Frequently Asked Questions
About ENGM 401
Sections B1 & B3
Fundamentals of
Engineering Finance
Winter 2009
Instructor: M.G.
Lipsett, Department of Mechanical Engineering,
This FAQ is maintained by the course instructor, and is located at http://www.ualberta.ca/~mlipsett/ENGM401/FAQ.htm
It was re-organized on Dec. 8, 2008.
IMPORTANT LINKS
The course website is located at http://www.ualberta.ca/~mlipsett/ENGM401/ENGM401.htm
Examples are found in the directory http://www.ualberta.ca/~mlipsett/ENGM401/Examples
A Glossary of terms can be found at http://www.ualberta.ca/~mlipsett/ENGM401/Glossary_complete_ENGG_401.htm
DON’T FORGET: A
Guide to Calculations can be found at http://www.ualberta.ca/~mlipsett/ENGM401/Guide_to_Calculations.pdf
If a student asks a question by email, then the answer gets posted here on the FAQ, so that all students have fair access to any additional information that may be provided. Other information that will be of interest to the whole class gets posted here as well. (Some previous questions from a previous year are posted for reference.)
COURSE CONTENT QUESTIONS
I had one question regarding valuation: what exactly is a
"multiple"? I read in the book
and from my understanding it is like a
barrier to entry, but how
is a privately owned company have a lower multiple and a public company have a
higher multiple?
The multiple is the
amount that you are willing to pay for a company divided by the (annual) EBIT
that the company historically reports (e.g. its most recent annual income
statement). Replacement of assets is a better gauge of barrier to entry. Shareholders
of a public company will expect a premium on their shares, thus upping the
multiple. (Apr 4/09)
For Assignment #9 problem 1i), I am really not sure what this
question is asking. I expected that we would be calculating a maximum cost to
be spent on asphalt, given an interest rate. However, I do not know why a
minimum cost would be calculated, or how to get that from the given MARR of 12%
when there is no return on investment from this capital cost project. Could you
please shed some light for me?
When there is no
revenue generated, you want to minimize the present worth of costs (which we
calculate using a discount rate, in this case MARR). What the question is asking is what is the breakeven amount for asphalt that would be equivalent
at the same MARR to the concrete option. You can think of it as “what’s
the most you would pay for asphalt” if you think of increasing costs to get to
breakeven, but don’t forget the objective here is to minimize costs.
(Supplemental) So, does this mean that we can find the
minimum cost of paving with asphalt by doing an NPV calculation over 20 years
for both options, then finding the repaving cost in years 0 and 10 for asphalt
by setting the NPV's for both options equal?
Rather than minimum
cost, think equivalent cost. The Present Worth of
Costs for each option will be the same at the breakeven point. You’ve pointed
out the important caveat that these have to be mutually exclusive options. That
means that they have to both address the same situation: providing a road
surface for 20 years. Repaving with asphalt will have to be done after ten
years, so be careful about when that would occur on the cash flow series. It’s
the initial paving cost that is being asked for. Also remember that we've
looked at an approach that allows one to make an equivalence comparison between
options that have different numbers of years. (Mar
29/09)
In
assignment #9 problem 1ii), I get 0% IRR for the case when the software takes
$150,000 to produce. How can that be?
Take a look at the FV series. It has a sum of zero without having to
impose a discount rate.
In our class discussion about uncertainty, I mentioned that taking the
weighted average of IRRs is not the preferred way to
do the problem. It is more appropriate
to take the expected value of the parameter of interest and then do the
calculation for that expected case (here, the IRR calculation). Only do the
expected value of IRRs themselves when you have no
other information for comparison. (Mar 29/09)
In
assignment #9, question 4 (7.7 in the text), the first bullet asks us what the
maximum incremental CCA that can be claimed over the next 10 years. Is this
just the sum of the maximum CCAs for each year?
You are correct; it means what is the maximum CCA that could be claimed
by the company, and in what year does that occur. The use of the term
incremental is not meant to be misleading. (Mar 29/09)
By now,
everyone should know the process of using Goal Seek to find IRR, which will
make the NPV go to zero. There is a function in Excel that will do this. If you
have a cash flow series in cells XXXX to YYYY, then typing the expression =IRR(XXXX:YYYY) (where XXXX:YYYY is the range of numbers of
the cash flow forecast) in a cell will cause that cell to display the value of
IRR for that cash flow forecast. This shortcut is especially useful when
calculating sensitivities in discounted cash flow analysis. There is an NPV
function too. (Mar 29/09)
Here are
the formulae on the last slide of Lecture 28:
Tax On Recapture = (BookValue
– BasisValue) x TR
Capital Gains Tax = (BasisValue –
Salvage Value) x TR / 2
DTE = Tax On Recapture + Capital Gains
Tax
For our
in-class example:
Tax on Recapture =
($29 716 – $246 000) × 35% = – $75 699.40
Capital Gains Tax = ($246 000 – $300 000) × 35% / 2 = – $9 450
DTE = – $75
699.40 – $9 450 = – $ 85 149.40
ATCF year 10 = $83 850 + $300 000 +(– $ 85 149.40) = $297 700.60
If you’re
interested in the underlying reasons why President Obama
is so ticked off with AIG using its bailout money to pay deferred compensation
to the money managers who fouled up in the first place, you might want to watch
Jon Stewart’s interview with Jim Cramer (host of Mad Money, an investment show)
on the Daily Show on March 12, 2009 at http://watch.ctv.ca/the-daily-show-with-jon-stewart/episodes/the-daily-show#clip149935
Is the project
due on Monday March 30th or Friday March 27th?
