BEC 3 - Financial Management & Capital Budgeting Flashcards
1
Q
Financing Function
A
raising necessary capital to Fund a business
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
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
4
Q
Corporate Governance Function
A
making sure that managerial behavior is ethical (toward all parties) & in the interest of the business’ owners
5
Q
Risk Management Function
A
identifying and managing the business’s various types of risk
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
7
Q
Working Capital Formula
A
Current Assets – Current Liabilities
8
Q
Current Ratio
A
Current Asset / Current Liabilities
9
Q
Quick Ratio (Acid Test)
A
Quick Assets / Current Liabilities
10
Q
Quick Assets
A
Cash + Marketable Securities + Accounts Receivable
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
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
13
Q
Cash Conversion Cycle Formula
A
ICP + RCP – PDP
- ICP: Inventory Conversion Period
- RCP: Receivable Collection Period
- PDP: Payable Deferral Period
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
15
Q
Accounts Receivable Collection Period
A
RCP = Avg AR / Avg CREDIT Sales per day
- avg # of days required to collect AR
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
17
Q
Several Purposes for Keeping Cash Balances
A
- Operations
- Trade Discounts
- Compensating Balances
- Speculative Balances
- Precautionary Balances
18
Q
Float
A
time it takes for checks to be mailed, processed, & cleared
19
Q
Pay By Draft
A
customers pay by check for SLOWER processing (3rd Party Instrument)
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
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
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
23
Q
Electronic Funds Transfer (EFT)
A
- Customers pay electronically for fastest processing
- eliminates float from both payments and receipts (AR & AP)
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)
25
Treasury Bills
- 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
26
Treasury Notes
- US government obligations with original maturities between 1 & 10 years
- pay coupons (interest payments) semi-annually
27
Treasury Bonds
- Same as Notes but with original maturities over 10 years
28
TIPS
- T-notes & T-bonds that pay a FIXED REAL RATE of interest by adjusting the principal semi-annually for inflation
29
Federal Agency Securities
- 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
30
Certificates of Deposits (CDs)
- Time deposits at Banks with Limited government insurance
| - Interest yields are typically higher then US Govt Securities
31
Commercial Paper
promissory notes issues by corporations with lives up to 9 months
32
Bankers' Acceptances
- 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
33
Money Market Mutual Funds
- invest in instruments with short maturities (<1 year)
| - generally stable value
34
Short Term Bonds Mutual Funds
- invest in instruments with maturities of under 5 years
| - generate higher returns than money market funds but with the potential for fluctuations in value
35
Stocks & Bonds
- individually offer substantially higher potential returns (also greater risk)
36
What does managing receivables include?
- establishing/updating credit approval mechanism
| - monitoring the resulting receivables
37
Methods of generating immediate cash
- Pledging: Loan (AR = collateral)
- Assignment: Loan (interest & fee for the advance)
- Factoring without recourse: sell AR (interest & fee)
38
What does factoring AR usually do?
improves AR Turnover Ratio
39
Accounts Receivable Turnover Ratio
Net CREDIT Sales / Avg AR
40
Number of Days of Sales in Avg AR
360 / AR Turnover3
41
What is Inventory Management?
- 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)
42
What is Materials Requirement Planning
- MRP: computerized system that uses demand forecasts to manage the production of finished goods & the required inventory for ram materials
43
Reorder Point Formula
Avg Daily Demand x Avg Lead Time
44
Safety Stock Formula
Reorder Point(@ MAX lead time) – Reorder Point(@ NORMAL lead time)
45
Economic Order Quantity Formula
Sqrt(2AP/S)
- A: Annual usage of inventory
- P: Placing order costs
- S: Storage costs for carrying for 1 period (obsolesce cost)
46
Just-In-Time (JIT)
- 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)
47
When can Just In Time be used effectively?
- 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
48
When do companies usually use backflush costing?
- in a mature JIT system because tracking costs in WIP is NOT effective
49
Backflush Costing
- 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)
50
What is Cycle Counting?
