B3 Flashcards
Characteristics of Relevant Costs
- direct costs
- prime costs
- discretionary costs (periodic annual budgeting decisions)
Alternative Terms for Relevant Costs and Revenues
Incremental Costs
Avoidable Costs and Revenues
**unavoidable and sunk costs
Cash Flow Effects: Direct and Indirect
- Direct: pays or receives cash
* Indirect: depreciation; net proceeds on the sale of old offsets cost of new
How to treat sale of old asset
Cash proceeds +tax savings from loss or -tax on gain
*same goes for selling the equipment in the year of disposal
Should pre-tax or after tax cash flows be used?
AFTER tax cash flows
Don’t forget to include the __________
DEPRECIATION TAX SHIELD
New equipment can do the following
Increase revenues and/or reduce expenses
What is the rate usually used for DCF?
*WACC (hurdle rate)
Limitation of DCF?
*uses one single interest rate even though rates are subject to fluctuate
Interpreting the NPV Method
Positive = Make Investment Negative = Do Not Make Investment
NPV Method
*can use different interest rates to adjust for risk and inflation
NPV Method is Superior to IRR because
*it is flexible enough to consistently handle either uneven cash flows or inconsistent rates of returns
Limits of the NPV Method
*not providing the true rate of return on the investment
Limited Capital and NPV
*allocate capital to the combination of projects with the maximum net present value
Profitability Index
= (present value of net future cash inflow)/(present value of net initial investment)
IRR
- determines the present value factor that yields an NPV equal to zero
- rate at which the present value of the cash inflows equals the present value of the cash outflows
Limitation of IRR
*cash is assumed to be reinvested at the internal rate of return
*can’t take into account uneven cash flows or differing rates
*does not consider profit, only the interest rate
SIZE MATTERS
Payback Period Method
- does not consider profitability
- measures the time it will take to recover the initial investment
- the greater the risk, the shorter the payback period should be
Payback Period Formula
- (net initial investment)/(increase in annual net after-tax cash flow)
- TAX SHIELD DEPRECIATION IS INCLUDED!!
Advantages/Disadvantages of Payback Method
- easy to use and understand
- emphasis on liquidity
- time value is ignored
- ignores future profitability
- reinvestment of cash is not considered
Discounted Payback Method
*same as payback period except it takes into account the time value of money
Degree of Operating Leverage
(delta EBIT) / (delta sales)
Degree of Financial Leverage
(delta EPS) / (delta EBIT)
Degree of Total Leverage
(delta EPS) / (delta sales)
- or: DOL x DFL
- *DO NOT ADD TOGETHER!!
*the greater the degree of leverage, the greater the risk but also potential for profits
Who influences operating and financial leverage?
Operating - the industry
Financial - management
WACC
(cost of equity x percentage) x (cost of debt after tax x percentage)
How can management maximize the value of the firm?
*mixture of debt and equity that produces the lowest WACC
Weighted Average Cost of Debt
(effective annual interest payments) / (debt cash available)
kre vs. kdx
kre = cost of equity financing kdx = cost of debt financing
Cost of Preferred Stock
(Dps) / (Nps)
outflow) / (NET inflow
Cost of Retained Earnings (kre)
CAPM = krf + [bi x (km - krf)]
DCF = (Div1 / P0) + g
Bond Yield Plus Risk Premium = kdt + PMR (pre-tax YTM + risk premium)
Return on Investment
ROI = income / (average assets = average PPE + average WC)
ROI = profit margin x investment turnover
Return on Assets
net income / average total assets
The higher the denominator used in the ROI computation…
the lower the return
Limitations of ROI
- short-term focus
* managers don’t want to invest because it lowers ROI
Residual Income Approach
= Net income - required return
- required return = net book value * hurdle rate
- ARBITRARY RATE
Economic Value Added (EVA)
*same as residual income except it uses the WACC
- Positive = performance is meeting standards
- Negative = performance is not meeting standards
Economic Value Added Component Issues
- Investment Valuation Issues: capitalization of R&D and current valuation of the balance sheet
- Income may be adjusted
Debt-to-capital ratio
(total debt) / (total capital = debt + equity)
total capital = total assets - NONINTEREST BEARING LIABILITIES
*INTEREST BEARING ONLY
Debt-to-equity Ratio
(total debt) / (total shareholder’s equity)
Working Capital Management
managing cash so that a company can meet its short-term obligations and includes administration of CA and CL
Net working capital =
CA - CL
Aggressive Working Capital vs. Conservative Working Capital
Aggressive = current ratio low Conservative = current ratio high
Quick Ratio
(cash + marketable securities + A/R) / current liabilities
Limitations of the Current Ratio
*cannot be used by itself; not necessarily the best indicator of the health of a company
Working Capital and Risk
*possible failure to meet current obligations and difficulty in obtaining short-term financing
Motives for Holding Cash
- transaction motive
- speculative motive
- precautionary motive (liquidity/safety)
Cost of Not Taking Payment Discount
(360 / (pay period - discount period)) * (discount% / 1 - discount%)
Lockbox Systems
good if additional interest income > bank fees
Concentration Banking
*single bank as a central depository; improved controls over inflow and outflow of cash
Factoring Accounts Receivable
- benefit > cost
* annualize all of it (know the difference between the annual fee and the financing fee)
Methods to Delay Disbursements
- defer payments
- drafts
- line of credit
- zero balance accounts (JIT checking)
Other Cash Management Techniques
- managing float (bank > books)
- overdraft protection
- compensating balance
Cash Conversion Cycle
= days in receivable + days in inventory - payables deferral period
How to Calculate Components in Cash Conversion Cycle
*figure out the turnover ratio and then divide 365 by that answer
Credit Policy Trade-offs
*if strict, days to collect go down but days in inventory increase
What is the largest source of short-term credit for small firms?
*trade credit
Most important factor in determining how much inventory a company is willing to carry
the carrying cost of the inventory
Most important factor for determining safety stock
*the sales forecast
Reorder Point
= safety stock + (lead time x sales during lead time)
Economic Order Quantity
*aims to minimize both ordering and carrying costs
Economic Order Quantity Formula
sqrt((2SO)C)
2 x annual sales x cost per purchase order) / (carrying cost per unit
Primary Purchase Order Cost
*production set-up costs
Other Inventory Management Issues
- JIT
- Kanban - visual signals that an item is needed
- Computerized Inventory Control - real-time communication
- Materials Requirements Planning - control the use of raw materials
Management of Marketable Securities
United States T Bills (least risk) –> Commercial Paper/Equity Securities
- HIGHLY liquid, low risk, higher returns than cash
- used as a hedge against a credit crunch
Periods of Low Rates vs. Periods of High Rates for Marketable Securities
Low = hold cash High = hold securities
