CH3 Flashcards
IRRELEVANT COSTS
COSTS THAT WILL BE THE SAME REGARDLESS OF THE CHOCSEN COURSE OF ACTION AND ARE USUALLY UNAVOIDABLE. THEY INCLUDE:
- UNAVOIDABLE COSTS
- SUNK COSTS
UNAVOIDABLE COSTS
COSTS THAT WILL BE THE SAME REGARDLESS OF THE CHOSEN COURSE OF ACTION AND ARE NOT RELEVANT TO FUTURE DECISION.
SUNK COSTS
UNAVOIDABLE COSTS BECAUSE THEY WERE INCURRED IN THE PAST AND CANNOT BE RECOVERED AS A REUSLT OF THE DECISION.
CASH FLOW EFFECTS
-DIRECT
DIRECT EFFECT MEANS THAT IT HAS AN IMMEDIATE EFFECT ON THE AMOUNT OF CASH AVAILABLE. FOR EXAMPLE, THE COMPANY DOES THE FOLLOWING:
- PAYS OUT CASH
- RECEIVES CASH
- MAKES A CASH COMMITMENT THAT IS DIRECTLY RELATED TO THE CAPITAL INVESTMENT
CASH FLOW EFFECTS
-INDIRECT EFFECT
TRANSACTIONS EITHER INDIRECTLY ASSOCIATED WITH A CAPITAL PROJECT OR THAT REPRESENT NON-CASH ACTIVITY THAT PRODUCES CASH BENEFITS OR OBLIGATIONS, FOR EXAMPLE:
-DEPRECIATION
NET EFFECT
IS THE TOTAL DIRECT AND INDIRECT EFFECTS OF CASH FLOWS FROM A CAPITAL INVESTMENT.
STAGES OF CASH FLOWS
- INCEPTION OF THE PROJECT (TIME PERIOD ZERO) OR TODAYS COST OUTFLOW.
- OPERATIONS-FUTURE CASH INFLOWS
- DISPOSAL OF PROJECT
FINANCIAL ANALYSIS:
DISCOUNTED CASH FLOW METHODS
- NET PRESENT VALUE
- IRR
OBJECTIVE AND COMPONENTS OF DISCOUNTED CASH FLOWAS USED IN CAPITAL BUDGETING
THE OBJECTIVE OF THE DISCOUNTED CASH FLOW METHOD IS TO FOCUS THE ATTENTION OF MANAGEMENT ON RELEVANT CASH FLOWS APPROPRIATELY DISCOUNTED TO PRESENT VALUE. THE FACTORS USED TO EVALUATE CAPITAL INVESTMENTS UNDER DCF INCLUDE:
- DOLLAR AMOUNT OF INITIAL INVESTMENT
- DOLLAR AMOUNT OF FUTURE CASH INFLOWS AND OUTFLOWS
- THE RATE OF RETURN DESIRED FRO THE PROJECT.
RATE OF RETURN DESIRED FOR THE PROJECT
THE RATE USED TO DISCOUNT FCF IS SET BY MANAGEMENT USING SEVERAL DIFFERENT APPROACHES:
- WACC
- ASSIGN A TARGET FOR NEW PROJECTS TO MEET
- MANAGEMENT MAY RECOMMEND THAT THE DISCOUNT RATE BE RELATED TO THE RISK SPECIFIC TO THE PROPOSED PROJECT.
LIMITATIONS OF DCF
-SIMPLE CONSTANT GROWTH (SINGLE INTEREST RATE) ASSUMPTION.
DISCOUNTED CF METHODS ARE WIDELY VIEWED AS SUPERIOR TO METHODS THAT DO NOT CONSIDER TIME VALUE OF MONEY. HOWEVER, DISCOUNTED CF METHODS DO HAVEAN IMPORTANT LIMITATION. THEY FREQUENTLY USE A SIMPLE CONSTANT GROWTH. THIS ASSUMPTION IF OFTEN UNREALISTIC BECAUSE OVER TIME AS MANAGEMENT EVALUATES ITS ALTERNATIVES ACTUAL INTEREST RATES OR RIKS MAY FLUCTUATE.
TO ACCEPT A PROJECT
THE PV OF FCF HAS TO EXCEED TODAYS OUTFLOW
ADJUSTMENTS TO RATE
RATES MAY BE MODIFIED-GENERALLY INCREASED OR ADJUSTED FOR
-RISK
-INFLATION
LOSS OF PURCHASING POWER=INCREASE IN RISK
MAJOR ADVANTAGE OF NPV OVER IRR
UNDER THE NPV DIFFERENT TIME PERIODS MAY BE USED. IF NPV> THAN 0, THE DECISION WILL BE ACCEPTABLE.
WHY IS THE NPV SUPERIOR THAT IRR?
BECAUSE IT IS FLEXIBLE ENOUGH TO CONSISTENTLY HANDLE EITHER UNEVEN CASH FLOWS OR INCONSISTENT RATES OF RETURN FOR EACH YR OF THE PROJECT.
LIMITATIONS OF NPV METHOD?
NPV IMPLIES RATE OF RETURN > HURDLE RATE
EVEN THOUGH NPV IS CONSIDERED THE BEST SINGLE TECHNIQUE FOR CAPITAL BUDGETING, THE NPV OF CAPITAL BUDGETING IS LIMITED BY NOT PROVIDING THE TRUE RATE OF RETURN ON INVESTMENT.
THE NPV PURELY INDICATES WHETHER AN INVESTMENT WILL EARN HURDLE RATE USED IN THE NPV CALCULATION.
IF CAPITAL IS LIMITED THEN MANGERS WILL
ALLOCATE CAPITAL TO THE COMBINATION OF PROJECTS WITH THE MAXIMUM NPV.
PROFITABILITY INDEX
IS THE RATIO OF THE PV OF NET FUTURE CASH INFLOWS TO THE PV OF THE NET INVESTMENT.
THIS RATIO IS ALSO REFERRED TO AS THE EXCESS PV INDEX. OR SIMPLY THE PV INDEX.
THE PROFITABILITY RATION WILL BE LIKELY OVER 1.0 WHICH MEANS THAT THE PVOF INFLOWS>THAN PV OF OUTFLOWS. THE HIGHER THE INDEX THE BETTER
INTERNAL RATE OF RETURN
IS ONE OF THE SEVERAL DISCOUNTED CF METHOS USED TO SCREEN THE ACCEPTABILITY OF INVESTMENTS.
THE IRR IS THE EXPECTED RETURN RATE OF A PROJECT. SOMETIMES IT IS CALLED THE TIME ADJUSTED RATE OF RETURN.
IRR OBJECTIVE
FOCUSES ON THE DECISION MAKER ON THE DISCOUNT RATE AT WHICH THE PV OF CASH INFLOWS = THE PV OF CASH OUTFLOWS (USUALLY THE INITIAL INVESTMENT).
THE IRR FOCUSES DECISION MAKERS ON PERCENTAGES.
WHEN DO YOU ACCEPT OR REJECT A PROJECT SUING THE IRR METHOD?
ACCEPT WHEN:
- IRR> HURDLE RATE
REJECT WHEN
- IRR
LIMITATIONS OF IRR
- UNREASONABLE REINVESTMENTS ASSUMPTION
- THE CF FROM THE INVESTMENT ARE ASSUMED IN THE IRR ANALYSIS TO BE REINVESTED AT THE IRR - INFLEXIBLE CF ASSUMPTION
- LESS RELIABLE THAN NPV SPECIALLY WHEN THERE ARE SEVERAL ALTERNATING PERIODS OF NET CASH INFLOW AND OUTFLOWS OR THE CF DIFFER SIGNIFICANTLY. - EVALUATES ALTERNATIVES BASED ENTIRELY ON INTEREST RATES
- DOES NOT CONSIDER PROFIT.
PAYBACK PERIOD METHOD
IS THE TIME REQUIRED FOR THE NET AFTER TAX CASH INFLOWS TO RECOVER THE INITIAL INVESTMENT IN A PROJECT.
OBJECTIVE OF PAYBACK PERIOD
FOCUSES ON DECISION MAKERS ON BOTH:
- LIQUIDITY
- RISK
PAYBACK METHOD
-LIQUIDITY FOCUS
MEASURES THE TIME IT WILL TAKE TO RECOVER THE INITIAL INVESTMENT IN THE PROJECT, THEREBY EMPHASIZING THE PROJECTS LIQUIDITY AND THE TIME DURING WHICH RETURN OF PRINCIPAL IS AT RISK.
PAYBACK METHOD
-RISK FOCUS
THE PAYBACK METHOD IS OFTEN USED FOR RISKY INVESTMENTS. THE GREATER THE RISK OF THE INVESTMENT, THE SHORTER PAYBACK PERIOD THAT IS TOLERATED BY THE COMPANY.
PAYBACK METHOD FORMULA
NET INITIAL INVESTMENT/ INCREASE IN ANNUAL NET AFTER-CASH FLOW (ANNUITY UNIFORM PAYMENTS)
PAYBACK METHOD-NON UNIFORM PAYMETS
THE NET CASH INFLOWS ARE ACCUMULATED UNTIL THE TIME THAT THEY EQUAL THE INITIAL INVESTMENT
ADVANTAGES OF PAYBACK PERIOD
EASY TO UNDERSTAND
EMPHASIS ON LIQUIDITY
DISADVANTAGES OF PAYBACK PERIOD
- TIME VALUE OF MONEY IS IGNORED
- PROJECT CF OCCURRING AFTER THE INITIAL INVESTMENT IS RECOVERED ARE NOT CONSIDERED.
