BEC Lecture 3 Flashcards
Define sunk costs.
Sunk costs are those costs that have already been incurred, are unavoidable in the future, and will not vary with the course of action taken.
What is the formula for after-tax cash flow?
After-tax cash flow =
(1 - Tax rate) x Pretax cash flows
The formula for computing a depreciation tax shield is:
Tax savings from the depreciation tax shield =
Tax rate x Depreciation deduction
What are the three general stages in which capital investment cash flows are categorized?
- Cash flows at the inception of the project
- Operating cash flows
- Cash flows from the disposal of the project
What approaches can management take to select the desired rate of return for a project?
- Use a weighted average cost of capital (WACC) method
- Assign a target rate for new projects
- Recommend that the discount rate be related to the risk of the project
Define net present value (NPV).
NPV is the difference between the present value of the cash inflows and outflows from a project.
How are investment decisions made using the NPV method?
If NPV is positive, then the investment should be made. If NPV is negative, then the investment should not be made.
What is the profitability index?
The ratio of the present value of net future cash inflows to the present value of the net initial investment. The higher the profitability ratio, the more desirable the project.
Define internal rate of return (IRR).
The IRR is the discount rate at which the present value of the cash inflows equals the present value of the cash outflows from the investment or project.
How are investment decisions made using the IRR?
An investment should be made when the IRR exceeds the hurdle rate.
What is the payback method formula?
Payback period =
Net initial investment
Increase in annual net after-tax cash flow
What is the equation to calculate the present value of $1?
PV = FV/ (1 + r)n
where:
- PV = present value
- FV = future value
- r = interest rate
- n = number of years
What is the equation to calculate the present value of an annuity?
PV = PMT x [1 - Lump sum*] / r
where:
- Lump sum is the PV of $1 in the final year
- PV = present value
- FV = future value
- r = interest rate
- n = number of years
Define operating leverage.
Operating leverage is defined as the degree to which a firm uses fixed operating costs, as opposed to variable operating costs.
Define financial leverage.
Financial leverage is defined as the degree to which a firm’s use of debt to finance the firm magnifies the effects of a given percentage change in EBIT on the percentage change in EP.
Define weighted average cost of capital (WACC).
The weighted average cost of capital is the average cost of debt and equity financing associated with the firm’s existing assets and operations.
What is the after-tax cost of debt formula (kdx)?
kdx = Pretax cost of debt x (1 - Tax rate)
What is the cost of preferred stock formula (kps)?
kps = Dps/Nps
- Dps = Preferred stock cash dividends
- Nps = Net proceeds of preferred stock
What is the cost of retained earnings (kre) using the CAPM formula?
kre = krf + risk premium kre = krf + [bi x (km-krf)]
- krf = Risk-free rate
- bi = Beta coefficient of the stock
- (km-krf) = PMR = Market risk premium
- km = Market rate
What is the cost of retained earnings (kre) using discounted cash flow (DCF)?
kre
What is the cost of retained earnings (kre) under bond yield plus risk premium (BYRP)?
kre = kdt + PMR
- kdt = Pretax cost of debt
- PMR = Market risk premium
Define the weighted average cost of capital by formula.
This is the terminology used in the cost of capital and it part of the WACC formula:
- wdx = (weight for) long term debt
- wpc = (weight for) preferred stock
- wcs = (weight for) common stock equity
- kwc = weighted average cost of capital
“k” stands does for the specific COST of each type of capital, and “w” stands for the WEIGHT of each. So, WACC would be:
kwc = (kdx x wdx) + (kds x wps) + (kre x wce)
Define return on investment (ROI).
Return on investment is used to assess the percentage of return relative to capital investment risk. ROI can be calulated as income divided by invested capital or as a product of profit margin (income/sales) and investment turnover (sales/assets).
What are the limitations of ROI?
- Short-term focus
- Disincentive to invest
Define return on equity (ROE).
