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CPA BEC 1 > BEC 3 - Financial Management & Capital Budgeting > Flashcards

BEC 3 - Financial Management & Capital Budgeting Flashcards

1
Q

Financing Function

A

raising necessary capital to Fund a business

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2
Q

Capital Budgeting Function

A

Choosing the best long term projects to which to dedicate the firm’s resources, based on the projects expected risks and returns

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3
Q

Financial Management Function

A
  • managing the business internal cash flows & capital structure (debt & equity mix)
  • minimizing financial costs
  • ensuring obligations can be paid when due
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4
Q

Corporate Governance Function

A

making sure that managerial behavior is ethical (toward all parties) & in the interest of the business’ owners

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5
Q

Risk Management Function

A

identifying and managing the business’s various types of risk

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6
Q

Managing Working Capital

A
  • making sure the business has the net short term financial assets to meet short term obligations
  • managing inventories and receivables
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7
Q

Working Capital Formula

A

Current Assets – Current Liabilities

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8
Q

Current Ratio

A

Current Asset / Current Liabilities

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9
Q

Quick Ratio (Acid Test)

A

Quick Assets / Current Liabilities

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10
Q

Quick Assets

A

Cash + Marketable Securities + Accounts Receivable

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11
Q

What does the Cash Conversion Cycle Measure?

A

of days from when a business pays for its INPUTS to when the business COLLECTS CASH from resulting sales of finished goods

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12
Q

What is the goal of the Cash Conversion Cycle

A
  • to shorten the CCC to minimize the need for financing

- Therefore, lowers costs of financing & improves profitability

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13
Q

Cash Conversion Cycle Formula

A

ICP + RCP – PDP

  • ICP: Inventory Conversion Period
  • RCP: Receivable Collection Period
  • PDP: Payable Deferral Period
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14
Q

Inventory Conversion Period Formula

A

ICP = Avg Inventory / COGS Per Day (OR Sales per day)

*avg # of days to convert inventory to sales

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15
Q

Accounts Receivable Collection Period

A

RCP = Avg AR / Avg CREDIT Sales per day

  • avg # of days required to collect AR
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16
Q

Accounts Payable Deferral Period

A

PDP = Avg Payables / [Purchases per day (or COGS/365)]

  • Avg # of days between buying inventory (including DM + DL for mfg entity) and paying for that inventory
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17
Q

Several Purposes for Keeping Cash Balances

A
  • Operations
  • Trade Discounts
  • Compensating Balances
  • Speculative Balances
  • Precautionary Balances
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18
Q

Float

A

time it takes for checks to be mailed, processed, & cleared

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19
Q

Pay By Draft

A

customers pay by check for SLOWER processing (3rd Party Instrument)

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20
Q

Zero Balance Accounts

A

Banks offering these accounts notify their customer each day of checks presented for payment & transfer only the funds needed to cover them

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21
Q

Concentration Banking

A
  • customers pay local branches instead of main offices so that the business gets funds quicker (REDUCING AR FLOAT)
  • periodic wire transfers from local branches to main offices can be costly
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22
Q

Lock Box System

A
  • customers send payments directly to the bank to speed up deposits & increase internal control over cash
  • eliminates check processing float
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23
Q

Electronic Funds Transfer (EFT)

A
  • Customers pay electronically for fastest processing

- eliminates float from both payments and receipts (AR & AP)

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24
Q

What is the purpose of managing marketable securities?

A
  • to maximize earnings by using ST investments instead of cash (or 0% checking accounts)
  • most important to consider LIQUIDITY & RISK (SAFETY)
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25
Q

Treasury Bills

A
  • ST obligations of the US government with original maturities under 1 year
  • use a ZERO-coupon format
  • virtually ZERO risk of capital losses even if sold before maturities
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26
Q

Treasury Notes

A
  • US government obligations with original maturities between 1 & 10 years
  • pay coupons (interest payments) semi-annually
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27
Q

Treasury Bonds

A
  • Same as Notes but with original maturities over 10 years
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28
Q

TIPS

A
  • T-notes & T-bonds that pay a FIXED REAL RATE of interest by adjusting the principal semi-annually for inflation
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29
Q

Federal Agency Securities

A
  • offerings that may or may not be backed by the full faith & credit of US government
  • do not trade as actively as Treasury’s but pay slightly higher rates
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30
Q

Certificates of Deposits (CDs)

A
  • Time deposits at Banks with Limited government insurance

- Interest yields are typically higher then US Govt Securities

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31
Q

Commercial Paper

A

promissory notes issues by corporations with lives up to 9 months

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32
Q

Bankers’ Acceptances

A
  • drafts drawn on banks that are payable at a specific future due date (not on demand, as checks would be) usually 30-90 days after being drawn
  • usually to pay or goods across international borders
  • trade in secondary markets @ a discount prior to their due date
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33
Q

Money Market Mutual Funds

A
  • invest in instruments with short maturities (<1 year)

- generally stable value

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34
Q

Short Term Bonds Mutual Funds

A
  • invest in instruments with maturities of under 5 years

- generate higher returns than money market funds but with the potential for fluctuations in value

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35
Q

Stocks & Bonds

A
  • individually offer substantially higher potential returns (also greater risk)
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36
Q

What does managing receivables include?

