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BEC > Chapter 3 - Financial Management and Capital budgeting > Flashcards

Chapter 3 - Financial Management and Capital budgeting Flashcards

1
Q

What is Capital Budgeting? How is it used?

A

Managerial Accounting technique used to evaluate different investment options

Helps management make decisions

Uses both accounting and non-accounting information

Internal focus

GAAP is not mandatory

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2
Q

What values are used in Capital Budgeting?

A

Capital Budgeting ONLY uses Present Value tables.

Capital Budgeting NEVER uses Fair Value.

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3
Q

When is the Present Value of $1 table used?

A

For ONE payment- ONE time.

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4
Q

When is the Present Value of an Annuity Due used?

A

Multiple payments made over time- where the payments are made at the START of the period.

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5
Q

When is the Present Value of an Ordinary Annuity of $1 (PVOA) used?

A

Multiple payments over time- where payments are made at the END of the period.

Think A for Arrears.

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6
Q

What is the calculation for the Present Value of $1?

A

1 / (( 1+i )^n)

i : interest rate
n : number of periods

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7
Q

What is Net Present Value (NPV)?

A

A preferred method of evaluating profitability.

One of two methods that use the Time Value of Money
: PV of Future Cash Flows - Investment

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8
Q

How is NPV used to calculate future benefit?

A

NPV : PV Future Cash Flows - Investment

If NPV is Negative- Cost is greater than benefits (bad investment)

If NPV is Positive- Cost is less than benefit (good investment)

If NPV : 0- Cost : Benefit (Management is indifferent)

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9
Q

What is the rate of return on an investment called?

A

The Discount Rate.

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10
Q

What does the Discount Rate represent?

A

The rate of return on an investment used.

It represents the minimum rate of return required.

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11
Q

What are the strengths of the Net Present Value system?

A

Uses the Time Value of Money

Uses all cash flows- not just the cash flows to arrive at Payback

Takes risks into consideration

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12
Q

What are the weaknesses of the Net Present Value system?

A

Not as simple as the Accounting Rate of Return.

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13
Q

How do Salvage Value and Depreciation affect Net Present Value?

A

NPV includes Salvage Value because it is a future cash inflow.

NPV does NOT include depreciation because it is non-cash.

Exception - If a CPA Exam question says to include tax considerations- then you have to include depreciation because of income tax savings generated by depreciation.

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14
Q

If multiple potential rates of return are available- which is used to calculate Net Present Value?

A

The minimum rate of return is used.

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15
Q

What is the Internal Rate of Return (IRR)?

A

It calculates a project’s actual rate of return through the project’s expected cash flows.

IRR is the rate of return required for PV of future cash flows to EQUAL the investment.

Investment / After Tax Annual Cash Inflow : PV Factor

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16
Q

Which rate of return is used to re-invest cash flows for Internal Rate of Return?

A

Cash flows are re-invested at the rate of return earned by the original investment.

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17
Q

How does the rate used for Internal Rate of Return (IRR) compare to that used for Net Present Value (NPV)?

A

Rate of return for IRR is the rate earned by the investment.

Rate of return for NPV is the minimum rate.

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18
Q

What are the strengths and weaknesses of the Internal Rate of Return system?

A

Strengths: Uses Time Value of Money- Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR

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19
Q

When is NPV on an Investment positive?

A

When the benefits are greater than the costs.

IRR is greater than the Discount Rate

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20
Q

When is NPV on an Investment Negative?

A

When Costs are greater than Benefits

IRR is less than the Discount Rate

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21
Q

When is NPV Zero?

A

When benefits equal the Costs

IRR : Discount Rate

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22
Q

What is the Payback Method? How is it calculated?

A

It measures an investment in terms of how long it takes to recoup the initial investment via Annual Cash Inflow

Investment / Annual Cash Inflow : Payback Method

Compare to a targeted timeframe; if payback is shorter than target- it’s a good investment. If payback is longer than target- it’s a bad investment.

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23
Q

What are the strengths of the Payback Method?

A

Takes risk into consideration

2 year payback is less risky than a 5 year payback

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24
Q

What are the weaknesses of the payback method?

A

Ignores the Time Value of Money

Exception: Discount payback method

Ignores cash flow after the initial investment is paid back

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25
Q

What is the Accounting Rate of Return?

A

An approximate rate of return on assets

ARR : Net Income / Average Investment

Compare to a targeted return rate; if ARR greater than target- good investment. If ARR less than target- bad investment.

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26
Q

What are the strengths of the Accounting Rate of Return (ARR)?

A

Simple to use

People understand easily

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27
Q

What are the weaknesses of the Accounting Rate of Return (ARR)?

A

Can be skewed based on Depreciation method that is used.

Ignores the Time Value of Money.

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28
Q

What is an Expected Return?

A

An approximate rate of return on assets.

29
Q

What is the primary focus of working capital management?

A

Managing inventory & receivables (current assets & liabilities)

30
Q

How is Net Working Capital calculated?

A

NWC : Current Assets - Current Liabilities

31
Q

What are the characteristics of effective Working Capital Management?

A

Shorten the cash conversion cycle

Don’t negatively impact operations

32
Q

What is the Inventory Conversion Period?

A

Average time needed to convert materials into finished goods and sell them

Average Inventory : (BI + E) / 2

Inventory Conversion Period : Average Inventory / Sales Per Day

33
Q

What is the Receivables Collection Period?

A

Average time needed to collect A/R

RCP : Average Receivables / Credit Sales Per Day

34
Q

What is the Payables Deferral Period?

