BEC 12 Flashcards
Under what circumstances is it better to use debt financing over equity financing - when is it the highest
High marginal tax rates and few noninterets tax benefits
Interest tax is deductible so the higher the tax rate the greater the tax savings by the debtor
If you have a low rate the tax benefit is reduced.
Also when there are few non interest tax benefits - the deduction for interest is more valuable
so you would choose debt financing when you have high marginal tax rates( so you can deduct the expense) and when there are few non interest tax benefits because this is an areas where you can deduct
If there are many other areas where you are already having any different non interest tax benefits - you are already paying low taxes and this extra benefit would be as important
What is the term that describes your income that remains after the cost of all capital has been deducted
economic value added
This is the value being created in a company in excess of its required return on capital
You take operating income
reduce it by tax
reduce it by required return on assets
= economic value added
What happens to to a bonds sensitivity to changes in market interest rates as it gets closer to its maturity date
It become less sensitive to changes in interest rates
When you have a bond at a premium what happens to its value over the three years till it matures
It will decrease in value because the bond’s premium will be reduced though amortization as it gets closer to its maturity value or face value
How do you calculate the cost of debt
It is the actual interest rate minus tax savings
cost of debt needs to reflect that interest payments are tax deductible
Therefore they will equal actual interest rates minus the tax savings
Both inflation and any risk premiums are already included in the interest rate so no need to adjust for these
ROI
ROI measures the profitability of an investment in relation to the average invested capital
If the investment would decrease the company’s overall ROI - they company may pass on the opportunity
The investment may be profitable, but it may drop the company’s overall ROI and therefore wouldn’t be taken - you are looking at profit percentage instead of absolute profit
Recessions, inflation and high interest rates have what in common
They all affect the economy as a whole rather than a single industry
So something like labor strike who only affect one industry is an area where a company could reduce its risk through diversification
Imputed interest rates
This is the interest commonly deemed incurred by different divisions based on their invested assets.
It does not appear on external f/s
It is an internal decisions making tool
the imputed interest accounts for the different amount of capital investment among the divisions
so your division could have a net profit of 90K but then you subtract 95K of imputed interest.
What is net preset value
It is the excess of the present value of cash inflows over the net present value of cash outflows
Paid 100,000 for equipment
the net present cashflow of the machine are 120,155
120155 - 100,000 = 20,155 = net present value
how do you use depreciation is capital budgeting
- It does involve cash - so it is not used as an expense when calculating cashflows when looking at different investment alternatives
- depreciation is tax deductible and IS used to calculate the tax benefit or cost
How do you use IRR
IRR is used to calculate the discount rate at which the present value of future cash flows is exactly equal to the amount of investment or zero
You use the WACC rate to compare to the IRR to see if you should make the investment
why would you choose debt financing versus equity financing
debt financing requires interest payment - these are tax deductible
Equity financing (issuing stock) requires dividend payment which are Not tax deductible
If you have a high tax rate this makes it more desirable to increase tax deductible expenses
debt vs equity - high tax rate
debt - because interest payments are deductible expenses
debt vs equity - co has a low aversion to risk
equity - because if you have bonds you MUST make regular interest payments, but if you issue equities you can always suspend dividends -
debt vs equity - low stock issuance costs
equity - cheaper to issue stock
debt vs equity - high debt to equity ratio
equity - This means that you are already have a lot of debt financing and therefore it will be tough to get favorable terms for additional bonds - therefore equity financing is better
What happens with a change in a companies cost of capital
Changes in cost of capital come from interest expense
Increases and decreases.
Changes in interest expense will affect net income
This will affect ROI
If your cost of capital remains the same - then there will be no effect on ROI
Interests rates and long term and short term investments - the relationships
Long term yields are typically greater than short term yields
This is due to maturity premiums that are added on
The investor is compensated for tying up their funds for longer than short term
If you expect low inflation in the future - inflation premiums will be lower. This may offset the maturity premium
If your investment has high liquidity - have a lower rate of
return than investment with low liquidity
Coefficients and derivatives
The closer a coefficient of +1 = the investments and the hedge are pretty much the same manner
A coefficient -1 means they are acting in the opposite manner
Your goal in trying to achieve a perfect hedge is that your hedge will be opposite of your investment
Example: -.91 is close to -1 meaning that it is acting adverse to your hedge and therefore is potentially effective
If it is near +1 they are acting the same - no good
close to zero - there is not a very good relationship
What is materials requirement planning
This is a forecast based tool to ensure that materials are available when needed
It focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as WIP an draw materials
