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CPA BEC > Chapter 3 > Flashcards

Chapter 3 Flashcards

1
Q

The profitability index is a variation of which of the following capital budgeting models?

A

Net Present Value. (Present value of net future cash inflows/Present value of net initial investment)

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2
Q

What is the most objective methodology used to develop the fair value of common shares?

A

Discounted Cash Flow (DCF) methods are considered to be the most rigorous and objective of the valuation methods

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3
Q

What is the equation to calculate the IRR?

A

Net incremental investment (investment required)/Net annual cash flows

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4
Q

What capital budgeting model is the best model for long-range decision making?

A

The discounted cash flow model (which includes NPV, IRR, and profitability index) because they take into account the time value of money

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5
Q

Define the internal rate of return

A

The internal rate of return is equal to the discount rate at which the investment is equal to zero

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6
Q

What is a limitation of the profitability index?

A

The profitability ratio requires detailed long-term forecasts of the project’s cash flows

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7
Q

What is the formula for the Cost of retained earnings?

A

= Risk free rate + [Beta * (Market return - Risk free rate)]

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8
Q

What is the overall cost of capital?

A

The rate of return on assets that covers the costs associated with the funds employed

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9
Q

How is the net cost of debt computed?

A

As the effective interest rate net of tax (not the coupon rate unless it is the same as the effective rate and there are no flotation costs)

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10
Q

What are the three elements needed to estimate the cost of equity capital?

A
  1. Current dividends per share (D)
  2. Expected growth rate in dividends (G)
  3. Current Market Price per share of common stock (P)
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11
Q

What is the primary disadvantage of using Return on Investment (ROI) instead of Residual Income (RI)

A

ROI may lead to rejecting projects that yield positive cash flows. Profitable investment centers may be reluctant to invest in projects that might lower their ROI (Bonus incentives may rely on it) = disincentive to invest

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12
Q

What is the investment turnover ratio?

A

Investment (asset) turnover = Sales/Average total assets

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13
Q

What is economic value added (EVA)?

A

EVA is a residual income method used for capital budgeting and performance evaluation. It represents the residual (excess) income of project earnings in excess of the cost of capital (including cost of equity) associated with invested capital.

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14
Q

How do you calculate times interest earned?

A

= earnings before interest and taxes (EBIT)/interest expense

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15
Q

How do you calculate ROI?

A

=Net income/Average operating assets

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16
Q

How do you calculate Economic Value Added? (EVA)

A

Step 1: Investment * Cost of capital = Required Return

Step 2: Net operating profit after taxes (EBIT * (1-T)) - Required Return = EVA

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17
Q

Which ratio is best used to compare the profitability of two electronics companies that differ in size?

A

Return on Assets: It is a profitability ratio that produces a percentage output, making it easy to compare companies that differ in size

18
Q

The optimal level of inventory is affected by what?

A
  1. The time required to receive inventory
  2. The cost per unit of inventory, which will have a direct impact on inventory carrying costs
  3. The costs of placing on order impacts order frequency, which effects order size and optimal inventory levels
19
Q

What is the market rate of interest on a one year US Treasury Bill?

A

It is compromised of the risk free rate of return and an inflation premium.

20
Q

What is a company’s average collection period used ot evaluate?

A

It is used to evaluate the liquidity of the firm through the calculation of the cash conversion cycle. Liquidity measurements focus on the ability of the company to meet obligations as they come due

21
Q

What is Materials Requirements Planning (MRP)?

A

It is an inventory management technique that projects and plans inventory levels in order to control the usage of raw materials in the production process. It primarily applies to work in process and raw materials

22
Q

In inventory management, the safety stock will increase if…

A

the variability of lead-time increases. If lead times become more variable, the amount of safety stock needed to reduce the risk of stock outs will increase

23
Q

What is the formula for the cash conversion cycle? Interpret it

A

Cash conversion cycle = Inventory conversion period + Receivables collection period - Payables deferral period (Decreasing inventory conversion and receivables collection means that cash is being collected sooner (fewer amount of days) and increasing the deferral period means deferring payment as late as possible also good for the conversion cycle

24
Q

What is the working capital financing policy that subjects the firm to the greatest risk of being unable to meet their obligations?

A

Permanent current assets with short-term debt.

25
Q

What is the formula to calculate the effective interest rate of financing arrangements?

A

= interest paid / net proceeds

net proceeds is amount the company can keep after the required cash is kept in

26
Q

which ratio would be most likely used to measure a company’s liquidity?

A

The acid test (quick) ratio

27
Q

The NPV method of capital budgeting assumes that cash flows are reinvested at?

A

The discount rate used in the analysis

28
Q

A firm with a higher degree of operating leverage compared to industry average implies:

A

The firm’s profits are more sensitive to changes in sales volume. (RULE: Operating leverage is the presence of fixed costs in operations, which allows a small change in sales to produce a large relative change in profits).

29
Q

What is the optimal capital structure?

A

It is the financial structure that would theoretically maximize shareholder wealth by maximizing the net worth of the company. (It’s an objective).

30
Q

What does appropriate working capital management do?

A

It matches the maturity life of each asset with the length of the financial instrument used to finance that asset

31
Q

What are methods of converting Accounts Receivable into cash?

A
  1. Collection agencies - used to collect overdue AR
  2. Factoring AR - selling AR to factor for cash
  3. Cash discounts - offering cash discounts to customers for paying AR quickly (or paying at all). For example 2/10 net 30
  4. Electronic Funds Transfer - a method of payment, which electronically transfers funds between banks
32
Q

How do you calculate the cost of carrying accounts receivable?

A

The variable cost of creating the account receivable times the cost of that capital during the collection period

33
Q

What are safety stock levels affected by?

A
  1. Uncertain sales forecasts - greater uncertainty means a higher level of safety stock should be carried
  2. Dissatisfaction of customers - If customers are dissatisfied with backorders (which occur when there are stock outs) then more safety stock should be carried to prevent stock outs
  3. Uncertain lead times - greater uncertainty means a higher level of safety stock is needed
    ( Reorder costs do not impact the level of safety stock)
34
Q

Which is included in inventory carrying costs, inspections or opportunity cost on inventory investment?

A

Opportunity cost - the economic cost of holding inventory includes the implicit (opportunity) cost of foregoing a return on the money invested in inventory (inspections are part of order costs)

35
Q

When the economic order quantity is used for a firm that manufactures it’s own inventory, ordering costs consist primarily of what?

A

Production Set-up

36
Q

What is a shortcut to calculate operating leverage?

A

Fixed Costs/Variable Costs

37
Q

What is one factor that might cause a firm to increase the debt in it’s financial structure?

A

An increase in the corporate tax rate (because interest is tax deductible but dividends aren’t if you had more equity)

38
Q

What is one way of calculating ROE?

A

Net profit margin * asset turnover * financial leverage

net income/sales) * (sales/assets) * (assets/equity

39
Q

When the risks of the individual components of a project’s cash flows are different, an acceptable procedure to evaluate these cash flows is to:

A

Discount each cash flow using a discount rate that reflects the degree of risk. Discount rates may be adjusted to factor differences in risks into cash flow analysis

40
Q

What changes in aggregate demand and supply causes a reduction in inflation?

A

A decrease in aggregate demand and a decrease in aggregate supply

41
Q

What is the efficient market hypothesis?

A

It implies that markets are efficient enough such that technical analysis (weak form), technical and fundamental analysis (semi-strong form), and both analyses plus insider information (strong form) do not provide an advantage to investors

CPA BEC (7 decks)

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