BEC 3.2

Question 1

Define operating leverage

Answer 1

Degree to which a firm uses fixed operating costs, as opposed to variable operating costs

Question 2

What is the degree of operating leverage (DOL) formula?

Answer 2

DOL = Percentage change in EBIT (earnings before interest and taxes) / Percentage change in sales

Question 3

Define financial leverage

Answer 3

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

Question 4

What is the degree of financial leverage (DFL) formula?

Answer 4

DLF = Percentage change in EPS / Percentage change in EBIT

Question 5

What is the degree of combined leverage (DCL) formula?

Answer 5

DCL = Percentage change in EPS / Percentage change in sales

Question 6

Define weighted average cost of capital (WACC).

Answer 6

Average cost of debt and equity financing associated with the firm’s existing assets and operations

Question 7

What is the after-tax cost of debt formula (kdx)?

Answer 7

kdx = Pre-tax cost of debt x (1 - Tax Rate)

Question 8

What is the cost of preferred stock formula (kps)?

Answer 8

kps = Dps / Nps

Dps = Preferred stock cash dividends
Nps = Net proceeds of preferred stock

Question 9

What is the cost of retained earnings (kre) using the CAPM formula?

Answer 9

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

Question 10

What is the cost of retained earnings (kre) using discounted cash flow (DCF)?

Answer 10

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

Question 11

What is the cost of retained earnings (kre) under bond yield plus risk premium (BYRP)?

Answer 11

kre = kdt + PMR
kdt = Pre-tax cost of debt
PMR = Market risk premium

Question 12

Define the weighted average cost of capital by formula

Answer 12

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)

Question 13

Define return on investment (ROI)

Answer 13

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)

Question 14

List the two alternative formulas of Return on Investment

Answer 14

ROI = Income / Investment Capital
ROI = Profit Margin (or Return on Sale) x Investment Turnover (Sales/Assets)

Question 15

What are the limitations of ROI?

Answer 15

• Short-term focus

- Disincentive to invest

Question 16

Define residual income

Answer 16

Measures the excess of actual income earned by an investment over the hurdle rate

Question 17

What is the formula for residual income?

Answer 17

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

Question 18

Define economic value added (EVA).How does EVA differ from residual income?

Answer 18

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

Question 19

Define the steps and formula for economic value added

Answer 19

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

Question 20

What is the formula for working capital?

Answer 20

Working capital = Current assets - Current liabilities

Question 21

What are three common motivations for holding cash?

Answer 21

1. Transaction Motive: having enough cash to meet payments arising from the ordinary course of business
2. Speculative Motive: having enough cash to take advantage of temporary opportunities
3. Precautionary Motive: having enough cash to maintain a safety cushion so that unexpected needs may be met

Question 22

What methods can be used to speed collections?

Answer 22

• Customer screening
• Prompt billing
• Payment discounts
• Expedite deposits
• Concentration banking
• Factoring accounts receivable

Question 23

What methods can be used to delay disbursements?

Answer 23

• Defer payments
• Drafts
• Line of credit
• Zero balance accounts

Question 24

What is the formula for computing the annual percentage rate for quick payment discounts?

Answer 24

(360 / Pay period - Discount Period) x (Discount % / 100% - Discount %)

Question 25

What is the cash conversion cycle formula?

Answer 25

Cash conversion cycle = Inventory conversion period + Receivables collection period - Payables deferral period

Question 26

How is the inventory conversion period calculated?

Answer 26

Inventory turnover = COGS / Avg inventory

Inventory conversion period = 365 / Inventory turnover

Question 27

How is the receivables collection period calculated?

Answer 27

AR turnover = Sales / Avg AR

Receivables collection period = 365 / AR Turnover

Question 28

How is the payables deferral period calculated?

Answer 28

AP Turnover = COGS / Avg AP

Payables deferral period = 365 / AP turnover

Question 29

What is the equation for economic order quantity EOQ)?

Answer 29

EOQ = Squareroot (2SO/C)

S = (S)ales in Units
O = Cost per Purchase (O)rder
C = (C)arrying Cost per Unit