 t = 9

r = quarterly rate, 4r = annualized rate

Repurchasing Stock

In multiples of 100,000 sharesMaximum per qtr = 500,000 sharesRepurchase price = market price + 10% Must have positive RE after transaction Must have a minimum of 3 million shares outstanding

Credit Rating

Based onCash on handEarnings growthDividend paymentsCapital structure

Bankers like consistency!

Forecasts

4 rolling quartersAnticipate future needsDeal with lead times

SpreadsheetsTemplates available in game folder

Forecasts

SalesProduction planCapital requirements (Chapter 9)Financial statements (Income, Balance Sheet, Cash flow) (Chapter 10)Cash flow is ultimate reality check!

Actual Results

Usually differ from projectionsExternal conditionsExecution failuresErrors in projections

Analyze reasonsTake corrective action

Two Year PlanDue at the start of week 7Start early and develop own templates or use game templatesIncome statement, cash flow statement, balance sheetBalance sheet must balance!Cash flow must agree with balance sheet!Net income – dividends = change in Retained Earnings

Final Thoughts

Only two keys to successSolid teamwork• Delegation of responsibilities• Efficient use of time

Clear focus on objectives• Drive business toward goals• Consistency

Congratulations

On your upcoming graduation !!