- REINVESTED CF IS NOT CONSIDERED
- TOTAL PROJECT PROFITABILITY IS NEGLECTED
DISCOUNTED PAYBACK METHOD
THIS VARIATION COMPUTES THE PAYBACK PERIOD USING EXPECTED CF THAT ARE DISCOUNTED BY THE PROJECTS COST OF CAPITAL. THE METHOD CONSIDERS THE TIME VALUE OF MONEY AND IS REFERRED TO AS THE BREAK EVEN METHOD OR BET
OBJECTIVE OF DISCOUNTED PAYBACK
TO EVALUATE HOW QUICKLY NEW IDEAS ARE CONVERTED INTO PROFITABLE IDEAS.
ADVANTAGES AND DISADVANTAGES OF THE DISCOUNTED PAYBACK PERIOD
THEY ARE THE SAME AS THE PAYBACK PERIOD EXCEPT THAT DISCOUNTED PAYBACK PERIOD INCORPORATES THE TVM (TIME VALUE OF $).
OPERATING LEVERAGE
IS DEFINED AS THE DEGREE TO WHICH A FRIM USES FIXED OPERATION COSTS AS OPPOSED TO VARIABLE OPERATING COSTS.
A FIRM THAT HAS HIGH OPERATING LEVERAGE HAS HIGH FIXED OPERATING COSTS AND RELATIVELY OW OPERATING COSTS.
IMPLICATION OF HIGH OPERATING LEVERAGE
A COMPANY WITH HIGH OPERATING LEVERAGE MUST PRODUCE SUFFICIENT SALES REVENUE TO COVER ITS HIGH FC. ONCE THE FC ARE COVERED, ADDITIONAL SALES REVENUE WILL GO STRAIGHT TO OPERATING INCOME (EBIT-ERNINGS BEFORE INTEREST AND TAXES) BECAUSE VC ARE LOW.
IMPLICATION OF LOW OPERATING LEVERAGE
IMPLIES THAT NEW SALES DOLLARS CAN ONLY BE ACHIEVED WITH ADDITIONAL VC. FOR COMPANIES WITH LOW OPERATING LEVERAGE ONLY THE MARGIN IN EXCESS OF VARIABLE COST IS PROFIT.
DEGREE OF OPERATING LEVERAGE FORMULA
% CHANGE IN EBIT/ % CHANGE IN SALES
OPERATING LEVEREGE TO RISK/RETURN DECISIONS
MANAGERS MUST CONSIDER THE LEVERAGE IMPLIED BY BUSINESS OPERATIONS IN CONSIDERING THE RISKS THAT THEY WILL ASSUME IN ADOPTION THEIR CAPITAL STRUCTURES.
–FIRMS WITH HIGHER % OF FC RELATIVE TO VC WILL HAVE A HIGHER DEGREE OF OPERATING LEVERAGE.
WHAT DOES A HIGHT DEGREE OF OPERATING LEVERAGE IMPLIES?
IMPLIES THAT A RELATIVELY SMALL CHANGE IN SALES (INCREASE OR DECREASE) WILL HAVE A GREATER EFFECT ON PROFITS AND SHAREHOLDER VALUE.
THE HIGHER A FIRM’S OPERATING LEVERAGE…
THE GREATER ITS POTENTIALLY PROFITABILITY BUT ALSO THE GREATEST RISK.
WHAT IS FINANCIAL LEVERAGE?
IS DEFINED AS THE DEGREE TO WHICH A FRISM USE OF DEBT TO FINANCE THE FIRMS MAGNIFIES THE EEFFECTS OF A GIVEN % CHANGE IN EVIT ON THE % CHANGE IN ITS EARNINGS PER SHARE.
WEHN MAKING FINANCING DECISIONS, A FIRM CAN CHOOSE TO ISSUE DEBT OR EQUITY WHAT HAPPENS WHEN A FIRM DECIDES TO GO WITH EACH DECISION INDEPENDENTLY?
-WHEN DEBT IS ISSUED:
THE FIRM GENERALLY MUST PAY FIXED INTEREST COSTS.
-WHEN EQUITY IS ISSUED:
DO NOT RESULT IN AND INCREASE IN FC BECAUSE DIVIDEND PAYMENTS ARE NOT REQUIRED.
WHAT IS THE RESULT OF FINANCIAL LEVERAGE IMPLICATION USING DEBT?
A COMPANY THAT ISSUES DEBT MUST PRODUCE SUFFICIENT OPERATING INCOME (EBIT) TO COVER ITS FIXED INTEREST COSTS.
ONCE FIXED INTEREST COSTS ARE COVERED, ADDITIONAL EBIT WILL GO STRAIGHT TO NET INCOME AND EPS.
WHAT IS THE FORMULA FOR FINANCIAL LEVERAGE?
% CHANGE IN EPS/ % CHANGE IN EBIT
APPLYING FINANCIAL LEVERAGE TO RISK/RETURN DECISONS
FIRMS WITHA HIGHER % OF FIXED FINANCING COSTS WILL HAVE A HIGHER DEGREE OF FINANCIAL LEVERAGE.
WHAT DOES A HIGHER DEGREE OF FINANCIAL LEVERAGE IMPLIES?
IT IMPLIES THAT A RELATIVELY SMALL CHANGE IN EBIT (INCREASE OR DECREASE) WILL HAVE A GREATER EFFECT ON PROFITS AND SHAREHOLDER VALUE.
THE HIGHER A FIRMS DEGREE OF FINANCIAL LEVERAGE, THE GREATER ITS PROFITABILITY BUT ALSO THE GREATEST ITS RISK.
HOW DO YOU CALCULATE COMBINED TOTAL LEVERAGE?
–% CHANGE IN EPS/ % CHANGE IN SALES
OR
–DOL X DFL
APPLYING COMBINED LEVERAGE TO RISK/RETURN DECISIONS
FIRMS WITH A HIGHER % OF FIXED OPERATING LEVERAGE IN ADDITION TO FIXED FINANCING COSTS WILL HAVE A HIGHER DEGREE OF COMBINED LEVERAGE.
–A HIGHER DEGREE OF COMBINED LEVERAGE IMPLIES THAT A RELATIVELY SMALL CHANGE IN SALES (INCREASE OR DECREASE) WILL HAVE A GREATER EFFECT ON EPS, PROFITS, AND SHAREHOLDER VALUE.
APPLYING LEVERAGE CONCEPTS TO BUSINESS DECISIONS
–OPERATING LEVERAGE
OPERATING LEVERAGE DECISIONS ARE OFTEN THE RESULT OF INDUSTRY CHARACTERISTICS RATHEN THAN MANAGEMENT DECISIONS.
APPLYING LEVERAGE CONCEPTS TO BUSINESS DECISIONS
–FINANCIAL LEVERAGE
FINANCIAL LEVERAGE DECISIONS ARE FOUNDATIONAL TO CAPITAL STRUCTURE AND ARE INFLUENCED BY THE AMOUNT OF OPERATIONAL LEVERAGE RISK IMPLIED BY THE INDUSTRY.
AS OPPOSED TO OPERATING LEVERAGE, FINANCIAL LEVARAGEIS A DECISION MADE BY MANAGEMENT.
WHAT IS A GOOD WACC ??
THE LOWER THE BETTER
WHAT IS WACC?
WEIGHTED AVERAGE COST OF CAPITAL (WACC) SERVES AS A MAJOR LINK BETWEEN THE LT INVESTMENT DECISONS ASSOCIATED WITHA CORP CAPITAL STRUCTURE AND THE WEATLH OF A CORP OWNERS.
CAPITAL STRUCTURE AND FIRM VALUE
THE MIXTURE OF DEBT AND EQUITY FINANCING THAT PRODUCES THE LOWEST WACC MAXIMIZES THE VALUE OF THE FIRM.
WACC FORMULA
COST OF EQUITY * % EQUITY IN CAPITAL STRUCTURE
PLUS
WEIGHTED AVERAGE COST OF DEBT* % DEBT IN CAPITAL STRUCTURE.
WHEN USING WACC AS THE HURDLE RATE
THE COMPANY SHOULD INVEST IN ANY PROJECT THAT WILL YIELD A HIGHER RETURN THAN WACC
APPLICATION OF WACC TO CAPITAL BUDGETING
THE HISTORIC WACC OF CAPITAL MAY NOT BE APPROPRIATE FOR USE AS A DISCOUNT RATE FOR A NEW CAPITAL PROJCT UNLESS THE PROJECT CARRIES THE SAME RISK AS THE CORP AND RESULTS IN IDENTICAL LEVERAGING CHARACTERISTICS.
COST OF CAPITAL COMPONETS
THE COST OF CAPITAL COMPRISES THE COST OF BORROWING (INTEREST RATES ON DEBT) AD THE COST OF EQUITY (RETURN REQUIRED BY INVESTORS IN EXCHANGE FOR ASSUMING RISK)
WHAT ARE THE COST OF CAPITAL COMPONENTS
- COST OF LTD
- COST OF PREFERRED STOCK
- COST OF RETAINED EARNINGS
COST OF LTD
IS EXPRESSED IN FORMULAS USING THE LETTERS “KDX” IS THE AFTER TAX COST OF RAISING LT FUNDS THROUGH BORROWING. SOURCES OF LTD INCLUDE ISSUANCE OF BONDS OR LT LOANS.
