BEC 3 Flashcards
Define sunk costs.
Costs that have already been incurred, are unavoidable in the future, and will not vary with the course of action taken
What is the formula for after-tax cash flow?
(1.0 - Tax Rate) x Pre-tax cash flows = After-tax cash flow
The forumla for computing a depreciation tax shield is:
Tax rate x depreciation deduction
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
What approaches can management 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
Define net present value (NPV)
Difference between the present value of the cash inflows and outflows from a project
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.
What is the profitability index?
Ratio of the present value of net future cash inflows to the present value of the net initial investment.
The higher the profitability index, the more desirable the project.
Define internal rate of return (IRR)
Discount rate at which the present value of the cash inflows equals the present value of the cash outflows from an investment/project
How are investment decisions made using IRR?
When IRR exceeds the hurdle rate
What is the payback method formula?
Payback period = Net initial investment / increase in annual net after-tax cash flow
Define operating leverage
Degree to which a firm uses fixed operating costs, as opposed to variable operating costs
What is the degree of operating leverage (DOL) formula?
DOL = Percentage change in EBIT (earnings before interest and taxes) / Percentage change in sales
Define financial leverage
Degree to which a firm’s use of debt to finance the firm magnifies the effects of a given percentage change in EBIT on the percentage change in EPS
What is the degree of financial leverage (DFL) formula?
DLF = Percentage change in EPS / Percentage change in EBIT
What is the degree of combined leverage (DCL) formula?
DCL = Percentage change in EPS / Percentage change in sales
Define weighted average cost of capital (WACC).
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 / Nps
Dps = Preferred stock cash dividends
Nps = Net proceeds of preferred stock
What is the cost of retained earnings (kre) using the CAPM formula?
kre = kft + (risk premium/[bi x (km - krf)]/PMR)
krf = Risk-free rate
bi = Beta coefficient of the stock
PMR = Market risk premium
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 or price of outstanding common stock
g = Market rate
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
Terminology used in the cost of capital and is part of the WACC formula:
- wdx = (weighted for) long-term debt
- wps = (weight for) preferred stock
- wcs = (weight for) common stock equity
- kwc = weighted average cost of capital
“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) + (kps x wps) + (kre x wcs)
Define return on investment (ROI)
Used to assess the percentage return relative to capital investment risk.
ROI can be calculated as:
Income / invested capital
or
- Product of profit margin (income/sales)
- Investment turnover (sales/assets)
List the two alternative 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
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
If the amount of the income from the investment exceeds the computed required return, performance objectives have been met
Define economic value added (EVA).
How does EVA differ from residual income?
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 calculate EVA
- 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 required amount of return and income after taxes
Required return = Investment x Cost of Capital
Step 2: Compare income to the required return
Economic value added = Income after taxes - Required return
What is the formula for working capital?
Working capital = Current assets - Current liabilities
What are three common motivations for holding cash?
- Transaction Motive: having enough cash to meet payments arising from the ordinary course of business
- Speculative Motive: having enough cash to take advantage of temporary opportunities
- Precautionary Motive: 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 methods can be used to delay disbursements?
- Defer payments
- Drafts
- Line of credit
- Zero balance accounts
What is the formula for computing the annual percentage rate for quick payment discounts?
(360 / Pay period - Discount Period) x (Discount % / 100% - Discount %)
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 = COGS / Avg inventory
Inventory conversion period = 365 / Inventory turnover
How is the receivables collection period calculated?
AR turnover = Sales / Avg AR
Receivables collection period = 365 / AR Turnover
How is the payables deferral period calculated?
AP Turnover = COGS / Avg AP
Payables deferral period = 365 / AP turnover
What is the equation for economic order quantity EOQ)?
EOQ = Squareroot (2SO/C)
S = (S)ales in Units
O = Cost per Purchase (O)rder
C = (C)arrying Cost per Unit
