B3 Flashcards
Capital budgeting
A process for evaluating and selecting the long-term investment projects of the firm.
Stages of cash flows in capital budgeting (3)
- Inception of the project
- Operations
- Disposal of the project
Step 1: “Net initial costs” components
Invoice price + shipping + installation \+ Increase in working capital - Decrease in working capital -Net proceeds from sale of old =Net outflow
Step 2: “Net inflows from operations” components
Cash flows generated from operations
+depreciation
=Net inflow
Step 3: “Net inflows from disposal” components
Selling price -Increase in working capital \+Decrease in working capital -Gain * T \+Loss * T =Net inflow
Net present value method (NPV)
Focuses decision makers on the initial investment amount that is required to purchase a capital asset that will yield return in an amount in excess of a management-designated hurdle rate
Capital rationing
Describes how limited investment resources are considered as part of investment ranking and selection decisions
Profitability index ratio
PVFCF/Initial investment
Internal rate of return
The expected rate of return of a project; focuses the decision maker on the discount rate at which the present value of the cash inflows equals the present value of the cash outflows
Payback period method
- The time required for the net after-tax cash inflows to recover the initial investment in a project
- Focuses on liquidity and risk
Payback period calculation
Net initial investment/Increase in annual net after-tax cash flow
Operating leverage
- The degree to which a company uses fixed operating costs rather than variable operating costs
- Capital intensive industries often have a high operating leverage
- Labor intensive industries generally have low operating leverage
Degree of operating leverage (DOL) calculation
% change EBIT/% change sales
Financial leverage
- The degree to which a company uses debt rather than equity to finance the company
- A higher degree of financial leverage implies that a relatively small change in earnings before interest and taxes will have a greater effect on profits and shareholder value
Degree of financial leverage (DFL) calculation
% change earnings per share/% change EBIT
Weighted average cost of capital
The average cost of all forms of financing used by a company
WACC formula
Cost of equity multiplied by the percentage equity in capital structure
+Weighted average cost of debt (after tax) multiplied by the percentage of debt in capital structure
Weighted average interest rate
effective annual interest payments/debt cash available
Cost of preferred stock formula
Preferred stock dividends/Net proceeds of preferred stock
3 methods of computing the cost of retained earnings
- capital asset pricing model (CAPM)
- discounted cash flow
- bond yield plus risk premium
CAPM key assumptions
- the cost of retained earnings is equal to the risk-free rate plus a risk premium
- the risk premium is equal to the systematic risks associated with the overall stock market
- the beta coefficient is a numerical representation of the volatility of the stock relative to the volatility of the overall market
- the risk premium is the stock’s beta coefficient multiplied by the market risk premium
- the market risk premium is the market rate of return minus the risk-free rate
CAPM formula
Risk-free rate + risk premium
Risk premium formula
Beta *market risk premium
Market risk premium formula
market return-risk free rate