–LTD IS TAX DEDUCTIBLE AND IS THE CHEAPEST BECAUSE OF THE TAX AND THE LEAST RISKIEST.
COST OF PREFERRED STOCK
“KPS” AFTER TAX CONSIDERATIONS ARE IRRELEVANT WITH EQUITY SECURITIES BECAUSE DIVIDENDS ARE NOT TAX DEDUCTIBLE.
FORMULA
PREFERRED STOCK CASH DIVIDENDS (DPS)/NET PROCEEDS OF PREFERRED STOCKS (NPS)
WHAT ARE THE 3 COMMON WAYS OF COMPUTING “KRE” OR COST OF RETAINED EARNINGS?
- CAPITAL ASSET PRICING MODEL (CAPM)
- DISCOUNTED CF (DCF)
- BOND YIELD PLUS RISK PREMIUM (BYRP)
WHAT ARE THE KEY ASSUMPTIONS OF CAPM?
- COST OF RE IS = TO RIKS FREE RATE PLUS A RISK PREMIUM
- RISK PREMIUM IS = TO THE RISKS ASSOCIATED WITH THE ENTIRE MARKEK RISK
- RISK PREMIUM IS THE PRODUCT OF SYSTEMATIC (NON-DIVERSIFIABLE) RISK.
- ARBITRAGE PRICING THEORY ASSUMES MULTIPLE RISKS (SYSTEMATIC AND UNSYSTEMATIC) SHOULD BE CONSIDERED AS PART OF CAPM NOT SIMPLY ONE RISK.
WHAT IS CAPM FORMULA?
KRE= RISK FREE RATE + RISK PREMIUM
KRE=KRF+(BI*(KM-KRF))
WHERE
krf=risk free rate
bi=beta coefficient
km=market rate
IF NPV OF A CAPITAL BUDGETING PROJECT IS POSITIVE, IT WOULD INDICATE THAT?
RATE OF RETURN FOR THE PROJECT IS > DISCOUNT (HURDLE) % RATE USED IN NPV COMPUTATION.
-NPV INDEX WILL BE > THAN 100% AS WELL
WHEN IS THE IRR LESS RELIABLE COMPARE TO NPV?
WHEN THERE ARE SEVERAL ALTERNATINGPERIODS OF CASHINFLOWS AND NET OUTFLOWS OR THE AMOUNT OF CASH FLOWS DIFFER SIGNIFICANTLY.
THE IRR IS STRICTLY A PERCENTAGE MEASURE OF??
OF RETURN
THE NPV WHAT KIND OF MEASURE?
AN ABSOLUTE.
WHEN THE RISKS OF THE INDIVIDUAL COMPONENT OF A PROJECTS CF ARE DIFFERENT, AN ACCEPTABLE PROCEDURE TO EVALUATE THESE CF IS TO?
DISCOUNT EACH CASH FLOW USING A DISCOUNT RATE THAT REFLECTS THE DEGRE OF RISK.
DISCOUNT RATES MAY BE ADJUSTED TO FACTOR DIFFERENCES IN RISK INTO CF ANALYSIS. DISCOUNT RATES MAY ALSO BE ADAPTED TO COMPENSATE FOR INFLATION.
WHAT IS PRESENT VALUE BASED ON (PV)
IT IS BASED ON THE CASH FLOWS OF AN ACTIVITY.
IRR DETERMINES?
THE DISCOUNT RATE THAT WILL EQUATE THE DISCOUNTED CASH INFLOWS WITHT HE OUTFLOWS, THUS RESULTING IN NO GAIN OR LOSS (BREAKEVEN).
IN EVALUATING A CAPITAL BUDGET, THE USE OF NPV IS GENERALLY NOT AFFECTED BY?
METHOD OF FUNDING THE PROJECT
BUT IT IS AFFECTED BY THE FOLLOWING:
-INITIAL COST OF THE PROJECT
-AMOUNT OF THE PROJECTS ASSOCIATED WITH DEPRECIATION TAX ALLOWANCE.
-AMOUNT OF ADDED WORKING CAPITAL NEEDED FOR OPERATIONS DURING THE TERM OF THE PROJECT.
THE CAPITAL BUDGETING MODEL THAT IS GENERALLY CONSIDERED THE BEST MODEL FOR LONG-RANGE DECISION MAKING IS THE?
-DISCOUNTED CASH FLOW MODEL. DISCOUNTED CASH FLOW METHODS INCLUDE: -NPV -IRR -PROFITABILITY INDEX
WHICH CAPITAL BUDGETING MODELS DO NOT CONSIDER THE TIME VALUE OF MONEY OR INITIAL INVESTMENT AFTER INVESTMENT IS COVERED?
PAYBACK AND BAILOUT METHODS
THE ANNUAL SAVINGS NEEDED TO MAKE AN INVESTMENT YIELD A SPECIFIC % IS WHEN?
PV OF CASH INFLOWS=PV OF CASH OUTFLOWS.
A PROJECTS NPV, IGNORING INCOME TAX CONSIDERATIONS IS NORMALLY AFFECTED BY THE?
PROCEEDS FROM THE SALE OF THE ASSET TO BE REPLACED.
-A PROJECTS NPV IS A FUNCTION OF CURRENT AND FUTURE CASH FLOWS, INCLUDING PROCEEDS FROM TEH SALE OF OLD ASSET.
BOOK DEPRECIATION
IT IS NOT RELEVANT TO CF DETERMINATION FOR CAPITAL BUDGETING PURPOSES BECAUSE DEPRECIATION IS A NON-CASH EXPENDITURE. THE ONLY CF EFFCT OF DEPRECIATION IS THE TAX SHIELD THAT IS GIVEN IN TAX DEPRECIATION.
CASH FLOW IS COMPUTED FROM NET INCOME BY:
ADD BACK NON-CASH EXPENSES TO NET INCOME:
- DEPRECIATION
- AMORTIZATION
DO NOT ADD BACK INTEREST EXP, SINCE IT HAS ALREADY BEEN PAID.
A CHARACTERISTIC OF THE PAYBACK METHOD BEFORE TAXES IS THAT IT…
NEGLECTS TOTAL PROJECT PROFITABILITY.
THE PAYBACK METHOD SIMPLY LOOKS AT THE TIME REQUIRED TO RECOVER THE INITIAL INVESTMENT SUBSEQUENT CASH FLOW ARE IGNORED.
WHAT ARE CONSIDERED A NON-FINANCIAL OR QUALITATIVE FACTORS?
- INCREASE IN MANUFACTURING FLEXIBILITY
- IMPROVED PRODUCT DELIVERY AND SERVICE
- REDUCTION IN NEW PRODUCT DEVELOPMENT TIME.
THE PROFITABILITY INDEX IS A VARIATION OF WHICH OF THE FOLLOWING CAPITAL BUDGETING MODELS?
-NPV
IT IS A VARIATION OF NPV CAPITAL BUDGETING MODEL.
THE FORMULA:
PVFC/PV INITIAL INVESTMENT.
ALSO REFERRED TO AS EXCESS PV INDEX OR PV INDEX. COMPANIES HOPE THAT THIS RATIO IS LESS THAN 1
WHICH IT TRANSLATES THAT PV OF INFLOWS>OUTFLOWS
WHEN A PROJECT HAS A POSITIVE NPV THEN THE REQUIRED RATE OF RETURN IS??
+ NPV==THE REQUIRED RATE OF RETURN MUST BE LESS THAN THE PROJECTED IRR
THE IRR IS THE RATE EARNED BY AN INVESTMENT THAT EQUATES TO A NPV OF ZERO.
WHAT WOULD BE MOST BENEFICIAL TO CONSIDER WHEN MANAGEMENT IS DEVELOPING THE CAPITAL BUDGET?
- PROFIT CENTER EQUIPMENT REQUESTS.
- IN DEVELOPING ITS CAPITAL BUDGET, MGT WOULD FIND EMPLOYEES INPUT ASSOCIATED WITH EQUIP REQUESTS FROM VARIOUS PROFIT CENTERS MOST HELPFUL. DEPARTMENTAL REQUESTS, APPROPRIATELY JSUTIFIED WOULD PROVIDE KEY INSIGHT INTO CAPITAL REQUIREMENTS OF THE BUSINESS TAHT ARE NOT OTHERWISE KNOWN.
IN EVALUATION COSTS FOR DECISION-MAKING, A COMPANY WOULD ALWAYS CONSIDER EACH OF THE FOLLOWING AS RELEVANT EXCEPT?
- VARIABLE COSTS
- VC CHANGE WITH THE LEVEL OF OUTPUT BUT MAY NOT CHANGE PURELY IN RESPONSE TO DIFFERENT SELECTED ALTERNATIVES. ALTHOUGH VC ARE FREQUENTLY RELEVANT, THEY ARE NOT ALWAYS RELEVANT.
WHAT COSTS ARE CONSIDERED IN EVALUATING COSTS FOR DECISION-MAKING?
- AVOIDABLE COSTS
- INCREMENTAL COSTS
- DIFFERENTIAL COSTS.
WHAT IS THE NPV OF AN INVESTMENT?
NPV OF AN INVESTMENT= THE DISCOUNTED AFTER TAX CF ASSOCIATED WITH THE INVESTMENT-INITIAL INVESTMENT.
IRR IS?
THE RATE THAT PROVIDES A ZERO NPV.
PAYBACK PERIOD FORMULA
INITIAL COST/ANNUAL NET CASH INFLOWS.
