CFA 4_Corp Finance

Question 1

Payback period (discounted or undiscounted)

Answer 1

The number of years required to recover initial cash outlay for investment. Used as a measure for liquidity purposes; however is useless as measure of profitability.

Question 2

Profitability index

Answer 2

PI = PV of future cash flows / CF0 [initial cash outlay]

Closely related to NPV, and follows same decision rules. If PI > 1.0 accept project.

Question 3

Crossover rate

Answer 3

Discount rate that makes NPVs of multiple projects equal. To find it, take the difference of each CF of two projects, and then take the IRR of those. That IRR is the crossover rate.

Question 4

NPV

Answer 4

PV of expected future cash flows. If NPV > 0 accept project.

NPV is the only acceptable criterion when ranking multiple projects. This is because IRR can be misleading due to 1) cash flow timing; 2) project size; 3) assumption of how project cash flows are reinvested.

NPV does however have the disadvantage of not considering the size of the project compared to the expected increase in value. NPV theoretically should increase stock price proportionate to the increase in firm value expected.

Question 5

IRR

Answer 5

Discount rate that makes PV of expected cash inflows equal to initial cost of project (ie makes NPV = 0). If IRR > required rate of return, accept the project. IRR can be misleading due to 1) cash flow timing; 2) project size; 3) assumption of how project cash flows are reinvested. In an unconventional CF pattern there can be multiple or no IRR(s).

Question 6

Weighted Average Cost of Capital (aka marginal cost of capital)

Answer 6

WACC = (Wd)(Kd(1 - tax rate)) + (Wps)(Kps) + (Wce)(Kce)

The weighted cost of debt (after tax) + weighted cost of preferred stock + weighted cost of common stock (equity). Weighting should be based off target capital structure. WACC should be used as discount rate in NPV calculations, and reference rate for IRR consideration. Kd = YTM

Question 7

Determine weight of debt from D/E ratio

Answer 7

Wd = (D/E) / (1 + D/E)

Question 8

Cost of preferred stock

Answer 8

Kps = preferred dividend [Dps] / market price of preferred share [P}* P = Dps / Kps

Question 9

Capital Asset Pricing Model (CAPM) for determining cost of equity capital

Answer 9

Kce = RFR + B*(E(Rm) - RFR)

Where E(Rm) is the expected RoR on the market. E(Rm) - RFR is the equity risk premium.

Question 10

Dividend discount model for determining cost of equity capital

Answer 10

Kce = (D1/P0) + g

Where P0 is current price and D1 is next year’s dividend.g = (1 - payout rate [retention rate])*(ROE)

Question 11

Bond yield plus risk premium approach for determining cost of equity capital

Answer 11

Kce = bond yield + risk premium

Question 12

Calculating project beta (pure-play method)

Answer 12

Basset = Bequity * [1 / (1 + ((1 - t) * d/e)]

This is a comparable company’s D/E ratio and tax rate. Unlevers.

Bproject = Basset * [1 + ((1 - t) * d/e)]

This is the subject’s D/E ratio and tax rate. Re-levers.

Question 13

CAPM adjusted for country risk premium

Answer 13

Kce = RFR + B*(E(Rm) - RFR + CRP)

Only difference from normal CAPM is “+ CRP” (country risk premium)

CRP = SYS * (annualized SD of equity index of developing country / annualized SD of sovereign bond market in terms of USD market)

Sovereign Yield Spread = difference b/w yield of govt bonds in developing country and similar Treasury bonds

Question 14

Calculation of break points (point when a component of a company’s WACC changes)

Answer 14

break point = amount of capital at which component’s cost of capital changes / weight of that component

Question 15

How flotation costs affect capital decisions

Answer 15

Flotation costs should be treated as an initial cash outflow that affects the NPV calculation.They should NOT directly adjust the cost of equity, because they are not an ongoing expense for the firm.

Question 16

Degree of operating leverage (DOL)

Answer 16

DOL = % change in EBIT / % change in sales

DOL is higher at lower levels of sales, and declines at higher levels of sales.

Question 17

Degree of operating leverage (DOL) for particular level of unit sales

Answer 17

DOL = (Q * (Price - Variable cost p unit)) / (Q * (Price - Variable cost p unit) - Fixed costs)

ie: DOL = Q * Contribution margin / Q * Contribution margin - FC

nb if you subtract Interest from denominator above it calculated for DTL

which becomes

DTL = (Revenue - TVC) / (Revenue - TVC - FC)*nb: DTL = (Rev - TVC) / (Rev - TVC - FC - I)

Question 18

Degree of financial leverage (DFL)

Answer 18

DFL = % change in EPS [or net income] / % change in EBIT

Question 19

Degree of financial leverage (DFL) for particular level of operating earnings

Answer 19

DFL = EBIT / (EBIT - interest)

Question 20

Degree of total leverage (DTL)

Answer 20

DTL = DOL * DFL

DTL = % change in EPS [net income] / % change in sales

DTL = (Q * (P - VC)) / (Q * (P - VC) - FC - I)DTL = (Rev - TVC) / (Rev - TVC - FC - I)

Question 21

Breakeven quantity of sales

Answer 21

Level of sales a firm must generate to cover all of its fixed and variable costs.

