descretionary financing needed/ external financing needed

DFN is based on percent of sales forecast method

how much we need to sustain future growth

garbage in garbage out

DFN is based on assumptions-make good ones

it helps us prepare for the future by what we know today, it helps prevent dumb mistakes

1) project sales revenues and expenses

2)forecast change in spontaneous balance sheet accounts

3) Deal with discretionary accounts

4)calculate RE

5)determine total financing needs

6)calculate DFN

RE

depreciation-FA - depreciation

forecasted interest expense

spontaneous accounts

do not increase automatically with sales- LTD, NP, CS

fixed Assets depend on full capacity or not

1) slow sales-increase prices

2) Examine capacity constraints-outsource, lower projected FA

3) Lower Dividend payout

4) Increase net margin or cut costs

sustainable growth rate- the only growth rate which allows the firm to maintain its present financial ratios and avoid the sale of new equity

SGR = ROE (1-b) = NI/S x S/E x A/E x (1-b)

How fast can the firm grow in a steady state the four ratios stay constant

the fastest steady rate that the firm can grow

profitability

asset utilization

leverage

plowback

NI/S

S/A
A/E

(1-b)

maximum sales growth a firm can have while maintaining a constant debt-to-equity ratio value without any new external equity financing.

(they can still get debt through AP, but they have to increase the equity through RE. to maintain the ratio)

good to negotiate with short-term lenders

it shows if they have enough cash in the short run how liquid they are

1) budgets indicate the amount and timing of future financing needs

2) make plans to take corrective action if they don't balance

3) provide the basis for performance evaluation

1) determine cash receipts- sales projections and AR collection historical data

2) estimate outflows (logistics and demand)

3) Create the budget net CF + beginning cash borrowing requirement

expectational data (return)

historical data (return)

expected return = sum of (probability(i) * rate(i))

annualized return = ins/outs * 360/holding period

interest rate without inflation

(fisher effect)

Rnominal = Rreal + inflation

banks show you the nominal

std deviation equation

std dev = sqrt(sum(Ri-Rmean)^2*prob of i)

one std dev = 68% of observations

+2 -2 std dev = 95% of observations

(normal curve)

std dev measure the firms total risk

diversifiable, idiosyncratic, firm specific

(not standard of measure)

company's labor force goes on strike

top management dies

oil tank burst and floods company

unexpected changes in interest rates

business cycle changes

unexpected cash flow changes due to tax changes

return on equity, the return on an investment required by investors given the investment's risk

Required rate of return = risk free rate(tbills) + Risk premium

discount the future value after you've determined the require rate of return

or

HPR-holding period return = (p1-po)/po

if there is a poorly diversivied investor like entrepreneurs

because this needs to take into account the firm risk

it adjusts for the degrees of freedom

= % variation

average R^2 is between 20-25%

by central limit theorom you need at least 30 observations

R^2 will always be higher than adjusted R^2

dependant variable distribution must be normal

errors are not correlated, they have to be random

• The model assumes that either asset returns are (jointly) normally distributed random variables or that investors employ a quadratic form of utility. It is however frequently observed that returns in equity and other markets are not normally distributed. As a result, large swings (3 to 6 standard deviations from the mean) occur in the market more frequently than the normal distribution assumption would expect.^[3]
• The model assumes that the variance of returns is an adequate measurement of risk. This might be justified under the assumption of normally distributed returns, but for general return distributions other risk measures (like coherent risk measures) will likely reflect the investors' preferences more adequately. Indeed risk in financial investments is not variance in itself, rather it is the probability of losing: it is asymmetric in nature.
• The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets (homogeneous expectations assumption).^{[citation needed]}
• The model assumes that the probability beliefs of investors match the true distribution of returns. A different possibility is that investors' expectations are biased, causing market prices to be informationally inefficient. This possibility is studied in the field of behavioral finance, which uses psychological assumptions to provide alternatives to the CAPM such as the overconfidence-based asset pricing model of Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam (2001)^[4].
• The model does not appear to adequately explain the variation in stock returns. Empirical studies show that low beta stocks may offer higher returns than the model would predict. Some data to this effect was presented as early as a 1969 conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is itself rational (which saves the efficient-market hypothesis but makes CAPM wrong), or it is irrational (which saves CAPM, but makes the EMH wrong – indeed, this possibility makes volatility arbitrage a strategy for reliably beating the market).^{[citation needed]}
• The model assumes that given a certain expected return investors will prefer lower risk (lower variance) to higher risk and conversely given a certain level of risk will prefer higher returns to lower ones. It does not allow for investors who will accept lower returns for higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock traders will pay for risk as well.^{[citation needed]}
• The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed with more complicated versions of the model.^{[citation needed]}
• The market portfolio consists of all assets in all markets, where each asset is weighted by its market capitalization. This assumes no preference between markets and assets for individual investors, and that investors choose assets solely as a function of their risk-return profile. It also assumes that all assets are infinitely divisible as to the amount which may be held or transacted.^{[citation needed]}
• The market portfolio should in theory include all types of assets that are held by anyone as an investment (including works of art, real estate, human capital...) In practice, such a market portfolio is unobservable and people usually substitute a stock index as a proxy for the true market portfolio. Unfortunately, it has been shown that this substitution is not innocuous and can lead to false inferences as to the validity of the CAPM, and it has been said that due to the inobservability of the true market portfolio, the CAPM might not be empirically testable. This was presented in greater depth in a paper by Richard Roll in 1977, and is generally referred to as Roll's critique.^[5]
• The model assumes just two dates, so that there is no opportunity to consume and rebalance portfolios repeatedly over time. The basic insights of the model are extended and generalized in the intertemporal CAPM (ICAPM) of Robert Merton, and the consumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.^{[citation needed]}
• CAPM assumes that all investors will consider all of their assets and optimize one portfolio. This is in sharp contradiction with portfolios that are held by individual investors: humans tend to have fragmented portfolios or, rather, multiple portfolios: for each goal one portfolio —

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the model has NO explanatory value

the alternative would be that it does have explanatory value

financing decision

investment decision

Liabilities and equity

assets

required return (investors)

cost of raising funds needed to operate the firm (financial managers)

coc - R (stockholders)

CAPM r * (1+float cost)

Build Up r * (1+float cost)

Gordon Growth P * (1-float)

= Ci/V*(Kics) + Co/V*(Kocs) + P/V*(Kps) +

N/V*(Kn)*(1-t) + B/V*(Kb)*(1-t)

Vo = sum( FCFFt/(1+WACC)^t)

k=WACC to solve for discounted cash flows

tells you if you should invest in a project or not

Vo = sum((FCFt/(1+k)^t) - IO)

sometimes we can use WACC in this equation (when you are extending the firm-NOT for new projects)

S = stock return - risk free / std dev

if its the same time yo udon't have to take out the risk free

(abnormal return)

the higher the sharpe return the better

theory of capital structure

(optimal D/E mix)

take debt until your WACC is minimized (until financial distress)