BEC - B2 (MC Practice) Flashcards
How do we calculate WACC? What model do we use?
WACC uses the CAPM model (Capital Asset Pricing Model)
Like this:
R = Risk FreeRate + Beta (Return from Market - RiskFreeRate)
Refer to Ratios Deck for more information.
How do we calculate the “cost of preferred stock” for a company?
The same way we calculate Effective Rate of Interest:
-The amount paid (as a dividend) / net proceeds (selling price - float/costs to issue) = cost (as a percentage)
Easier presentation:
Cost of PS = dividend paid / net proceeds
NOTE IMPORTANT: Dividend paid is calculated by multiplying the percentage BY THE PAR VALUE!
What are the three elements needed to estimate the cost of equity capital?
- Current Dividends per share (also known as “D”)
- Expected growth rate in dividends (also known as “g”)
- Current market price per share of common stock (also known as “P”)
How do you estimate the cost of retained earnings for a company, using the DCF method?
K (cost of RE) in percentages = D / P + G
K% = (dividend at the end of the period/beginning of next period) / Current Stock Price… + Growth rate percentage
Use DCF method to estimate the cost of retained earnings for this company:
Current stock price: $30
Estimated dividend at the end of this year: $3/share
Expected Growth Rate: 10%
K = (3 / 30) + 10%
=10% + 10% = 20%
What types of behavior (change the % of debt/equity in financial structure) will the following events encourage?
- Increase in PE ratio?
- Increased economic uncertainty?
- Decrease in times interest earned ratio?
- Increase in corporate income tax rate?
1) will encourage issuance of more equity
2) will decrease incentives to issue debt (decrease interest cost as well)
3) will decrease incentives to issue debt (decrease in times interest earned means earnings have declined compared with interest cost… more debt is unwise)
4) will encourage higher % of debt in capital structure
Overall cost of capital for a firm is (which):
1) Rate of return on assets that covers the costs associated with the funds employed
2) Cost of the firm’s equity capital at which the market value will remain unchanged
3) Maximum rate of return on assets
4) Minimum rate of return a firm must earn on high-risk projects
1) Ding ding ding
Firms must earn at least a return rate on investments >= their cost of capital, or otherwise the investments are losing money… therefore decreasing the value of a firm.
Which of these possible sources of new capital for a firm has the lowest after tax cost?
- Preferred stock
- Common stock
- Bonds
- Retained Earnings
-Bonds. Debt is a cheaper source of financing than equity. Bonds are the cheapest form.
Plus, the company issuing bonds receives a tax deduction on interest paid. This further reduces the cost of bond financing.
When will a bond sell at a premium?
When the market rate of return is less than the stated coupon rate.
What is the relationship between a firm’s beta factor and the return on capital investment, as it relates to creating value for shareholders?
If rate of return exceeds the beta factor, then the overall value of the firm will increase.
How do you calculate net cost of debt?
Effective interest rate * net of tax. NOT coupon rate… we use effective interest rate (cost of debt)
How do we calculate EPS?
Net Income / Shares Outstanding
What type of bond is most likely to maintain a constant market value?
Floating rate bonds. Automatically adjust the return on a financial investment to produce a constant market value for that instrument.
How do you calculate market rate of interest on a one-year t-bill?
Risk free rate of interest + Inflation Premium
The optimal capitalization for an organization can usually be determined by the ?
Lowest total WACC. This will maximize shareholder’s equity
If a company prefers a method that “increases the credit worthiness of the company”… what does this really mean?
It means the company prefers issuing common stock > debt, because issuing common stock increases equity, and does not have an effect on debt. Therefore, debt to equity ratio is decreased. Subsequently, the credit-worthiness of the firm goes up.
Which of the following describes commercial paper?
- Generally does not have an active secondary market
- Has an interest rate lower than T-Bills
- Is generally sold only through investment banking dealers
- Has a maturity date > 1 year
- True. CP has a secondary market available, but generally this is not an active secondary market. CP is usually sold to the money markets by highly creditworthy companies
- False. Interest rate on CP is below the prime rate, but still above the T-Bill rate usually
- False. CP can be sold in many ways
- False. CP matures (generally) in under 9 months
What are some of the primary characteristics of commercial paper issuance?
