BEC 3.32

Question 1

Leverage

Answer 1

• uses fixed costs

- amplifies risk and potential return

Question 2

Operating leverage

Answer 2

• Fixed (salary) = Total cost is “independent” of sales

- Variable(sales) = Total cost is “dependent” on sales

Question 3

DOL( Degree of operating leverage)

Answer 3

DOL = % change in EBIT / % change in sales

EBIT = earnings before income tax

Question 4

Fixed Leverage

Answer 4

Fixed (debt) = Interest expense is “independent” of profit

Variable (equity) = Dividends “dependent” of profit

Question 5

DFL( Degree of financial leverage)

Answer 5

DFL = % change in EPS(earnings per share) / % change in EBIT

Question 6

Combined Total Leverage

Answer 6

do not add them together instead multiply, DOL x DFL = Combined Total leverage

Question 7

WACC and optimal capital structure

Answer 7

• the optimal capital structure is the one with the lowest WACC(weighted average cost of capital)

FCFF/WACC

WACC = cost of equity multiplied by the percentage equity in capital structure + Weighted average cost of debt* multiplied by the percentage debt in capital structure

• MAKE sure it is AFTER tax considerations

Question 8

Weighted-average cost of debt

Answer 8

• pre-tax only step 1
• step 2 take YTM “market rate” x (1 -tr) = after tax cost(relevant)

weighted average interest rate ( or YTM “market rate” = effective annual interest payments / debt cash available

( outflow / net inflow)

Question 9

Cost of long-term debt

Answer 9

-Debt is typically the cheapest form of capital(compared to equity), since the government makes interest payments tax deductible, and it is less risky for the lenders since they get paid back in bankruptcy before the stockholders

To get cost of long term debt take the debt x (1 - tr). i.e if your debt is $100,000 and the tax rate is 30% since the debt is tax deductible your cost of detb is only $70,000

Question 10

Cost of Preferred stock

Answer 10

• is GREATER than the cost of debt, since dividends are not tax deductible and the stockholders assume more risk than lenders so it costs more

Outflow(dividends) / net inflow = Cost

Question 11

Cost of retained earnings(common equity)

Answer 11

• Greater cost than debt and preferred stock, since common stockholders assume the greatest level of risk in the event of a bankruptcy

Question 12

Risk premium

Answer 12

• if beta = to 1 the company is equally as risky as the stock market
• if beta is greater > than 1 the company is riskier than the stock market
• and if beta is less < than 1 the company is safer than the stock market

Question 13

Cost of retained earnings formula(CAPM)

Answer 13

rfr(risk free rate)
mr(market rate)
b = beta

= rfr +[ b x (mr - rfr)]

Question 14

Discounted cash flow formula(cost of retained earnings DCF)

Answer 14

Div1 = forecasted dividend in future
= Div0(today’s dividend) x ( 1 + g)
P = price of stock
g = growth

DCF=[Div1 / P] + g

Question 15

Bond Yield Plus Risk Premium(cost of retained earnings BYRP)

Answer 15

BYRP = Pre-tax YTM + Risk premium

Question 16

ROI (return on investment)

Answer 16

ROI =Income / Investment capital( or “avg. assets) (or Avg PPE + Avg WC(working capital)

OR

ROI = profit margin* x Investment turnover**

Profit margin = Income / sales
Investment turnover** = Sales / invested capital

Question 17

ROA ( return on assets)

Answer 17

ROA = Net income / total average assets

Question 18

Residual income EVA( economic value added)

Answer 18

Residual income is the income earned beyond what was desired

Residual income = Net income - required return in $*

*required return in $ = hurdle rate x net book value

Question 19

EVA( economic value added)

Answer 19

• same exact formula as residual income, except the hurdle rate for required rate of return MUST be that companies WACC(weighted average cost of capital)

Question 20

Debt-to-capital ratio

Answer 20

• Measure of financial leverage, i.e risk

= Total debt / Total Capital(= Debt + Equity)

Question 21

Debt-to-Asset ratio

Answer 21

= total debt / total assets

Question 22

Debt-to-equity ratio

Answer 22

Total debt / total shareholders equity

Question 23

Working Capital

Answer 23

Current Assets - Current Liabilities

Question 24

Quick Ratio

Answer 24

Cash + Marketable securities + Receivables / Current Liabilities

Question 25

APR of quick payment discount

Answer 25

= [360 / Pay period - discount period] x Discount / 100 - Discount %

Question 26

Lockbox systems

Answer 26

Good if the additional interest income is > then the bank fees

Question 27

Zero balance account

Answer 27

cash is only transferred into account in time to pay checks , that way can earn interest on the money until you are ready to pay

Question 28

Cash conversion cycle(avg number of days to create cash from core business)

Answer 28

= inventory conversion period + Receivables collection period - Payables deferral period

Question 29

Inventory conversion period

Answer 29

inventory turnover = Cost of goods sold / average inventory

THEN

365 / inventory turnover

Question 30

Receivables collection period

Answer 30

A/R turnover = Sales / avg A/R

Then

365 / A/R turnover

Question 31

Payables deferral period

Answer 31

A/P turnover = Cost of goods sold / Avg. A/P

Then

365 / A/P turnover

Question 32

Reorder point

Answer 32

= Safety stock + (Lead time x Sales during lead time(a week or day))

Question 33

Economic order quantity

Answer 33

2SOC

E = Square Root of [ 2 x Sales x order cost / carrying cost per unit]

Question 34

Just-in-time

Answer 34

-reduces carrying costs, only order something if you know the customer wants it