BEC - Financial Management Flashcards
Basis risk
The risk of loss form ineffectivness of the hedge that results when offsetting investments don’t experience price changes in entirely opposite direcitons as expected.
FCF
Free cash flow = NI + noncash expense + changes in WC - CapEx
Payback period
Payback period = Cash outlay / Cash inflows
Accounting rate of return (also known as simple rate of return)
Accounting rate of return (simple rate of return) = (avg annual incremental revenues - avg annual incremental expenses) / initial or avg investments
*Depreciation expense is explicitly recognized under the accounting rate of return approach
Profitability index
Profitability index = PV of cash inflows / Project cost
A project would be economically feasible ONLY IF the PI > 1
OR
Profitability index = NPV / project cost
A project would be economically feasible if the
NPV is 0 or positive
While both the NPV and IRR approaches wil lresult in the same accept or reject outcome, differences between the methodologies
The after-tax cash flows are calculated by deducting tax expense from the before-tax cash flows.
NPV and IRR criteria will always lead to the same accept or reject decision.
A project has a present value of future net cash inflows of $120,000 and an initial investment of $110,000. Calculate the excess present value index for the project.
Answer: 109.1%
This answer is correct. It is calculated as follows:
Present value of future net cash inflows ÷ Initial investment × 100
= 120,000/110,000 x 100%
The IRR uses the net incremental investment and the net annual cash flows. However, it does not include the incremental average operating income.
Only very creditworthy firms can issue commercial paper.
Serial bonds are attractive to investors because
Investors can choose the maturity date that suits their financial needs
When calculating the cost of capital, the cost assigned to retained earnings should be
Lower than the cost of external common equity
What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?
To reduce the interest rate on the bonds being sold
The calculation of depreciation is used in the determination of the net present value of an investment for which of the following reasons?
Depreciation increases cash flow by reducing income taxes
This answer is correct because depreciation is a noncash expense that affects future cash flows through its effect on income taxes.
A company has an outstanding one-year bank loan of $500,000 at a stated interest rate of 8%. The company is required to maintain a 20% compensating balance in its checking account. The company would maintain a zero balance in this account if the requirement did not exist. What is the effective interest rate of the loan?
Answer: 10%
The effective rate is calculated by dividing the interest amount by the outstanding balance less the compensating balance requirement.
The annual interest amount is equal to $40,000 (8% × $500,000) and the compensating balance amount is equal to $100,000 (20% × $500,000). The effective interest rate is equal to 10% [$40,000 ÷ ($500,000 – $100,000)].
issuance of common stock involves no fixed charges, no fixed maturity dates and will increase the creditworthiness of the company.
A bond with a floating rate will generally hold a steady market value because its value will not change due to changes in prevailing interest rates.
When a firm finances each asset with a financial instrument of the same approximate maturity as the life of the asset, it is applying
Answer: hedging approach
The strategy of matching asset and liability maturities is referred to as a hedging approach. The strategy helps ensure that funds are generated from the assets when the related liabilities are due.
Which of the following is a disadvantage of the internal rate of return as a method of evaluating investments?
IRR has limitations when evaluating mutually exclusive projects
Coefficient of variation
Coefficient of variation = std deviation / expected return
Trade credit is the largest source of short-term financing for most small firms. It occurs automatically with the purchase of goods and services.