A
  • establishing/updating credit approval mechanism

- monitoring the resulting receivables

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37
Q

Methods of generating immediate cash

A
  • Pledging: Loan (AR = collateral)
  • Assignment: Loan (interest & fee for the advance)
  • Factoring without recourse: sell AR (interest & fee)
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38
Q

What does factoring AR usually do?

A

improves AR Turnover Ratio

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39
Q

Accounts Receivable Turnover Ratio

A

Net CREDIT Sales / Avg AR

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40
Q

Number of Days of Sales in Avg AR

A

360 / AR Turnover3

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41
Q

What is Inventory Management?

A
  • budgeting for inventory purchase decisions
  • when to place orders (or start production) to replace inventory
  • how much to purchase (or to produce)
  • requires weighing conflicting factors (carry costs, order costs, lead time, need)
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42
Q

What is Materials Requirement Planning

A
  • MRP: computerized system that uses demand forecasts to manage the production of finished goods & the required inventory for ram materials
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43
Q

Reorder Point Formula

A

Avg Daily Demand x Avg Lead Time

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44
Q

Safety Stock Formula

A

Reorder Point(@ MAX lead time) – Reorder Point(@ NORMAL lead time)

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45
Q

Economic Order Quantity Formula

A

Sqrt(2AP/S)

  • A: Annual usage of inventory
  • P: Placing order costs
  • S: Storage costs for carrying for 1 period (obsolesce cost)
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46
Q

Just-In-Time (JIT)

A
  • to keep inventories low, order as LITTLE as possible & order as CLOSE to the time when their inventories are needed as possible
  • goods are produced on demand rather than based on long-range forecasts of sales
  • units in process for a relatively short period of time (efficient & high speed / mature JIT system)
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47
Q

When can Just In Time be used effectively?

A
  • storage costs (non-value added operations) are HIGH
  • lead times are LOW
  • needs for safety stock are LOW (good relationship with reliable suppliers)
  • costs per purchase order are LOW
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48
Q

When do companies usually use backflush costing?

A
  • in a mature JIT system because tracking costs in WIP is NOT effective
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49
Q

Backflush Costing

A
  • AKA Delayed or Endpoint Costing
  • all mfg costs are charged DIRECTLY TO COGS
  • @ end of the accounting period, the company determines if there are inventories
  • If inventories exist, costs are allocated FROM COGS to INVENTORY accounts (such as finished goods using standard costs)
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50
Q

What is Cycle Counting?

A
  • technique to manage & audit inventory

- focuses on counting small subsets of inventory in specific locations

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51
Q

Inventory Turnover Ratio

A

COGS / Avg Inventory

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52
Q

of Days in Avg Inventory

A

360 / AVG inventory

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53
Q

FV Factor Formula

A

1 / PV Factor

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54
Q

Convert PV Ordinary Annuity to Annuity Due

A

(PV of Ordinary Annuity Factor)x(1+Interest%) = PV Annuity Due Factor

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55
Q

Payback Period Formula

A

Initial Investment / After Tax Annual Net Cash Inflow

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56
Q

Disadvantages of the Payback Period Method

A
  • does not consider the project’s total profitability
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57
Q

Payback Period

A

length of time it takes for an initial investment to be recovered in cash

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58
Q

Internal Rate of Return

A
  • the discount rate at which NPV = 0
  • the rate of interest that equates the PV Cash O/F = PV of Cash I/F
  • can be used to compare alternative instruments
  • could compare against Hurdle Rates
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59
Q

Internal Rate of Return Formula

A

Investment / Annual Cash Flows = PV Factor (for NPV=0)

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60
Q

Advantages of the Internal Rate of Return

A
  • time value of money
  • Hurdle Rates (similar risk)
  • More readily understandable than NPV
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61
Q

