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BEC > Capital Structure > Flashcards

Capital Structure Flashcards

1
Q

What is capital structure

A

This is how a firm uses different sources of funds to finance its operations and growth

This is in a combination of debt and equity

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2
Q

What is the cost of capital

A

This is evaluating the opportunity cost of using capital in one project (or investment) versus another.

Example - you have 10M to spend - you can upgrade equipment or purchase bands.

You evaluate the expected returns on each to see which is the better use of the 10M

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3
Q

How do you calculate the Weighted Average Cost of Capital

A

It is taking the relative weighted costs of different capital sources to arrive at a single or weighted average cost of capital

Thi sis then used as a benchmark to evaluate future projects or investments:

Example: My capital cost is 9% - therefore any project or investment need to be greater than 9% for me to consider doing it

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4
Q

Asset Structure

A

This is how a business uses assets to generate earnings - usually ROA - Return on Assets

first thing management will decide is how to acquire assets : what blend of debt and equity financing should be used to get the capital that I need to then go out and buy the assets thatI need

The second issue is how can the business maximize the returns on the asset base

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5
Q

What is the formula ROA

A

Return on Assets = Net Income / Total Assets

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6
Q

What is the difference between asset structure and capital structure

A

Capital structure - is long term debt and equity

Asset Structure are the assets listed on the balance sheet

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7
Q

What is the difference between current assets and long term assets

A

Current Assets - provide the companies liquidity

Long Term assets are geared toward generating earnings

What type of long term assets a business holds depends on the businesses strategic goals and nature of its business, industry and markets it operated in

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8
Q

What are Loan covenants

A

These are restrictions/requirements places on a loan or a line of credit by the lender

If the lender is out of compliance - the loan is due immediately

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9
Q

What are examples of loan covenants

A

Meeting ratios - debt to equity ratios or working capital requirements

Limits on taking on additional debt

Collateral attached to a loan

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10
Q

What are growth ratios and examples

A

These are used to evaluate an entire business , their earnings or sale, expenses, or even entire economies

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11
Q

What are the measures of profitability: Profit Margin, Return on Assets, Return on Equity

A

Profit Margin: gross margin, Contribution Margin, operating margin Pretax margin, Net profit margin

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12
Q

Gross Margin

A

Revenue - COGS

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13
Q

Contribution Margin

A

Revenue - Variable Expenses

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14
Q

Operating Margin

A

Operating Income / Revenue

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15
Q

Pretax Margin

A

Earnings before Tax / Revenue

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16
Q

Net Profit margin

A

Net income / Revenue

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17
Q

What is financial leverage

A

This is the amount of debt a business uses to buy assets

It s really the ratio of debt to equity that business uses to acquire assets

Example: ABC buy equipment for 10K down and a loan of 90K. ABC earns 20K with the equipment. ROA is 20K / 10K = 200%

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18
Q

The rules on leverage and risk

A

the more leverage you use - the more risk

The more debt you take on the higher your chances that you wont or can’t pay it back

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19
Q

What business types make the risk of high leverage more risky

A

This risk is increased with cyclical businesses

Also veyr risky for businesses with low barriers to entry - because competition can make sales fluctuate

Best to be a business with steady and predictable revenue

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20
Q

What are the tax advantages of debt

A

Interest expense is deductible

But is a company increases their amount of debt - lenders will tighten their conditions

  • they will charge higher interest rates, have more restrictive covenants
  • This will result in increasing your risk of default
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21
Q

What is working capital

A

This is the difference between a firm’s current assets and its current liabilities

The point is that working capital is to meet the need of the company

Example - purchasing inventory and having enough cash to meet obligations when they come due

Current Assets - Current Liabilities

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22
Q

Liquidity Ratio:

Working Capital
Current Ratio
Quick Ratio

A

working capital - CA - CL

current ratio - CA / CL

Quick ration CA - inventory and prepaids / CL

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23
Q

times interest earned

A

(Net Income + Interest expense + Income Tax Expense) / Interest expense

This is the measure of the ability of current earnings to cover interest payment for a given period

24
Q

average collections period

A

365 * Avg. A/R / credit sale sales

this measures how long it takes of rte business to receive payment owed from A/R

25
Q

What is the cash conversion cycle

A

Days inventory outstanding + Days sales outstanding + Days payable outstanding

It measures how long it takes cash invested in inventory to return as cash received from customers

days inventory outstanding - # of days it takes to sell a batch of inventory

days sales outstanding - # of days needed to collect account receivable

days payable outstanding - # of days before the business needs to pay its own bills

26
Q

why is it a good idea to not pay your bills soon

A

The longer you wait - the longer you can hold and invest cash

27
Q

Inventory Turnover

A

COGS / Avg Inventory

Inventory turnover measures how many times inventory is cycled through in a period

It can help identify over and under stocking inventory, obsolete, or slow moving inventory

28
Q

receivables turnover

A

net credit sales / Avg receivables

This measures how many times receivables are earned and collected in a period.

