BEC Finance Flashcards
Long-term financial management considerations
Dividend policy management, Capital budgeting
Short-term financial management considerations
Trade accounts payable, Inventories, Cash management
Weighted average cost of capital (WACC)=
Cost of capital (%) x weight of total capital provided by each source and added all together for total, a company would want to minimize this value, this value also represents hurdle rate used when considering new investments
Bonds payable (pretax)
If bond payable cost of capital % does not take deductibility of interest on taxes into consideration, must do pretax% x (1-tax rate)=cost of capital%
Opportunity cost
Discounted dollar value of benefits lost from an alternative opportunity as a result of choosing another alternative. For cost of capital, each source of financing must have expected rate of return that is better than next best alternative of investments of comparable risk (this is the opportunity cost of investor)
Why would you want to not use company-wide WACC?
Different divisions or projects may have different levels of risk. High risk divisions will over-invest in new projects and low-risk divisions will under-invest in new projects.
Product cost
Cost assigned to goods that were either purchased or manufactured for resale.
What is the opportunity cost of idle space that has no other use?
Zero
Is the gain on the sale of a van relevant to making the decision to purchase a new van?
No, only purchase price of new van and disposal cost of old van are relevant.
Cost
Monetary measure of a resource, NOT the same as expense, expense results from portion of resource that is used up. In short run, these can be different, in long-run they are the same.
Types of costs
- Sunk- cost of resources incurred in the past, not relevant
- Opportunity cost
- Differential or incremental costs- costs that are different between two ore more alternatives, these are the only relevant costs when choosing between alternatives (variable costs change, fixed costs usually do not)
Cost of capital
Cost associated with each element of capital structure, based on risk & level of interest
- Cost of debt- lowest cost
- Cost of preferred stock
- Cost of common stock- most risky so highest cost
Annuity
Series of equal amounts, ordinary annuity payments received at end of each period, annuity due payments paid at the beginning of each period (greater value than ordinary annuity because first payment is not discounted and for FV one additional period is compounded)
Present value of annuity due=
Annuity payment x (PV of ordinary annuity factor + 1) OR (Annuity payment x PV factor) +Annuity payment where PV factor is one LESS period than total periods
FV of annuity due=
Periods of interest earned is one more than ordinary annuity, find appropriate FV factor and subtract 1 from that value (ex. use line 6 of table but there are only 5 actual periods)
PV of a perpetual annuity=
PV=Annual Payment/Discount rate
Tells you how much to invest today earning DR% interest to ensure you get $AP every year forever
$30,000 for first two years and $20,000 savings for year 3=
$10,000 annuity for 2 years and $20,000 annuity for 3 years to equal same values
Interest
Money paid for the use of money
Market interest rate
Prevailing rate of interest paid on interest-bearing instruments or charged on borrowings as determined by the supply and demand of funds in market.
Rate of interest depends on:
- Credit rating of issuer
- Duration
- Amount
- Liquidity (more liquid=lower interest)
- Special covenants- if a security has seniority then it has lower risk b/c it has priority claim over other securities
Nominal (quoted) rate=
Real (inflation free) rate of interest- ST US Treasury securities are common starting point
PLUS
Inflation risk premium- based on avg expected inflation rate over life of security (higher inflation=higher rate) PLUS
Default risk premium- based on risk of default (ex. different between risk of corp bond vs. US Treasury bond)
PLUS
Maturity premium- compensates for risk that longer-term fixed-rate instruments will decline in value as a result of an increase in the market rate of interest
PLUS
Liquidity premium- compensates for the fact that come securities cannot be converted to cash on short notice (higher for illiquid securities)
PLUS/MINUS and special premiums or discounts
Annual percentage rate (APR)=
Interest/ (Principle x fraction of year), a variation of the I=PxRxT equation
Annualized effective interest rate without compounding on loans that are for a fraction of a year, APR is required basis for interest rate disclosure in US.
Effective rate of interest=
Annual dollar cost of the loan/net useable proceeds of the loan (ex. A corporation obtains a loan of $200,000 at an annual rate of 12%. The corporation must keep a compensating balance of 20% of any amount borrowed on deposit at the bank, but it normally does not have a cash balance account with the bank. What is the effective cost of the loan? 24,000/160,000=15%)
Stated (nominal) interest rate
Annual rate specified in loan agreement, does not take compounding effects of frequency of payments or effects of inflation into consideration.