WHAT IS IRR?
A TIME-ADJUSTED RATE OF RETURN FROM AN INVESTMENT. THE IRR IS ONE OF MANY CAPITAL BUDGETING TECHNIQUES THAT UTILIZE PV CONCEPTS TO VALUE BOTH THE INVESTMENT AND RELATED CF.
IRR OF RETURN FORMULA?
INVESTMENT/CASH FLOW=PV FACTOR
THE HIGHER THE PV FACTOR, THE LOWER THE COMPUTED RATE (IRR).
INCREASES TO INVESTMENT OR CF SERVE TO INCREASE THE PV FACTOR.
WHICH OF THE FOLLOWING IS AN ADVANTAGE OF NPV MODELING?
IT ACCOUNTS FOR COMPOUNDING OF RETURNS. THE NPV METHOD ASSUMES THAT POSITIVE CF ARE REINVESTED AT HURDLE RATE THEREBY CONSIDERING COMPOUNDING.
VARIOUS METHODOLOGIES CAN BE USED TO DEVELOP A FV COMMON SHARES. THE MOST OBJECTIVE METHODOLOGIES ARE CONSIDERED TO BE:
DISCOUNTED CF (DCF) METHODS -DCF ARE CONSIDERED THE MOST RIGOROUS AND OBJECTIVE OF THE VALUATION METHOD.
WHAT IS THE FORMULA FOR CALCULATING THE PROFITABILITY INDEX?
PV OF ANNUAL AFTER TAX CF/ ORIGINAL CASH INVESTED IN PROJECT.
LIMITATIONS OF PROFITABILITY INDEX
IT REQUIRES DETAILED L.T FORECASTS OF THE PROJECT CASH FLOWS. FOR LONGER TERM PROJECTS CF PROJECTIONS MIGHT BE EITHER UNAVAILABLE OR UNRELIABLE.
INTERNAL RATE OF RETURN (IRR)
IS THE PV OF PROJECTS EXPECTED CASH INFLOW= PROJECTS CASH OUTFLOWS.
THE IRR IS THE RATE USED TO ARRIVE AT NPV OF ZERO.
WHAT COSTS ARE IGNORE WHEN TRYING TO REPLACE EQUIPMENT?
ORIGINAL COST OF OLD MACHINE BECAUSE IT IS A SUNK COST.
NET INCOME NUMBERS AND NPV
NET INCOME NUMBERS ARE NOT USED IN NPV COMPUTATIONS.
THE DISCOUNT RATE IS DETERMINED IN ADVANCE FOR WHICH OF THE FOLLOWING CAPITAL BUDGETING TECHNIQUES?
THE DISCOUNT OR HURDLE RATE IS DETERMINED IN ADVANCE FOR COMPUTATIONS OF NPV. PROJECT CF ARE DISCOUNTED BASED UPON A PREDETERMINED RATE AND COMPARED TO THE INVESTMENT IN THE PROJECT TO ARRIVE AT A POSITIVE OR NEGATIVE PV. ADVANCE DETERMINATION OF MANAGEMENTS REQUIRED RETURN IS INTEGRAL TO DEVELOPMENT AND EVALUATION OF NPV
WHEN IS ANNUITY DUE USED?
IF CASH INFLOWS ARE RECEIVED AT THE BEGINNING OF THE YEAR
WHEN IS ORDINARY ANNUITY USED?
WHEN CASH INFLOWS ARE RECEIVED AT THE END OF THE YEAR.
WHAT METHOD SHOULD BE USED IF CAPITAL RATIONING NEEDS TO BE CONSIDERED WHEN COMPARING CAPITAL PROJECTS?
PROFITABILITY INDEX
-THE PROFITABILITY INDEX IS USED FOR CAPITAL RATIONING. THE PROFITABILITY INDEX IS THE RATIO OF PV OF FUTURE CASH INFLOWS TO PV OF NET INITIAL INVESTMENT. RANKING AND SELECTION OF INVESTMENTS IS MADE BY LISTING IN DESCENDING ORDER. LIMITED CAPITAL RESOURCES ARE APPLIED IN ORDER OF INDEX UNTIL RESOURCES ARE EITHER EXHAUSTED OR INVESTMENT REQUIRED BY NEXT PROJECT EXCEEDS REMAINING RESOURCES.
WAAC
THE LOWER THE BETTER
PURPOSE OF WAAC
HELPS AS A MAJOR LINK BETWEEN THE LT INVESTMENT DECISIONS ASOCIATED WITH A CORPORATIONS CAPITAL STRUCTURE AND THE WEALTH OF A CORPORATION OWNERS. THE THEORETHICAL OPTIMAL CAPITAL STURCTURE IS THE MIX OF FINANCING INSTRUMENTS THAT PRODUCES THE LOWEST WACC.
WAAC FORMULA
(COST OF EQUITY * PERCENAGE OF EQUITY IN CAPITAL STRUCTURE) + (WEIGHTED AVERAGE COST OF DEBT * PERCENTAGE DEBT IN CAPITAL STRUCTURE)
COST OF DEBT
INTEREST RATE * (1-TAX RATE)
APPLICATION OF WACC AS A HURDLE RATE?
APPROPRIATE APPLICATION OF WACC AS A HURDLE RATE FOR CAPITAL PROJECTS INVOLVES THE USE OF WEIGHTED AVERAGE COST OF CAPITAL AS A HURDLE RATE FOR CAPITAL PROJECTS INVOLVES USE OF WIGHTED AVERAGE COST OF EACH ADDITIONAL NEW DOLAR OF CAPITAL RAISED AT THE MARGIN AS THE CAPITAL NEED ARISES.
COST OF LT DEBT
IS THE CHEAPEST ONE IT CARRIES THE LOWEST COST OF CAPITAL. INTEREST COST IS TAX DEDUCTIBLE. THE HIGHER THE TAX RATE THE MORE INCENTIVES EXISTS TO USE DEBT FINANCING.
AFTER COST OF DEBT FORMULA
PRE TAX COST OF DEBT * (1-TAX RATE)
COST OF PREFERRED STOCK
AFTER TAX CONSIDERATIONS ARE IRRELEVANT WITH EQUITY BECAUSE DIVIDENDS ARE NOT TAX DEDUCTIBLE. PREFERRED STOCK PAYMENTS REPRESENT PAYMENTS TO STOCKHOLDERS.
FORMULA OF COST OF PREFERRED STOCK
PREFERRED STOCK CASH DIVIDENDS/NET PROCEEDS OF PREFERRED STOCK
OR
NET OUTFLOW/NET INFLOW
COST OF RETAINED EARNINGS
COST OF CAPITAL OBTAIND THROUGHT RETAINED EARNINGS IS = TO TH RATE OF RETURN REQUIRED BY THE FIRMS COMMON STOCKHOLDERS.
A FIRM SHOULD EARN AT LEAST AS MUCH ON ANY EARNINGS REAINED AND REINVESTED IN THE BUSINESS AS STOCKHOLDERS COULD HAVE EARNED ON AN ALTERNATIVE INVESMENT OF EQUIVALENT RISK.
3 METHOS OF COMPUTING COST OF RETAINED EARNINGS
- CAPM
- DISCOUNTED CF
- BOND YIEND PLUS RISK PREMIUM
CAPM ASSUMPTIONS
- COST OF RE IS EQUAL TO THE RISK FREE RATE PLUS A RISK PREMIUM
- RISK PREMIUM IS EQUAL TO THE RISK ASSOCIATED WITH THE ENTIRE MARKET RISK.
- RISK PREMIUM IS THE PRODUCT OF SYSTEMATIC (NON
DISCOUNTED CASH FLOW ASSUMPTIONS
- STOCKS ARE NORMALLY IN EQUILIBRIUM RELATIVE TO RISK AND RETURN
- THE ESTIMATED EXPECTED RETURN WILL YIELD AND ESTIMATED REQUIRED RATE OF RETURN.
- THE EXPECTED GROWTH RATE MAY BE BASED ON PROJECTIONS OF PAST GROWTH RATES, A RETENTION GROWTH MODEL, OR ANALYST FORECASTS.
DISCOUNTED CF FORMULA
KRE=(D1/P0)+G
BOND YIELD PLUS RISK PREMIUM ASSUMPTIONS
- EQUITY AND DEBT SECURITY VALUES ARE COMPARABLE BEFORE TAXES
- RISK ARE ASSOCIATED WTIH BOTH THE INDIVIDUAL FIRM AND THE SATE OF THE ECONOMY
- RISK ESTIMATION CAN BE DERIVED BY USING MARKET ANALYSTS SURVEY APPROACH OR BY SUBTRACTING THE YIELD ON AVERAGE (A-RATED) CORPORATE LT BOND FROM AN ESTIMATE OF THE MARKET RATE.
BOD YIELD PLUS RISK PREMIUM FORMULA
PRE TAX COST OF LTD + MARKET RISK PREMIUM
RETURN ON INVESTMENT
PROVIDES FOR THE ASSESMENT OF A COMPANYS PERCENTAGE RETURN TO ITS CAPITAL INVESTMENT RISK. THE ROI IS AN IDEAL PERFORMANCE MEASURE FOR INVESTMENT STRATEGIC BUSINESS UNITS.
