Intro to Financial Management

1. Intro to Financial Management Financing Mix

2. Review Exam

3. Income Stream Risks • Business risk • Economy • Business cycle • Competition • Operating risk • Capital structure risk

4. Operating Risk The greater the fixed costs, the greater the risk. Why? Operating cost structure – ratio between fixed and variable costs. Does a manager have control over the operating cost structure?

5. Operating RiskBreak-even Analysis

6. Break-even Analysis Example: You are getting into the T-shirt business. Plain T-shirts cost you $9 each. You figure you can print your message on each shirt for a $1 each. You rent space for your shop for $200. You estimate you can sell the shirts, because you are oh-so clever, for $20 each. 1. What is your break-even units? 2. What is your break-even dollars?

7. Operating Leverage • Amount of fixed costs vs. variable costs in revenue stream • An indicator of risk Example: You are getting into the T-shirt business. Cloth costs you $5 for each T-shirt and you will make your own shirts. You figure you can print your message on each shirt for a $1 each. You rent space for your shop for $200 and a T-shirt making machine for $200. You estimate you can sell the shirts, because you are oh-so clever, for $20 each. 1. What is your break-even units? 2. What is your break-even dollars?

8. Firm Financing • Financial structure • The right hand side of the balance sheet • Capital structure • Stock and bond mix • Do not consider accounts payable and accrued expenses

9. Capital StructureFinancial Leverage • Use of fixed-income securities to fund firm activities • Bonds and preferred stock • Magnifies the revenue effects on EPS and ROE • Leverage – making money using other people’s money • What’s the downside?

10. Capital Structure • Independence Hypothesis • Capital structure does not affect the cost of capital • Capital structure does not affect the firm’s value • Moderate view • Accounts for the fact that interest is tax deductible • Considers that firm can default debt capacity • Debt capacity – max debt in capital structure that will still maintain lowest cost of capital

11. Capital StructurePractical Matters • Want leverage ratio to be in a reasonable range • Too small, don’t take advantage of other people’s money, leverage • Too small, another firm may buy you with your own money • Too large, high risk • Target leverage ratio around 2 (=> debt ratio around .5) • Coverage ratio • Shows if you can afford the risk • Use times interest earned = operating income / interest expense • Want > 2.5 • For both ratios, look at industry averages • Match borrowing maturity with asset term • Buy short-term assets with short-term liabilities • Buy long-term assets with long-term liabilities or equity