BEC 3 Flashcards
Payback period
Net initial investment/ Increase in annual net after-tax cash flow
Calculate IRR
First calculate:
Net incremental investment (investment required)/ Net annual cash flows = Factor of the IRR
Second: Located the factor derived above to identify the rate of return it represents.
Profitability index
also referred as “excess present value index”
The profitability index is a varitation of the net present value capital budgeting model.
Profitability index= Present value of net future cash inflows/ Present value of net initial investment
IRR computed as
Investment / Cash flows = PV factor
Operating leverage
Defined as the degree to which a firm uses fixed operating costs, as opposed to variable operating costs.
Financial leverage
Defined as the degree to which a firm uses debt to finance the firm, not purely operating fixed costs. The firm can choose to issue debt or equity.
Weighted-average cost of capital
The weighted average cost of capital is frequently used as the hurdle rate within capital budgeting techniques.
Investments that provide a return that exceeds the weighted-average cost of capital should continuously add to the value of the firm.
Capital Asset Pricing Model (CAPM)
C= R+ b(M-R)
C=Cost of capital
R=Risk-free rate
b=Beta
M=Market rate of return
Cost of equity capital (K)
K = D/P + G
D=Future Dividend (or D X 1 + G)
P=Price (Current market price)
G=Growth
Three elements needed to estimate cost of equity capital are:
1) Current dividends per share (D)
2) Expected growth rate in dividends (G) and
3) Current market price per share of common stock (P)
Return on Investment (ROI)
ROI=Income/ Average Investment
Residual Income (RI)
RI= Income - (Investment X Hurdle rate)
Investment turnover ratio
Investment turnover= Sales/ Invested capital
aka Asset turnover = Sales/ Total assets
Asset turnover ratio
Asset turnover= Sales/ Assets
Times interest earned ratio
Times interest earned ratio = Earnings before interest and taxes (EBIT)/ Total interest expense
Return on equity (ROE)
ROE= Net income/sales X Sales/Assets X Assets/Equity
aka ROE= Net income/ Total equity
Optimal level of inventory
Optimal level of inventory is affected by:
1) time required to receive inventory
2) cost per unit of inventory, which will have a direct impact on inventory carrying costs
3) cost of placing an order impacts order frequency, which affects order size and optimal inventory levels.
Inventory turnover
COGS/ Average Inventory
Cost of credit discount
=360/(total pay period - discount period) X Discount %/ (100%-Discount%)
Material requirements planning (MRP)
Is an inventory management technique that projects and plans inventory levels in order to control the usage of raw materials in the production process. MRP applies to WIP and raw materials.
Economic Order Quantity (EOQ)
EOQ= }2SO/C
EOQ= Order size
S= Annual Sales quantity in units
O=Cost per purchase Order
C=Annual cost of Carrying one unit in stock for one year.
Present value
PV= FV/ (1+r)^n; FV=1
What is the factor for the PV of $1 to be received two years in the future at an int rate of 6%?
PV=1/(1+.06)^2=0.890
Then, calculate the present value of an annuity
Step 1: Calculate PV factor for 1
As last step = 0.890
Step 2: 1- discount factor/ rate of return
=1-0.890/.06=1.8333
NRV and IRR
The required rate of return must be less than the project’s internal rate of return (IRR). The IRR is the rate earned by an investment that equates to a net present value (NPV) of zero. By definition, a project with a positive NPV will have an IRR greater than the required rate of return used to compute that NPV.
Relevant Terms
Incremental costs: represent the change in cost associated with different alternatives and are considered synonymous with relevant
Differential costs: represent the change in cost associated with two separate courses of action and are considered synonymous with relevant
Avoidable costs: represent the costs that can be averted by selecting different courses of action and are considered synonymous with relevant