Project #2 is due Monday March 30, 2009, in class (no exceptions except
documented medical or personal emergencies). The day of the week is incorrectly
given as Friday on the front page of the project.
For
Project 2 Problem 3, I was wondering if the reclamation cost specific to the cogen unit is something that I should consider yearly? Or should I just deduct this in year 15? When I
deduct this value would it be from the corrected inflated value, or the
original value? I’m guessing inflated? Also what exactly does incurred mean,
can you give me an example?
To incur a cost simply means to have to pay for something. Reclamation
occurs at the end of the project, and so the costs are incurred then. The estimate
of those costs is quoted in today’s dollars for the cost to do the reclamation
itself. Recall that a cash flow series represents the actual cash flows that
are expected to occur at the time when they happen. There is a short
explanation in the Guide to Calculations that should be helpful. Make sure you
state any assumptions as part of your analysis. (Nov 23/07)
When do we use the incremental IRR?
When we have to
choose one of the alternatives, we use IIRR to decide whether the extra
investment is worth it. In the case of a project, the extra investment is the
incremental capital cost of the more expensive alternative. (Dec. 2/07)
When we're
considering if an investment is worth it we usually look at whether the IRR
> MARR, if this is the case then we go ahead with the investment. Is this also true if we compare IRR to
WACC?
Yes. IRR must be greater than the hurdle rate for the investment to be worthwhile. A company can have a number of hurdle rates, including using WACC. Recall that WACC is the return that represents the overall return associated with a company's financing, thus the company's risk tolerance. Management might set MARR for a specific investment opportunity higher than WACC because the opportunity has more risk. If an investment opportunity is considered to have the same level of risk as overall, then IRR > WACC would be used as the hurdle rate.
(Supplemental)
Another question is that the NPV must be greater than zero for a specific MARR
in order for the investment to be acceptable, does this also hold true for WACC
since it is also a hurdle rate?
Yes.
(Supplemental) Thanks
for your reply, so in other words WACC will either be less than or equal to
MARR since MARR is the minimum allowable rate of return?
So if you were to
have
MARR = 25%
WACC = 20%
you would compare the IRR or IIRR to the MARR
and not the WACC right? Thanks again.
In the scenario you describe, MARR for the investment would be set above WACC if the investment were higher risk than the average risk of other investments the company had. MARR may be less than WACC if the investment is lower risk than average for the company. In these scenarios, the investment is gauged against the MARR that is set for it. (Dec. 2/07)
In Assignment 8
problem #2 iii): I don't think my question is vital for answering the problem
in this case, but I want to fully understand this. The IRR of the gas turbine (cheaper)
option is 21%. The incremental IRR, due to spending more on the more expensive
(windmill) option, is 20%. However, the total IRR of the windmill option is
given as 19%. Mathematically, doesn't the IRR of the more expensive option have
to be somewhere between the IRR
of the cheaper option and the incremental
option? ie, if your IRR
on your first $5000 of initial capital
cost is 21%, the incremental IRR on the
next $5000 of initial capital cost is 20%, won't the IRR on the whole $10000 of initial capital cost be
20.5%? Regardless of the initial capital
costs of the cheaper and more expensive options, respectively, doesn't the IRR of the more
expensive option have to be somewhere in
between the IRR of the cheaper option and the incremental IRR?
Recall that IRR depends on the entire cash flow series (costs and benefits) and the discounting rate. The initial capital cost has a huge effect on IRR (because later future sums have a progressively lower weighting), but capital cost is not the whole story. It is often the nature of the benefits that determines the incremental IRR, and so assessing the range of the IIRR based on capital costs doesn't work. (Mar 19/09)
In Assignment #8
problem #4, the question mentions the 30% rule applying to PIT in some cases.
Am I correct in
assuming that we are only applying it to PI in this case?
There is no information about municipal tax rates; and so for this simple mortgage case, we assume that the purchasers can put 30% of their annual combined before tax income (as of the time of purchase) toward the mortgage payment (which pays down both principal and interest on the mortgage). (Mar 19/09)
For problem #3 in
Assignment #8, the instructor not skiing in years 4 and 5 obviously means he
does not pay for daily rentals. Does it also mean he does not tune up his skis
these years, or does he tune them up because he plans to ski and then later
fails to do so?
You can make either assumption. For simplicity, not paying for a tune-up makes sense (in other words, deciding at the outset not to ski, or more likely not getting around to the tune-up until a ski trip is actually planned). (Mar 19/09)
In assignment #8, for
problem #3 (the ski equipment purchase or rental), the question states that
skis are purchased now (year 0) in anticipation of the upcoming ski
season. I assume this implies that the
instructor starts skiing during year zero, but since the rentals also take
place in year zero should we assume that there is no inflation between now and
when the skis are rented in year zero or should we be assume a full years worth
of inflation which would affect the present value of the ski rentals? As well, is it safe to assume the skis do not
need a tune up prior to the first season that they are used?
For the purposes of this question, assume that the purchase is now and that the instructor skis during year one and beyond. You can also assume that all the expenses for a particular year get rolled into a total expense at the end of that year. It is indeed safe to assume that there is no tune-up charge prior to the first season. (Mar 16/09)
In assignment 8, for
the first part of the second question do we assume there is a water resistant
watch bought on the 24 year?
There are two ways to approach this question, either by comparing the cash flow series directly, or by calculating the equivalent uniform annual cost.
If taking the first approach, ask yourself under what circumstances that cost at the end of the series would be a good assumption, and whether those conditions apply in this case. Consider what residual value (if any) each of the two options has as of the end of year 24. (Mar 14/09)
I have a general question
regarding calculating NPV when using excel.