ROE is a measure of the rate of return earned by a company on the equity component of its capital structure. It shows how well a company is using its funds to generate earnings.
What is the equation for the DuPont ROE?
DuPont ROE =
Net profit margin x Asset Turnover x Financial leverage
where:
- Net profit margin = Net income/Sales
- Asset Turnover = Sales/Average total assets
- Financial leverage = Average total assets/Equity
What is the equation for the extended DuPont ROE?
Extended DuPont ROE =
Tax Burden x Interest Burden x Operating Income Margin
x Asset Turnover x Financial Leverage
where:
- Tax Burden = Net Income/Pretax income
- Interest Burden = Pretax Income/EBIT
- Operating income margin = EBIT/Sales
- Asset Turnover = Sales/Average total assets
- Financial Leverage = Average total assets/Equity
Define residual income.
The residual income method measures the excess of actual income earned by an investment over the hurdle rate.
What is the formula for residual income?
Residual income = Net income - Required return
Where the Required Return is equal to:
Net book value x Hurdle rate = Required return
If the amount of income from the investment exceeds the computed required return, performance objectives have been met.
Define economic value added (EVA).
How does EVA differ from residual income?
EVA measures the excess of income after taxes earned by an investment over the rate of return defined by the company’s WACC. EVA differs from residual income in the following ways:
- WACC must be used to calculate EVA.
- The income and investment numbers used to calculate EVA are generally adjusted to produce a more accurate analysis of economic profit.
Define the steps and formula for economic value added.
Step 1: Calculate the required amount of return and income after taxes.
Investment x Cost of capital = Required return
Step 2: Compare income to the required return.
Income after taxes - Required return = Economic value added
What is the formula for working capital?
Current assets - Current liabilities = Working capital
What are three common motivations for holding cash?
-
Transaction Motive
A transaction motive for holding cash concerns having enough cash to meet payments arising from the ordinary course of business. -
Speculative Motive
A speculative motive for holding cash concerns having enough cash to take advantage of temporary opportunities. -
Precautionary Motive
A precautionary motive for holding cash concerns having enough cash to maintain a safety cushion so that unexpected needs may be met.
What methods can be used to speed collections?
- Customer screening
- Prompt billing
- Payment discounts
- Expedite deposits
- Concentration banking
- Factoring accounts receivable
What methods can be used to delay disbursements?
- Defer payments
- Drafts
- Line of credit
- Zero-balance accounts
What is the formula for computing the annual percentage rate for quick payments discounts?
Period rate x Number of periods per year
Period Rate =
Discount %
100% - Discount %
Periods in a Year =
360
Pay period - Discount period
What is the cash conversion cycle formula?
Cash Conversion Cycle =
Inventory Conversion Period
+ Receivables Collection Period
- Payables Deferral Period
How is the inventory conversion period calculated?
Inventory turnover =
Cost of Goods Sold
Average Inventory
Inventory conversion period =
365
Inventory turnover
How is the receivables collection period calculated?
AR turnover =
Sales
Average AR
Receivables collection period =
365
AR turnover
How is the payables deferral period calculated?
AP turnover =
Cost of goods sold
Average AP
Payables deferral period =
365
AP turnover
Explain factoring as a mechanism for speeding cash collections.
Factoring involves the sale of accounts receivable to another party (a factor) in exchange for cash.
The selling company will receive an upfront cash advance of X% of their receivables and will be charged both a fee on all receivables purchased and an interest rate on the upfront advance (while saving on collection related expenses).
The factor will collect the fees and interest, while assuming the responsibility of collection on the receivables owed by the customers of the selling company.
What is the equation to calculate the reorder point for inventory?
Reorder point =
Safety stock + (Lead time x Sales during lead time)
What is the equation for economic order quantity (EOQ)?
E = Square root (2SO / C)
- E = Order Size
- S = Sales in Units
- O = Cost per Purchase Order
- C = Carrying Cost per Unit
