Basic College Accounting.com

Individual Cost Of Capital-Common Stocks

slang — Sat, 17 May 2008 06:18:51 +0000

There are two means of getting finance from common stocks namely:

Retained earnings or internal common equity(Ke)
External common equity (Kne)- the issuance of NEW common stocks.

Let’s see how we can compute the aforesaid’s cost of capital

Methods To Compute Of Cost Of INTERNAL Common Equity

Dividend Growth Model
Capital Asset Pricing Model (CAPM)

Dividend Growth Model

The value of common stock is equal to the PRESENT VALUE OF EXPECTED FUTURE DIVIDENDS, discounted at the stockholders’ required rate of return
Formula is Po = D1/(Ke-g)

Where Po = price of the stock today

D1= dividend at the end of the first year

Ke= required rate of return on equity

g = constant growth rate of dividends

If dividends are paid at a constant annual rate of growth(g) which is less than Ke:

Ke= Dividend in year 1/Market price + Annual growth rate in dividends

Therefore Ke(Required rate of return)= D1/Po + g

Illustration Using the DIVIDEND GROWTH MODEL BASIS

Company XYZ Ltd’s recently received $0.15 dividend per share and expect dividends to growth at an annual rate of 10%. The market price of the security is $3, compute the investors’ required rate of return using the Dividend Growth Model:

Suggested Solution:

Ke( Required rate of return)

= D1/Po + g

= $0.15(1+0.1) / $3 + 0.1

= $0.165/3+0.1

=0.155

=15.5%

Factors Affecting A Company’s Cost Of Capital

slang — Sat, 17 May 2008 05:37:25 +0000

Some of the major factors which affect a firm’s cost of capital are:

1.0 Dependent on the overall country’s economic conditions

When inflation rate is increasing, cost of doing business is more expensive hence investors and lenders will demand a higher rate of return which results in a higher cost of capital
When the economy is on its upbeat trend where demand for funds increases and supply of funds are limited or not increasing proportionately to demand then the lenders and financiers increase their lending rate which will also increase a firm’s cost of capital

2.0 Dependent on the company’s business risk

The higher a firm’s business risk, the higher the investors’ required rate of return and the cost of capital will also increased.

3.0 Dependent on the company’s financial risk

Where a company is highly geared, the lending institutions will consider the firm’s financial risk to be quite high hence would require a higher rate of return from the firm hence increasing the firm’s cost of capital

4.0 Dependent on the Size of Financing

Where the firm’s size namely its assets or sales turnover cannot justify the size of financing needs, the lenders will be more cautious and will impose a higher cost of fund which will then increase the company’s cost of capital

Basic Understanding Of Cost Of Capital/Weighted Average Cost Of Capital

slang — Sat, 17 May 2008 05:15:59 +0000

Very often, we heard of the terms “cost of capital” and or weighted average cost of capital (WACC) used in maximization of shareholders’ wealth or in the Economic value added methodology.

What is this Cost of Capital or Weighted Average Cost Of Capital?

Firstly let’s look at what’s Cost of Capital:

It is the required rate of return that a firm must at least earn to cover the cost of raising funds from its investors namely the debt and equity holders
It therefore represents the overall cost of financing to the firm
It is always associated with risk in the sense that it is the rate that must be earned by the firm at a given level of risk hence it is normally used as the discount rate in analyzing investments or capital budgeting proposal. In the event the rate of return to be earned from the investment is higher than the firm’s cost of capital, the wealth of the shareholders will then be maximized.

The REASON to know a firm’s cost of capital:-

Is because a firm’s cost of capital is the rate of return which links the firm’s investment and its financing decision. Put it simply, if a firm has an overall cost of capital/financing rate of 10% but invested in projects that earned less than 10%, then shareholders’ wealth will be eroded.

Next we move on to Understand the Company’s Weighted Average Cost Of Capital :-

The company’s cost of capital is actually its “weighted average cost of capital (WACC) which is simply

The average of the firm’s cost of funds from ALL investors including all types of lenders/debts borrowing and stockholders.

This weighted average cost of capital weighs each category of source of financing PROPORTIONATELY

A firm’s weighted average cost of capital is a composite of the individual costs of financing weighted by the percentage of financing provided by each source.

How To Compute A Company’s Weighted Average Cost of Capital (WACC)

We can compute a company’s weighted average cost of capital(WACC) by:

First calculate the individual cost of financing like cost of debt, preferred stock and common stock

Secondly determine the percentage(weight) of debt, preferred stock and common stock to be used in the financing

Lastly, to calculate the firm’s WACC by multiplying the individual cost of financing with the percentage of financing.

