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.