When the future value (ie A) is an expense do
we enter the value as "negative"?
For example, in our homework when the person buys a watch for $300
dollars, would you enter the amount as "-300" in excel? Thanks.
In general, if you are doing an NPV with both benefits and costs, the
benefits will be positive and the costs negative. How you set up the cash flow
series will determine how the costs are expressed. For example, in Lecture 26
there is an example with the “NPV of costs” for two options. In that case the
cash flows for costs are expressed as positive numbers. (Mar 16/09)
Can you post those
lyrics?
Here you go: Bohemian Rhapsody for Engineers. Just don’t ask me to sing. (Mar. 13/09)
In assignment #7
question #1 for the true/false cash flow diagrams, how exact does the answer
have to be?
A small margin of error on the order of a dollar or so would
be close enough. (Mar 12/09)
In assignment #7 problem 2 (7.2 in the text), I’m not sure
where to start.
Think about what options your
uncle has (there are three). What is being asked for the effective discount
rate is the interest rate at which one cash flow series is equivalent to
another. Several investment alternatives are offered, and we need to compare
them on an equivalence basis (i.e., at some point in time). The effective
discount rate tells us whether any other investment option (at a particular
interest rate) will be more or less attractive than what the one that is
offered at that effective discount rate.
The latter part of the question asks you whether there is any difference
in the risk between organizations, and whether that would affect your recommendation
to your uncle. (Mar 12/09)
Regarding Problem #4 in Assignment #6, in which my friend
pays me back 8%, is this 8% for a period of 20 years, or is this friend more
generous and offering 8%
simple interest for 20 periods of 1 year? Since a
7% return over a 20 year period would be unreasonably low, I assume that the 7%
average return is per year, making 8% for a period of 20 years an exceedingly
low return.
When an interest rate is stated,
we assume that the interval is annual unless told otherwise. And so the simple
interest period would be annual, and the friend is offering a lump sum that is
equivalent to a set of uniform payments plus repaying the principal as well (at
the end of the set of periods). The interest rate that you expect to get on your
investment portfolio is based on annual compound interest (again, because we
are not told differently). And yes, 8% with a compounding period of 20 years
would be a really low return rate on an investment. (Mar. 5/09)
In Assignment 6 problem 3, I've done my research on the two
companies in a similar industry and I'm having a lot of trouble finding some of
the information. What should I do?
There is a lot of flexibility in
answering this question. The intent is to get some exposure to real financial
reports by publicly traded companies, which can be found on their corporate web
sites. Summaries of a company’s financial information can be found on sites
such as www.finance.google.com and www.finance.yahoo.com, as well as on the web
sites of exchanges where a particular stock is listed, such as the Toronto
Stock Exchange: www.tsx.com. It is at times a bit difficult to determine the
exact financial information for a particular ratio. In such a case, you may
state the ratio using the closest approximation you can find in the reported
information for the companies. Typically, in a particular sector, the reporting
formats should be pretty similar. (Mar.4/09)
In assignment #6 problem 2, I’m not sure what is being
asked.
You are considering what happens when
a company’s sales go up, and what will be the effect on receivables and
inventory. (We looked at some increasing sales scenarios in class.) Then think
about what’s changing, how the Days Sales Outstanding ratio might be affected
by these changes (up, down, or no change), and why. (Mar. 4/09)
In Assignment #6 problem #1, how do we find the present
value of the bond?
In this case we do not have any
information to find the equivalence of the annuity payments and balloon
repayment of the bond (we know the time but we don’t have a market interest
rate), and so we simply look at the price of the bond (how much it cost to buy
the bond) and how much we will earn annually from it, without applying a
discounting rate for the time value of money. (Mar. 4/09)
For the project problem 2, what is the "forecast"
of earnings? Is that the same as the pro forma income statement for the 4th
quarter?
Yes, a forecast is a prediction,
also called a projection. In this case, the fourth quarter income statement
will be a prediction, because it hasn't happened yet. (Mar 1/09)
For the project problem 4, what does "new strategic
market" mean exactly? Is this one
where you are assuming there are other companies that have competitive
technology?
A strategic market is one that is
important for the long-term success of the business. A new market is one that a
company is trying to get in. State any assumptions you make about competitors, and about what it would take to attract
customers. (Mar 1/09)
I have some questions about the project:
Problem # 1
i) I think what you were saying in the frequently asked
question is that when it asks for the book break even price per tonne, it is only asking for the current operating
condition (case A, book breakeven). Please confirm.
ii) It says "what is the book break even price per tonne, assuming that no other factors change", but it
does not say what factors change. For sure operating income and margin change
but does Margin % stay the same and COGS change, or does COGS stay the same and
Margin % change?
iii) Lastly when production is 80% it says the depreciation
is $60M per year. Is the SG and A still $81M/yr with
$60M of that depreciation? Or is the SG and A now $96M with $60M of that
depreciation?
Problem # 2
iv) Is the SG and A listed in the table for the
1'st and 2'nd quarters including depreciation or excluding depreciation?
v) Is the 40% drop in sales from the second quarter to the
forth quarter? Or is it a 40% drop per quarter as in 40% from the second
quarter to the third quarter and then another 40% from the 3'rd to the 4'th? If
it is the first case and it is 40% every 2 quarters can we assume this trend
holds true for the future as well or does it change to 40% per quarter in the
future?
Thank you
Your questions are good, and I
won't answer all of them completely.
