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BEC > Capital Budgeting > Flashcards

Capital Budgeting Flashcards

1
Q

What is the formula for the payback period?

A

Initial investment / After tax annual net cash flows =

Length of time to recover investment

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2
Q

What is the formula for IRR?

A

Investment / Annual cash flows = PV factor

Discount rate where NPV = 0

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3
Q

What is the formula for ARR?

A

Accounting income / Average investment = ROI

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4
Q

What is the formula for NPV?

A

PV cash inflows using cost of capital rate (hurdle rate)
- PV cash outflows
= NPV

(+) = good
(-) = bad
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5
Q

What are advantages and disadvantages of payback period?

A

A - easy to understand

D - does not take into account time value of money

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6
Q

What are advantages and disadvantages of IRR?

A

A - takes into account time value of money, takes into account investments with similar risk, more understandable than NPV
D - some cash flows may yield multiple IRRs, some may not have IRR that NPV = 0

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7
Q

What are the advantages and disadvantages of ARR?

A

A - easy to understand
D - does not take into account time value of money, does not account for different risk, different depreciation methods yield different ARRs

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8
Q

What are advantages and disadvantages of NPV?

A

A - takes into account time value of money, takes into account risk, takes into account total profitability, yield results in dollars
D - more complex, some may not understand, does not take into account managers not following scheduled cash flows

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9
Q

What is the relationship between IRR and NPV?

A

NPV > 0, IRR > discount or hurdle rate
NPV = 0, IRR = discount or hurdle rate
NPV < 0, IRR < discount or hurdle rate

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10
Q

What is the profitability index?

A

Ratio of PV of cash inflows to initial cost of project, used to decide which project to invest in first

PV annual after-tax cash flows / Original investment

Index > 1 is good

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11
Q

What is the formula for annual financing costs?

A

AFC =
Discount % / (100% - Discount %)
x
365 or 360 / (Total pay period - Discount period)

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12
Q

What is the formula to calculate the cost of a loan?

A

Interest paid / (Principal - Compensating balance)

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13
Q

What are examples of positive debt covenants?

A

Provide annual audited F/S
Maintain certain financial ratios
Maintain life insurance for key employees

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14
Q

What are examples of negative debt covenants?

A

Not borrowing additional sums
Not selling certain assets
Not exceeding certain levels of dividend payments
Not exceeding compensation limits

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15
Q

What is the formula for the current yield?

A

Annual interest paid / Bond market price

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16
Q

What is the formula for the effective annual interest rate?

A

EAR = (1 + r/m) m power - 1

r = stated interest rate
m = compounding frequency
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17
Q

What are advantages of debt financing?

A 
Tax deductible
Fixed payment
Do not give up control 
Excess earnings go to owners
Lower issue costs
During inflation debt paid back with less valuable dollars
18
Q

What are disadvantages of debt financing?

A

Pre-determined payments
Lose flexibility due to covenants
High debt increases risk

19
Q

What are advantages of C/S financing?

A

Flexibility in amount of dividend
Less risk
Attractive to investors

20
Q

What are disadvantages of C/S financing?

A

Higher issue costs
Ownership dilution with new issues
Not tax deductible
Results in higher cost of capital

21
Q

What are advantages of P/S financing?

A

Flexibility to skip dividends
Less risk
C/S holders do not give up control
Company usually keeps excess earnings

22
Q

What are disadvantages of P/S financing?

A

Higher issue costs
Not tax deductible
Issues with dividends in arrears

23
Q

What is the Degree of Operating Leverage?

A

Measures how the size of a business’s fixed costs affects its performance when revenues change

DOL = % change in EBIT / % change in sales volume

24
Q

What is the Degree of Financial Leverage?

A

Measures how much a business relies on debt financing

DFL = % change in EPS / % change in EBIT

25
Q

How is the cost of debt financing calculated?

A

Either:
Yield to maturity x (1 - tax rate)
or
(Interest expense - tax deduction for interest) / Carrying value of debt

26
Q

How is the cost of P/S financing calculated?

A

Dividend / Net issue price

27
Q

How is the cost of existing C/S financing calculated?

A

CAPM = Risk free rate + ((Expected market rate - risk free rate) x Beta)
or
Dividend Yield + Growth Rate =
Next expected dividend / Current stock price + Expected growth in earnings

28
Q

How is the cost of new C/S financing calculated?

A

Next expected dividend / (Current stock price - flotation costs) + Expected growth in earnings

29
Q

What is the Weighted Average Cost of Capital?

A

Calculates firm’s effective cost of capital by multiplying portion financed with debt, P/S, and C/S
Businesses seek to minimize WACC

30
Q

What is formula for Free Cash Flow?

A

NOPAT + Depreciation + Amortization - Capital Expenditures - Net increase in WC

31
Q

What is formula for Residual Income?

A

Net Income - Interest on investment

Interest on investment = Invested capital x RRR

32
Q

What is formula for Economic Value Added?

A

NOPAT - Cost of financing

Cost of financing = (Total assets - Current liabilities or Invested Capital) x WACC

33
Q

What is formula for Economic Rate of Return on C/S?

A

Dividends + Change in price / Beginning price

34
Q

What is formula for ROI?

A

Either:
Net Income / Total assets or average invested capital
or
Return on sales (NI / Sales) x Asset turnover (Sales / Total Assets)

35
Q

What is formula for Return on Assets?

A

Net Income / Average total assets

36
Q

What is formula for Return on Equity?

A

Net Income - Preferred dividends / Average common S/E

37
Q

What is formula for Times Interest Earned Ratio?

A

EBIT / Interest expense

38
Q

What is formula for Market Capitalization?

A

C/S price per share x C/S share O/S

39
Q

What is formula for Market/Book Ratio?

A

Either:
C/S price per share / BV per share
or
Market Cap / C/S equity

40
Q

What is formula for BV per share?

A

C/S equity / C/S shares O/S

41
Q

What is formula for PE ratio?

A

C/S price per share / EPS

BEC (14 decks)

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