BEC 3.2 Flashcards
Capital management, including working capital
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 taxesRequired return = Investment x Cost of Capital
Step 2: Compare income to the required returnEconomic 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
