Chapter 3

Question 1

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

Answer 1

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

Question 2

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

Answer 2

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

Question 3

What is the equation to calculate the IRR?

Answer 3

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

Question 4

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

Answer 4

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

Question 5

Define the internal rate of return

Answer 5

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

Question 6

What is a limitation of the profitability index?

Answer 6

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

Question 7

What is the formula for the Cost of retained earnings?

Answer 7

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

Question 8

What is the overall cost of capital?

Answer 8

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

Question 9

How is the net cost of debt computed?

Answer 9

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)

Question 10

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

Answer 10

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

Question 11

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

Answer 11

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

Question 12

What is the investment turnover ratio?

Answer 12

Investment (asset) turnover = Sales/Average total assets

Question 13

What is economic value added (EVA)?

Answer 13

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.

Question 14

How do you calculate times interest earned?

Answer 14

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

Question 15

How do you calculate ROI?

Answer 15

=Net income/Average operating assets

Question 16

How do you calculate Economic Value Added? (EVA)

Answer 16

Step 1: Investment * Cost of capital = Required Return

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

Question 17

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

Answer 17

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

Question 18

The optimal level of inventory is affected by what?

Answer 18

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

Question 19

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

Answer 19

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

Question 20

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

Answer 20

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

Question 21

What is Materials Requirements Planning (MRP)?

Answer 21

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

Question 22

In inventory management, the safety stock will increase if…

Answer 22

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

Question 23

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

Answer 23

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

Question 24

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

Answer 24

Permanent current assets with short-term debt.

Question 25

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

Answer 25

= interest paid / net proceeds | net proceeds is amount the company can keep after the required cash is kept in

Question 26

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

Answer 26

The acid test (quick) ratio

Question 27

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

Answer 27

The discount rate used in the analysis

Question 28

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

Answer 28

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).

Question 29

What is the optimal capital structure?

Answer 29

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

Question 30

What does appropriate working capital management do?

Answer 30

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

Question 31

What are methods of converting Accounts Receivable into cash?

Answer 31

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

Question 32

How do you calculate the cost of carrying accounts receivable?

Answer 32

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

Question 33

What are safety stock levels affected by?

Answer 33

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)

Question 34

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

Answer 34

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)

Question 35

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

Answer 35

Production Set-up

Question 36

What is a shortcut to calculate operating leverage?

Answer 36

Fixed Costs/Variable Costs

Question 37

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

Answer 37

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

Question 38

What is one way of calculating ROE?

Answer 38

Net profit margin * asset turnover * financial leverage | net income/sales) * (sales/assets) * (assets/equity

Question 39

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:

Answer 39

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

Question 40

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

Answer 40

A decrease in aggregate demand and a decrease in aggregate supply

Question 41

What is the efficient market hypothesis?

Answer 41

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