BEC - Financial Management Flashcards
Cost Defined
The amount paid in cash or other resources for a good or service
Expense Defined
The portion of Cost that relates to the portion of a good or service that has been used up.
Sunk Costs Defined
Costs of resources that have been incurred in the past and cannot be changed by current or future decisions
•not relevant in making current decisions.
Ex: cost of a piece of machinery that needs to be replaced.
Opportunity Cost Defined
Discounted dollar value of benefits lost from an opportunity not taken as a result of choosing another opportunity.
•relevant in current decisions.
Ex: revenue lost from an alternative not selected.
Differential/Incremental Cost Defined
Costs that are different between two or more alternatives.
•Cost elements that are the same are not relevant in making economic comparisons.
Cost of Capital Defined
Cost of long-term funds - (debt/equity) - used to finance an operation.
•long-term debt, preferred stock and common stock
Cost of Debt Defined
Rate of return that must be paid to attract (investors) and retain lenders’ (funds)
•rate of return required is determined by many factors. (Level if interested Rate in generally market, perceived default risk of the firm, etc.)
Generally _____ is considered less risky than equity
DEBT.
Required rate of return of debt (cost of debt) is less than on preferred or common stock.
Cost of Preferred Stock Defined
Rate of return that must be paid to attract and retain preferred shareholders’ investment.
•had characteristics of debt and equity.
- dividends expected and paid before common dividends & possible claim to additional dividends and priority claim to assets upon liquidation.
- more risky than debt, but less risky than common stock. (RRoR goes the same way)
Cost of Common Stock Defined
Rate of return that must be paid to attract and retain common shareholders’ investment.
- determined by (a) perceived risk of stock, (b) expected dividends (c) expected price appreciation.
- most risky (RRoR is greater than on debt or preferred stock)
Underlying concept of Cost of Capital
Rate of return required by each source is determined by the OPPORTUNITY COST each source has in the market for comparable risk.
Weighted Average Cost of Capital (WACC) Defined
Rate of return of each source of Capital weighted by its share of the total capital.
- percent of total capital is determined for each source is calculated
- percent of each is multiplied by the cost of Capital for that source of Capital
- resulting weighted costs of Capital are summed to get the weighted average cost of Capital.
Product Cost (Inventoriable cost) Defined
The Cost assigned to goods that were either purchased or manufactured for resale.
Present Value of a Single Amount
Determined the value now - at the present - of a single amount to be received in the future.
Future Value of a Single Amount
Determined the value at some future date of a Single Amount invested now
•Assumes annual “compounding” (I.e. Interest is earned on unpaid interest)
Interest Defined
Cost of the use of money.
Fixed interest rate
Percentage rate of interest does. It change over the life of the instrument.
Variable interest rate
Percentage rate of interest can change over the life of the instrument.
•changes relate to Fed rate or prime rate
Changing based of interest
Rate type may change over the life of the instrument.
Stated interest rate
Annual rate of interest specified (stated) in a contract
- rate per loan agreement, bond coupon rate
- does not take into account compounding effects of frequency of payments
Simple interest
Interest computed on original principal only
•no compounding in interest calculation
•no interest paid on interest
Compound interest
Interest computed on principal plus accumulated unpaid interest
•interest is paid on interest.
Effective interest rate
Annual interest rate implicit in the relationship between the re proceeds of a borrowing and the dollar cost of that borrowing.
- calculation = net cost of borrowing (amount of interest) / net proceeds (amount borrowed less interest)
- net proceeds received may be less than amount borrowed due to:
- Discounting-interest deducted in advance
- Compensating balance requirement
Annual Percentage Rate (APR)
Annualized effective interest rate without compounding on a borrowing that is for a fraction of a year.
- calculation APR = effective rate for fraction of year x number of fractions in year. (Semi annually =2)
- APR is the legally required basis for interest rate disclosure in US
Effective Annual Percentage Rate (EAPR) aka “Annual percentage yield”
Annual percentage rate WITH COMPOUNDING on borrowings for fraction of a year
Negative Interest Rate
Interest rate terms under which the owner of funds pays a recipient interest to hold (and possibly use) the funds.
•the owner pays another party interest for holding and using the owners funds.
Theory behind negative interest rate
Encourages businesses and individuals to spend, lend or invest funds, rather than pay to have those funds held by a financial institution.
