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