- Can only be issued by credit-worthy large corporations (use of the open market is restricted to these guys only)
- CP also avoids the expense of maintaining a compensating balance with a commercial bank
- CP provides a broad distribution for borrowing
- CP helps the borrower’s name be more widely known
Marketable securities with the least amount of default risk are
US Treasury Securities
What are the related consequences of issuing debt, as opposed to equity?
- Relatively low after tax cost (due to interest deduction)
- Reduced EPS
- Reduction of control over the company
- Increased financial risk
- True. Interest payments on debt are tax deductible, creating a tax shield. Lower return rates, reducted further by a tax shield, are an advantage
- Financial leverage = higher EPS as a result of issuing debt. EPS goes up because # of shares stays the same, but NI presumed to be higher (otherwise why are we issuing the money?). EPS is not going to be reduced most likely
- Control of the company is reduced when we issue equity
- True. Financial risk goes up, this is a disadvantage
Using the dividend growth model, how do we calculate the cost of retained earnings (AKA the required return)
Cost of RE = D1 / P0 …. + growth rate
AKA
Dividend to be paid out NEXT year (period), divided by the CURRENT stock price. Plus the assumed growth rate.
What does the beta coefficient measure?
A particular stock’s percentage change, compared to (divided by) the percentage change in the market over the same period.
How do we calculate after-tax cost of debt?
Numerator: AFTER TAX interest cost, divided by
Denominator: Issuance price
What does market capitalization equal?
-Number of common shares outstanding, multiplied by
-the fair market value per share.
ie. 1000 shares of common stock issued at $50 per share, with $80 FMV.
Market Cap = 1000 * 80 = 8,000
If a problem asks you to compute the expected rate of return using CAPM…
Dont focus on debt part.
Just do the CAPM formula:
Expected = Risk free rate (treasury rate) + Beta * (MR - RF)
What are Jack’s common slip ups in the following…
If a problem asks you about the expected rate of return on preferred stock…
WATCH OUT to make sure the DIVIDEND is annual… not quarterly.
WATCH OUT that you do not confuse expected rate of return (current dividend / current price), with Required Rate of Return according to the Dividend Growth model…
(D1 / P0 + g)
What causes financial leverage of a company to increase?
A higher debt to equity ratio. When a company issues more bonds (increasing the percentage of debt to equity), financial leverage increases
If a firm uses higher degree of fixed operating costs, as opposed to variable costs (ie paying salaries versus commissions), they are using the concept of:
- fixed leverage
- financial leverage
- combined leverage
- operating leverage
- No. Fixed leverage is not a thing (fake)
- No. Financial leverage = the degree to which a firm uses debt to finance the firm.
- No. Combined leverage = using both fixed operating costs and fixed financing costs to magnify returns to firm’s owners
- Yes. Operating leverage is the degree to which a firm uses fixed operating costs, as opposed to variable operating costs. Each additional dollar in sales has a higher impact (no additional variable operating costs)
How do we calculate times interest earned ratio?
= EBIT (earnings before interest and taxes, incl. depreciation) / interest expense
How do we calculate operating leverage?
= Fixed operating costs / variable operating costs
Which of the following could be an indicator of corporate failure, in comparison to the rest of its industry?
- High fixed assets / non current liabilities
- High RE / total assets
- High Cash Flow / total liabilities
- High fixed costs / total cost structure (high operating leverage)
-D is correct. High operating leverage means you must generate a certain amount of sales in order to meet your fixed obligations. If you don’t hit that number, higher risk and could cause your firm to fail.
Other notes:
-C is actually a positive indicator for a corporation (high CF to total liabilities is a good thing)
How do we calculate debt ratio?
Total Debt (liabilities) / total assets.
Financial leverage =
The amount of debt a firm uses to buy assets.
Specifically, it’s the debt / equity ratio.
Inventory at an auto store has a high risk of obsolescence. What feature below is important to this store?
- Having a high quick ratio
- Having a high number of DSO
- Having a low inventory turnover ratio
- Having a high debt ratio
- A: having a high quick ratio is important, which means more liquid short-term assets on its balance sheet.
- High DSO is bad because that means it takes a long time to collect receivables. Low DSO means the company is getting its cash faster from customers
- Low inventory turnover ratio is not desirable, because inventory stays on store shelves longer, takes longer to convert into cash
- High debt ratio is not desirable, as it indicates the company is highly leveraged and at default risk.