- technique to manage & audit inventory
| - focuses on counting small subsets of inventory in specific locations
51
Inventory Turnover Ratio
COGS / Avg Inventory
52
of Days in Avg Inventory
360 / AVG inventory
53
FV Factor Formula
1 / PV Factor
54
Convert PV Ordinary Annuity to Annuity Due
(PV of Ordinary Annuity Factor)x(1+Interest%) = PV Annuity Due Factor
55
Payback Period Formula
Initial Investment / After Tax Annual Net Cash Inflow
56
Disadvantages of the Payback Period Method
- does not consider the project's total profitability
57
Payback Period
length of time it takes for an initial investment to be recovered in cash
58
Internal Rate of Return
- 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
59
Internal Rate of Return Formula
Investment / Annual Cash Flows = PV Factor (for NPV=0)
60
Advantages of the Internal Rate of Return
- time value of money
- Hurdle Rates (similar risk)
- More readily understandable than NPV
61
Disadvantages of the Internal Rate of Return
- with different assumption = multiple IRRs
| - some CF patterns may not have an IRR for which project's NPV equates to zero
62
Accounting Rate of Return
computes approximate rate of return
63
Accounting Rate of Return Formula
Accounting Income / AVG (or Initial) Investment
64
Advantages of the Accounting Rate of Return
- easy to compute & understand
| - used (often) to rate managerial performance (simple & intuitive)
65
Disadvantages of the Accounting Rate of Return
- no time value of money
- no differences in risk across investments (no project risk)
- using different depreciations methods = different ARR's
66
Net Present Value (NPV)
- 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
Advantages of the NPV
- 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
Disadvantages of the NPV
- 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
Excess of PV Index (or Profitability Index)
- 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
Profitability Index Ratio
PV of Annual Aftertax Cash Flows / Original Cash Invested in the Project
71
Interpolations
using available data to “fill in the gaps” in data relevant to a business
72
Extrapolation
using available data to make projections outside for which there is available data
73
When do forecasts tend to be the most accurate?
when economic conditions are most stable
74
Momentum
short term trends will continue ('rally')
75
Mean Reversion
deviations from Long Term patterns will eventually be corrected ('Correction')
76
Existing forecasting systems are very from?
being able to determine when mean reversions will take place
77
Cost of Not Taking discount (AFC – Annual Financing Cost) Forumla
AFC = [Discount% / (100%-Discount%)] * [365/(Total Pay Period – Discount Period)]
78
What do compensating balances affect?
Increases the effective interest rate paid on the net part of the loan that borrowers get to use
79
Effective Cost of The Loan Formula
Cost of the Loan = Interest Paid/(Net Funds Available)
*Net Funds Available=Principal – Compensating Balance
80
LIBOR
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
Positive Covenant
what the borrower MUST DO
82
Negative Covenant
what the borrower MAY NOT DO
83
Income Bonds
make interest payments only if the business has earnings in excess of some preset level.
84
Private Debt (Var. Interest)
business obligations that may not be readily resold to general public
85
Public Debt (Fixed Interest)
business obligations that MAY BE readily sold to the general public in markets that the SEC regulates
- Eurobonds are included
86
Euro Bonds
bonds denominated in USD that are sold abroad – not only Europe
87
Callable Bonds
force to redeem at the BORROWER's demand before maturity date
88
Redeemable Bonds
BONDHOLDER may demand repayment in advance of the normal maturity date should certain events occur (i.e. company buyout)
89
Current Yield
Annual Interest Paid / Current Bond Market Price = Current Yield
- at Discount: CY>Stated Rate
- at Premium: CY
90
Yield to Maturity
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
Effective Annual Interest Rate (EAR) Formula
EAR = (1+ r/m)^3 - 1
- r: stated interest rate
- m: compounding frequency
92
Yield Curve
Illustrates the relationship between short & long term interest rates
- important in determining whether to use LT FIXED or VAR rate financing
93
What does the price of a bond depend on?
1. Economy-wide risk-free interest rate
&
2. The credit risk involved in that bond (bond agencies)
94
PV of the Proceeds of a Bond formula
(Face*PV lump sum @ Effective%) + (Face*Stated%*Time)
95
Variations of Bond Interest
1. Zero Coupon Bonds
2. Floating Rate Bonds (& Reverse Floaters)
3. Registered Bonds
4. Junk Bonds
5. Foreign Bonds
96
Registered Bonds
- 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
Foreign Bonds
- interest and face value in another currency
98
Advantages of Debt Financing
- 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
Disadvantages of Debt Financing
- 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
Benefits of Leasing (as a Lessee)
- 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
Advantages of Using Common Stock to Finance
- 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
Disadvantages of Using Common Stock for financing
- 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
Possible features of Preferred Stock
1. Cumulative dividends
2. Redeemability
3. Callability (business's decision)
4. Convertibility
5. Participation
6. Floating Rate
104
Advantages of Preferred Stock
- 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
Disadvantages of Preferred Stock
- 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
What must you take into account to make appropriate financing decisions?
- Leverage & Cost of Capital
107
Explain Degree of Operating Leverage
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
Degree of Operating Leverage Forumla
Percentage Change in EBIT / Percentage Change in Sales Volume
109
Increases in Revenue for businesses with HIGH FIXED COSTS (ie high DOL) reults in?