I'll try to give you some pointers. They may be a bit cryptic; but part
of the exercise is to force you to think through your assumptions, and then
link them to reasonable analysis for good decisions.
i) Read Q 1 carefully. It states which breakeven cases you
should consider.
ii) The only thing you are
manipulating is the price point at which book breakeven occurs.
iii) State your assumptions if you
think that any of the conditions change, and how the assumptions affect your
analysis.
iv) Given the nature of the company, what do you think? If not in
SG&A, where would it appear?
v) There's enough information in
the problem to tell you which scenario is the case.
Good luck with the project. (Feb
24/09)
I do not quite understand the last part of Problem 1 on the
project where it asks to "comment on the pros and cons of regulators
putting societal values in monetary terms through taxation". Would these
taxes be in the form of decreased revenue per tonne?
Until recently, airborne emissions
were an externality, that is, a free use of the environment. Government
regulators can put a limit on the activities of companies. For example,
regulations may limit the amount of emissions of different types, and impose penalties
on companies that exceed those limits, either as a tax per unit emitted - or as
a fine if the exceedance is not permitted under
legislation. The revenue for the company in this case would come from
government taxation of companies that are producing carbon dioxide, whereby
those companies pay taxes per tonne of carbon dioxide
that they produce. If a company decides to invest in technology and to do its
own carbon capture and storage, then it can reduce its tax expenses. In some
countries, companies get credits for showing that they produce fewer emissions
than other companies, and those credits have value on the open market. (Feb
20/09)
For the second question of the project, I am just wondering
if we can assume that SG&A and COGS remains approximately the same for the
fourth quarter as in the first and second even though there is a drop in sales.
Also do we include depreciation into the SG&A in our income statement, and
if so how?
Use your best judgment based on
the information available, and state your assumptions. For example, if you
assume that production continues at the same rate when sales drop, be prepared
to state clearly whether and under what circumstances that might happen for
that kind of business, and the implications, for COGS, margin, and SG&A. If
there is information about depreciation in the question, then use it. Recall
that companies very seldom change their depreciation rate. (Feb 19/09)
In the first project question, I was wondering what the 80%
nominal means for question 1, and also do I need to find the book break even
for every case. Aren't they all the
same? I have another question. For the
second part of the first question do you want us tp find the 80%
nominal for all three cases a,b, and c?
or just a?
There are five cases to consider:
base case, higher price, lower price, "book breakeven" at 90%
utilization, and "book breakeven" at 80% utilization. Often in
analyzing scenarios there will be an assessment of the sensitivity of the
outcome to one or more variables. The difference between nominal production and
actual production utilization is defined in the guide to calculations. Unless
otherwise stated, you can assume that the service duty is 100%. (Feb 19/09)
In the first question of project when it talks about the carbon
tax being at 30, 35, or 40 dollars a tonne of carbon
dioxide. Do those numbers correspond to the amount of revenue the company you
work for is making or is that direct tax that they owe to the government?
The company is in the business of
carbon capture and storage (CCS), and as such has the government as its client.
For this reason, the quoted values would be the company’s sales revenue on a
per tonne basis. (In reality, the price that a
company would charge for delivering a service for the government is usually
more complicated than this, involving a bidding process, and there would be
government overheads associated with administering the program, and so the unit
tax would likely be higher than the unit revenue that the company would see,
unless the company had a unique technology and the government were willing to
spend more than the tax collected, as an economic incentive to the industrial
sector being taxed.)
It is worth noting that the
numbers in this example are fictitious. There is a range of numbers being
considered for setting prices on carbon credits (and “debits”), and there is as
yet no commercial process for permanent carbon sequestration. The standard
approach is to look at offsets, i.e., the emissions differential between
technologies that deliver the same output, e.g. a thermal coal electrical power
plant vs. a nuclear power plant. Full cycle costs and emissions should be
considered (including building the plant, transportation and processing of
fuel, permanent storage of waste, and decommissioning). (Feb. 15/09)
For Assignment 5 Question 2, do we use a different
definition of leverage?
Use our standard definition of
leverage, under the assumption that the long-term debt is only bank debt. (Feb.
14/09)
For Assignment 5 Question 1, which definition of leverage
should we use? We saw at
least 4 definitions of leverage in class. The most likely
definitions would be liabilities divided by equity or liabilities divided by
assets. As well, it appears that Assets do not equal Total Liabilities +
Equity, which violates the fundamental equation of accounting. How do we deal
with this?
As you
have noted, there are different debt management ratios; but we consider only
one type in this course when we calculate leverage. Our leverage calculations are
based on the ratio of bank debt to total assets, as described in Lecture 13 and
in the guide to calculations. You’re right; there is an error in how the
question is set up. Thanks for pointing this out. Go ahead and solve it
according to the standard method, despite the imbalance. I'll make sure that it
is corrected in future! (Feb 14/09)
I just have a few quick
questions about the 401 midterm:
1) What is economy of scale?
2) I can not figure out #16 and
#27 on the practice midterm as for some reason I don't have the relevant
example in my notes (margin ex. #3 in lecture 5). If you have available production capacity how
do you know how much you can discount an item and still make profit? Are you still making profit? or are you maintaining contribution margin? Or what is going
on in these cases?
3) In lecture 7 the answer to
the first review multiple choice question is C.
Why is A and B wrong?
1)
Economy of scale, as discussed in class, is the reduced cost of materials
associated with volume buying from suppliers. This kicks in at high volumes of
sales.
2) There
is an extensive discussion in the text on contribution margin in the text, as
well as in the solution guide to assignment 2. If you have covered your
indirect costs and you have additional production capacity available, then you
can offer a discount - but if you discount beyond the margin, then you are
losing money.