Append below is a simple illustration on the computation of a company’s weighted average cost of capital (WACC):

Illustration:

Company ABC Ltd has the following sources of capital and has also determine its individual cost of capital:

Sources of Capital/Financing	$	Cost of Capital
Bonds	300,000	10%
Preferred stock	100,000	13%
Common stock	600,000	16%
	1,000,000

The Management intends to invest in a $500,000 investment project with an expected rate of return of 12.5%.

Should the firm make the investment?

Suggested Solution:

Step 1: Determine the individual cost of financing

In this case, it has been given.

Step 2: Determine the weightage(%)

Sources of Capital/Financing	$	Capital Structure (%)
Bonds	300,000	30%
Preferred stock	100,000	10%
Common stock	600,000	60%
	1,000,000	100%

Step 3: Compute the company’s WACC by multiplying the individual cst of financing with the weightage/% of financing:

Sources of Capital/Financing	Capital Structure (%)	Cost of Capital	WEIGHTED COST%
	(A)	(B)	(A) X (B)
Bonds	30%	8%	2.4%
Preferred stock	10%	14%	1.4%
Common stock	60%	18%	10.8%
	100%		14.6%

Final Step:

Compare the firm’s weighted average cost of capital (WACC) with the proposed rate of return from the capital investment:

Firm’s WACC = 14.6% Versus Rate of Return from Investment=12.5%

Reject the investment proposal as the firm’s WACC is higher than the project’s rate of return otherwise shareholders wealth will be eroded.

Goals Of The Firm

slang — Sat, 17 May 2008 02:38:14 +0000

From Finance’s stand-point there are two main goals:

Profit Maximization
Shareholders’ Wealth Maximization

Let’s look at what is

PROFIT MAXIMIZATION:

Simply a single-period or a short-term goal to be achieved within one year
Management mainly focus on efficient utilization of capital resources to maximize profits WITHOUT considering the consequences of its actions towards the company’s future performance.

Drawbacks/disadvantages of Profit Maximization Goal:

a. It is only a SHORT TERM concept

b. It does NOT consider the timing of returns

c. It IGNORES risk

Next, let’s look at what is

SHAREHOLDERS’ WEALTH MAXIMIZATION:

Shareholders’ wealth is regarding the maximizing of the total market /market price of the existing shareholders’ common stock
It can be achieved by considering many factors whether short or long term pertaining to decisions/actions made affecting the present and future earnings per share, timing of returns, dividend policy and other factors that can affect the market price of the company stock

Unlike profit maximization, it has the following advantages:

Its applies to the principle of time value of money wherein a dollar received today is worth more han it is to be received say 1 year later. By considering time value of money, this will lead to an overall increase in the company’s earning

To achieve shareholder’s wealth maximization, management needs to consider the uncertainty or risk factor. It accept a certain degree of risk when it is compensated with the same level of return

Increase in shareholders’ wealth will directly lead to increase in cash flows. It is not concern only with accounting earnings/profits but CASH FLOWS.

To achieve shareholders’ wealth maximization, the firm has to achieve all the short-term target like sales/earnings growth and dividend payout targets. Only when these short term targets being achieved, the firm will then be attractive to the potential investors which might raise the stock price..

Salient point to note:

Referring to the above two goals, we see that Profit Maximization(short-term) is actually a part of Shareholders Wealth Maximization. The ultimate or long term goal of a firm is actually to maximize shareholders’ value where we see the growth and sustainability of the market share prices of the owners’ common stock increasing from one year to another.

Unfortunately, in today’s world, there are still many companies who aggressively look towards immediate/short-term profit maximization as the main and ultimate goal. The major reason can be blamed to big incentives like bonus/stock options given by the shareholders to its top management when sales or earnings target being achieved.

Working Capital Management:Extending Credit Terms To Increase Sales

slang — Sat, 17 May 2008 01:59:14 +0000

It is very normal for students of financial management being asked question on the effect of extending credit terms to increase sales.

Append below is a simple illustration for a better understanding of investment in receivables or extension of credit terms:

Illustration:

Company ABC Ltd has a current sales of $2.6 million. It wants to increase its sales by relaxing its credit policy. The current credit term is 45 days and the proposed terms of credit is 60 days. However the company believes that bad debts will increase from 1.5% to 2% of sales and sales should increase by 10%. The variable operating costs are 72% of the sales. The corporate tax rate is 35% and that the company requires an after-tax return of 15% on its investment.

Question:

Should Company ABC Ltd extend its credit policy from 45 days to 60 days?

