B3 - Financial Modeling Projections and Analysis Flashcards by Maria Castro

Define sunk costs.

Sunk costs are those costs that have already been incurred, are unavoidable in the future, and will not vary with the course of action taken.

How well did you know this?

Not at all

Perfectly

What is the formula for the after-tax cash flow?

(1.0 - tax rate) x Pre-tax Cash Flows = After-tax Cash Flow

How well did you know this?

Not at all

Perfectly

The formula for computing a deprciation tax shield is:

Tax rate x Depreciation deduction = Tax savings from the depreciation tax shield

How well did you know this?

Not at all

Perfectly

What are the three general stages in which capital investment cash flows are categorized?

Cash flows at the inception of the project
Operating cash flows
Cash flows from the disposal of the project

How well did you know this?

Not at all

Perfectly

What approaches can mangement take to select the desired rate of return for a project?

Use a weighted-average cost of capital (WACC) method
Assign a target rate for new projects
Recommend that the discount rate be related to the risk of the project

How well did you know this?

Not at all

Perfectly

Define *net present value *(NPV).

NPV is the difference between the present value of the cash inflows and outflows from a project.

How well did you know this?

Not at all

Perfectly

How are investment decisions made using the NPV method?

If NPV is positive, then the investment should be made. If NPV is negative, then the investment should not be made.

How well did you know this?

Not at all

Perfectly

What is the profitability index?

The ratio of the present value of net future cash inflows to the present value of the net initial investment. The higher the profitablity index, the more desirable the project.

How well did you know this?

Not at all

Perfectly

Define internal rate of return (IRR).

The IRR is the discount rate at which the present value of the cash inflows equals the present value of the cash outflows from an investment or project.

How well did you know this?

Not at all

Perfectly

How are investment decisions made using IRR?

An investment should be made when the IRR exceeds the hurdle rate.

How well did you know this?

Not at all

Perfectly

What is the *payback method *formula?

Payback period =
_ Net initial investment _
Increase in annual net after-tax cash flow

How well did you know this?

Not at all

Perfectly

Define operating leverage.

Operating leverage is defined as the degree to which a firm uses fixed operating costs, as opposed to variable operating costs.

How well did you know this?

Not at all

Perfectly

What is the *degree of operating leverage *formula?

DOL =
Percentage Change in EBIT
Percentage Change in Sales

How well did you know this?

Not at all

Perfectly

Define financial leverage.

Financial leverage is defined as the degree to which a firm’s use of debt to finance the firm magnifies the effects to a given percentage change in EBIT on the percentage change in EPS.

How well did you know this?

Not at all

Perfectly

What is the *degree of financial leverage *formula?

DFL =
Percentage Change in EPS
Percentage Change in EBIT

How well did you know this?

Not at all

Perfectly

What is the degree of combined leverage formula?

DCL =
Percentage Change in EPS
Percentage Change in Sales

How well did you know this?

Not at all

Perfectly

Define *weighted-average cost of capital *(WACC).

The weighted-average cost of capital is the average cost of debt and equity financing associated with the firm’s existing assets and operations.

What is the *after-tax cost of debt *formula (kdx)?

kdx = pre-tax cost of debt x (1 - tax rate)

What is the *cost of preferred stock *formula (kps)?

kps = Dps/Np

Dps = Preferred stock cash dividends

Nps = Net proceeds to preferred stock

What is the cost of retained earnings (kre) using the CAPM formula?

kre = krf + [bi x (km krf)]

krf = Risk-free rate

bi = Beta coefficient of the stock

PMR = Market risk premium (km - krf)

km = Market rate

What is the *cost of retained earnings *(kre) using discounted cash flow (DCF)?

kre = (D₁/P₀) + g

D₁ = Dividend per share expected at the end of one year

P₀ = Current market value of price of outstanding common stock

g = Constant growth rate of dividends

What is the *cost of retained earnings *(kre) under bond yield plus risk premium (BYRP)?

kre = kdt + PMR

kdt = Pre-tax cost of debt

PMR = Market risk premium

Define the *weighted-average cost of capital *by formula.

This is the terminology used in the cost of capital and is part of the WACC formula:

wdx = (weight for) long-term debt
wps = (weight for) preferred stock
wcs = (weight for) common stock equity
kwc = weighted-average cost of captial

“k” stands for the specific COST of each type of capital, and “w” stands for the WEIGHT of each. So, WACC would be:

kwc = (kdx x wdx) + (cps x wps) + (kre x wcs)

Define return on investment (ROI).

Return on investment is used to assess the percentage return relative to capital investmetn risk. ROI can be calculated as income divided by invested capital or as a product of profit margin (income/sales) and investment turnover (sales/assets).

List the two alternate formulas of Return on investment.

ROI = Income / Investment Capital ROI = Profit Margin (or Return on Sale) x Investment Turnover (Sales/Assets)

What are the limitations of ROI?

* Short-term focus * Disincentive to invest

Define *residual income*.

The residual income method measures the excess of actual income earned by an investment over the hurdle rate.

What is the formula for residual income?

Residual income = Net Income - Required Return Where the Required Return is equal to: Net Book Value _x Hurdle rate _ Required Return If the amount of the income from the investmetn exceeds the computed required return, performance objectives have been met.

Define *economic value added* (EVA). How does EVA differ from residual income?

EVA measures the excess of income after taxes earned by an investment over the rate of return defined by the company's WACC. EVA differs from residual income in the following ways: * WACC must be used to calculated EVA. * The income and investment numbers used to calculate EVA are generally adjusted to produce a more accurate analysis of economic profit.

Define the steps and formula for *economic value added*.

Step 1: Calculate the required amount of return and income after taxes. Investment _x Cost of capital_ Required Return Step 2: Compare income to the required return. Income after taxes - Required return = Economic Value Added

What is the formula for *working capital*?

Current assets - Current liabilities = Working capital

What are the three common motivations for holding cash?

1. **Transaction Motive** A transaction motive for holding cash concerns having enough cash to meet payments arising from the ordinary course of business. 2. **Speculative Motive** A speculative motive for holding cash concerns having enough cash to take advantage of temporary opportunities. 3. **Precautionary Motive** A precautionary motive for holding cash concerns having enough cash to maintain a safety cushion so that unexpected needs may be met.

What methods can be used to speed collections?

* Customer screening * Prompt billing * Payment discounts * Expedite deposits * Concentration banking * Factoring accounts receivable

What mehods can be used to delay disbursements?

* Defer payments * Drafts * Line of credit * Zero balance accounts

What is the formula for computing the annual percentabe rate for quick payment discounts?

_ 360 _ x _Discount%_ Pay period - discount period 100% - Disc%

What is the *cash conversion cycle* formula?

Cash conversion cycle = Inventory conversion period + Receivables collection period - Payables deferral period

How is the inventory conversion period calculated?

Inventory turnover = _Cost of goods sold_ Average inventory Inventory conversion period = _ 365 _ Inventory turnover

How is the receivables collection period calculated?

AR turnover = _ Sales _ Average AR Receivables collection period = _ 365 _ AR turnover

How is the payables deferral period calculated?

AP turnover = _Cost of goods sold_ Average AP Payables deferral period = _ 365 _ AP turnover

What is the equation for *economic order quantity*?

EOQ = square root of: 2SO / C S = Sales In units O = Cost per purchase order C = Carrying cost per unit