Real interest rate (RIR)
Rate of interest after taking into account the effects of inflation on the value of funds received. =Nominal interest rate-inflation rate
Simple interest
Interest computed on original principle only
Compound interest
Interest computed on principle and accumulated unpaid interest. Can use FV of $1 table or FV=P(1+R)^N equation to compute
Effective interest
Annual interest rate implicit in relationship between net proceeds from loan and dollar cost of loan. (Interest paid/principle)/# years
Effective annual percentage rate
APR with compounding on loans that are a fraction of a year. =(1+1/P)^P - 1 with P=# of periods in a year
Negative interest
Amount charged to hold money, point is to encourage spending and investment rather than saving.
Normal yield curve
Upward sloping curve showing yield % and maturity time of security with longer rates higher than short-term rates.
Process of estimating fair value (market value) of an asset, liability, equity or a business enterprise.
Financial valuation
Price received to sell an asset or paid to transfer a liability between market participants.
Accounting fair value
US GAPP ranking of quality of inputs
Level 1- Unadjusted, quoted prices in active markets for identical items
Level 2- Observable, quoted prices for similar items in active markets or quoted prices for identical or similar in inactive markets, other observable inputs (interest rates) or inputs derived from market data (price per square foot of similar homes)
Level 3- Unobservable, reflect entity assumptions and developed based on best information
US GAAP Valuation Approaches
- Market approach- uses prices and other relevant info generated by market transactions of identical items, market participant will not pay more than it costs for a similar item
- Income approach- Uses valuation techniques to convert future amounts of economic benefits to today’s value, based on premise that market participant is willing to pay the present value of future economic benefits
- Cost approach- considers replacement cost, not as common of an approach
CAPM formula
RR=RFR+B(ERR-RFR) RFR- risk-free rate of return (considers time value of money) ERR= expected rate for benchmark for asset class B=beta of investment, measures systematic risk reflected by volatility of investment ERR-RFR= excess market return (premium)
Beta in CAPM model
If beta=1 then investment is of average risk, if less than 1 then less risky than average and if more than 1, it is a high risk investment
CAPM
Capital asset pricing model- determines relationship between risk and expected return and uses that measure in valuing securities, portfolios, capital projects and other assets. Uses time value of money and estimated risk to compute.
A graph that plots beta would show relationship between:
Asset return and benchmark return
CAPM Assumptions/Limitations
- All investors assumed to have equal access
- Asset risk measured solely by variance from asset class benchmark
- No external cost-ex. commission, taxes
- No restrictions on borrowing/lending at RFR
- Assumed to be market benchmark available, if not, CAPM cannot be used
- Uses historical data
CAPM Uses
- Analysis of securities
- Corporate investments (establishes hurdle rate)
- Establishing fair compensation for regulated monopoly
Option
Contract that entitles owner to buy (call) or sell (put) an asset at a stated price within a specified period. A form of derivative instrument (contract).
6 factors for valuing an option:
- Current stock price relative to exercise price of option
- Time to expiration (more time=more value)
- RFR- higher=greater option value
- Measure of risk- higher=greater option value
- Exercise price
- Dividend payment on optioned stock- smaller payments=greater option value because more earnings are retained to increase stock price
Models of option pricing:
- Black-Scholes- options exercised only at expiration date (European-style options), no dividends paid, stocks whose price increases in small increments and discounting uses RFR but DOES consider likelihood that stock will pay off and option will be exercised
- Binomial Option Pricing Model (BOPM)- tree estimate of option value at a number of time points between valuation date and exercise date, can be used for American-style options that can be exercised at anytime and for stock that pays dividends
Business valuation process:
- Standards and premise of valuation- why is business being valued? assumptions under which it is being valued? (is it a going concern, assets being separately sold)
- Economic environment assessment- macro and local environments and status of industry
- Financial statement analysis- common-size analysis (using total revenue for income and total assets for balance sheet), trend or ratio analysis
- Formulation of valuation (3 options)
3 major formulas used for valuation:
- Market approach
- Income approach
- Free cash flow
- Asset approach
Market approach to valuation of business
Determines value by comparing to other entities with similar characteristics in same industry, can use publicly traded entity for comparison. Adjustments will be needed for the share of entity being valued and any lack of marketability (non-public entities are less marketable). Disadvantage is it is difficult to find comparable public companies to non-public companies.
Income approach to business valuation
Determines NPV of benefit stream generated by entity with discount (WACC or CAPM) or capitalization rate used needed to attract investors.
P/E ratio
Market price/earnings per share
PEG ratio
P/E ratio/EPS growth rate, permits easier comparison between entities in different stages of growth
Free cash flow approach to valuation
Cash an entity generates after cash expended to maintain or expand capital asset base. Shows cash available to pursue opportunities. Good for entities with no dividend history and that have years of reliable cash flow. Calculated by computing NPV of future free cash flows at appropriate discount rate.
