BEC 12

Question 1

Under what circumstances is it better to use debt financing over equity financing - when is it the highest

Answer 1

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

Question 2

What is the term that describes your income that remains after the cost of all capital has been deducted

Answer 2

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

Question 3

What happens to to a bonds sensitivity to changes in market interest rates as it gets closer to its maturity date

Answer 3

It become less sensitive to changes in interest rates

Question 4

When you have a bond at a premium what happens to its value over the three years till it matures

Answer 4

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

Question 5

How do you calculate the cost of debt

Answer 5

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

Question 6

ROI

Answer 6

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

Question 7

Recessions, inflation and high interest rates have what in common

Answer 7

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

Question 8

Imputed interest rates

Answer 8

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.

Question 9

What is net preset value

Answer 9

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

Question 10

how do you use depreciation is capital budgeting

Answer 10

• 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

Question 11

How do you use IRR

Answer 11

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

Question 12

why would you choose debt financing versus equity financing

Answer 12

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

Question 13

debt vs equity - high tax rate

Answer 13

debt - because interest payments are deductible expenses

Question 14

debt vs equity - co has a low aversion to risk

Answer 14

equity - because if you have bonds you MUST make regular interest payments, but if you issue equities you can always suspend dividends -

Question 15

debt vs equity - low stock issuance costs

Answer 15

equity - cheaper to issue stock

Question 16

debt vs equity - high debt to equity ratio

Answer 16

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

Question 17

What happens with a change in a companies cost of capital

Answer 17

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

Question 18

Interests rates and long term and short term investments - the relationships

Answer 18

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

Question 19

Coefficients and derivatives

Answer 19

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

Question 20

What is materials requirement planning

Answer 20

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