Proportionately larger increases in Return on Equity
110
Increases in revenue having lower variable costs results in?
Proportionately larger increases in Profit
111
Degree of Financial Leverage
- extension of DOL focusing only on debt financing (interest costs)
112
Degree of Financial Leverage Formula
Percentage Change in EPS / Percentage Change in EBIT
113
Leveraged Buyout (LBO)
- 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
Cost of Debt Financing Formula
A) YTM*(1-Effective Tax Rate%)
Or
B) (Interest Expense – Tax Deduction for Interest) / CV of Debt
115
Cost of P/S Financing
Stipulated Dividend / Net Issue Price
116
Methods to Estimate the Cost of Existing C/S Financing
1. CAPM
2. Arbitrage Pricing Model
3. Bond Yield Plus Method
4. Dividend Yield Plush Growth Rate Method
117
CAPM Formula
Risk-Free Rate + [(Expected Rate of Return – Risk-Free Rate)*Beta]
118
Beta Coefficient
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
Arbitrage Pricing Model
more detailed version of CAPM that uses separate excess returns & Betas for various factors contributing to a stock performance
120
Bond Yield Plus Method
based on the historical relationship between equities and debt (simply adds 3%-5% to interest rate on the businesses long term debt)
121
Dividend Yield Plus Growth Rate Formula
(Next Expected Dividend/Current Stock Price) + Expected growth in earnings
122
Cost of New C/S vs. Cost of Existing C/S
costs are higher than existing stock since the business must recover the cost of issuing the new shares (selling or floatation costs)
123
Cost of New C/S Formula
[Next Expected Dividend / (Current Stock Price-Floatation Costs)] + Expected growth in earnings
- similar to Dividend Yield Plus Growth Rate
124
Businesses seek capital structures that ________ their WACC. Why?
“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
Optimal Capital Structure involves are trade off between
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
What are the use of valuations?
- evaluate investments
- financial reporting
- mergers & acquisition
- capital budgeting
- tax reporting
- Litigation
127
What are the 3 Major Approaches to Valuation?
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
Horizontal Merger
Same Market (Ie competitors)
129
Veritical Mergers
in the same supply chain
130
Conglomerate Mergers
unrelated markets
131
Discount Cash Flow Analysis
- method for valuing potential merger targets
| - determine the PV of Expected Cash Flows from the acquisition, discounted at COST OF EQUITY CAPITAL
132
Market Multiple Method
- method for valuing potential merger targets
Current Earnings*Price-Earnings Ratio
133
Methods for valuing potential merger targets
1. Discounted Cash Flow Analysis
| 2. Market Multiple Method
134
Gross Margin Formula
Gross Profit / Net Sales
135
Operating Profit Margin
Operating Profit / Net Sales
136
Free Cash Flow
NOPAT + Depreciation + Amortization – Capital Expenditures – Net Increase in Working Capital
137
Residual Income
Operating Profit – Interest on Investment
- Interest on investment = Invested Capital*Required Rate of Return
138
Economic Value Added (EVA)
NOPAT - (total assets - current liabilities)*WACC
139
Cost of Financing
(Total Assets – Current Liabilities)*WACC
140
Economic Rate of Return on C/S
(Dividends + Change in Price)/Beginning Price
141
Return on Investments (based on Assets)
Net Income / Total Assets (or avg invested capital)
142
DuPont ROI Analysis
Return on Sales*Total Assets
Return on Sales = Net Income / Sales
Asset TO = Sales / Total Assets
143
Return on Assets
Net Income / Average Total Assets
144
Return on Equity
Net Income / Average CS holders Equity
- Average CS Holders equity = Stockholders Equity – PS Liquidation Value
145
Total Assets Turnover Ratio
Sales / Average Total Assets
146
Fixed Asset Turnover Ratio
Sales / Average Net Fixed Assets (after subtraction of Accum. Dep)
147
Debt to Total Assets Ratio
Total Liabilities / Total Assets
148
Debt to Equity Ratio
Total Debt / Total Equity
149
Times Interest Earned Ratio
EBIT / Interest Expense
150
Market Capitalization Ratio
CS Price per Share * CS outstanding
151
Market Book Ratio
2 Methods
1. CS Price per share * BV per share
2. Market Capitalization / CS holders equity
152
Book Value Per Share Ratio
CS Holders Equity / CS outstanding
153
Price Earnings (PE) Ratio
CS price per share / EPS
154
What does sales to Cash flow ratio measure?
financial strength
155
Investment Turnover Ratio
Sales / BV (or Net Worth)