3) Making
the warranty terms less strict will not reduce returns. Tightening quality
specifications may reduce bad debt by improving product quality; but it will
not necessarily lead to increased gross revenue (although it may) and it will
more likely increase costs than reduce them. The most correct answer is c. (Feb
5/09)
In
the sample midterm in question 33 it asks “A company should expect a higher
margin as its revenue increases because of economies of scale.” The answer that
is listed is true, although isn't it possible that due to diminishing returns
the margin may not increase, and may decrease.
I understand that a company would not want to sell more product if this
were the case (margin not increasing) and it would be illogical to follow such
a course of action, but companies should not blindly expect that just by trying
to sell more, they will make more money. So should a company blindly believe
that if they sell more they will make more money, or do they need to look at if
and how diminishing returns may decrease their profits?
A good
observation. Let me explain the context
of that question. Other circumstances being the same, a company should expect
to reduce its unit cost of production at higher sales volumes because of
economy of scale. (I think you would agree with that.) What you have described
is a case in which the market is unable to absorb additional production. This
is an economic issue that seldom affects a single company, unless it commands a
huge market share in a limited market. There is nothing about this being a
special case in the question, and so the statement in question 33 is more
generally true than false. Many financial "rules" have
counterexamples, but the rules are still generally true. In fact, it’s better
to think of them as good guidelines rather than “laws” of finance. (Feb 5/09)
I just have a few questions in regards to
the sample midterm:
1. Question 38 says, most aircraft have a
CCA rate of 25%. True or false? How would I have known
that it was true?
2. I am a little unclear of what price you
know to discount at when you are selling to other markets. Is it as long as you
are not operating at capacity you can sell at a discounted price? For example
if I am operating at 95% efficiency can I increase my production by 5% and sell
it at a discount equal to the CM. ie. if my contribution margin is 25% can I sell 5% more at a
discount of 25%?
3. I am unclear of the purpose of CCA and
UCC. Is its purpose to cover the income tax that would be imposed on the
depreciating assets if they depreciated faster?
4. What should I know about principal
payments and interest? Should I just know the methods of payment and what they
can be used for?
1) CCA rates are given in the text. I explicitly mentioned the page in class. Please note that material in the text and other resources can be tested, not just the lecture notes.
2) If you have excess capacity and don't have to worry about covering indirect costs, you can discount up to the margin without losing money.
3) CCA is an expense that a company can claim on its income tax. UCC is an aspect of how CCA is calculated. This is described in the guide to calculations and the text (as well as the lecture notes).
4) The appendices are considered to be part of the eligible material for testing. There is a difference in where interest and principal repayment show up on financial statements.
Hope these are helpful. (Feb 5/09)
I
have a question regarding the practice midterm you have posted, # 44 (in the
true or false),which states "All other things being equal, if a company
decides to change its depreciation period it will not change the next year's
cash flow from operations." I was
just wondering why this is true because if you change depreciation the cash
flow is going to affected when you add Operating
Income and Depreciation. And since the
depreciation changed wouldn't the cash flow change?
Check the definition of cash flow
from operations. It is operating income with depreciation added back in (or
equivalently: Contribution Margin - SG&A without any depreciation expense).
Operating income includes that non-cash expense called depreciation. No matter what
what you use for depreciation as a non-cash expense
that reduces operating income, the depreciation amount is being added back in.
Cash flow from operations is not affected by depreciation. Hope this clarifies
the definition. (Feb 4/09)
In Assignment #4 Question 3, the sum of the current
liabilities that are shown only adds up to $28,000.
Use the stated value of $30,000
for Current Liabilities (with taxes payable changed to $7000). Sorry for the
error. (Jan 31/09.)
I have a quick question about other income and salvage
value. In Assignment 3 (question 3.10) where you salvage the
equipment for $4 mill, where does this occur on the financial statement? Is it sold at the very end of the "Past
Year"? Is it a coincidence that the
other income is $400,000?
Disposal of assets is covered in
Lecture 9, including where salvage value appears on the income statement. As
far as the income statement itself, it will include all of the revenue and
expenses for the period, regardless of exactly when they occur. There is enough
information in the question that you don't need to know the timing within the
period (“Next Year”). Other income represents one-time events that can have
various sources. Sometimes the numbers in a question are just for convenience.
If you see information that refers to a circumstance that would lead to that
amount of other income, then it may be important. Otherwise it is just another
number on the statement. (Jan 25/09)
I've been trying to
complete number 2 (3.3) of assignment 2. I've been able to follow along most
things we've dealt with or talked about but this question is really confusing
me. I'm wondering if you could point me
in the right direction or explain the question more thoroughly? Thanks for the
consideration.
In this problem, your big concern is the margin: the difference between net revenue (sales) and COGS (direct cost of goods sold). Read section 3.4.2 in the course text, and think about our discussion in class: when a company has excess capacity (in other words, it's not totally busy), then it can take on additional business, and accept some amount of a discount (because it will still make money even if the incremental contribution margin percentage is not as high as the contribution margin percentage for regular business activities). Once a company covers its SG&A costs, then it is profitable as sales volume grows, provided that the incremental net revenue exceeds the incremental COGS expenses.
An exception to this rule of thumb is when the company does not want to compromise the contribution margin, expressed as a fraction of (Net Revenue – COGS)/(Gross Revenue) for strategic reasons (such as a forthcoming sale of the business, in which case preserving margin percentage is important for assessing the long-term value creation potential of the business.