Disadvantages of the Internal Rate of Return

A
  • with different assumption = multiple IRRs

- some CF patterns may not have an IRR for which project’s NPV equates to zero

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62
Q

Accounting Rate of Return

A

computes approximate rate of return

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63
Q

Accounting Rate of Return Formula

A

Accounting Income / AVG (or Initial) Investment

64
Q

Advantages of the Accounting Rate of Return

A
  • easy to compute & understand

- used (often) to rate managerial performance (simple & intuitive)

65
Q

Disadvantages of the Accounting Rate of Return

A
  • no time value of money
  • no differences in risk across investments (no project risk)
  • using different depreciations methods = different ARR’s
66
Q

Net Present Value (NPV)

A
  • the excess of PV Of Cash I/F over the PV of Cash O/F
  • the time value discount rate used is known as the HURDLE RATE of return (or cost of capital)
  • most accepted approach to compare projects financially
67
Q

Advantages of the NPV

A
  • time value of money
  • accounts for risk using high discount rates for riskier projects
  • accounts for total profitability
  • yield result in dollars which may be interpreted as the change in owners wealth if project is carried out
68
Q

Disadvantages of the NPV

A
  • more computations involved (not simple/intuitive)
  • some audiences may understand less readily
  • do NOT account that managers may not actually follow the originally scheduled investments (or expenses)
69
Q

Excess of PV Index (or Profitability Index)

A
  • used to choose which projects to carry out first when faced with several potential projects with positive NPVs
  • if the ratio > 1.0… NPV Is positive
70
Q

Profitability Index Ratio

A

PV of Annual Aftertax Cash Flows / Original Cash Invested in the Project

71
Q

Interpolations

A

using available data to “fill in the gaps” in data relevant to a business

72
Q

Extrapolation

A

using available data to make projections outside for which there is available data

73
Q

When do forecasts tend to be the most accurate?

A

when economic conditions are most stable

74
Q

Momentum

A

short term trends will continue (‘rally’)

75
Q

Mean Reversion

A

deviations from Long Term patterns will eventually be corrected (‘Correction’)

76
Q

Existing forecasting systems are very from?

A

being able to determine when mean reversions will take place

77
Q

Cost of Not Taking discount (AFC – Annual Financing Cost) Forumla

A

AFC = [Discount% / (100%-Discount%)] * [365/(Total Pay Period – Discount Period)]

78
Q

What do compensating balances affect?

A

Increases the effective interest rate paid on the net part of the loan that borrowers get to use

79
Q

Effective Cost of The Loan Formula

A

Cost of the Loan = Interest Paid/(Net Funds Available)

*Net Funds Available=Principal – Compensating Balance

80
Q

LIBOR

A

London Interbank Offered Rate: common base rate for many business and consumer loans abroad and in the US
- computes rates for many short term maturities and currencies including the USD

81
Q

Positive Covenant

A

what the borrower MUST DO

82
Q

Negative Covenant

A

what the borrower MAY NOT DO

83
Q

Income Bonds

A

make interest payments only if the business has earnings in excess of some preset level.

84
Q

Private Debt (Var. Interest)

A

business obligations that may not be readily resold to general public

85
Q

Public Debt (Fixed Interest)

A

business obligations that MAY BE readily sold to the general public in markets that the SEC regulates
- Eurobonds are included

86
Q

Euro Bonds

A

bonds denominated in USD that are sold abroad – not only Europe

87
Q

Callable Bonds

A

force to redeem at the BORROWER’s demand before maturity date

88
Q

Redeemable Bonds

A

BONDHOLDER may demand repayment in advance of the normal maturity date should certain events occur (i.e. company buyout)

89
Q

Current Yield

A

Annual Interest Paid / Current Bond Market Price = Current Yield

  • at Discount: CY>Stated Rate
  • at Premium: CY
90
Q

Yield to Maturity

A

effective rate

  • interest rate at which the PV of Cfs of interest and Principal will equal the current selling price of the bond
  • at Discount: YTM>CY
  • at Premium: YTM>CY
91
Q

Effective Annual Interest Rate (EAR) Formula

A

EAR = (1+ r/m)^3 - 1

  • r: stated interest rate
  • m: compounding frequency
92
Q

Yield Curve

A

Illustrates the relationship between short & long term interest rates

  • important in determining whether to use LT FIXED or VAR rate financing
93
Q

What does the price of a bond depend on?