It indicates the effectiveness of the collections policies

29
Q

What is the objective of inventory management

A

It is to determine ad maintain optimal amounts of all inventories

30
Q

How do you decide what is the optimal level of inventory a company should maintain

A

The cost of inventory is directly related to how much inventory a company should keep on hand.

if the costs of carrying inventory are rising - should keep as little as possible

If the costs of carrying inventory are falling then you should carry more inventory

31
Q

What is JIT inventory

A

It reduces inventory on hand - thus reducing unnecessary costs

JIT depends on the following:

  • more frequent deliveries by suppliers
  • vendor’s will guarantee their products are free from defects - so do not need to be inspected by you when they are delivered
  • It reduces inventory in hand and therefore is a higher risk of running out of inventory
  • carrying costs are lower
32
Q

Accounts Payable Management

A

The most important thing is that businesses pay their bills on time

  • improves relationship with vendors and suppliers
  • Will get better discounts and credit terms
  • These better discounts will boost profitability
  • Cashflow is essentail because you need enough of it on hand to take advantage of discounts
33
Q

LOC - and debt covenants

A

LOC - nothing is owed until you charge against it

Debt convenants - these are with long term debt -

  • They usually include stipulations on maintaining a certain level of working capital or staying above a working capital ratio
34
Q

Cash Management

A
  • This is trying to make sure a firm doesn’t have too much cash or not enough cash
35
Q

What if you have too much cash or too little

A
  • This is an inefficient use of resources

- Too little causes problems of liquidity

36
Q

What is a lockbox system

A
  • Customer spay directly to the bank in a lock box - bank employees are the only ones who deal with the cash

lots of key controls here - very safe

37
Q

zero balance account

A
  • This a cash management tool that removes any excess cash at the end of each day
  • This is used for special purposes like paying payroll checks
38
Q

Accounts receivable Management

A
  • The goal here is to maximize profits
  • If you grant credit too easily ( loosely) then you run the risk of increasing your bad debt because too many people are not credit worthy
  • If your policies are too tight - you might turn down customer that would actually pay
39
Q

What is with A/R turnover and how do you use it

A
  • You want to turnover receivables as many times as possible during a year
  • the more you do it - it shows you are efficient you are at collecting cash on credit sales
  • This way fewer credit sales are written off
  • a lower number is best
40
Q

Why do you want to factor your receivable

A

Sell to a third party at a discount in order to get cash sooner than waiting for the customers to pay

Accepting credit cards is an example of factoring. you get cash from the credit card company in exchange for a fee - this way the risk that the customer does not pay is transferred to Visa - its their problem

41
Q

Financial Valuation Methods

A

This is the process of assigning value to assets an liabilities

42
Q

Three levels of determining fair value

A

I - highest and most reliable - - observable quoted market prices for identical assets/liabilities in an active market.

II - observable quotes for SIMILAR assets liabilities in an active market

III - These are unobservable - estimates based on judgements

43
Q

Three Valuation approach sot develop fair value

A

Market - uses prices etc. generated by market transactions that are identical or comparable to those being valued

Income - converts future amounts to PV to see what the future amounts are worth

Cost approach - what would it cost to construct a replacement item

44
Q

What is GAAP’s real about about valuation

A

It is based on exit price ( not replacement cost) It is the amount you would receive to sell an asset or be paid to transfer a liability

arms length transactions

BOTH location and conditions are taken into account when determining price

45
Q

Options pricing - Black Scholes model - advantages and disadvantages

A

There are advantages and disadvantages to the Black Scholes model:

Limitations

  • It assumes the stock does not pay dividends
  • It assumes the risk-free rate of return for discounting remains constant
  • It assumes the option can be exercised only at the expiration date

Advantages

  • It discounts the exercise price
  • It uses the probability that the option will be exercised
  • It uses the probability that the price of the stock will pay off within the time of expiration
46
Q

What is binomial Option Pricing

A

This is a pricing method for options where a price tree and probable values are calculated based on volatility,expiration dates, and probabilities

47
Q

CAPM - Capital Asset Pricing Model

A

This is a model that evaluates the relationship between risk and expected return for assets, but usually stocks

it uses:

1) the risk-free rate of return
2) Beta

48
Q

What is the risk free rate of return

A

Thi sis the hypothetical rate for return for “no-risk” and is based on the rate for a 3-month US treasury Bill

49
Q

What is Beta

A

This is a measure of how volatile an investment is compared to the rest of the market

Beta of 1 = means its equal
Beta of .5 means its half as volatile as comparable items

Beta of 1.5 = means it is 1/2 MORE volatile than comparable items

50
Q

What is the formula for CAPM

A

RRR - RFR = B (Err - RFR)

RRR - required rate of return
RFR - risk free rate of return
Beta - a measure of volatility
ERR - Expected rate of return

51
Q

Dividend Discount Model

A

This model uses the predicted dividends of a company and discounts them back to PV

If the PV of the dividend of a per share basis > current share price = stock is undervalued and a good investment

If PV of dividend per share < current share price = stock is overvalued and is a bad investment

52
Q

How do you value a business

A

Market approach - Your business is compared to other similar businesses with similar characteristics in the same market

Income Approach - A fair value is derived from the businesses’s income streams - use net PV or a discount cash flow

Asset Approach - The fair values of the individual assets of the business are added up and equal the value of the business - used when a business is liquidated to pay its debts

53
Q

Comparing Investments: Payback period approach

A

The payback period approach determines how many years it will take to recover the initial investment cost

You take the upfront projected cost and divide it bytes expected annual cashflows

Its easy to use and understand

disadvantage - it ignores the time value of money, it ignores cashflow you will get after the payback period, and it doesn’t measure total project profitability

54
Q

Comparing Investments: Net present value

A

It compares the present value of expected cash flows of the project to the initial cash investment in the project

If net present value is zero or positive - then the project is considered economically feasible

55
Q

Comparing Investments: Economic Value Added

A

This is a metric to measure economic profit

It also is a form of measuring residual income

EVA = Net Operating Profit After Tax ( NOPAT) - (Invested Capital * Weighted average)

56
Q

Comparing Investments: Discounted Cash Flows (DCF)

A

DCF is a method of discounting future cash flows of a business to present value on a per-share basis to compare to the current share price to see if a potential investment is under valued or overvalued by the market

57
Q

Comparing Investments: Internal Rate of Return

A

This method determines the discount rate that would make the net present value of after-tax cashflows equal to zero . Then any potential investment or project that returns an IRR greater than zero would have a value

BEC (30 decks)

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