FORMULAS OF ROI
ROI=INCOME/INVESTMENT CAPITAL (AVG ASSETS)
OR
ROI= PROFIT MARGIN * INVESTMENT TURNOVER
DEFINITION AND INTERPRETATION OF ROI
INCOME IS EXPRESSED AS % OF SALES (PROFIT MARGIN CALCULATION) AND SALES ARE EXPRESSED OF INVESTED CAPITAL (THE INVESTMENT TURNOVER CALCULATION). THE HIGHER THE % THE BETTER.
RETURN ON INVESTMENT FORMULA
PROFIT MARGIN (INCOME/SALES) * INVESTMENT TURNOVER (SALES/INVESTED CAPITAL)
RETURN ON ASSETS
ROA IS SIMILAR TO ROI, EXCET THAT ROA USES AVERAGE TOTAL ASSETS IN THE DENOMINATOR RATHERN THAN INVESTED CAPITAL
ROA FORMULA
NET INCOME/AVG TOTAL ASSETS
ROI/ROA ASSET VARIATIONS
ASSET VARIATION USED IN ROI AND ROA COMPUTATION IMPACT THE RESULTS. THE APPROPRIATE ASSET VALUATION DEPENDS ON THE STRATEGIC OBJECTIVE OF THE COMPANY AND THE DIRECTION ORGANIZATION THAT LEADERSHIP WANTS TO GIVE ITS MANAGERS.
ASSET VALUATIONS
- NET BV
- GROSS BV
- REPLACEMENT COST
- LIQUIDATION VALUE
HOW DO ADJUSTMENTS TO ROI DENOMINATOR AFFECT ROI?
ADJ TO THE ROI DENOMINATOR RAISE THE BAR ON ASSET, PROJECT OR COMPANY PERFORMANCE. THE HIGHER THE DENOMINATOR USED IN THE ROI THE LOWER THE RETURN.
LIMITATIONS OF ROI
IS DESIGNED TO DIRECT MANAGERS TO ACHIEVE CORPORATE OBJECTIVES AND PROVIDE BASIS FOR INCENTIVES. ROI COMPUTATIONS HAVE LIMITATIONS
- SHORT FOCUS
- DISCENTIVE TO INVEST.
ASSET EFFECTIVENESS AND/OR EFFICIENCY
RESIDUAL INCOME AND EVA
THE RESIDUAL INCOME METHOD MEASURES THE EXCESS OF ACTUAL INCOME EARNED BY AN INVESTMENT OVER THE REQUIRED (TARGET OR HURDLE) RETURN REQUIRED BY THE COMPANY.
WHILE ROI PROVIDES A % MEASUREMENT, RESIDUAL INCOME PROVIDES AN AMOUNT. LIKE ROI, RESIDUAL INCOME IS A PERFORMANCE MEASURE FOR INVESTMENT SBUS
RESIDUAL INCOME FORMULA
NET INCOME - REQUIRED RETURN
WHERE REQUIRED RETURN=NBV *HURDLE RATE
RESIDUAL INCOME BENEFITS
-REALIST TARGET RATES
HISTORICAL WEIGHTED AVERAGE COST OF CAPITAL IS OFTEN USED OR HURDLE RATE. HOWEVER THE RATE OPTIMALLY USED IS THE TARGET RETURN SET BY THE COMPANYS MANAGEMENT.
-FOCUS ON TARGET RETURN AND AMOUNT
RESIDUAL INCOME WEAKNESSES
- REDUCED COMPARABILITY
- TARGET RATES REQUIRE JUDGMENT
EVA-ECONOMIC VALUE ADDED
SAME AS RESIDUAL EXCEPT HURDLE IS WACC.
EVA FORMULA
1.INVESTMENT * COST OF CAPITAL=REQUIRED RETURN
2. INCOME AFTER TAXES-REQUIRED RETURN=EVA
POSITIVE IS GOOD NEGATIVE IS BAD
EVA ISSUES
-EVA CAN BE REFINED USING INVESTMENT OR INCOME ADJUSTMENT TO PRODUCE A MORE ACCURATE ANALYSIS OF ECONOMIC PROFIT (VALUE ADDED).
A. CAPITALIZATION OR R&D
B. INCOME DETERMINATION.
EVA ISSUES
CAPITALIZATION OF R&D
CURRENT VALUATION OF BS
-THE ORGANIZATION MAY CAPITALIZE R&D COSTS:
AS PART OF ITS ASSET BASE ALONG WITH OTHER VALUE ADDING INVESTMENT IN ADVERTISING AND TRAINING.
- CURRENT VALUATION OF B/S:
BS ACCOUNTS ARE GENERALLY REVALUED TO PRESENT CURRENT COSTS
EVA ISSUES
INCOMDE DETERMINATION
INCOME MAY BE ADJUSTED TO ELIMINATE THE IMPACT OF CERTAIN TRANSACTIONS AND THEREBY CREATE A NEARLY CASH BASIS IS
- ADJ TO THE BS IMPACT THE IS
- DEFERRED TAXES ARE IGNORED.
DEBT TO CAPITAL RATIO
IS A MEASURE OF FINANCIAL LEVERAGE.
TOTAL DEBT / TOTAL CAPITAL (DEBT+EQUITY)
DEBT TO CAPITAL RATION INTERPRETATION
THE LOWER THE RATIO THE GREATER THE LEVEL OF SOLVENCY AND GREATER THE ABILITY TO PAY DEBTS. THE DEBT TO CAPITAL RATIO IS ALTERNATIVELY EXPRESSED AS TEH DEBT TO ASSET RATION.
DEBT TO ASSET RATIO
TOTAL DEBT/TOTAL ASSETS
DEBT TO ASSET RATION INTERPRETATION
THIS RATIO INDICATES LT DEBT PAYING ABILITY, THE LOWER THE BETTER
DEBT TO EQUITY
TOTAL DEBT/TOTAL SHAREHOLDERS EQUITY
DEBT TO EQUITY INTERPRETATION
THE DEBT TO EQUITY RATIO RELATES THE 2 MAJOR CATEGORIES OF CAPITAL STRUCTURE TO EACH OTHER AND INDICATES THE DEGREE OF LEVERAGE USED. THE LOWER THE RATIO, THE LOWER THE RISK INVOLVED.
GOAL OF WORKING CAPITAL MANAGEMENT
IS SHAREHOLDER WEALTH MAXIMIZATION.
WHAT IS WORKING CAPITAL?
CURRENT ASSETS-CURRENT LIABILITIES
BALANCING PROFITABILITY RISK
WIC IS EXPENSIVE TO CARRY BECAUSE IT MUST BE FINANCED WITH EITHER LTD OR STD OR WITH STOCKHOLDERS EQUITY. ADEQUATE WIC RESERVES HOWEVER MITIGATE RISK, POTENTIALLY REDUCE RETURNS AND THEREBY INCREASE PROFITABILITY.
AGRESSIVE WIC MANAGEMENT?
INCREASE RATIO OF CURRENT LIABILITIES TO NON-CURRENT LIABILITIES (MORE CURRENT ASSETS FINANCED WITH CURRENT LIABILITIES).
CONSERVATIVE WIC MANAGEMENT?
INCREASE RATIO OF CURRENT ASSETS TO NON CURRENT ASSETS (MORE CURRENT ASSETS FINANCED BY NON-CURRENT LIABILITIES)
CURRENT RATIO
CURRENT ASSETS/CURRENT LIABILITIES
CURRENT RATION INTERPRETATION
- THE TIMES CURRENT ASSETS EXCEED CURRENT LIABILITIES, A WAY OF MEASURING ST SOLVENCY. THIS RATIO DEMONSTRATES A FIRMS ABILITY TO GENERATE CASH TO MEET ITS ST OBLIGATIONS.
- THE BEST SINGLE INDICATOR OF TEH COMPANY’S ABILITY TO MEET ST OBLIGATIONS. IT MEASURES
- LIQUIDITY AT A POINT IN TIME BUT NOT INDICATIVE OF FCF
DECREASE IN CURRENT RATIO IS DUE TO WHAT?
A DECLINE IN CURRENT RATION, IMPLIES A REDUCED ABILITY TO GENERATE CASH:
- INCREASE IN SHORT TERM DEBT
- DECREASE IN CURRENT ASSETS
QUICK RATIO (ACID TEST)
CASH+MARKETABLE SECURITIES+RECEIVABLES
DIVIDED BY CURRENT LIABILITIES
QUICK RATIO INTERPRETATION
A MORE RIGOUROUS TEST OF LIQUIDITY BECASUE INVENTORY AND PREPAIDS ARE EXCLUDED FROM CURRENT ASSET CALCULATION. INVENTORY IS THE LEAST LIQUID OF CURRENT ASSETS.
THE ABILITY TO MEET CURRENT OBLIGATIOSN WITHOUT LIQUIDATING INVENTORY IS IMPORTANT.
LIMITATIONS OF CURRENT RATIO
UNLESS ST LIQUIDITY IS RELEVANT ISSUE, THE CURRENT RATIO IS NOT NECESSARLY THE BEST MEASURE OF THE HEALTH OF A BUSINESS.
WORKING CAPITAL AND RISK
LESS WIC=INCREASE RISK BY EXPOSING THE COMPANY TO THE LIKELIHOOD OF A POSSIBLE FAILURE TO MEET CURRENT OBLIGATIONS.
LESS WIC=INCREASE IN RISK BECAUSE IT MAY REDUCE THE FIRMS ABILITY TO OBTAIN ADDITIONAL ST FINANCING.
