B2 - Financial management Flashcards
the benefits of debt financing over equity financing are likely to be highest
if the marginal tax rate is high and there are few non interest tax benefits
WACC
1,000,000/3,000,000 8% = 2.67%
2,000,000/3,000,0009%=6%
2.6+6=8.6%
The net cost of debt financing is
.14*.70= 9.8% == Effective Interest Rate Net of TAx
WACC is frequently used as a hurdle rate within capital budgeting techniques
investments that provide a return that exceed the wacc should continuously add to the value of the firm
an increase in the corporate tax rate might cause a firm to
increase the debt in its financial structure because interest is tax deductible, while dividends are not deductible.
Discounted cash flow model – K = D/P + G =
Dividend 3/30 +10%= 20%
Expected Rate of Returns Using Capital Asset Pricing Model(CAMP)
C= r + B (m-r)
Equity Market expected = 12%
US treasury Bond current = 5%
Beta Coefficient =.60
Tax rate = 40%
C = r+B (m-r) C = .05 + .60 (.12-.05) =.092
The most frequently used measure for cost of debt
actual interest rate minus tax savings
The optimal capitalization for an organization can be determine by the lowest Total WACC
Capitalization at wacc serves to maximize shareholder equity
capital investments whose rate of return exceed the rate of return associated with the firms beta factor will increase the value of the firm
increase value of firm
The overall cost of capital
is the rate of return on assets that cover the cost associated with the funds employed
The cost of capital considers
the cost of all funds, whether they are short term, long term, new or old
Because debt is a cheaper form of financing than equity
Bonds will have the cheapest form of financing
Three elements to estimate cost of equity capital are
Current Dividends per Share D
Expected growth Rate in Dividends G
Current Market Price Common Stock P
the cost of prefer stock is computed in a manner consistent with the computation of effective rate of interest
dividend paid ($20 PV * Dividend 9%) = 1.8 net proceeds (40- 5) = 35 1.8/35=5.14
CAMP = cost of retained earnings
C = R + B (M-R) = CAMP is a method used to calculate the required rate of return on retained earnings (Equity)
EPS -earnings per share is calculated
Net Income and dividing it by the number of common shares of stock outstanding
The market rate of interest on a one year us treasury bill is comprised of
Risk free rate of return and inflation premium.
the beta coefficient represents
the measure of a particular stock percentage change compared to the percentage change in the market over the same period.
The optimal capital structure
is the financial structure that would theoretically maximize shareholder wealth by maximizing the net worth of the company
Commercial Paper Market
- Avoids the expense of maintaining a compensating balance
- Provides a broad distribution for borrowing
- accrues a benefit to the borrower, because its name becomes more widely known
The effective interest rate in the form of discounted note
$100,000 for one year @ 9% = 100,000*.09 = 9,000
100,000-9,000= 91,000; therefore interest charged divided by cash proceeds = 9,000/91,000=9.89
the principle that deficiencies should be reported in ongoing separate evaluations and deficiencies should be reported
Monitoring
the net cost of debt is computed as the effective interest rate net of tax
Do not use the coupon rate
discounted cash flow model
k = D/P+G or Dividend/Stock Price + Growth
the overall cost of capital is the
Rate of return on assets that covers the costs associated with the funds employed
The financial manager should establish a hurdle rates for capital investments
At or above the WACC to ensure that the company receives returns equal to its costs of long - term capitalization
the three elements needed to estimate the cost of equity are
Current Dividends per share
Expected growth rate in dividends
Current Market Price per share of common stock
R=D / (P+G)
the cost of preferred stock is computed, similarly to the computation of the effective interest rate
Dividend paid ($20 PV * 9%) / Net proceeds 40-5)
Operating Leverage is defined as the degree
to which a firm uses fixed operating cost as opposed to variable costs
Times Interest Earned Ratio
EBIT(Earnings Before Interest and Taxes)/Interest Expense
Income after tax = 5.4 Mil
Interest Expense = 1 Mil
Tax Rate = 40%
5.4/.60 = 9 Mil = Income after tax
Pretax income+ int expense = 9+1= 10/1 = 10
Debt-to-Equity Ratio
Total Debt / Total shareholder ‘s equity
Financial leverage is the degree to which a company uses debt rather than equity to finance the company
financial leverage increase when the debt to equity ratio increases - Using a higher % of debt (bonds) for future investments would increase financial leverage
to calculate financial leverage EBIT must first be calculated
EBIT / EBIT - I - (P/(1-T))
if a company does not have preferred stock
the degree of total leverage would decrease in proportion to a decrease in financial leverage
operating leverage is the
degree to which a company uses fixed costs rather than variable costs. The computation for operating leverage is the ratio of fixed cost/variable cost
Day’s sales in AR may be calculated as
Ending AR / Avg daily sales
Working capital policy is deemed to be more conservative
as an increasing portion of an organization assets, permanent current assets, and temporary current assets are funded by long term financing
Net Working Capital
is defined as the difference b/t CA & CL
CA Increased by 120 CL Decreased by 50 , then Net Working Capital increase by 170
CA = 500 + 120 CA = 620 CL = 300 - 50 = CL = 250 NWC = 200 = NWC = 370 = increase by 170
Avg Inventory
Cost of Sale / Inventory Turnover
Inventory Turnover = COGS / AVG INVENTORY
The working capital financing policy that finances permanent assets with ST debt
Subjects the firm to the greatest Risk of being unable to meet the firms maturing obligations
Working capital
working capital increases only if CA are increased or CL are decreased. Exchanging AP(CL) for a Two year Note (LTL) would decrease CL and increase WC
Quick (acid-test) ratio
Cash + Marketable securities + receivables / CL = the formula is Quick assets / CL –> Quick Assets exclude inventory and pre-paids from the CA
To evaluate ST liquidity management
management uses quick ratio