In the circumstance when the company is at full capacity, different strategies have to be applied to be able to undertake additional business activities. Some of these have been discussed in class.
Hope this makes the question more clear.
For Assignment 2
Problem #1, what account would show the value of the new equipment?
You can add a separate asset account called “equipment.”
Out of personal
curiosity, I decided to look a little into the question of whether the Fisher
Space Pens were developed at no cost to NASA. From what I can gather,
originally, NASA proposed to use mechanical pencils in space, however, there
was a concern over the price paid (~$130/unit in 1965), as well as the fact the
pencils were flammable, a concern after Apollo 1, and the fact that small bits
of lead would break off, which is a concern in microgravity environments.
Paul Fisher
independently developed his space pen, with no investment on the part of NASA,
and then presented his pen to them in 1965. NASA, concerned about the problems
they had had with the pencils, tested them thoroughly, then ordered 400 for the
Apollo program in 1968. The
Sources:
"Space
Pen", Wikipedia http://en.wikipedia.org/wiki/Fisher_space_pen
Scientific
NASA History
Division, "The Fisher Space Pen"
http://history.nasa.gov/spacepen.html
Very interesting, thank you. I
guess I’ll have to revise my joke! Reading the Scientific American article, it
appears that Paul Fisher invested $1 million in developing the pen. As a rough
estimate (assuming the pens and refills cost the same), the revenue in 1968 was
3 x 1500 = $4500, which seems like a very low initial return on investment.
Civilian sales must have been brisk to produce a decent return. Maybe we should
use the Fisher Space pen as a case study later in the course. The Fisher Space
Pen Co. (
I am tossing a hypothetical
scenario. Suppose we lived in a country
that doesn’t deal in interest (or suppose that lending money to the bank with
interest is not an option for an individual).
How would one then compare the worth of two different investment
options?
Even if there is no potential to earn interest in this hypothetical situation, money will still be worth more to you today than in the future. What it means is that you will have to discount future earnings by your own personal “inflation rate,” in other words your own WACC. Then different investment option will have a MARR that reflects the extra value that they will create. I’m speculating now, but I guess in this situation you’d be willing to accept more risk in other ventures to create wealth (because there’s no easy alternative of just putting money in a financial institution to accumulate some interest). (Dec. 2/07)
The last slide of
Lecture 26 has an accompanying spreadsheet in the http://www.ualberta.ca/~mlipsett/ENGM401/Examples directory. It shows the solution for a
breakeven analysis problem by interpolating to solve for the number of
years. How did that interpolation work?
What we are trying to solve for in Lecture 26 (slide 19) problem #2 is how many years would the corrosion-resistant part have to last to have the equivalent uniform annual cost of the untreated part. The cost of the untreated part is $350 x (A|P,10%,6) = $80.36. The corrosion-resistant part equivalent uniform annual cost (Option B) must be at least this low, so we have to find the number of years that will give the same amount, that is $500 (A|P,10%, n) = $80.36. So now we know that (A|P,10%, n) = $80.36 / $500 = 0.1607, and we look in the Uniform Series Capital Recovery Table (on slide 10 of Lecture 21) and find that in the column for (A|P,10%,n) the value 0.1627 for n = 10 (barely visible) and 0.1540 for n =11. That means that the solution lies somewhere between 10 and 11 years. By interpolation, we can solve n = 10 + (0.1627 - 0.1607)/(0.1607 b- 0.1540) = 10.23 years. (Note that it would be possible to solve for n from the analytical formula, but not without transforming the variables or doing an iterative solution, because n appears as an exponent in two parts of the equation.) (Nov. 14/07)
What is the market value of a bond?
A bond has a fixed coupon rate, meaning that the same amount is paid at the end of each year for ten years, as a percentage of the face value of the bond (the Principal). At the end of the final period, you also get the Principal back (the original amount). The market interest rate is the discount rate that affects the future value of those amounts. In reality, the market interest rate changes all the time, but for our purposes, we assume that it is constant, because we have no information that makes us believe the discount rate is going to be different from what it is right now. The market value of the bond is simply the present value of the uniform series of annuity amounts plus the present value of the principal repayment, using the market interest rate for the discount rate. The principal repayment of the original amount at the end of the term is a future value, which is why we have to calculate its present value. (Oct. 25/07)
Today in class when
you talked about the stock market I started to wonder more about it. I was
wondering if you could either talk about the stock market a bit more in class,
or post some resources on the course website.
Thank you for your email asking about how financial markets works. Here is a really brief explanation, and a few links that may be useful.
Companies need access to funds to be able to run their business. If they do not have enough funds within the company, they basically have two financing options to bring funds into the company.
The first option is to take on debt. The company can borrow money from a bank or other lender, which the company then has to pay back with interest. Alternatively, if the company meets certain conditions, it will be allowed to issue bonds on one of the bond exchanges, which is a type of financial market. The company can then issue a bond offering, which means that it will sell bonds to people (or other companies) which have a schedule for repayment with interest. Each bond is in effect a lending contract, a loan that the company must pay back. Those who buy the bonds will make money on the interest, and get their original payment back as well (the principal). The bond market is the mechanism for selling and buying bonds, which people access through financial institutions (such as banks).