How do AFDA affect working capital?
When bad debt expense is recorded for a period, it subsequently affects AFDA by reducing net AR (net realizable receivbles decreases with an offsetting AFDA). Since Wroking Capital = CA - CL… if your AR goes down, then your CA is also gonna go down…
How do we calculate the inventory turnover ratio?
COGS / Average inventory
When a firm finances each asset with a financial instrument of the same approximate maturity as the life of the asset, it is applying?
Working capital management (appropriate WCM, that is).
How do we calculate net working capital?
WC = CA - CL
How do we determine an appropriate level of working capital? What must we take into consideration:
- Benefit of current assets versus current liabilities proportion
- Probability of “technical insolvency”
If a company becomes more conservative in its working capital policy, which of the following could be a result?
- Increase in ratio of CA / units of output
- Decrease in quick ratio
- Increase in funds invested in CS, decrease in funds invested in marketable securities
- Decrease in permanent working capital
1) Yes, could definitely result. Increase in CA / units of output
2) No. The opposite would happen (Quick Ratio should go up)
3) No. The opposite would happen (marketable securities investment tends to increase with more conservative Working Capital, while investments in common stock would probably decrease).
(NOTE for this one… working capital increases when you issue common stock for cash… not when you invest in other companies’ common stock…)
4) No. The opposite would happen.
Riskier move:
Financing fluctuating current assets with short-term debt?
Or financing permanent current assets with short-term debt?
The policy that finances permanent current assets with short-term debt subjects the firm to the greatest risk of being unable to meet obligations.
What does the phrase “sales volume at cost” really mean?
COGS. Whenever you see sales volume at cost, think COGS.
How do we calculate the cash conversion cycle formula?
Cash conversion cycle = days in inventory + days sales in accounts receivable, - days of payables outstanding
Think about it like: how long does it take the company to buy inventory on credit, sell that inventory on credit, collect cash on the sale, and use the proceeds to pay the vendor for their purchase.
According to the SCOR model of supply chain operations, when management collects and processes vendor payments… what process are they completing
Source.
What is the reorder point for a company in the following situation:
- sells 10,000 units per year
- order quantity is 2,000 units
- safety stock = 1,300 units
- Lead time is 4 weeks
- Standard year for the company has 50 weeks
First, understand what reorder point is:
-the point at which we must reorder inventory to keep safety stock above threshold
-Need at least 1,300 on hand at all times
-Lead time to place an order and receive it is 4 weeks.
-Therefore, how much is sold during the lead time before we can receive new order?
-10,000 / 50 = 200 units per week. 4 weeks = 800 units
So…
Lead time units sold (800) + safety stock (1,300) = reorder point (2,100 units)
Which of the following is NOT an inventory carrying cost?
- Inspections
- Opportunity cost on inventory investment
- Obsolescence and spoilage
- Insurance
- Inspections… this is a ORDER COST, not a carrying cost
- Opportunity cost on inventory investment is also a carrying cost… implicit in the cost of holding inventory. You forego a return on the money you invested.
How would we calculate the total cost of safety stock?
Cost of holding the stock + the stockout cost (usually annual)
If we use the EOQ model for a firm that manufactures its own inventory, ordering costs primarily consist of…
Production set-up.
If EOQ is 200 units for a product and safety stock is 50, what is the average inventory of this product?
EOQ = point (quantity) at which you reorder. In this case, 200.
Average quantity therefore = 200 / 2 = 100
Safety stock = 50
100 + 50 = 150
Which financial instrument generally provides the largest source of short-term credit for smaller firms?
Trade credit.
Which of the following provides a spontaneous source of financing for a firm?
- AP
- Debentures
- Preferred Stk
- AR
- AP. You can finance something and owe a customer a payable spontaneously.
- Debentures = wrong. They take time to issue
- PS = wrong. They take time to issue
- AR = wrong. AR takes time to factor.
In applying the supply chain operations refernce (SCOR) model… a company would include ALL of the following within its planning phase, except…
- Selecting vendors
- Assessing capacity concerns and capabilities
- Determining demand requirements
- Making make/buy decisions
- No. You do not actually select the vendors during planning. This is a decision you make during sourcing.