A
  1. Economy-wide risk-free interest rate
    &
  2. The credit risk involved in that bond (bond agencies)
94
Q

PV of the Proceeds of a Bond formula

A

(FacePV lump sum @ Effective%) + (FaceStated%*Time)

95
Q

Variations of Bond Interest

A
  1. Zero Coupon Bonds
  2. Floating Rate Bonds (& Reverse Floaters)
  3. Registered Bonds
  4. Junk Bonds
  5. Foreign Bonds
96
Q

Registered Bonds

A
  • use a register in which the borrower has the names & addresses of bond holders so that payments can be sent directly to the bondholder (not a broker)
  • actual bond certificate will NOT be issued
97
Q

Foreign Bonds

A
  • interest and face value in another currency
98
Q

Advantages of Debt Financing

A
  • interest is tax-deductible
  • for fixed rate, the obligation is fixed for better planning
  • no ownership dilution (vs. equity financing)
  • excess earnings accrue to owners (not debt holders)
  • less costly (vs. equity financing)
  • during inflationary periods, debt is paid back with less valuable dollars
99
Q

Disadvantages of Debt Financing

A
  • must make payments, regardless of earnings
  • effectively forgo control by agreeing to terms of loan and bond covenants
  • high levels of debt can increases risk of business failure & wipe out owners claims
  • May reduce stock prices (despite positive effects on returns on equity)
100
Q

Benefits of Leasing (as a Lessee)

A
  • if unable to obtain credit, may lease instead
  • terms often less strict than in bond indentures
  • do not often involve down payment
  • during bankruptcy, creditors have weaker rights over leased assets
  • reduced costs if lessor’s tax benefits are transferred over to lessee
  • under operating leases, do not have to recognize asset or liability (only rent expense)
101
Q

Advantages of Using Common Stock to Finance

A
  • Dividend payments are NOT fixed (depend on performance)
  • Less risk to lender if rely on equity more (therefore reduces borrowing costs)
  • attracts investors because of entitled future profit growth
102
Q

Disadvantages of Using Common Stock for financing

A
  • Higher cost of issuance than debt issue costs
  • Higher cost of capital
  • ownership dilution (new issuance of c/s)
  • dividends are NOT tax deductible
103
Q

Possible features of Preferred Stock

A
  1. Cumulative dividends
  2. Redeemability
  3. Callability (business’s decision)
  4. Convertibility
  5. Participation
  6. Floating Rate
104
Q

Advantages of Preferred Stock

A
  • flexibility of being able to skip dividends
  • less risk to lenders if rely more on equity (reduces borrowing costs)
  • no ownership dilution
  • more earnings does not mean P/S holders receive them
105
Q

Disadvantages of Preferred Stock

A
  • high costs of issuing
  • higher cost of capital (Dividend Rates > Interest Rates)
  • Dividends are NOT tax deductible
  • Accumulating skipped dividend payments may be difficult to reduce the backlog AND/OR find new sources of funding
106
Q

What must you take into account to make appropriate financing decisions?

A
  • Leverage & Cost of Capital
107
Q

Explain Degree of Operating Leverage

A

DOL: measures how the size of a business’s FIXED COSTS (relative to total costs) affects its performance when revenues change

  • higher fixed costs exposes a larger business risk (measured by DOL)
108
Q

Degree of Operating Leverage Forumla

A

Percentage Change in EBIT / Percentage Change in Sales Volume

109
Q

Increases in Revenue for businesses with HIGH FIXED COSTS (ie high DOL) reults in?

A

Proportionately larger increases in Return on Equity

110
Q

Increases in revenue having lower variable costs results in?

A

Proportionately larger increases in Profit

111
Q

Degree of Financial Leverage

A
  • extension of DOL focusing only on debt financing (interest costs)
112
Q

Degree of Financial Leverage Formula

A

Percentage Change in EPS / Percentage Change in EBIT

113
Q

Leveraged Buyout (LBO)

A
  • a method of financing the acquisition of all or a voting majority of O/S shares of a company
  • financed primarily with debt secured by the assets of the target company
114
Q

Cost of Debt Financing Formula

A

A) YTM*(1-Effective Tax Rate%)

Or

B) (Interest Expense – Tax Deduction for Interest) / CV of Debt

115
Q

Cost of P/S Financing

A

Stipulated Dividend / Net Issue Price

116
Q

Methods to Estimate the Cost of Existing C/S Financing

A
  1. CAPM
  2. Arbitrage Pricing Model
  3. Bond Yield Plus Method
  4. Dividend Yield Plush Growth Rate Method
117
Q

CAPM Formula

A

Risk-Free Rate + [(Expected Rate of Return – Risk-Free Rate)*Beta]

118
Q

Beta Coefficient

A

the correlation between changes in the stock price & changes in the price of the overall market (volatility)

i.e. Market Increases by 5% & Individual Stock Price increases by 10%

(B=2.0)

119
Q

Arbitrage Pricing Model

A

more detailed version of CAPM that uses separate excess returns & Betas for various factors contributing to a stock performance