A

Average time between materials and labor purchase and their A/P payment

Average Payables : (BP + EP) / 2

Payables Deferral Period : Average Payables / (COGS/365)

35
Q

What is the Cash Conversion Cycle?

A

Amount of time it takes to receive a cash inflow (Customers) after making a cash outflow (Vendors)

Inventory Conversion Period
+ Receivables Collection Period
- Payables Deferral Period
: Cash Conversion Cycle

(Inventory Really (-Pays) Cash)

36
Q

What traits should Cash and Short-Term Investments have?

A

Liquid

Safe

37
Q

For what are Letters of Credit used?

A

Used for importing goods.

Issued by importer’s bank.

38
Q

What is the advantage of using Trade Credit?

A

No interest cost if paid timely.

39
Q

What is a Lockbox System? What are the advantages?

A

Customer Payments are sent to a bank-managed PO box.

Employees don’t have access to cash.
Deposits are more timely.
Interest income from deposits should pay for the Lockbox fees (if they don’t- lockbox is not beneficial)

40
Q

What is float?

A

Time it takes to mail a payment and have it clear your bank account

Maximize float on cash payments

Minimize float on cash receipts

41
Q

What are Zero Balance Accounts?

A

Regional bank sends enough cash to cover daily checks

Advantages:
Checks take longer to clear -more float
Low amounts of cash tied up for compensating (minimum) balances

42
Q

What is the difference between Treasury Bills- Notes and Bonds?

A

Treasury Bills: Short term (less than one year) Think: $1 Bill

Treasury Notes: Medium term (less than 10 years- more than 1)

Treasury Bonds: Long term (greater than 10 years) Think: government is in long-term bondage to you; they owe you money

43
Q

What is commercial paper?

A

Similar to T-Bill- but issued by corporations instead of Government

Greater than 9 Months Maturity

Unsecured

Issued by large firms

44
Q

What are the advantages and disadvantages of Commercial Paper?

A

Advantages: Financing at less than Prime. No compensating balances required.

Disadvantages: Unpredictability of markets. Credit crisis emerges and large insurance/investment companies aren’t lending.

45
Q

What is Economic Order Quantity?

A

The order quantity that minimizes inventory costs.

EOQ : Square Root of (2DO/C)

D : Unit Demand (Annual)
O : Order Cost
C : Cost of Inventory

46
Q

What is Carrying Cost?

A

The cost of keeping inventory.

47
Q

What is Order Cost?

A

Cost of executing an order and starting product production.

48
Q

What is inventory reorder point?

A

How low inventory should get before it should be re-ordered.

IOP : Average Daily Demand x Average Lead Time

49
Q

What is a Just In Time (JIT) system?

A

Orders inventory so that you get it just in time for when it’s needed

JIT is valuable when Order Cost is low and Cost of Carrying Inventory is high

50
Q

What is Factoring of receivables?

A

Receivables are sold to a financing company where they pay less than the value of the receivables due to a discount related to risk of non-collection

51
Q

What is a Trade Discount?

A

Buyer saves if paid early

Example: 1/10 Net 30

1% Discount if paid within 10 days

If not- bill is still due in 30 days

52
Q

What is the cost of forgoing a discount?

A

(Discount % x 365) / ((100% - Discount) x (Pay Period - Discount Period))

53
Q

What is the Prime Rate?

A

A benchmark used for lending only to the best customers

Most customers will be charged Prime + 3%- for example

If the lending institution and the customer are not in the same country- the LIBOR rate is often used

54
Q

What is the Nominal (Face- Coupon- Stated) Rate?

A

Interest rate stated on the face of a bond.

55
Q

How is Current Yield calculated?

A

CY : Interest Payment / Bond Price

56
Q

What is the Effective (YTM- Market) Rate?

A

PV of Principle + Interest : Bond Price

57
Q

What is a Zero Coupon Bond?

A

No interest payments made

Bond sold at a discount

Interest reflected when Bond matures

58
Q

What are the characteristics of a Junk Bond?

A

High interest rate

High default risk

59
Q

What are debenture bonds?

A

Bonds unsecured by collateral

60
Q

What are subordinated debentures?

A

Debenture Bonds that will be repaid if any assets are left after liquidation of a company

61
Q

What are Redeemable Bonds?

A

Provision in Bond contract allows demand of Bond payment under certain circumstances

62
Q

What is a Callable Bond?

A

Borrower can pay off debt early

63
Q

What is a Convertible Bond?

A

Lender can demand payment via company stock instead of money

64
Q

What is a Sinking Fund?

A

Borrower deposits regular sums into an account that will eventually pay off the debt

65
Q

What is the disadvantage of Common Stock in comparison to bonds?

A

Common Stock is more expensive to issue than debt.

Why? Investors demand a greater ROI than debtors (bondholders)

66
Q

What is the advantage of Preferred Stock?

A

Hold dividend priority over common stock

67
Q

What is Weighted Average Cost of Capital?

A

A company uses this to determine the true cost of their capital

Example:
Debt costs 5%; 40% of Cap.
Equity costs 12%; 60% of Cap.
(5% x 40%) + (12% x 60%)
WACC : 9.2%
68
Q

What is CAPM?

A

A stock’s expected performance is based on its beta (risk) compared to that of the stock market.

More risk : more expected return.

69
Q

How is Cost of Debt calculated?

A

(Interest Expense - Tax Benefit) / Carrying Value of Debt

BEC (7 decks)

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