- Yes. You should assess capacity concerns in planning
- Yes. You should determine demand during planning.
- Yes. You should determine whether to make or buy during planning.
What is true about the characteristics of trade credit?
- Not for small firms
- Subject to risk of buyer default
- Usually an inexpensive source of external financing
- Source of long term financing for a seller
- No, it is actually very common for small firms
- Yes. It is definitely subject to risk of buyer default
- No. It is rather expensive usually, on the contrary
- No, it is not a source of long-term financing.
IMPORTANT How do we calculate the annual cost of credit for a decision of whether to forego sales discounts in order to delay using cash? ie. Supplier terms of credit are 2/10, n 30 360 day year Garo pays net 30
-Annual cost of credit = 360 / (30 - 10) * 2% / (100% - 2%)
Aka … year / extra days you can invest * discount foregone / discount you pay for either way
360 / 20 * 2% / 98%
THIS ANNUAL COST OF CREDIT is basically telling us what we are forgoing by not taking advantage of a discount. For example… if the cost of credit is 36%, and the cost of borrowing from a bank in order to pay for this early discount is 10%… then we should do it, because we don’t want to miss out on that 36% opportunity cost.
What is the formula for EOQ?
EOQ = sq rt (2SO / C) EOQ - order size S - sales quantity in units O - cost per purchase order C - annaul cost of carrying one unit in stock for one year
How can a firm delay disbursements?
- A draft
- A centralized disbursement function
- Trade discounts
- Factoring
- Yes. Checks (or paying by a draft) allows for a float period, delays disbursements
- No, not necesarily
- No, these impact accoutns receivable not disbursements
- No, this has no effect on disbursements
How does a lockbox system accelerate the collection of AR?
System of mailboxes where customers send payments. Bank for the company checks these mailboxes frequently and immediately deposits checks received.
Another way of saying it: Lockboxes minimize collection “float” - speeding up collection
What are the primary methods for converting AR into cash?
- Collection agencies
- Factoring your AR
- Cash discounts as an incentive
- Electronic fund transfers (electronic transfer between banks)
(How do we calculate) / What is the formula for a zero-growth model?
Price = Dividend / Discount rate (rate of return).
Alternatively. Discount rate (rate of return) = Dividend / Price
How do we calculate the PEG ratio?
PEG = (P per share / E per share) / (Growth % * 100)
Key to this formula: Growth percentage * 100 is the denominator. Do not forget to convert to percentage.
When using a constant growth dividend discount model, what is the formula?
P (in year t) = Dividend (in year T + 1) / (Required return - growth rate)
Simplified:
Current Share Price = Dividend next year / (R - G)
Expected return on a stock is equal to:
Dividends + increase in stock value
Example problem: a stock priced at $50/share is expected to pay $5 in dividdends and trade at $60 next year… What is the expected return?
Return dividends: $5 Return stock growth: $10 Total Return: $15 Cost to buy: $50 =15/50 = 30%
What is included within the value of a bond?
- Future interest payments to be received by the bondholder
- Payment of principal when the bond matures
In terms of the assumptions used by the Black Scholes option pricing model, which ones are valid and which ones are invalid?
Valid:
- No taxes or transaction costs exist
- Stock prices behave in a random manner
- The stock pays no dividends
Invalid:
- The options cannot be exercised until maturity (they are European style)
- Risk Free Rate is constant over the option’s life
- Volatility is constant over the option’s life
What does Cox-Ross-Rubinstein model do (binomial model) in valuing stock options versus black scholes?
- Consideration of an option over time (not just at maturity)
- Used for stocks that pay dividends without modifying the model
What is the formula for calculating a bond’s price?
Interest payment Y1 / (1 + discount rate Y1) + Interest payment Y2 / (1 + discount rate Y2) + …. final year:
(Principal + Interest Payment final year) / (1 + discount rate final year)
Also known as…
= FV * coupon rate / (1 + market rate) + (FV * coupon rate) / (1 + market rate)^2 + … (Principal + interest) / (FV * coupon rate)^#
When determining accounting estimates of fixed assets, which of the following sources of information would be considered LEAST reliable:
- Expected Usage
- Industry Consensus
- Historical information
- Market information
- A: No. Level of expected usage is an important factor in estimating useful life and related depreciation
- B: Yes: Industry consensus information would be the least acceptable out of these options, as fixed assets are usually unique to each company such as condition, degree of use, maintenance, etc.