Suggested Solution

	$	$
Sales Increase (10 % of $2.6m)		260,000
Contribution margin (100-72%=28%)		72,800
Less:
Bad debts
1.5% x$2.6m	39,000
2.0% x($2.6×1.1=$2.86m)	58,000
Incremental bad debts		(19,000)
Operating profit before tax		53,800
Operating profit after tax		34,970

Increase in receivables investment
=(New sales/360 days x 60 days) deduct (Old sales/360 days x 45 days)	$476,660-$325,000	151,660

Expected rate of return =Operating profits after tax/Increase in receivables investment		34,970/151,660 =23.06%
Less: Original rate of return		15%
Incremental rate of return		8.06%

Yes, it is to the advantage of Company ABC Ltd to extend its credit policy as it achieve a higher rate of return of 8.06%

What is Cash Management & Motives/Reasons To Hold Cash

slang — Fri, 16 May 2008 17:52:09 +0000

Cash Management:-

Is the maintaining of liquidity of a firm to minimize the risk of insolvency. ( An insolvent company is one where it is unable to meet its maturing liabilities on time because it has inadequate liquidity to meet its debt obligation)

Cash Management is also about the proper balancing of keeping cash without letting it idling around.

Remember that profit is not equating to cash flow. A highly profitable company might collapse if without adequate cash flow due to the tying up of company’s funds with the accounts receivable and worsen by the needs to make regular payments like wages, rent & utilities, taxes

Motives/Reasons of Holding Cash:

· Three(3) motives advocated by British economist, John Maynard Keynes namely for:

· Transaction motive

· Precautionary motive and

· Speculative motive

The Transaction motive:

Maintaining cash for the purpose of meeting cash needs arising in the ordinary course of doing business.

Includes regular payments like wages, utilities, acquisition of fixed assets and inventories

Note that the amount of cash needed for transaction requirements depends on the nature of business and varies from industry to industry.

The Precautionary motive:

Maintaining of cash balance as buffer for UNEXPECTED needs that may arise.

Either holding in cash or marketable securities that can be liquidated easily

The Speculative motive:

Holding cash for potential profit making situation like purchasing raw materials in bulk in anticipation of a fall in price

Functions Of Finance Manager

slang — Fri, 16 May 2008 16:39:06 +0000

The main objective of the Finance Manager is to manage funds in such a way so as to ensure their optimum utilization and their procurement in a manner that the risk, cost and control considerations are properly balanced in a given situation. To achieve the objective the Finance Manager performs the following functions in the following areas:-

Forecasting and Planning

The need to estimate/forecast the requirement of funds for both the short term(working capital requirements) and the long term purpose(capital investments).

Forecasting the requirements of funds involves the use of budgetary control and long-range planning

Financing Decision

Helps to decide what type of Capital structure the company needs to have re: whether these funds would be raised re: from loans/borrowings or from internal source(share capital)

To raise sufficient long term funds to finance fixed assets and other long term investments and to provide for the needs of working capital

Investment Decision

In projects using the various capital budgeting tools like Payback method, accounting rate of return, internal rate of return, net present value.
Assets management policies are to be laid down regarding the various items of current assets like accounts receivable by coordinating with the sales personnel, inventory with production

Dividend Decision

Taking into consideration, earnings trend, share market price trend, fund requirement for future growth, cash flow situation and others.

Financial negotiation

Plays a very important role in carrying out negotiations with the various financial institutions, banks and public depositors for raising funds on favourable terms

Cash Management

The finance manager needs to ensure the supply of adequate, timely and cheap fund to the various parts of the organization
That there is no excessive cash idling around

Evaluating financial performance

To need to constantly review the financial performance of the various units of organization generally in terms of ROI(return on investment. Such review assists management in seeing ow the funds have been utilized in the various divisions and what can be done to improve it.

Dealing with relevant parties in the Financial Markets

Where the company is a listed entity, the need to interact with the Stock Exchange
To deal with money markets and capital markets for financing or investment of idling funds
To foster relationships with bankers, investors, underwriters of equity and bond issuances and other government regulatory bodies.

LCCI Cost Accounting Third Level(3016) Series 2, 3 & 4

slang — Thu, 15 May 2008 03:50:28 +0000

The aim of the examination is to test the candidate’s knowledge and understanding of

The methods, principles and techniques by which both planned and actual costs of operations, processes, departments, products or services are established

Responsibility for effective use of resources involving control by variance analysis

Relevant costs for decision making

SYLLABUS CONTENT

1.0 Further aspects of the Second Level Cost Accounting Syllabus

2.0 Stock Control

Use of free stock balance. Calculation and use of economic order quantity(EOQ)

3.0 Marginal Costing

Distinction from the absorption costing principle particularly as to the effect on stock valuation and reported profits

Relevance and use of contribution as a basis for various decisions, particularly with reference to limiting factors. Opportunity costs. Avoidable costs. Sunk costs. Calculation of break-even points. Break-even charts involving traditional, contribution and profit volume(P/V) presentations

4.0 Variance Accounting

Preparation and coordination of functional, cash and master budgets. Limiting factor. Fixed, flexible and rolling budgets. Human behaviour considerations. Setting standard costs. Types of standard. Comprehensive sales and production cost variance analysis, including mixture variances. Calculation and relevance of control ratios-activity, capacity and efficiency

5.0 Accounting Systems

Interlocking and integrated accounting systems

Use of control accounts. Reconciliation and causes of different profits

Notional costs

6.0 Presentation of information to management

EXAMINATION REQUIREMENTS:

A 3- hour examination. 5 questions are to be answered from a choice of 6

Graph paper are provided. Calculators ( no printout, silent, cordlss no word display facilities are allowed.

