BEC 3 Flashcards
What is the formula for after-tax cash flow?
(1-Tax rate)*Pre-tax cash flows = After-tax cash flows
Define sunk costs
Sunk costs are those costs that have not already been incurred, are unavoidable in the future, and will not vary with the course of action taken
The formula for computing a depreciation tax shield is:
Tax rate * Depreciation deduction = tax savings from the depreciation tax shield
What are the 3 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)
NPV is the 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?
The 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)
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 are investment decisions made using the IRR?
An investment should be made when the IRR exceeds the hurdle rate
What is the payback method formula?
(Net initial investment)/(Increase in annual net ATCF) = Payback period
What is the equation to calculate the PV of $1?
PV = FV/(1+r) to the n PV = present value; FV = future value; r = interest rate; n = # of years
what is the equation to calculate the present value of an annuity?
PV = PMT * [1-{1/(1+r) to the n}]/r
PV = present value
FV = future value
r = interest rate
n = number of yearsDefine operating leverage
Operating leverage is defined as the degree to which a firm uses fixed operating costs, as opposed to variable operating costs
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 of a given percentage change in EBIT on the percentage change in EPS
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 = Pretax cost of debt * (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 = krf + (risk premium)/[bi*{(km-krf)/PMR}]
krf = risk-free rate; bi = Beta coefficient of the stock; PMR = market risk premium; km = market rateWhat 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 year 1 P0 = current market value or 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 = Pretax cost of debt PMR = market risk premium
Define the weighted average cost of capital by formula
kwc = (kdx * wdx) + (kps * wps) + (kre * wcs)
wdx = weight 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
Define return on investment (ROI)
Return on investment is used to assess the percentage return relative to capital investment risk.
ROI = income/invested capital = (profit margin)*(investment turnover)
profit margin = income/sales
investment turnover = sales/assets
what are the limitations of ROI?
- Short term focus
2. Disincentive to invest (investment myopia)
define return on equity (ROE)
ROE is a measure of the rate f return earned by a company on the equity component of its capital structure. It shows how well a company is using its funds to generate earnings
What is the equation for the DuPont ROE?
DuPont ROE = (net profit margin)(asset turnover)(financial leverage)
Net profit margin = net income/sales
Asset turnover = sales/average total assets
Financial leverage = average total assets/equity
What is the equation for the extended DuPont ROE?
Extended DuPont ROE = (tax burden)(interest burden)(operating income margin)(asset turnover)(financial leverage)
Tax Burden = net income/pretax income
interest burden = pretax income/EBIT
Operating income margin = EBIT/Sales
Asset turnover = sales/average total assets
financial leverage = average total assets/equity
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 Required Return = Net Book Value * 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?
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 calculate 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*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
What are the 3 common motivations for holding cash?
- Transaction Motive: concerns having enough cash to meet payments arising from the ordinary course of business
- Speculative Motive: concerns having enough cash to take advantage of temporary opportunities
- Precautionary Motive: 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 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) * (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/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 = COGS/Average AP
Payables Deferral Period = 365/AP Turnover
Explain factoring as a mechanism for speeding cash collections
Factoring involves the sale of A/R to another party (a factor) in exchange for cash.
The selling company will receive an upfront cash advance of X% of their receivables and will be charged both a fee on all receivables purchased and an interest rate on the upfront advance (while saving on collection related expenses)
The factor will collect the fees and interest, while assuming the responsibility of collecting on the receivables owed by the customers of the selling company
What is the equation to calculate the reorder point for inventory?
Reorder point = Safety Stock + (Lead time * sales during lead time)
What is the equation for Economic Order Quantity (EOQ)?
E = square root of [(2*S*O)/C] E = order size S = Sales in units O = cost per purchase Order C = Carrying cost per unit