MOTIVES FOR HOLDING CASH
- TRANSACTION MOTIVE-MEET PAYMENTS IN THE ORDINARY COURSE OF BUSINESS
- SPECULATIVE MOTIVE-TAKE ADVANTAGE OF TEMPORARY OPPORTUNITIES.
- PRECAUTIONARY MOTIVE-IT IS IMPORTANT TO HAVE ENOUGH CASH ON HAND TO MAINTAIN A SAFETY CUSHION SO THAT UNEXPECTED NEEDS MAY BE MET.
DISADVANTAGES OF HIGH CASH LEVELS
- NEGATIVE ARBITRAGE EFFECT (INTERST OBLIGATIONS>INTEREST INCOME)
- INCREASE ATTRACTIVENESS AS A TAKEOVER TARGET
- INVESTOR DISSATISFACTION WITH ALLOCATION OF ASSETS (FAILURE TO PAY DIVIDENDS)
PRIMARY METHODS OF INCREASING CASH LEVELS
- SPEED COLLECTIONS
- CUSTOMER SCREENING AND CREDIT POLICY
- PROMTP BILLING
- PAYMENT DISCOUNTS
- EXPEDITE DEPOSITS
- CONCENTRATION BANKING
- FACTORING AR
APR OF QUICK PAYMENT DISCOUNT FORMULA
DISCOUNT/(100-DISCOUNT) * 360/(PAY PERIOD-DISCOUNT PERIOD)
METHOD OF DELAY DISBURSEMENTS
- DEFER PAYMENTS
- DRAFTS
- LINE OF CREDIT
- ZBA
CASH CONVERSION CYCLE FORMULA
INVENTORY CONVERSION PERIOD + RECEIVABLES COLLECTION PERIOD -PAYABLES DEFERRAL PERIOD
INVENTORY CONVERSION PERIOD FORMULA
INVENTORY TURNOVER=
COGS/AVERAGE INVENTORY
*THE LOWER THE BETTER
INVENTORY CONVERSION PERIOD
365/INVENTORY TURNOVER
RECEIVABLES COLLECTION PERIOD FORMULA
AR TURNOVER=
SALES/AVG AR
*THE LOWER THE BETTER
RECEIVABLES COLLECTION PERIOD=
365/AR TURNOVER
PAYABLES DEFFERAL PERIOD FORMULA
AP TURNOVER
COGS/AVG AP
AP DEFERRAL PERIOD
365/AP TURNOVER
TRADE CREDIT
AKA A/P
PROVIDES THE LARGEST SOURCE OF ST CREDIT FOR SMALL FIRMS. REPRESENTS THE PURCHASE OF GOOD AND SERVICES AS PART OF USUAL CUSTOMARY BUSINESS TRANSACTIONS THAT ARE PAID FOR ONLY 30-45 DAYS AFTER ACQUISITION.
THE LOWER THE CARRYING COST OF INVENTORY…
THE MORE INV COMPANIES ARE WILLING TO CARRY.
EOQ
ATTEMPTS TO MINIMIZE ORDERING AND CARRYING COSTS.
EOQ ASSUMPTIONS
ASSUMES DEMAND IS KNOWN AND IS CONSTANT THROUGHT THE YEAR
DOES NOT CONSIDER STOCKOUT COSTS
DOES NOT ACCOUNT FOR COSTS OF SAFETY STOCK
ASSUMES ORDER AND CARRYING COSTS ARE FIXED.
EOQ FORMULA
E= SQUARE ROOT OF 2SO/C
DISCOUNTED CASH FLOW METHOD FORMULA
D/P + G
D=DIVIDEND PER SHARE EXPECTED AT THE END OF ONE YR
P= CURRENT MARKET VALUE OR PRICE OF THE OUTSTANDING CS
G= CONSTANT RATE GROWTH IN DIVIDENDS
IF NO END OF YER DIVIDEND IS GIVEN THEN USE THE FOLLOWING FORMULA TO FIND OUNT THE DIVIDEND AT THE END OF YR.
D1=D0 * (1+G)
WHAT WOULD CAUSE A FIRM TO INCREASE THE DEBT IN ITS FINANCIAL STRUCTURE?
AN INCREASE IN CORP INCOME TAX RATE.
AN INCREASE IN CORP INCOME TAX RATE MIGHT CAUSE A FIRM TO INCREASE THE DEBT IN ITS FINANCIAL STRUCTURE BECAUSE INTEREST IS TAX DEDUCTIBLE. WHILE DIVIDENDS ARE NOT.
THE OVERALL COST OF CAPITAL IS THE…
RATE OR RETURN ON ASSETS THAT COVERS THE COSTS ASSOCIATED WITH THE FUNDS EMPLOYED. FIRMS MUST AT LEAST EARN A RETURN RATE ON INVESTMENT EQUAL TO THEIR COST OF CAPITAL, OR THE INVESTMENT ARE LOSING MONEY AND THEREFORE DECREASING THE VALUE OF THE FIRM.
THE COST OF EQUITY CAPITAL IS MEASURED BY
CAPM
IF BREWER CORP BONDS ARE CURRENTLY YIELDING 8% IN THE MARKETPLACE, WHY WOULD THE FIRMS COST OF DEBT BE LOWER?
INTEREST IS DEDUCTIBLE FOR TAX PURPOSES. SINCE INT EXP IS A TAX DEDUCTION, THE COST OF BREWER CORP IS LOWER THAN THE MARKET YIELD RATE ON DEBT.
THE THEORY UNDERLYING THE COST OF CAPITAL IS PRIMARILY CONCERNED WITH THE COST OF?
ANY COMBINATION OF OLD OR NEW, SHORT-TERM OR LONG-TERM FUNDS. THE COST OF CAPITAL CONSIDERS THE COST OF ALL FUNDS, WHETHER THEY ARE ST OR LONG TERM NEW OR OLD.
FINANCIAL LEVERAGE WOULD INCREASE AS A RESULT OF?
FINANCING ITS FUTURE INVESTMENT WITH A HIGHER PERCENTAGE OF BONDS.
-FINANCIAL LEVERAGE INCREASES WHEN THE DEBT TO EQUITY RATION INCREASES. USING HIGHER PERCENTAGE OF BONDS FOR FUTURE INVESTMENTS WOULD INCREASE FINANCIAL LEVERAGE.
RESIDUAL INCOME IS A BETTER MEASURE OF PERFORMANCE EVALUATION OF AN INVESTMENT CENTER MANAGER THAN ROI BECAUSE?
DESIRABLE INVESTMENT DECISIONS WILL NOT BE NEGLECTED BY HIGH-RETURN DIVISIONS.
RESIDUAL INCOME MEASURES ACTUAL DOLLARS THAN AN INVESTMENT EARNS OVER ITS REQUIRED RETURN RATE. PERFORMANCE EVALUATION ON THIS BASIS WILL MEAN THAT DESIRABLE INVESTMENT DECISIONS WILL NOT BE REJECTED BY HIGH-RETURN DIVISIONS.
ROI FORMULA
INCOME/INVESTMENT
WHEN CALCULATING RESIDUAL INCOME WHAT IS INCLUDED?
RESIDUAL INCOME=NI-REQUIRED RETURN
REQUIRED RETURN= NBV * HURDLE RATE
NBV=WIC+PP&E
THE SEGMENT MARGIN OF AN INVESTMENT CENTER AFTER DEDUCTION THE IMPUTED INTEREST ON THE ASSETS USED BY THE INVESTMENT CENTER IS KNOWN AS?
RESIDUAL INCOME
-RESIDUAL INCOME IS THE SEGMENT MARGIN OF AN INVESTMENT CENTER AFTER DEDUCTION THE IMPUTED INTEREST (HURDLE RATE) ON THE ASSETS USED BY THE INVESTER CENTER.
ROI??
IS THE RATIO OF INCOME EARNED TO THE INVESTMENT.
ROA??
IS THE RATIO OF INCOME PRODUCED TO ASSETS EMPLOYED.
THE BASIC OBJECTIVE OF THE RESIDUAL INCOME APPROACH OF PERFORMANCE MEASUREMENT AND EVALUATION IS TO HAVE A DIVISION MAXIMIZE ITS
INCOME IN EXCESS OF A DESIRED MINIMUM AMOUNT .
THE IMPUTED INTEREST RATE USED IN THE RESIDUAL INCOME APPROACH FOR PERFORMANCE MEASUREMENT AND EVALUATION CAN BEST CHARACTERIZED AS THE?
HISTORICAL WACC FOR THE COMPANY.
HISTORICAL WACC OF CAPITAL IS USUALLY USED AS THE TARGET OR HURDLE RATE IN THE RESIDUAL INCOME APPROACH.
CAPITAL INVESTMENTS REQUIRE BALANCING RISK AND RETURN. MANAGERS HAVE A RESP TO ENSURE THAT THE INVESTMENT THAT THEY MAKE IN THEIR OWN FIRMS INCREASE SHAREHOLDER VALUE. MANAGERS HAVE MET THAT RESPONSIBILITY IF THE RETUR ON CAPITAL INVESTMENT….
EXCEEDS THE RATE OF RETURN ASSOCIATED WITH THE FIRMS BETA FACTOR.
-A CAPITAL INVESTMENT WHOSE RATE OF RETURN EXCEEDS RATE OF RETURN ASSOCIATED WITHT THE FIRMS BETA FACTOR WILL INCREASE THE VALUE OF THE FIRM.