120
Q

Bond Yield Plus Method

A

based on the historical relationship between equities and debt (simply adds 3%-5% to interest rate on the businesses long term debt)

121
Q

Dividend Yield Plus Growth Rate Formula

A

(Next Expected Dividend/Current Stock Price) + Expected growth in earnings

122
Q

Cost of New C/S vs. Cost of Existing C/S

A

costs are higher than existing stock since the business must recover the cost of issuing the new shares (selling or floatation costs)

123
Q

Cost of New C/S Formula

A

[Next Expected Dividend / (Current Stock Price-Floatation Costs)] + Expected growth in earnings

  • similar to Dividend Yield Plus Growth Rate
124
Q

Businesses seek capital structures that ________ their WACC. Why?

A

“MINIMIZE” their WACC

  • lower WACC results in lower required rates of return (hurdle rates) & are more likely to find projects that add to shareholder wealth
125
Q

Optimal Capital Structure involves are trade off between

A
  1. Higher costs of equity
  2. Higher debt-to-asset ratios result in higher interest rates
  • Must find a Debt-to-Asset Ratio that minimizes WACC
  • At very LOW debt-to-asset ratios: business reduce their WACC by relying more on debt
  • At very HIGH debt-to-asset ratios: businesses reduce their WACC by relying less on debt
126
Q

What are the use of valuations?

A
  • evaluate investments
  • financial reporting
  • mergers & acquisition
  • capital budgeting
  • tax reporting
  • Litigation
127
Q

What are the 3 Major Approaches to Valuation?

A
  1. Using Actual Prices for IDENTICAL assets traded in liquid markets
  2. Using the prices of SIMILAR assets traded in liquid markets
  3. Using Valuation Models (used if neither 1 and 2 are traded in liquid markets)
128
Q

Horizontal Merger

A

Same Market (Ie competitors)

129
Q

Veritical Mergers

A

in the same supply chain

130
Q

Conglomerate Mergers

A

unrelated markets

131
Q

Discount Cash Flow Analysis

A
  • method for valuing potential merger targets

- determine the PV of Expected Cash Flows from the acquisition, discounted at COST OF EQUITY CAPITAL

132
Q

Market Multiple Method

A
  • method for valuing potential merger targets

Current Earnings*Price-Earnings Ratio

133
Q

Methods for valuing potential merger targets

A
  1. Discounted Cash Flow Analysis

2. Market Multiple Method

134
Q

Gross Margin Formula

A

Gross Profit / Net Sales

135
Q

Operating Profit Margin

A

Operating Profit / Net Sales

136
Q

Free Cash Flow

A

NOPAT + Depreciation + Amortization – Capital Expenditures – Net Increase in Working Capital

137
Q

Residual Income

A

Operating Profit – Interest on Investment

  • Interest on investment = Invested Capital*Required Rate of Return
138
Q

Economic Value Added (EVA)

A

NOPAT - (total assets - current liabilities)*WACC

139
Q

Cost of Financing

A

(Total Assets – Current Liabilities)*WACC

140
Q

Economic Rate of Return on C/S

A

(Dividends + Change in Price)/Beginning Price

141
Q

Return on Investments (based on Assets)

A

Net Income / Total Assets (or avg invested capital)

142
Q

DuPont ROI Analysis

A

Return on Sales*Total Assets

Return on Sales = Net Income / Sales

Asset TO = Sales / Total Assets

143
Q

Return on Assets

A

Net Income / Average Total Assets

144
Q

Return on Equity

A

Net Income / Average CS holders Equity

  • Average CS Holders equity = Stockholders Equity – PS Liquidation Value
145
Q

Total Assets Turnover Ratio

A

Sales / Average Total Assets

146
Q

Fixed Asset Turnover Ratio

A

Sales / Average Net Fixed Assets (after subtraction of Accum. Dep)

147
Q

Debt to Total Assets Ratio

A

Total Liabilities / Total Assets

148
Q

Debt to Equity Ratio

A

Total Debt / Total Equity

149
Q

Times Interest Earned Ratio

A

EBIT / Interest Expense

150
Q

Market Capitalization Ratio

A

CS Price per Share * CS outstanding

151
Q

Market Book Ratio

A

2 Methods

  1. CS Price per share * BV per share
  2. Market Capitalization / CS holders equity
152
Q

Book Value Per Share Ratio

A

CS Holders Equity / CS outstanding

153
Q

Price Earnings (PE) Ratio

A

CS price per share / EPS

154
Q

What does sales to Cash flow ratio measure?

A

financial strength

155
Q

Investment Turnover Ratio

A

Sales / BV (or Net Worth)

CPA BEC 1 (16 decks)

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