Qbe = (fixed operating costs + fixed financing costs) / contribution margin

contribution margin = price - variable cost per unit

OPERATING breakeven quantity of sales = fixed operating costs / contribution margin

Operating doesn’t include fixed financing costs.

Question 22

Operating breakeven quantity of sales

Answer 22

fixed operating costs / contribution margin

NB: doesn’t include fixed financing costs.

Question 23

Components of business risk

Answer 23

Sales risk: uncertainty about firm’s sales

Operating risk: uncertainty about EBIT caused by fixed operating costs

Question 24

Effect of dividend payment on firm

Answer 24

Reduces assets (cash) and equity (retained earnings). Result is increased debt/asset ratio and increased debt/equity ratio.

Question 25

Ex-dividend date / Holder-of-record date

Answer 25

Ex-dividend date: Cutoff date for receiving dividend after declaration date. You will only receive dividend if you buy BEFORE the ex-dividend date, not on it. Occurs 2 days before holder-of-record date.Holder-of-record date: Date on which shareholders of record are designated to receive the dividend. Payment date comes later.

The ex-dividend date is normally determined by the Securities Exchange on which the shares are listed. The corporation determines the holder-of-record date and declaration date.

Question 26

Earnings yield

Answer 26

EPS / Share price

In a share repurchase, if EY is greater than after-tax yield on funds to repurchase shares, then EPS will rise.

In a share repurchase, if EY is less than after-tax yield on funds to repurchase shares, then EPS will fall.

Given the price-to-earnings ratio (P/E) we can compute earnings yield by just flipping the terms.

Question 27

EPS after share buyback

Answer 27

total earnings - after tax cost of funds / shares outstanding after buyback

Question 28

Book value per share after share buyback

Answer 28

BVPS = Book value before repurchase - Amount of buyback / Number of shares after buyback

BVPS will decrease if repurchase price is greater than original BVPS.

BVPS will increase if repurchase price is less than original BVPS.

Question 29

Primary sources of liquidity [3]

Answer 29

1) Cash balances; 2) Short-term funding; 3) Cash flow management

Question 30

Operating cycle

Answer 30

days of inventory + days of receivables

The avg number of days it takes to turn raw materials into cash proceeds.

Days of inventory = 365 / inventory turnover

Days of receivables = 365 / receivables turnover

Question 31

Cash conversion cycle

Answer 31

avg days of inventory + avg days of receivables - avg days of payables

Question 32

Float factor

Answer 32

Avg daily float / (Amt of checks deposited / Days in month)

Question 33

% discount from face value

Answer 33

face value - price / face value

Question 34

Discount-basis yield (bank discount yield)

Answer 34

(face value - price / face value) * (360 / days)

Question 35

Money market yield

Answer 35

(face value - price / price) * (360 / days)

Question 36

BEY for ST discount securities

Answer 36

(face value - price / price) * (365 / days)

Same as Money market yield, except 365 days

Question 37

Cost of trade credit (cost of not taking trade discount)

Answer 37

[1 + (% discount / 1 - % discount)]^(365/days past discount) - 1

Question 38

Number of days of payables

Answer 38

accounts payable / avg day’s purchases

Question 39

Effective annualized cost of a line of credit

Answer 39

(Interest + Commitment fee / Usable loan amount) * 12

Question 40

Effective annualized cost of a banker’s acceptance

Answer 40

(interest / loan amount - interest) * 12

eg. The effective annualized cost (%) of a banker’s acceptance that has an all-inclusive annual rate of 5.25% for a one-month loan of $2,000,000 is closest to:

(2,000,000 * 0.0525 * 1/12) / (2,000,000 * (1 - 0.0525 * 1/12)) * 12

Question 41

Effective annualized cost of commercial paper

Answer 41

(interest + dealer’s commission + backup costs / loan amount - interest) * 12

Question 42

Open-end fund

Answer 42

Trade at NAV (no premium or discount). Managers use invested cash of new investors to invest in new securities. Investors can redeem shares (sell them back to fund) at NAV.

Closed-end fund: managers do not take new investments or redeem investor shares.

Question 43

Mutually exclusive vs. independent projects

Answer 43

Mutually exclusive: only ONE project in a set of possible projects can be accepted. Don’t be fooled by misleading answers.

Independent: projects that are unrelated and both can be accepted.

Question 44

Pull vs. Drag on liquidity

Answer 44

A “pull” on liquidity occurs when disbursements are made too quickly (e.g. current liabilities are paid instead of being held or when credit availability is reduced or limited). A “drag” on liquidity occurs when receipts lag (i.e. non-cash current assets do not convert to cash quickly). Consequently, a reduction in a credit line is a “pull” on liquidity.