BETA CONSIDERATIONS
B=1 AS RISKY
B>1 MORE RISKY
B
INVENTORY TURNOVER
COGS/AVG INVENTORY
INVENTORY CONVERSION PERIOD
365/INVENTORY TURNOVER
AR TURNOVER
SALES/AVG AR
INVENTORY CONVERSION PERIOD
365/REC TURNOVER
PAYABLES TURNOVER
COGS/AVG AP
AP DEFERRAL PERIOD
365/AP TURNOVER
CASH CONVERSION CYCLE FORMULA
INV CONVERSION PERIOD+REC COLLECTION PERIOD+PAYABLE DEFERRAL PERIOD.
THE AMOUNT OF INVENTORY THAT A COMPANY WOULD TEND TO HOLD IN STOCK WOULD INCREASE WHEN….
-THE AMOUNT OF INVENTORY CARRYING COST DECREASES.
THE AMOUNT OF INVENTORY THAT COMPANY TEND T TO HOLD IN STOCK WOULD DECREASE AS THE:
- VARIABILITY OF SALES DECREASES
- COST OF RUNNING OUT OF STOCK DECREASES
- LENGHT OF TIME THAT GOODS ARE IN TRANSIT DECREASES.
A DECREASE IN WHAT WOULD CAUSE EOQ TO INCREASE?
-A DECREASE IN CARRYING COSTS
WHAT IS FLOAT
THE DIFFERENCE BETWEEN THE BALANCE OF CHECKS OUTSTANDING, WHICH HAVE NOT CLEARED THE BANK AND DEPOSITS MADE BUT WHICH HAVE NOT YET CLEARED THE BANK
THE OPTIMAL LEVEL OF INVENTORY WOULD BE AFFECTED BY ALL OF THE FOLLOWING EXCEPT
-CURRENT LEVEL OF INVENTORY
THE OPTIMAL LEVEL OF INVENTORY IS AFFECTED BY
- TIME REQUIRED TO RECEIVE INVENTORY
- COST/UNIT OF INVENTORY, WHICH WILL HAVE DIRECT IMPACT ON INVENTORY CARRYING COSTS.
- COST OF PLACING ON ORDER IMPACTS ORDER FREQUENCY, WHICH IMPACTS ORDER SIZE AND OPTIMAL LEVELS.
WHEN DOES WIC INCREASE OR DECREASES??
WORKING CAPITAL INCREASE= CURRENT ASSET INCREASE
WORKING CAPITAL DECREASE=CURRENT LIABILITY DECREASE
IF CURRENT ASSETS INCREASE AND CURRENT LIABILITIES DECREASE WHAT HAPPENS TO WIC?
INCREASE BY THE SUM OF BOTH EX
CURRENT ASSETS INCREASED BY 120,000
CURRENT LIABILITIES DECREASED BY 50,000
THEREFORE WIC INCREASED=170,000
AS A COMPANY BECOMES MORE CONSERVATIVE WITH RESPECT TO WIC, IT WOULD TEND TO HAVE…
AN INCREASE IN THE RATIO OF CURRENT ASSETS TO NON CURRENT ASSETS.
-WIC POLICY IS DEEMED TO BE MORE CONSERVATIVE AS AN INCREASING PORTION OF AN ORG LONG TERM ASSETS, PERMANENT CURRENT ASSETS, AND TEMP CURRENT ASSETS ARE FUNDED BY LONG TERM FINANCING.
IN INVENTORY MANAGEMENT, THE SAFETY STOCK WILL TEND TO INCREASE IF??
VARIABILITY OF LEAD TIME-INCREASES.
- IF LEAD TIMES BECAME MORE VARIABLE, THE AMOUNT OF SAFETY STOCK NEEDED TO REDUCE THE RISK OF STOCK OUTS WILL INCREASE.
- HIGH CARRYING COST WOULD DECREASE SAFETY STOCK.
WHAT IS THE EFFECT ON INVENTORY TURNOVER AND INVENTORY PERCENTAGE WHEN SWITCHING FROM TRADITIONAL TO JIT INVENTORY..
INVENTORY TURNOVER=INCREASE
INVENTORY PERCENTAGE= DECREASE
-IN JIT PRODUCTS ARE PRODUCED JIT TO BE SOLD. THEREFORE, JIT SYSTEMS MAINTAIN A MUCH SMALLER LEVEL OF INVENTORY COMPARED TO TRADITIONAL SYSTEMS. AND INVENTORY AS A % OF TOTAL ASSETS DECREASES.
THE WORKING CAPITAL POLICY THAT SUBJECTS THE FIRM TO THE GREATEST RISK OF BEING UNABLE TO MEET THE FIRMS MATURING OBLIGATIONS IS THE POLICY THAT FINANCES
PERMANENT CURRENT ASSETS WITH STD
-THE WORKING CAPITAL FINANCING POLICY THAT FINANCES PERMANENT CURRENT ASSETS WITH STD SUBJECT THE FIRM TO THE GREATEST RISK OF BEIN UNABLE TO MEET FIRMS MATURING OBLIGATIONS.
PURCHASED OF LT ASSET ON THE LAST DAY OF THE CURRENT YR. WHAT ARE THE EFFECTS ON ROI AND RESIDUAL INCOME??
ROI=DECREASE
RESIDUAL INCOME=DECREASE
WHICH OF THE FOLLOWING INVENTORY MANAGEMENT APPROACHES ORDERS AT A POIN WHRE CARRYING COSTS=NEAREST RESTOCKING COSTS IN ORDER TO MINIMIZE TOTAL INVENTORY COST?
-EOQ
THE ECONOMIC ORDER QUANTITY METHOD INVENTORY CONTROL ANTICIPATES ORDERS AT A POINT WHERE CARRYING COSTS ARE NEAREST TO RESTOCKING COSTS. THE OBJECTIVE OF EOQ IS TO MINIMIZE TOTAL INVENTORY COSTS.
MAIN OBJECTIVE OF EOQ
TO MINIMIZE TOTAL INVENTORY COSTS
ASSET TURNOVER
SALES/ASSETS
WHAT IS THE FIRMS COST OF DEBT?
THE NET COST OF DEBT IS COMPUTED AS:
EFFECTIVE INTEREST RATE * (1-TAX RATE)
–THE COUPON RATE IS NOT USED EXCEPT WHEN THE COUPON=EFFECTIVE INTEREST AND THERE ARE NO FLOATATION COSTS.
WHAT IS THE PRIMARY DISADVANTAGE OF USING ROI RATHER THAN RESIDUAL INCOME TO EVALUATE THE PERFORMANCE OF INVESTMENT CENTER MANAGERS?
-ROI MAY LEAD TO REJECT PROJECTS THAT YIELD POSITIVE CASH FLOWS.
-PROFITABLE INVESTMENT CENTER MANAGERS MIGHT BE RELUCTANT TO INVEST IN PROJECTS THAT MIGHT LOWER THEIR ROI, SPECIALLY IF THEIR BONUSES ARE BASED ONLY ON THEIR INVESTMENT CENTER (ROI) EVEN THOUGH THOSE PROJECTS MIGHT GENERATE POSITIVE CF FOR THE COMPANY AS A WHOLE.
THIS CHARACTERISTIC IS OFTEN KNOWN AS THE DISINCENTIVE TO INVEST.
WHAT RATIO IS APPROPRIATE FOR THE EVALUATION OF AR?
DAYS SALES OUTSTANDING
-AMONG THE RATIOS LISTED, THE RATION THAT IS APPROPRIATE FOR EVALUATION OF AR IS THE # OF DAYS SALES ARE OUTSTANDING. SALES ARE RELATED TO AR SO THE MORE DAYS THE SALES ARE OUTSTANDING, THE LONG THE AR ARE OUTSTANDING.
DAY SALES FORMULA
DAY SALES= ENDING AR/ AVG DAILY SALES
WHY WOULD FIRM GENERALLY CHOOSE TO FINANCE TEMPORARY ASSETS WITH SHORT TERM DEBT?
BECAUSE MATCHING THE MATURITIES OF ASSETS AND LIABILITIES REDUCES RIKS.
-MATCHING THE MATURITIES OF CURRENT ASSETS AND CURRENT LIABILITIES AS THEY COME DUE IS DESIGNED TO ENSURE LIQUIDITY AND REDUCE RISK OF CASH SHORTAGES. TEMP ASSETS SUCH AS INVENTORIES, GENERALLY AND SEASONAL INVENTORIES SPECIFICALLY MIGHT BE FINANCED WTIH ST DEBT SUCH THAT THE EARNINGS FROM THE SALES OF THOSE TEMP ASSETS COULD BE USED TO LIQUIDATE THE RELATED OBLIGATIONS AS THEY COME DUE AND ENSURE THAT CASH IS AVAILABLE TO MEET CF REQUIREMENTS.
THE OPTIMAL CAPITALIZATION FOR AN ORGANIZATION USUALLY CAN BE DETERMINED BY THE??
LOWEST TOTAL WACC
(WEIGHTED AVG COST OF CAPITAL)
CAPITALIZATION OF WACC SERVES TO MAXIMIZE SHAREHOLDERS EQUITY.
WHAT IS THE DEGREE OF FINANCIAL LEVERAGE?
IT RELATES TO THE RISK ASSUMED BY A FIRM USING A FIXED DEBT SERVICE COSTS TO FINANCE OPERATIONS
WHAT IS THE DEGREE OF TOTAL LEVERAGE?
IT RELATES THE RISK ASSUMED BY A FIRM USING A COMBO OF BOTH DEBT SERVICE COTS TO FINANCE OPERATIONS AND FC TO OPERATE BUSINESS.