The second option is to sell an equity share in the company to raise funds. If the company meets certain conditions, it will be allowed to sell stock on one of the stock exchanges. The company issues stock, which other people and companies buy through brokers. Those stocks continue to trade on the exchange, and if someone buys the stock they now have an ownership share in the company. Market forces of supply and demand determine the stock price. The current stock price times the number of shares in the company gives the current market capitalization for that company. If people think the stock is a good buy, then lots of people will try to buy it, and the price gets driven upward (because there are fewer people willing to sell the stock at the current price, but they are willing to sell at a higher price). If people aren’t willing to buy the stock at the current price, then they might offer a lower price, which sellers can either accept (and sell the stock) or reject (and keep the stock). Investors and traders use financial ratios and other relevant information to decide on the prices at which they would buy or sell a stock. Sometimes apparently irrelevant circumstances can really affect a stock. No one can predict how a stock will actually perform, but comparative analyses are useful. There are very severe penalties for using inside information to gain an unfair advantage in the market - that’s why Martha Stewart went to jail.
Here are some web sites that discuss a range of investing issues, including how the stock market and other financial markets work:
http://googolplex.cuna.org/23314/ajsmall/story.html?doc_id=378
http://www.straightdope.com/mailbag/mstockmarket.html
The book “Investing for Canadians for Dummies” is a worthwhile introduction to investment, and includes a short explanation of financial markets.
Near the end of the course we will discuss valuation, which is the process of evaluating the worth of companies (Chapter 8 in the text) Some of the financial ratios we’ve discussed are used in valuation. The course syllabus for ENGG 401 doesn’t go into the structure of financial markets in any detail or how they actually work. Professor Peter Flynn will be giving a guest lecture on December 5th (the last day of class) to talk about personal finance for engineers, which will talk a bit about personal investing strategies, but not about the stock market per se.
I’m glad that you are enjoying the “Other Topics,” which is stuff that I wish someone had told me at the beginning of my career. This sounds like a topic that it worth adding to the list. If others are interested in how markets work, they should let me know and I’ll add it to the list of Other Topics for discussion. (Oct. 20/07)
I’m confused about Profit
Margin on Sales equaling Net Operating Income divided by Sales. Shouldn’t it be
Operating Income or Net Income?
This financial ratio needs to be looked at carefully for a given company. In the course text the numerator is called Operating Income, but this may not necessarily be our standard definition of Operating Income. Some companies use Earnings Before Interest and Taxes (EBIT) for the numerator (which is what we would call Operating Income in our discussion of Income Statements). Some companies use After Tax Earnings; others use something in between for income. Once again, consistency by a company is what is important, and you should look at what a company or analyst uses to calculate a ratio. If you are asked to calculate Profit Margin on Sales, you will be given the context of what to use for Operating Income. (Oct. 20/07)
In Lecture 9 there is
a worked example of depreciation for tax purposes. Why did you use the 50% rule
when you sold the Bronco in Year 5?
Remember that the 50% rule applies to the sum of transactions for that asset class. Even though the Bronco was sold, there was also a bunch of computers purchased, which meant the sum of transactions was positive for year 5, and so the 50% rule applied. (Sept 26/07)
In Lecture 3 there is a brief mention about the Power of Categories in Timing of Reports. Here is a bit more of an explanation.
Sometimes things take a while to happen in a business, and so the financial report needs to show how the business is creating value, even though all the money hasn’t come in and all the bills haven’t been paid yet. For example, Work In Progress is categorized as an Asset; but it gets re-categorized as an Expense when the product is sold (when the revenue is “booked”). This accounting trick removes potential imbalances associated with reporting over a time interval.
But why do that? Isn’t all the money that is spent doing the work tracked as expenses?
(I mean, a liability, or is it equity…). That’s the potential problem. By showing money going out (expenses going up), without showing that the company is doing something that is creating value (doing work for an eventual sale) would create a distorted picture of how the company is performing. To avoid this problem, the costs associated with production are captured as work in progress (an asset account).
Think of it in terms of debits and credits:
An increase in an expense account is equivalent to an increase in an asset account, because the business is spending money to create value (in the eventual sale). Both are debits. Since assets = liabilities + equity, when the liability associated with expenses goes up, the assets have to go up by the same amount for the fundamental equation of accounting to hold true. This equation has to balance in the reporting period, so re-categorizing is used to make sure the equations balance. If this were not done, then there could be huge swings between reports. If a big sale didn’t happen until after the reporting period, then the business would appear to be in trouble because expenses (debits) would be high without the sales revenue (credits)
If expenses all got booked as liabilities with no associated sales revenue coming in, then costs would keep climbing during the period and it would look as though the company is just losing money, with (revenue - expense) going down and down (which looks like the company is just bleeding), and then a huge revenue injection later on (maybe in the next reporting period). Instead, by booking expenses as WIP (the asset going up being a debit), and then converting those costs to expenses (also a debit) at time of sale, the financial reports will show that value is being created even before the sale actually happens. Note that the company can only count the expenses as WIP assets, not the value of the eventual sale. There is a document that has this information plus some scruffy illustrations at http://www.ualberta.ca/~mlipsett/ENGM401/The_Power_of_Categories_in_Timing_of_Reports.doc
(Sept 10/07)
I remember you speaking about how
''Business succeeds through the: rule of law.''
Perhaps I missed you saying it but, what exactly is
the ''rule of law?'' Is the rule simply: ''Money talks''?
The three general conditions for businesses to be successful in an economy are: the rule of law, access to fair and open markets, and technology. The rule of law simply means that there are established due legal processes that a country follows, and that you can't just get away with something because you're powerful or you know the person in charge. But now that I think of it, people with money can hire more expensive lawyers, so maybe money does talk. (Sept 6/07)
COURSE ADMINISTRATION QUESTIONS
13) Would it be
possible to put the lecture numbers on the course notes? It would make
organizing them easier.