•used by EU central bank and Japan’s national bank
Valuation Defined
Process of assigning worth or value to something.
Financial Valuation Defined
Process of estimating the FV of an asset, liability, or an entire business.
Accounting FV Defined
Price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (per FASB).
Value is at a point in time called the …..
Measurement date.
Level 1 Inputs
Unadjusted quoted prices obtained at the measurement date in active markets for assets and liabilities identical to those being valued.
*most reliable.
Level 2 Inputs
Observable for the item being valued, either directly or indirectly but are other than quoted prices described in Level 1
- quoted prices for similar, but not identical, item in active market
- quoted prices for identical or similar item in market that is not active
- Inputs other than quoted prices that are observable for the item being valued
- Inputs derived principally from or corroborated by market data or other.
Level 3 Inputs
Unobservable for item being valued.
- based on assumptions and internal data
- should only be used when level 1 & 2 are not available.
Ex: expected cash flows, expected life of an asset, likelihood of events occurring.
3 US GAAP approaches to developing FV
- Market approach
- Income approach
- Cost approach
Market Approach (aka Sales Comparison Approach)
Uses prices other than relevant info generated by market transactions for items identical or comparable to item being valued
•common in establishing value of pre-existing house or building
Income Approach
Uses valuation techniques to convert future amounts of economic benefits or sacrifices of economic benefits to determine what the future amounts are worth at valuation date.
Techniques include: •discounted CFs •option pricing models •earnings capitalization models •etc.
Cost Approach (aka Replacement cost Approach or reproduction cost Approach)
Uses valuation techniques to determine the amount required to acquire or construct a substitute item.
- more limited than market or income approaches
- especially useful for specialized item (no comparables in the market)
Active markets include ….
Stock markets, bond markets, commodities markets, currency markets, over-the-counter markets
•active market price for identical item = FV
A market is not active when ….
- few relevant transactions are available
- prices are not current or vary substantially
- little publicly available information
Level 2 Inputs would be used when…
Examples:
•stock restricted from trading, but similar to traded shares
•securities traded in brokered markets, rather than public markets
•residential and commercial property with comparable sales
•private debt securities for which there is publicly traded debt with comparable risks and terms
Capital Asset Pricing Model (CAPM) Defined
An economic model that determines a measure of relationship between risk and expected return.
- used in valuing various assets
- incorporates risk-free rate of return and a risk measurement called “beta”
Beta Defined
Measure of systematic risk as reflected by the volatility of an investment or other asset.
•measure of volatility of an asset when compared to a benchmark for the whole class of the asset
Beta = 1
Asset being valued moves in line with benchmark
•asset being valued has the same level of systematic risk as that class of asset.
Beta > 1
Asset being valued moves greater than benchmark.
•asset being valued is more volatile (more systematic risk) than that class of asset.
Beta < 1
Asset being valued moves less than benchmark
•asset being valued is less volatile (less systematic risk) than that class of asset.
CAPM assumptions and limitations
- there is an asset class and benchmark for the asset being valued.
- all investors have equal access to all investments of the class being valued and all use a one-period time horizon.
- asset risk is measured solely by variance if the asset being valued from asset class benchmark
- no external costs involved - no commissions, taxes, etc.
- no restrictions on borrowing or lends at the risk-fees rate; all parties can do so
- uses historical data, which may not be appropriate for computing future returns.
Option Defined
Contract that entities owner to buy or sell an asset at a stated price within a specified period
- American style - option permits exercise any time before expiration
- European style - option permits exercise only at maturity date.
Black Scholes Model was Developed to value options under specific circumstances, including…
- for European call options.
- stock pays no dividends.
- stock prices increase in small increments.
- risk-free rate of return is assumed constant.
TWO NEW UNIQUE FEATURES
•uses probabilities: probability that the price of the stock (security) will pay off by expiration date & probability that the option will be exercised.
•discounting of the exercise price.
What to know for the Black Scholes Model
- It is a technique for valuing options on securities.
2. It’s different because it uses probabilities and discounting.
Binomial Model (BOMP)
Uses ‘tree’ diagram to estimate values at a number of time points between the valuation date and the expiration date.
Business Valuation Defined
The estimation of the economic value of a business entity or portion thereof.
Market Approach (aka Guideline Public Company Method)
Determined Value of a business by comparing it with highly similar entities for which there is a readily determinable market.