LCCI Cost Accounting Second Level(2016)-Series 2,3 & 4

slang — Thu, 15 May 2008 03:33:52 +0000

The aim of the examination is to test the candidate’s knowledge and understanding of

The purposes of cost accounting, the terminology used and the methods by which the costs of operations, processes, departments, products or services are ascertained using the absorption principle

Elementary aspects of the marginal principle, optional technique and costing systems

SYLLABUS CONTENT

1.0 General

Cost units; Cost centres; Cost classification into direct or indirect by function or into cost behaviour categories; Elements of costs; Coding; Form Design; Accounting entries

2.0 Costing For Materials

Ordering; Receiving; Inspection; Storage and issue procedures. Documents involved in stores routine; Perpetual inventory records; Continuous stock taking and treatment of discrepancies; Method of pricing stores issues and effect on reported profits; Maximum stock, minimum stock and re-order levels

3.0 Costing For Labor

Time and output records; Methods of remuneration and effect on unit cost; Payroll preparation and wages analysis; Treatment of overtime premium, shift premium and idle time

4.0 Costing for Overhead

Main sources of total overheads, including depreciation, using a fixed asset registers: Use of production and service cost centres; Allocation: Apportionment; Re-apportionment of service cost centres. Basis for and calculation of absorption rtes; Use of absorption rates; Under or over absorption

5.0 Costing Methods for

Specific orders – Job, batch and contract

Continuous process- Normal loss. Scrap Value. Abnormal loss or gain; Work in progress; Equivalent units; Joint products & By products

Provision of services- Service organizations, both internal and external

6.0 Marginal Costing

Elementary knowledge of the use of contribution for decisions and the effect on stock values and reported profits

7.0 Optional Techniques

Elementary knowledge of budgeting and standard costing restricted to prime cost variance analysis

8.0 Costing Systems

Simple examples of integrated accounting systems. Basic understanding of uniform costing

EXAMINATION REQUIREMENTS:

A 2 ½- hour examination. 5 questions are to be answered from a choice of 6

Graph paper are provided. Calculators ( no printout, silent, cordless no word display facilities are allowed.

LCCI Management Accounting Third Level(3023)-Series 2,3 & 4

slang — Thu, 15 May 2008 03:18:53 +0000

The aim of the examination is to test the candidate’s knowledge and understanding of the basic principles involved in short-term cost behaviour, short and long-term decision making and short-term profit control, cash management and product cost ascertainment

SYLLABUS CONTENT

1.0 Short-term Cost Behaviour

Effective assessment of the cost effects of the various alternatives open to management
Fixed, variable and semi-variable costs.
Segregation of semi-variable costs into fixed and variable components

2.0 Short-term Decision Making

· Basic principles upon which short-term decision should be based

· Marginal costs,

· Contribution Theory.

· Cost Volume Profit Analysis

· Preparation of break even charts-their value and limitations

· Differential costing

· Cash flow statements

· Key or limiting factors

3.0 Short-term Profit Control

Appreciation of the principles and comprehension of control documents
Principles of profit control; Preparation of standard costs and budgets; Variance analysis and the reporting of variances; Control standards; Control diagnosis.

4.0 Cash Management

· The effects of management decisions on the cash flows

· Concept of working capital; The effect of sales expansion on working capital; Product/Project life cycles; Cash Budgeting.

5.0 Long-term Decison Making and Control

Appreciation of useful techniques and the production of data
Long term financial planning; Discounted cash flow techniques ; Relevant costs

6.0 Product Cost Ascertainment

The methods by which the costs of operations, processes, departments or products are ascertained
Problem of charging overheads to products; Overhead analysis technique; Overhead absorption techniques ; Overhead under and over absorption

7.0 Transfer Pricing and Performance Evaluation

Its importance in decentralized organization
Reasons for transfer pricing and an introduction to the problems it may create within highly interdependent structures

8.0 Information Processing

An appreciation of system design
The influence of information technology upon management accounting systems; The collection, recording and presentation of information for decision making

EXAMINATION REQUIREMENTS

A three hour examination 5 questions to be answered from a choice of 6.

Graph paper will be provided and calculators can be used ( no printout, no word display facilities, silent and cordless)