- C: No. Historical information is quite important, and can help estimate useful lives on fixed assets and methods of depreciation
- D: No. Market information is very valuable.
A company wants to value one of its product patents using the market approach. What does this entail?
- Review similar patent sale transactions, see how much each of those were valued at.
- Take the median of all patent transactions.
A record company is trying to value the copyrights to an album. They use the replacement cost approach for valuation. Which of the following should be included?
- Legal fees
- Materials and Labor
- Overhead
- Production costs
- Development costs
- Opportunity costs
- General administration allocation
- Yes, legal fees
- Yes, m plus labor
- Yes, overhead
- Yes, production costs
- Yes, development costs
- Yes, opportunity costs!
- NO: not general administration allocation. If it ain’t overhead, keep it in period expenses (back office). Not tied to creation of album.
What are the inputs in the Black-Scholes model?
- Current price of underlying stock
- Option exercise price
- Risk-free interest rate
- Time until expiration
- Measure of risk tied to the underlying stock
When estimating cash flow for use in capital budgeting, how do we treat depreciation?
-Utilized in determining tax costs or benefits. Asset value is determined based on the present value of future after-tax cash flows… and they consider the tax impact of depreciation deductions.
KEY: DEPRECIATION IS NOT A CASH OUTFLOW. It provides a TAX SHIELD when we compute after-tax cash flows… and should be added back to the cash inflows to get net cash inflow.
What is one limitation of the profitability index?
Requires DETAILED long-term forecasts of a project’s cash flows.
What is the PI? It is a ratio of the PV of net FCF’s (in) to the PV of net investment (out)
Which one of the following should be used if capital rationing needs to be considered when comparing capital projects?
- IRR
- ROI
- Profitability Index
- NPV
-Profitability index = Ratio of PV of net future cash inflows /
Present value of net initial investment
We rank and select investments by listing projects in descending order, based on the highest ratio. We apply capital resources (finite amount) in the order of the index
Which method recognizes time value of money, by discouting the after-tax cash flows over the life of a project, using a company’s minimum desired rate of return?
This would be the Net Present Value method.
All of the following are rates used in the analysis of NPV technique… EXCEPT:
- Cost of capital
- Discount rate
- Hurdle rate
- Accounting rate of return
-4: accounting rate of return
This is a separate capital budgeting technique, not a rate within the NPV method calculation.
The four that you need in order to calculate NPV are:
- (a) Cost of capital: the cost of borrowing
- (b) Discount rate: *
- (c) Hurdle rate: *
- (d) Required rate of return: *
(b) , (c) and (d) are all synonymous terms for an arbitrary rate set by management.
Which metric equates the PV of a project’s expected cash inflows to the PV of a project’s expected cash outflows?
Internal rate of return (IRR). Focus is on the discount rate at which PV of inflows = PV of outflows. IRR = the rate used to arrive at NPV of zero.
What is the ratio for the calculation of the payback model?
Initial cash outlay / increase in annual net after-tax cash flows = payback period
Note: don’t worry about discount rate and PV’ing. only concerned with after-tax cash flows
Payback period question:
Company invests 100K in new ovens to improve their baking and production processes. The company ovens have a useful life of 5 years, no salvage value. After-tax cash flows are uneven:
Company uses an 8% hurdle rate for its investments, what is the payback period in years for the ovens?
Answer process:
- Add up uneven cash flows, until we surpass the original 100K investment
- In whatever year we surpass it… divide the amount we needed to recover by the total amount received in that year, to get decimal %
After tax-cash flows, discounted at 10%, are equal to the initial investment. What is the internal rate of return?
10%.
Which one of these statements about investment decision models is true?
- Payback rule: ignores all cash flows after the end of the payback period
- NPV model: accept an investment when rate of return > incremental borrowing rate
- Discounted payback rate: takes into account cash flows for all periods
- IRR rule: accept the investment if the opportunity cost of capital > IRR
- Yes, true
- No, false. NPV method measures absolute return, not a rate.
- No, false. Discounted payback considers time value of money, but ignores any cash flow after payback has been achieved…
- No, false. The opposite is true (when IRR > hurdle rate, then accept). REMEMBER, The IRR - discount rate at which NPV of the project = zero.