Asset approach to business valuation
Fair value of entity by adding values of individual assets (net value). Appropriate when going out of business NOT when valuating non-controlling fractional interest or a going concern.
Types of business combinations:
- Merger- merge into one business, acquiring entity remains
- Consolidation- combines two+ entities to create new one, previous businesses no longer exist
- Acquisition- entity gets controlling interest of another, both still exist in parent/subsidiary relationship
Reasons for valuation:
- Expected synergies- combination will be better than when alone
- Economies of scale
- Reduce competition
- Diversification-new goods/services, new geographical areas
- Supply chain control (vertical integration)
- Bargain purchase opportunities
If business valuation (purchase price) exceeds net fair value of individual items
Intangible asset goodwill recognized
If business valuation (purchase price) is less than net fair value of individual items
Extraordinary gain recognized
Which of the following could be used to hedge a net receivable denominated in British pounds by a U.S. company?
A currency put option would enable the U.S. company to lock in the price at which it could sell (put) the British pounds when received.
A derivative security…
has a value based on another security or index (derives its value from another)
Which of the following statements regarding forward contracts is true?
The buyer of a forward contract gains when prices increase, and the seller of a forward contract loses when prices increase.
Hedging vs. speculation
Risk management strategy vs. business investment to make profit
What are two elements of hedging?
Hedged item- item at risk of loss and Hedged instrument- contract or arrangement entered into to mitigate risk of loss
Commonly hedged items:
- Inventory/commodity prices
- Foreign currency exchange rates
- Interest rates
- Credit (default) risk
Derivative
The most common type of instrument used for financial hedging. Involves a underlying (specified price or rate) and a notional amount (specified unit of measure). Requires no initial investment or a very small one and terms require net settlement=notional amount x underlying.
Futures contract
Contract to deliver or receive commodity in the future at a price set now. Executed through clearinghouse, contract is standardized, settlement occurs daily.
Forward contract
Same as futures contract except executed directly between parties and can be customized, settled only at the end of the contract.
Option contracts
Contracts between buyer and seller that give buyer the option to buy (call) or sell (put) an asset in the future at a price set now (strike price). Gives buyer right to buy/sell but does not require them to do so. Can be done on an exchange or between parties.
Swap contracts
Agree to exchange cash flows (interest), currencies, commodities or risks. Executed directly between parties for any amount or length of time.
Costs of hedging:
- Reduced profit from unnecessary hedging
- Loss of benefit from possible favorable changes
- Feeds charged for contracts
- Internal administration costs of contracts
Risks of hedging:
- Credit risk- counterparty to contract fails to meet obligations
- Market risk- adverse changes in market that affect hedged item
- Basis risk- ineffective hedge that results when offsetting investments do not experience price changes in entirely opposite directions as expected
Credit terms of “2/10, net 30” mean that the debtor may take a 2% discount from the amount owed if payment is made within 10 days of the bill, otherwise the full amount is due within 30 days. The 2% discount is the interest rate for the period between the 10th day and the 30th day; it is not the effective annual rate of interest
The computation of the annual rate of interest using $1.00 would be:
Interest 1
APR = _______ x ________________
Principal Time fraction of year
.02 1
APR = ___ x ______ = .0204 x (360/20) =
.98 20/360
APR = .0204 x 18 = 36.73%
Thus, the effective annual interest rate for not taking the 2% (.02) discount is 36.73%. The 20 days in the 360/20 fraction is (30 - 10), the period of time over which the discount was lost as a result of not paying early.
Inherent in every project are the elements of risk and reward. Risk is
Deviation of actual returns from expected returns and can come from incomplete or incorrect analysis, unanticipated changes in laws, interest rates, costs, etc.
Reducing risk involves:
- A diverse and large portfolio where more than one outcome is possible for any project
- Determine if risk affects all projects (not influenced by diversification), these are usually risks from macroenvironment
Risk-reward relationship
Greater risk=greater reward (reward above risk-free rate=risk premium)
Rate of return required to attract and maintain capital
Cost of capital (hurdle rate, discount rate)
Which one of the following identifies the rate of return required by investors to compensate them for deferring current consumption when making an investment?
Risk-free rate
Beta in context of capital budgeting
Relative riskiness of project with weighted average beta of all project investments be a measure of firm’s total risk of projects and therefore is measure of investor risk.
Which one of the following approaches to capital project evaluation is primarily concerned with the relative economic ranking of projects?
