Business 4970 Accounting Finance Other Interesting Stuff Overview

Business 4970 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 point Seiko

Basic Strategies Choose your approach Rolex, Timex, Seiko Establish goals in writing Market share Unit cost Net income ROA ROE Stock price

Performance Measurement Performance measures (Weighting Factors) should support strategies Timex—UPC, market share Rolex—probably not UPC, or market share Financial leverage—ROE, not ROA

Basic Financial Statements Income statement Cash flow statement Balance 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 accounts Translation of foreign currency into $US (you can’t add apples and oranges)

Calculation of Consolidated Sales See page 179 (177) of Players Manual Home Area sales total (Intracompany and outside): $2, 199 Intracompany sales: $1, 190 M 2 sales to outsiders: $755 M 3 sales to outsiders: $755 N/P/S sales to outsiders: $806 (4841/6)

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

Calculation of Consolidated Cost of Goods Sold Beginning inventory total: $549 $271 +$118 + $42 (250/6) Cost of goods manufactured: $1, 494 Intracompany purchases: $1, 190 $397 + $396 (2, 380/6) Ending inventory total: $523 $287 + $86 + $64 (382/6)

Calculation of Consolidated Cost of Goods Sold Total goods available for sale = Beginning inventory + Cost of goods manufactured + intracompany purchases Consolidated 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 inventory Consolidated cost of goods sold: $1, 520 ($549 + $1, 494 - $523)

Cost Structure TC = VC + FC Increased volume reduces unit fixed cost Increased 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 142 (141) of Players Manual

Production Cost Analysis Equipment depreciation for one quarter: $107, 000 Plant depreciation for one quarter: $26, 000 Six 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 units Equipment depreciation per unit: $. 343 Plant depreciation per unit: $. 083 Labor cost per unit: $2. 880 Produce 328, 000 units Equipment depreciation per unit: $. 326 Plant depreciation per unit: $. 079 Labor 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 137 -138 (136 -137) of Players Manual

Production Layoffs and Deactivation Production layoffs and deactivation lowers morale and output for several quarters A 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 taxes Losses may be carried forward to offset future income and reduce future taxes No loss carrybacks are allowed See page 189 (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 Carryforwards The consolidated net income is not reduced in the future quarter, since the loss was deducted from consolidated net income in the prior quarter In 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 quarter The Home Area uses the Equity Method of Accounting for its investment in subsidiaries, including N/P/S Equity 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 income See page 190 (187) of Players Manual

Foreign Currency Gain or Loss N/P/S beginning Capital Stock: 4573 N/P/S beginning Retained Earnings: 1128 (assumed) Beginning Equity in N/P/S: 6701 Beginning exchange rate: 6. 0 Ending exchange rate: 6. 3 (Rate rises) Foreign currency loss: $6 (see page 188)

Cash Flow Statement Net Operating Cash Flows Net Investment Cash Flows (Home Area) Net Financing Cash Flows (Home Area) See page 195 (192)

Cash Flow Statement A good company has Operating Net Cash Flow ≥ Operating Net Income If Operating Net Cash Flow ≤ Operating Net Income, there is usually a build up in Accounts Receivable and Inventories A 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 required Hopefully, you will have excess operating cash flow at a later date

Investing Excess Cash “Investments” CDs Repayment of debt Repurchase of stock Need for liquidity

Operating Cash Inflows All sales are on credit For Merica: 50% collected current quarter; 50% next quarter For N/P/S: 40% collected current quarter; 60% next quarter (See page 192) 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 cash Taxes 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. 194)

Investing and Financing Cash Flows Subsidiary Dividends Received and Dividends Paid to Parent result in zero net cash flow from a consolidated point of view Subsidiary 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 follow The year end balance sheet, is the Q 4 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 date The 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 earned The inconsistent use of current and historical exchange rates necessitates the use of an Accumulated Foreign Currency Adjustment (see pages 207 -209)

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 subsidiaries The 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 M 2, M 3, and N/P/S are added to the Home Area’s assets and liabilities In 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 subsidiaries Since 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 earnings To 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 207 Home Area NI: $122 M 2 NI: $ 35 M 3 NI: $ 35 N/P/S NI: $ 63 (374/6) Total NI: $255 Total Sub NI: $ 133

Consolidated Retained Earnings Intercompany dividends: M 2: $ 35 (100% payout) M 3: $ 35 (100% payout) N/P/S: $ 50 ((316/6)x. 8) (80% payout) Total: $ 115 Subsidiary Earnings Retained: $ 18 “Outside” dividends: $ 209

Consolidated Retained Earnings Beginning RE: $ 2, 685 + Home Area NI: +122 +M 2 NI: + 35 +M 3 NI: + 35 +N/P/S NI: + 63 (374/6) - Outside Dividends: -209 Ending RE: $ 2, 731

Repurchase of Stock repurchases are accounted for using the “par value, ” not the cost method Even 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 cash The book value of the repurchased shares is subtracted from Capital Stock The excess of the repurchase price over book value is subtracted from retained earnings

Capital Structure Debt vs. Equity Financing ROA • 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 loans Bonds Stock

Bank Loans Emergency loans Very expensive • • 1 st time 2 nd time 3 rd time After 3 r r + + 5% 15% 30% 45% Generally due to poor planning Hurts credit rating, causes sales force resignations, and decline in demand

Bank Loans For 1 Quarter Automatic repayment of P + I Maximum: 50% of (AR + Inventory), or $2. 5 million Clean out 1 in 4 Qtrs

Bonds 10 year, callable Interest rate determined on day of issue Issued 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 Qtr 5% call premium

Stock 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 Current shares outstanding New issue Price of new issue $ 10. 00 6, 000 100 $ 9. 84 Avg price per share after issue $ 9. 997 Credit rating 1 yields 10% premium Credit rating 3 requires 10% discount $ 10. 00 6, 000 1, 000 $ 8. 57 $ 9. 796

Current Stock Price Conditions in the stock market Consistent earnings growth Consistent dividend payout Dividend policy Riskiness of stock Based on credit rating

Investor ROI n-8 r= n P n – P 8 + Dt - 1 t=9 Pn – P 8 = increase in stock price since Q 8 n Dt = dividends paid after Q 8 t=9 r = quarterly rate, 4 r = annualized rate

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

Credit Rating Based on Cash on hand Earnings growth Dividend payments Capital structure Bankers like consistency!

Forecasts 4 rolling quarters Anticipate future needs Deal with lead times Spreadsheets Templates available in game folder

Forecasts Sales Production plan Capital requirements (Chapter 9) Financial statements (Income, Balance Sheet, Cash flow) (Chapter 10) Cash flow is ultimate reality check!

Actual Results Usually differ from projections External conditions Execution failures Errors in projections Analyze reasons Take corrective action

Two Year Plan Start early and develop own templates or use game templates Income statement, cash flow statement, balance sheet Balance sheet must balance! Cash flow must agree with balance sheet! Net income – dividends = change in Retained Earnings

Final Thoughts Only two keys to success Solid teamwork • Delegation of responsibilities • Efficient use of time Clear focus on objectives • Drive business toward goals • Consistency

Congratulations On your upcoming graduation !!