WHICH OF THE FOLLOWING TERMS REPRESENTS THE RESIDUAL INCOME THAT REMAINS AFTER THE COST OF ALL CAPITAL INCLUDING EQUITY CAPITAL HAS BEEN DEDUCTED?
-EVA-ECONOMIC VALUE ADDED
IT IS A RESIDUAL INCOME TECHNIQUE USED FOR CAPITAL BUDGETING AND PERFORMANCE EVALUATION.
-IT REPRESENTS THE RESIDUAL (EXCESS) INCOME PROJECT EARNINGS IN EXCESS OF THE COST OF CAPITAL INCLUDING COST OF EQUITY. ASSOCIATED WITH INVESTED CAPITAL.
THE INCREASE OF RELATIVELY STABLE DEMAND OVER A 3 YR PERIOD IN EACH OF THE FIRST 3 QUARTERS OF THE YEAR FOLLOWED BY AN INCREASE OF BETWEEN 40-50% IN THE FINAL QUARTER OF THE YEAR OVER AVERAGE SALES IN THE 3 QUARTERS IN EACH YR IS INDICATIVE OF
SEASONAL FLUCTUATIONS IN DEMAND FOR A PRODUCT THAT WOULD REQUIRE APPROPRIATE INVENTORY MANAGEMENT.
WHAT STRATEGY WOULD MOST LIKELY IMPROVE A COMPANIES AR TURNOVER RATIO?
AR TURNOVER RATIO=SALES/AR
FACTORING (SELLING) RECEIVABLES WOULD REDUCE THE AMOUNT OF AR THEREBY INCREASING AR TURNOVER RATIO.
WHAT RATE IS MOST COMMONLY COMPARED TO IRR TO EVALUATE WHETHER TO MAKE AN INVESTMENT?
-WACC
WACC IS FREQUENTLY USED AS THE HURDLE RATE WITHIN CAPITAL BUDGETING TECHNIQUES. INVESTMENT THAT PROVIDE A RETURN THAT EXCEEDS WACC SHOULD CONTINOUSLY ADD VALUE TO THE FIRM.
PRIME RATE?
THE RATE OF INTEREST THE GOVERMENT OFFERS TO BANKS WHEN LENDING MONEY
ECONOMIC ORDER ASSUMPTION EOQ??
- PERIODIC DEMAND IS KNOWN.
- EOQ ASSUMES THAT PERIODIC DEMAND IS KNOW, ANNUAL SALES VOLUME IS A CRUCIAL VARIABLE IN THE EOQ.
- THE CARRYING COST/UNIT IS ANTICIPATED TO REMAIN CONSTANT
- COST OF PLACING AN ORDER IS ANTICIPATED TO REMAIN CONSTANT.
INVENTORY TURNOVER
COGS/AVG INVENTORY
WAAC IS ATTRACTIVE TO POTENTIAL SHAREHOLDERS WHEN…
WACC IS LOW
ONE OF THE COMPANIES OBJECTIVES IS TO MINIMIZE WACC.
THE MIXTURE OF DEBT AND SECURITIES THAT PRODUCES THE LOWEST WACC MAXIMIZES THE VALUE OF A COMPANY.
AN INCREASE IN WHAT WOULD CAUSE MANAGEMENT TO REDUCE INVENTORY?
AN INCREASE IN CARRYING COST.
EXAMPLE. SUPPOSED ITEM A REQUIRES TO BE REFRIGERATED SO THAT IT WILL NOT SPOIL. IF ELECTRICITY PRICES ARE RISING, MGT WOULD PREGER TO HAVE LOWER INVENTORY ON HAND BECAUSE OF THE ELECTRICITY (COST OF CARRYING THE ITEM).
RETURN ON TOTAL ASSETS
EVALUATES THE PROFITABILITY OF A FIRM.
DAYS OF SALES OUTSTANDING
365/AR TURNOVER
DEBT TO TOTAL ASSETS RATIO
MEASURES SOLVENCY NOT PROFITABILITY
DAYS OF INV ON HAND
365/INV TURNOVER
INV TURNOVER= USED TO EVALUATE THE EFFICIENCY OF THE FIRM.
ROI FORMULA
OPERATING PROFIT(NI)/ INVESTMENT (AVG ASSETS) -ROI IGNORES THE RATE % ASSOCIATED WITH INVESTMENT (EXTERNAL BORROWING RATE).
AVERAGE COLLECTION PERIOD IS USED TO EVALUATE???
LIQUIDITY OF A FIRM THROUGH THE CALCULATION OF CASH CONVERSION CYCLE.
LIQUIDITY FOCUSES ON THE ABILITY OF THE COMPANY TO MEET OBLIGATIONS AS THEY COME DUE.
ROI IS COMPOSED OF 2 FORMULAS
- PROFIT MARGIN=
INCOME/SALES - INVESTMENT TURNOVER
SALES/AVG INVESTMENT
ROI IS CRITICIZED AS A PERFORMANCE MEASURE SINCE IT IS NOT WELL BALANCED MEASURE. WHAT CHARACTERISTIC OF EFFECTIVE PERFORMANCE MEASURE DOES THE ROI LACK?
-ROI ENCOURAGES SHORTSIGHTED BEHAVIOR THAT DEFERS OR AVOIDS INVESTMENT FOR THE SAKE OF CURRENT ROI PERFORMANCE. SHORT TERM BENEFITS ARE EMPHASIZED OVER LONG TERM COMMITMENTS.
CHARACTERISTICS OF ROI
- ROI IS EASY UNDERSTOOD
- ROI IS A SIMPLE AND RELATIVELY OBJECTIVE COMPUTATION THAT CAN BE DRAWN FROM ACCOUNTING.
- IT IS CONTROLLED OR INFLUENCED BY MANAGERS AND CAN BE MANIPULATED.
WHAT WOULD INCREASE THE QUICK RATIO?
-SELLING OBSOLETE INVENTORY AT A LOSS
SELLING OBSOLETE INVENTORY AT A LOSS WOULD INCREASE THE QUICH RATIO. THE REDUCTION OF INVENTORY VALUES AND RECORDING OF LOSS WOULD HAVE NO IMPACT ON QUICK ASSETS. THE ADDITION OF CASH HOWEVER, WOULD INCREASE CASH WITH NO IMPACT IN CURRENT LIABILITIES.
COST OF PREFERRED STOCK FORMULA??
DIVIDENDS PAID (PAR VALUE* % DIVIDEND)/NET PROCEEDS (MARKET PRICE-FLOATATION COSTS)
**FLOATATION COSTS INCLUDE COST OF ISSUING STOCK.
EFFECTIVE RATE OF INTEREST
AMOUNT PAID ON THE LOAN (LOAN * ANNUAL RATE)/ NET PROCEEDS (LOAN -COMPENSATING BALANCE)
INVENTORY TURNOVER
COGS/AVG INVENTORY
CASH CONVERSION CYCLE INCLUDES??
AVERAGE COLLECTION PERIOD+INVENTORY CONVERSION PERIOD-PAYABLE DEFERRAL PERIOD.
A FIRM THAT DESIGNS ITS COST STRUCTURE TO INCLUDE A HIGHER DEGREE OF OPERATING FC THAN VC BY ELECTING TO PAY SALARIES INSTEAD OF COMMISSIONS IS MAGNIFYING THE IPACT OF EACH ADDITIONAL SALES DOLLAR USING THE CONCEPT OF:
- OPERATING LEVERAGE.
- OPERATING LEVERAGE IS DEFINED AS THE DEGREE TO WHICH A FIRM USES FIXED OPERATING COSTS, AS OPPOSED TO VARIABLE OPERATING COSTS. A FIRM THAT HAS HIGH OPERATING LEVERAGE HAS HIGH FIXED OPERATING COSTS AND RELATIVELY LOW VARIABLE OPERATING COSTS ANS USES THIS COST STRUCTURE TO MAGNIFY THE FINANCIAL RESULTS OF EACH ADDITIONAL DOLLAR IN SALES.
THE MARKET RATE OF INTEREST ON A ONE YR US TREASURY BILL IS COMPRISED OF?
RISK FREE RATE OF INTEREST + INFLATION PREMIUM
COST OF COMMON EQUITY FORMULA
(DIVIDEND PER SHARE AT THE END OF YR/SELLING PRICE OR CURRENT MARKET VALUE) + CONSTANT GROWTH RATE IN DIVIDENDS.
QUICK RATIO/ACID TEST FORMULA
CASH+AR/CURRENT LIABILITIES
**THIS COMPUTATION EXCLUDES PREPAIDS AND INVENTORY IN THE NUMERATOR.
MATERIAS REQUIREMENTS PLANNING (MRP)
IT COCUSES ON A SET OF PROCEDURES TO DETERMINE INV LEVELS FOR DEMAND-DEPENDENT INVENTORY TYPES SUCH AS WIP AND RAW MATERIALS.
-MRP PRIMARILY APPLIES WIP AND RAW MATERIALS.
COST OF DEBT MOST FREQUENTLY IS MEASURED AS
ACTUAL INTEREST MINUS TAX SAVINGS.
WHAT PERFORMANCE MEASURE MAY LEAD A MANAGER OF AN INVESTMENT CENTER TO FORGO INVESTMENTS THAT COULD BENEFIT THE COMPANY AS A WHOLE?
-ROI
TIMES INTEREST EARNED FORMULA
EBIT/TOTAL INT EXP