Profitability index approach
Payback period approach
Determines number of years needed to recover initial cash investment in project, if less than maximum allowed, then accept project. Must use NET cash inflows from project (revenues-expenses)
How is depreciation considered in payback period approach?
The tax shield from depreciation is recognized as a cash inflow (savings)
What items are not recognized in the payback period approach?
Residual value or cash inflows at the end of a project. No cash inflow after payback period are recognized.
Advantages of payback period approach
- Easy
- Useful in evaluating liquidity of project (how fast cash can be recovered)
- Short max period reduces uncertainty
Disadvantages of payback period approach
- Ignores time value of money
- Ignores cash flows received after payback period
- Does not measure total project profitability
- Max payback period may be arbitrary
Which one of the following is the capital budgeting evaluation approach that determines the number of periods required for the discounted cash inflows of a project to equal the discounted cash outflows?
Discounted payback period approach.
Discounted payback period approach differs from payback period approach in which way?
Considers the time value of money, so just take PV of cash flows each year, will result in longer payback period than undiscounted approach
The accounting rate of return=
Average annual incremental revenues-average annual incremental expense (change in accounting income)/Initial (or average) Investment
Which one of the following methods of evaluating potential capital projects would take into account depreciation expense that was non-deductible for tax purposes?
Accounting rate of return approach.
What expenses does ARR approach consider?
Depreciation expense, income tax expense and residual (salvage) value (only if using average initial investment)
Average investment= (Initial investment+residual value)/2
Using average investment gives higher ARR
Advantages of ARR?
Easy, consistent with financial statement values (revenue/expenses), considers entire life of project
Disadvantages of ARR?
Ignores time value of money, uses accrual accounting values, not cash flows, difference depreciation methods=different result
Valuation with cash flows:
- Working capital is cash outflow
- Residual value and liquidated investment at end of project=cash inflow
- Depreciation tax shield=cash inflow (cash outflow savings)
NPV=
PV cash inflows-PV cash outflows, if this value is zero or positive, you would want to pursue the project, uses discount (hurdle) rate
Advantages of NPV
- Recognizes time value of money
- Relates project rate of return to cost of capital
- Considers the entire life of project
- Easier to computer than IRR
Disadvantages of NPV
- Requires estimation of cash flows over entire life of project
- Assumes cash flows from new revenues or cost savings are immediately reinvested @ hurdle rate
Assess a project by comparing the present value of expected cash inflows of project with expected cash outflows.
Net present value
Evaluates a project by determining discount rate that equates PV of project’s future cash inflows with the PV of project’s cash outflows. Determined rate is rate of return on project. This is the rate of return that would make PV of project’s cash flows=0
Internal rate of return
Tam Co. is negotiating for the purchase of equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment is acquired. The equipment’s estimated useful life is 10 years, with no residual value, and it would be depreciated by the straight-line method. Tam’s predetermined minimum desired rate of return is 12%. Present value of an annuity of 1 at 12% for 10 periods is 5.65. Present value of 1 due in 10 periods at 12% is .322.
In estimating the internal rate of return, the factors in the table of present values of an annuity should be taken from the columns closest to
5 because 20,000 x 5= 100,000 and this would be where NPV=0
Advantages of IRR
- Considers time value of money
- Considers entire life of project
- Meaning of resulting rate is intuitive
Disadvantages of IRR
- Difficult to compute
- Requires estimation of cash flows over entire life of project
- Requires that all future cash flows be in same direction (positive or negative)
- Assumes immediate reinvestment at IRR
- Limited usefulness when comparing projects of different sizes, lengths or cash flow timing
Preferable methods for ranking and valuating projects:
NPV and Profitability index
Profitability index (PI)
Cost/benefit ratio, takes into account both cash for benefit expected from each project and cost of each project
=PV of after-tax cash inflows/project cost (PI>=1 desirable)OR
=NPV/project cost (PI>=0 desirable, that means project would provide value at least equal to discount rate)
Probability assignment
Way of measuring risk of project outcome. Takes the PV of cash inflows x probability of each cash flow to give an expected value (EV).
Risk assessment methods for projects:
- Probability assignment
- Risk-adjusted discount rate (use different rate for different risk)
- Time-adjusted discount rates (longer time, higher discount rate)
- Sensitivity analysis
- Scenario analysis
- Simulation, decision-tree analysis
Capital project ranking decisions most use:
Profitability index and NPV
PV factor=
Initial cost/annual savings
Calculated first when computing IRR, to decrease IRR then you increase cost or decrease savings, to increase IRR you decrease cost or increase savings
The discount rate is determined in advance for which of the following capital budgeting techniques?
NPV
