B2: Financial Management Flashcards
What is the formula for CAPM?
Cost of RE = Risk Free Rate + Rate Premium
Risk Free Rate + (Beta ( Market Return - Risk Free Rate))
What are the three elements needed to estimate the cost of equity capital for use in weighted average cost of capital?
- Current dividends per share (D)
- Expected growth rate in dividends (g)
- Current market price per share of common stock (P)
R = (D1/P0) + g
* Pay attention to current year dividends or dividends today.
If dividends today, Multiply D0 by (1 + g)
What is operating leverage?
The degree to which the firm uses fixed operating costs, as opposed to variable operating costs.
OL = Fixed costs / Variable Costs
High operating leverage - high fixed operating costs, low variable costs, uses cost structure to magnify financial results of additional dollars in sales.
EX: Opting to pay salaries instead of sales commissions. Company earns more on sales after fixed costs are covered
What is the formula for FCF?
Free Cash Flow
Net Income after taxes
+ non cash expenses
- Increase in working capital
- capital expenditures
How do you value a bond’s price?
Present value of the future cash flows, discounted using the market rate
What are the inputs to the Black-Scholes model for valuing stock options?
- current price of underlying stock
- options exercise price
- risk free interest rate
- time until expiration
- measure of risk
BS model requires European options - can only be exercised at maturity of option period
What is the profitability index of a project?
Present value of net future cash inflows
Present value of net initial investment
Used to rank qualifying projects if cash to invest in profitable projects is limited.
What is the Net Present value ?
Recognizes time value of money by discounting the after tax cash flows over the life of a project, using company’s minimum desired rate of return. Evaluates economic value added to see if it is worth doing a project.
- Calculate after tax cash flows:
- annual net cash flow x (1-TR)
- Add depreciation benefit:
- Depr.x TR
- Multiply result by PV of annuity
- Subtrract inital cash outflow
How do you calculate Operating Cash Flows?
Pretax cash inflows x (1 - TR)
+ Deprecation X TR
Depreciation acts as a tax shield
What is IRR ?
This method determines the discount rate that would make the net present value of after-tax cash flows equal to zero. Then, any potential investment or project that returns an IRR greater than zero would have value.
Net incremental investment/ Net annual cash flows = PV Factor of IRR
What is Payback Period Approach?
how many years it will take to recover the initial project investment cost.
Take the upfront project cost, and you divide it by the expected annual cash flows. If the project cost will be recovered in the specified time, you would accept the
project. If not, you would reject the project. This emphasizes liquidity.
Advantages: Simple, easy to understand
Disadvantage: Ignores time value of money, doesn’t measure total project profitability, cash flows after payback are ignored.
What are the inputs of IRR?
Internal Rate of Return
Net incremental investment
Net annual cash flows
- This is the factor of the IRR. The IRR determines the compound interest rate of an investment where the PV of cash inflows equals the PV of cash outflows.
What is a commercial paper and what are the advantages?
Short term unsecured debt instrument issued by corporation. Matures in 270 days or less. Restricted to a small number of the most credit worthy large corporations.
Advantages:
- Avoids expense of compensating balance
- provides broad distribution for borrowing
- Benefit to borrower, name becomes more widely known
What is market capitalization?
Common shares outstanding X FMV per share
What is the hedging principal for financing? (self liquidating debt, concerning maturity structure of entity’s finance)
Maturity structure of an entity’s financing shoudl be consistent with the cash flow produced by the asset being financed.
Meaning, fund short term investments with short term debt, long term assets with long term debt.
What are zero coupon bonds?
Increase in value each year as they approach maturity, providing the owner with the total payoff at maturity.
How do you calculate the weighted average cost of debt?
1) Weighted average interest rate
2) After Tax Cost of Debt
How do you calculate the cost of preferred stock?
Outflows divided by inflows .
Annual dividends /
Market Value less issuance costs
How do you calculate the cost of retained earnings with the Capital Asset Pricing Model?
Risk free rate - risk premium
What is the total debt ratio?
Total Liabilities
Total Assets
The lower the ratio, the greater the rate of solvency
What is the inventory reorder point?
= Safety stock + (Lead time x sales during lead time)
Need to havea consistent idea of sales
Example, safety stock is 20 units, lead time is 3 weeks, and you sell 5 units a week. Reorder when you get down to 45 units.
What is economic order quantity? EOC
Trade off between carrying costs and ordering costs.
How do you calculate the price of a security using Gordon Dividend Growth Model?
Pt = D(t+1) / (R - G)
Price today equals
D Next Year
divided by Rate - Growth
How do you calculate the growth rate of a company?
Retention ratio X Return on equity
Retention ratio is what is left after dividends paid out
Does IRR use time value of money?
Yes. Discounts all cash flows over the life of the project.
Measures the rate that would make the PV of future cash flows equal to cost of initial investment.
Recognizes salvage value as a future cash inflow.