That’s a very good suggestion. I will do that in future. (Mar 19/09)
12) What material is
covered in Midterm #2?
The course content being tested in midterm #2 is Chapters 4 through Chapter 7 Section 2 in the text, which corresponds to lectures 11 through 21, and relevant posted examples and material in the guide to calculations and glossary. (Mar 5/09)
11) I was just
wondering when we would get Assignment #5 back? Also, will we get the Project
and/or solutions to the project before
the midterm? Do we even get those? Thanks.
Solution guides for assignment #5 have already been available in class. I only received the marked assignments back from the TAs yesterday, and so I will distribute them on Friday, along with the solution guide for assignment #6. The project is currently being marked, and will not be returned before the midterm. You do not need the project for the midterm. I will discuss the project in class but there will not be a solution guide provided. I hope this answers your questions. (Mar. 5/09)
10) Are the lecture
notes posted with the notes?
No. As explained in the first lecture, lecture slides are posted to assist with note taking, not to replace note taking. You can contact the instructor to make arrangements to see the annotated slides if you missed any lectures.
9) I am registered in
Section B3. Am I in the wrong section?
You’re in the right place. A small number of students are registered in a separate section B3; but they take the same lectures, do the assignments and projects, and write the same exams as Section B1.
8) Do the assignments
have to be done on engineering paper to be acceptable?
No, that is not a requirement; but a neatly done assignment is appreciated. (Jan 5/09)
7) I was wondering if
we could get a copy of the midterm for studying purposes.
Midterms are not distributed in any of the sections of ENGM 401. That's why there is a special sample midterm, which has questions of similar content and style for study purposes. Note that midterms in ENGM 401 are non cumulative, with only a slight overlap in content for midterms 2 and 3. If you would like to review your midterm with me and check which questions you had trouble with, I'd be happy to do so. (Dec. 8/08).
6) What are the
differences amongst the different editions of the text? Can I use an older
edition?
The short answer is that you should use the third edition. Each subsequent edition has substantial changes to the text, and a number of minor errata have been corrected. Many "insert boxes" have been added to break up the monotony of the flow of the text. Some additional material of interest has been added, along with more examples in the text. The first edition has no glossary. The chapter on the Balance Sheet was rewritten for the 2nd Ed, so that virtually all discussion of debt, leverage and preferred shares is now moved up into this chapter, rather than being in chapter 6 (Ratios). The 2nd edition text moved what was problem 6.6 into what is now problem 4.5. Students are responsible for any errors arising from using an obsolete text or course notes package. (Dec. 8/08)
5)
Why aren’t the actual excel
spreadsheets posted?
Sometimes in class spreadsheets are displayed. In most cases, the key information is given on a lecture slide (or written in during the class for students to copy down), and a pdf version of the spreadsheet is posted on the course website. The examples are meant to be illustrations for your understanding. You’ll actually learn more by examining the pdfs and creating your own spreadsheets than you would merely plugging numbers into a template. The calculation procedures are described in the guide to calculations. If any of the information is not clear about where the data come from or how calculations are done, then please contact the instructor. (Dec. 8/08)
4) What course
material will the first midterm cover, and what’s the format?
Midterm #1 will cover chapters 1, 2, 3, and 4 of the text. The midterm will be in multiple choice format, with 20 5-choice questions and 25 true-false questions. It will be open-book (including own notes). Bring a calculator. The 5-choice questions will be weighted higher than the true-false questions. Some questions (not many) will require simple calculations.
Note that midterm problems in general cover:
• defining terms and activities in engineering management,
• identifying quantitative financial information in the context of business situations,
• filling out or interpreting financial information on statements,
• calculating and interpreting metrics (such as financial ratios) that pertain to engineering finance and engineering management scenarios, and
• analyzing engineering financial situations such the time-value of money and interest calculations.
Some sample midterms are being prepared and will be posted on the website. In the meantime, there are a number of worked examples in directory http://www.ualberta.ca/~mlipsett/ENGM401/Examples/ including pdfs of spreadsheets from the lectures. There is a sample midterm #1 posted on the website. You might want to use these samples to make up your own questions for studying. Definitions of terms sometimes depend on the circumstances, so read the questions carefully and choose the most correct answer. (Dec. 8/08)
3) Can we hand in the assignment outside of class?
After the solutions have been posted, no assignment will be accepted. You can always hand in and assignment early to the instructor or a TA. You can make arrangements with the instructor in advance to hand it in late if there’s a compelling reason, on a case-by-case basis. (Dec. 8/08)
2) When’s the final?
There are three midterms in this course, which will be held in class. The exam schedule is set up so that finals won’t be double-booked; but as the course outline states, there is no final exam in this section of ENGM 401. (Dec. 8/08)
1) How do I print the lecture slides?
One of the reasons for posting the slides on the website early is so that students can bring copies to class to annotate. Not all of the lecture information is printed on the slides - there is blank space provided for additional notes. Please note that these slides are copyrighted, and can not be distributed or modified without the copyright holder’s permission. The slides that are posted so far for the lectures are in pdf format with two slides per page. (Last year the slides were also available in other formats but students preferred this format.) On a PC, you can view them directly in Internet Explorer with the Adobe plug-in, and then print from there. You can save a copy on your own computer and use Acrobat Reader to view and print the slides (respecting copyright, of course). If you have trouble printing, first make sure that you have the latest update of Reader. If all else fails, you are welcome to stop by my office to borrow a set of hard copies of lectures to date, which you may photocopy once for personal use, and then return my set. Please let me know if you have continuing trouble printing the slides, or if the URL is a broken link. (Dec. 8/08)