•adjustments can be made. (Premiums and discounts)
Income Approach
Determined Value by calculating net present value of the benefit stream generated by the entity being valued
- net present value = entity value
- net present value is calculated using discount rate
- discount rate should be based on rate of return needed to attract investor funding given the level of risk.
Alternative income Approach methods:
- Discounted cash flows–uses discounted CFs to get present value.
- Capitalization of earnings–applies capitalization or interest rate to earnings to get value.
- Earnings multiple–applies a multiple factor to earnings to get value.
- Free cash flow–applies discount rate to free cash flows to get present value. (Variation of discounted CF method)
Asset Approach
Determines value. Y adding values of individual assets that comprise the entity being valued.
- FV of each individual asset (and liability) is determined.
- sum of NET assets is value of entity.
Valuation of individual assets requires the use of specific valuation technique:
- income Approach
- market approach
- cost Approach
The asset Approach is less appropriate for …
- valuing going concern
* valuing non-controlling interest
The asset Approach is more appropriate for …
- valuing entity in liquidation
* for entity with little or no cash flows or earnings.
The P/E ratio (price/earnings) for a share of common stock is computed as
Market price / EPS
•both values are on a per share basis.
Hedging Defined
A management strategy for mitigating (reducing) the risk of loss associated with certain transactions and positions.
•the purpose of hedging is not to make a profit, but to reduce risk.
Hedged Item Defined
The recognized asset, recognized liability, firm commitment, planned transaction or other item that is at risk of loss.
Hedging Instrument Defined
The contract (or other arrangement) entered into to mitigate (or eliminate) the risk of loss associated with the hedged item.
•primary instrument used in finance is the derivative.
Derivatives are contracts with all 3 of the following elements…
- One or more “underlyings” and one of more “notional amounts”.
- Requires no initial net investment or one that is smaller than would be required for other types of similar contracts.
- Terms requires or permit a net cash settlement. (Doesn’t need to fulfill the contract if cash can be paid - most derivatives are settled with cash for the net difference between the contract price and the market price).
Derivatives: underlying Defined
A specified price, rate or other variable (ex: stock price, a commodity price, and interest rate, a foreign exchange rate, etc.)
Derivatives: notional amount Defined
A specified unit or measure (ex: shares of stock, pounds or bushels of a commodity, number of currency units, etc.)
Derivative value (or settlement amount) of a derivative instrument Is determined as…
Units of notional Amount X underlying
Ex: number of shares of stock X price per share
Major derivative instruments include (4)…
- Futures contracts
- Forward contracts
- Option contracts
- Swap contracts
Futures contracts
Contract to deliver or receive a commodity, foreign currency, security instrument, or other asset in the future at a price set now.
- executed through a clearinghouse (futures exchange)
- standardized contract terms - item, quantity, quality, delivery
- Have margin requirements, marked-to-market and settled daily.
Forward Contracts
- executed directly between contracting parties
- can be customized to any item, quantity, delivery date, etc.
- settled only at end of contract (expiration)
- gain on forward contract would be recognized as payment from counterparts to settle contract (ex: cash settlement in lieu of delivery of inventory)
Option Contracts
Contract between a buyer and seller that give the buyer of the option the right to buy (call option) or sell (put option) a particular asset in the future at a price set now (strike price).
- buyer had the right to buy or sell, but it not required to do so.
- buyer will exercise option only if economically favorable to do so.
- Contracts are traded either on an exchange or over-the-counter as contracts negotiated between parties.
Swap contracts
Contract between a buyer and seller by which they agree t exchange cash flows (typically related to interest), currencies, commodities, or risk.
- executed directly between contracting parties.
- can be customized for any item, amount or length of time.
- for CF swaps, commonly only interest CFs are swapped, not principal amounts.
Capital Budgeting Defined
The process of measuring, evaluating and selecting long-term investment opportunities for a firm.
Project Risks: Risk Defined
The possibility of loss or other unfavorable results that derives from uncertainty implicit in future outcomes.
Risk-Reward Relationship: Reward Defined
The benefit expected or required from investment of resources in capital projects and other undertakings.
Evaluation and selection of captain projects: payback period Approach
Determines the number of years needed to recover the initial cash investment in a project and compares that time with a pre-established maximum payback period.
- if payback period is less than or equal to maximum period = accept project
- if payback period is greater than maximum period = reject project
•useful in evaluating project liquidity.