What is the calculation for internal rate of return?
Investment / cash flows = PV factor
A firm can best delay disbursements through the use of what?
A draft.
Paying by means of a draft allows the firm to take advantage of the float period, delaying cash disbursements.
Marginal analysis question:
- Average daily cash outflows: $3M per day
- New system can delay payments up to 2 days
- Company earns 10% on excess funds
- What should they pay per year for this system?
- 3M * 2 = $6M saved
- $6M * .10 = 600K. Easy.
When we evaluate capital budget projects, the use of the net present value model is generally NOT affected by … ___?
- Initial cost of the project
- Method of funding the project
- Amount of added working capital needed for operations during the term of the project
- Amount of the project’s associated depreciation tax allowance
- No, this is one of the most important items in the calcualtion of NPV
- Yes. This does NOT affect the caluclation of NPV. The method of financing, as well as the cost, are both independent of the process of determining whether NPV is positive
- No. Added working capital requirements and salvage value both affect cash flow. Cash flow is the central piece of the NPV model. All cash flows are included.
- No.. A depreciation tax allowance will provide a tax shield. This impacts cash flow and must be considered as well.
What does a positive NPV mean?
NPV uses a Hurdle rate to discount cash flows.
Positive NPV means the project is acceptable.
What is the formula for NPV - ie. a company makes an investment of $100K in property, has a contract to sell it for $120K in a year, and has a guaranteed interest rate of 10%
NPV = -investment + future cash flow(s) / (1 + interest rate)^T
Note:
Future cash flows are across different years. Need to discount each year’s cash flow accordingly.
What is the formula for PEG ratio
PEG Ratio = (P at0 / EPS at0) / (G x 100)
What is the formula for calculating the cost of a credit policy (ie. the annual interest cost)
Cost =
(360 days / (Total pay period - Discount period)) *
(Discount % / (100% - Discount %)
This gives you the COST of customers TAKING the discount… which means more $ foregone on the front end, so you can reinvest the money you will obtain more quickly from customers.
How do we calculate the losses from a stockout cost?
Expected stockout cost + carrying cost
As used in Capital Budgeting Analysis… the internal rate of return uses which of the following items in computation?
- Net incremental investment
- Incremental average operating income
- Net annual cash flows
- Yes:
- No
- Yes
IRR determines the compound interest rate (of an investment) whereby the present value of cash inflows = present value of cash outflows. It is also the discount rate that results in a NPV of zero.
IRR Calculation:
Net incremental investment / Net annual cash flows = Factor of the IRR
Which of the following is an example of an indirect cash flow effect?
- Cash at inception of a project
- Increased payroll expenses
- Depreciation tax shield
- Increase in expected future operating cash flows
-C: depreciation tax shield (reduces taxable income and the amount of cash taxes paid out), via the virtue of a depreciation expense - which is a noncash expense.
Which of the following is correct re: valuation of bonds?
- Market rate of return < stated coupon rate… the market value of the bond will be > face value, and the bond will sell at a premium
- Change in required return will affect shorter maturity bonds more than longer maturity bonds
- When Interest rates are rising, and subsequently the required rate of return rises, the market value of a bond will increase
- The MV of a discount bond > face value during a period of rising interest rates
- True. Premium when coupon rate > market interest rate
- False. Longer maturity is affected more by a change in required return
- False. When interest rates and required rates of return increase, then the PV of a bond’s cash flows are worth less than before and MV will decrease for that bond.
- Market interest rates rising will not help a discount bond have greater value… they will only drive it down.
Controller’s group reviews a sample of accounting estimates each year. Controller is involved with initially approving accounting estimates. How would you describe the procedures in place for thsi company?
-Inadequate. Lacking approval on estimate reviews by a manager, and also there are no regular review periods.
When we calculate the annual cost of financing, for a factoring agreement in which the company effectively pays money in order to reduce collection time and expenses… what formula do we use for the annual cost of financing?
We divide the same way we calculate the EAR:
Net cost to finance / Proceeds from the advance payment
(Net cost to finance will be inclusive of fees and interest on the AR that is being factored and the amount that is advanced for said AR.)
The cost of equity capital is measured by which method?
the CAPM method!
