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
Discounted cash flow method key assumptions
- stocks are normally in equilibrium relative to risk and return
- The estimated expected growth rate of return will yield an estimated required rate of return
- The expected growth rate may be based on projections of past growth rates, a retention growth model, or analysis forecast
DCF formula
(future dividend/current market price) + constant rate of growth
BYRP key assumptions
- equity and debt security values are comparable before taxes
- risks are associated with both the individual firm and the state of the economy
- risk estimation can be derived by using a market analysts’ survey approach or by subtracting the yield on an average corporate long-term bond
BYRP formula
pretax cost of long-term debt + market risk premium
Return on investment (ROI) formulas
income/investment capital(D+E)
OR
Profit margin*investment turnover
ROA formula
Net income/Average total assets
ROE formula
Net income/Total equity(A-L)
DuPont Model’s 3 Distinct Components
- Net profit margin
- Asset turnover
- Financial leverage
Net profit margin calculation
Net income/sales
Asset turnover
Sales/Average total assets
Financial leverage
Average total assets/equity
Extended DuPont Model’s 5 Components
- Tax burden
- Interest burden
- Operating income margin
- Asset turnover
- Financial leverage
Tax burden (definition & formula)
-The extent to which a company retains profits after paying taxes
Net income/Pretax income
Interest burden (definition & formula)
-Reflects how much in pretax income a company retains after paying interest to debt holders
Pretax income/EBIT
Operating income margin (definition & formula)
-A measure of company profits earned on sales after paying operating costs
EBIT/Sales
Residual income (definition & formula)
-Measures the excess of actual income earned by an investment over the return required by the company
=Net income-Required Return
(required return=NBV* hurdle rate)
Economic Value Added (definition & formula)
-Computes required return based on a hurdle rate determined my management, and the EVA measures the excess of income after taxes earned by an investment over the return rate defined by the company’s overall WACC
-Step 1: investment*cost of capital=required return
-Step 2: NOPAT-required return
(NOPAT=net operation profit after taxes)
Working capital management
Involves managing cash so that a company can meet its short term obligations and include all aspects of the administration of current assets and current liabilities
Current ratio
current assets/current liabilities
Quick ratio
(Cash + marketable securities + receivables)/current liabilities
The optimal level of inventory is affected by…(3 things)
- The time required to receive inventory
- The cost per unit of inventory, which will have a direct effect on carrying costs
- The cost of placing an order impacts order frequency, which affects order size, and optimal inventory levels
The commercial paper market has 3 main benefits
- Avoids the expense of maintaining a compensating balance with a commercial bank
- Provides a broad distribution for borrowing
- Accrues a benefit to the borrower because its name becomes more widely known
Advantages of the NPV method
- flexible
- doesn’t require a constant rate of return
Disadvantages of the NPV method
limited by providing the true rate of return on the investment
Net profit margin definition
Net income expressed as a percentage of sales
Investment turnover definition
Sales expressed as a percentage of invested capital
Extended DuPont model 5 distinct components
- Tax burden
- Interest burden
- Operating income margin
- Asset turnover
- Financial leverage
Investment turnover calculation
Sales/Assets
Debt to Total Capital Ratio
Total debt/total capital
Debt to total capital interpretation
Provides indicators related to an organization’s long term debt paying ability. The lower the ratio, the greater the level of solvency and the greater the presumed ability to pay debts
Debt to assets ratio
Total debt/total assets
Debt to assets interpretation
Long-term debt paying ability, the lower the ratio, the better protection afforded to creditors
Debt to equity ratio
Total debt/Total shareholders equity
Debt to equity interpretation
Relates the two major categories of capital structure to each other and indicates the degree of leverage used, the lower the ratio, the lower the risk involved
Times interest earned ratio
Earnings before interest and taxes (EBIT)/interest expense
Times interest earned interpretation
The times interest earned ratio measures the ability of the company to pay its interest charges as they come due. It is a measure of long-term solvency.
Aggressive working capital management
Increase the ratio of current liabilities to non-current liabilities (more current assets financed with current liabilities)
Conservative working capital management
Increase the ratio of current assets to non-current assets (more current assets financed by non-current liabilities)
Methods to speed collections of cash
- customer screening and credit policy
- prompt billing
- payment discounts
- expedite deposits (EFT & lockbox systems)
- concentration banking
- factoring accounts receivable
APR of quick payment discount formula
(360/pay period-discount period)* (discount/100-discount%)
Methods to delay disbursements
- defer payments
- drafts/checks
- line of credit
- zero balance accounts
Cash conversion cycle explanation
the length of time from the date of the initial expenditure for production to the date cash is collected from the customers and the vendors are paid for initial expenditures
Cash conversion cycle formula
inventory conversion period+receivables collection period-payables deferral period
Calculating the inventory conversion period
- inventory turnover= cost of goods sold/average inventory
2. inventory conversion period=365/inventory turnover
Inventory turnover ratio explanation
the number of times a year inventory is sold
Inventory conversion period explanation
the average number of days inventory is held before it is sold
Calculating the receivables collection period
- AR turnover=sales/average AR
2. Receivables collection period=365/AR turnover
Accounts receivable turnover explanation
measures the number of times receivables are collected over an accounting period
Receivables collection period (days sales outstanding)
measures the number of days after a typical credit sale is made until the firm receives payment
Calculating payables deferral period
- AP turnover=cost of goods sold/average AP
2. AP deferral period= 365/AP turnover
Accounts payable turnover explanation
the number of times a year a company pays its suppliers
Accounts payable deferral period explanation
the average number of days it takes for a company to pay its suppliers
Reorder point (explanation & formula)
The inventory level at which a company should order or manufacture additional inventory to meet demand and to avert incurring stockout costs
=safety stock + (lead time*sales during lead time)
Stockout costs
Include loss of income from product unavailability, the cost of restoring goodwill, and additional expenses incurred to expedite shipping.
Economic order quantity (EOQ) (explanation & assumptions)
An inventory model that attempts to minimize both ordering and carrying costs. Assumes that demand is known and is constant throughout the year, does not consider stockout costs, nor does it account for costs of safety stock, also assumes that carrying and ordering costs are fixed.
EOQ formula
E=square root (2Sales*Order cost/Carrying cost per unit)
