Chapter 9 - Financial Planning and Analysis Flashcards
Opportunity Cost of Funds
The rate at which funds can be invested
If a firm pays less than the present value of discounted future cash flows, what rate of return will it achieve?
A rate higher than the discount rate
Two Options for PV of Foreign Currency Cash Flows
Translate foreign currency cash flows with a forward rate, then use the domestic discount rate
Discount the foreign currency cash flows using a foreign rate, then translate using spot FX rate
How to best minimize distorted comparison for foreign currency discounting of cash flows?
FCY cash flows should be discounted using an appropriate foreign currency interest rate
Operating currency cash flows should be discounted using an appropriate operating currency interest rate
Idle Capacity
Unused capacity of partially used facilities
Can repaying debts allow for the time value of money to be effective?
Yes
How does a stated interest rate less than 1 year impact PV / FV calculations?
Use that rate but then make sure the compounding periods are also increased
Lower interest rate but compounded much more frequent
How is a firm’s required return determined?
The opportunity cost that its investors forego
Relevant cash flows are commonly referred to as ______________?
Incremental or marginal cash flows
Capital
(FP&A Related)
Long Term Debt + Equity
The relevant cost for the primary sources of permanent capital would be their ___________?
Marginal cost
The rate of return the market would demand if funds were raised today
Should issuance costs be considered in the determination of the cost of debt?
Yes
The Cost of Equity primarily determines the cost that applies to equity funds that are obtained through __________?
Retained earnings
Is the cost of issuing additional common stock higher or lower than the cost of equity obtained through retained earnings?
Higher because the company will receive less per share due to issuance expenses
The cost of equity is focused on which type of equity funding?
Common equity
A higher WACC does what to the EVA?
Drops it
A higher WACC will result in what for the NPV?
A lower NPV
What is the summary takeaway regarding a higher WACC?
Firms that have a higher WACC have a harder time creating value and are less competitive
Is a negative EVA always a bad thing?
Not necessarily if it results from investment in a new project that will pay higher yields later on (timing difference)
What happens to the stock price if EVA continues to be negative?
It will decrease
Four Important Calculations and Criteria for Capital Budget Decision Making
Payback Period
NPV
Profitability Index
IRR
Two shortcomings of the Payback Period
Doesn’t consider time value
Doesn’t consider cash flows after payback period
What discount rate is used for calculation of NPV?
WACC
Profitability Index
All values above 1 should be considered further
NPV vs. Profitability Index
(What is each measuring?)
NPV = overall change in a firm’s value
PI = how many times the upfront investment earns back its initial value
Can the PI be useful for things outside of cash?
Yes, it can be used for other constrained factors
IRR
The discount rate (cost of capital) at which the NPV equals zero
How should the IRR be evaluated when compared to the WACC?
IRR greater than WACC should be considered further
Does the IRR alone provide information on the expected change in firm value?
No
Alternative to using WACC for capital budgeting decisions?
Internally determined hurdle rate
If cash flows change signs, what happens with regards to the IRR?
Multiple IRRs are possible
Sensitivity Analysis vs. Scenario Analysis
Changing one variable vs. multiple
Scenario Analysis is often used to determine what?
Best and worst case scenarios
Monte Carlo Analysis
Assigning probabilities and multiple simulations to create a bell curve
RADR
Risk-Adjusted Discount Rate
Discount rate is adjusted based on the inherent risk
Very valuable for companies with multiple divisions of varying risks
RAROC
Risk-Adjusted Return on Capital
Measures expected profitability of a project from a risk-adjusted standpoint
Who are the primary users of RAROC?
Financial institutions assessing value of relationships
If Return on Assets is below the WACC but there is a net profit and positive cash flow, what will likely happen?
Stock price will likely fall even though they have two positive metrics
Treasury’s Role in the Budgeting Process
Manage short-term assets and liabilities
Assess impacts on debt covenants and credit ratings
Managing financing of long-term assets
May need to adjust strategy for liquidity requirements
Master Budget’s Two Components
- Operating Budget (Profit Plan)
- Financial Budget
(Broken out between the two like Operating Cash Flows and Investing/Financing Cash Flows)
What is zero-based budgeting?
Each item in the budget has to be justified
Which must be developed first, the Operating Budget or the Financial Budget?
Operating Budget as sales will determine how the business generates cash and the relevant operational costs
Financial Budget Steps
Capital Budget
Cash Budget
Identify financing sources
Budget Purposes
Planning and control
Resource allocation
Communication and coordination tool
Cost Drivers
Business activities that influence costs
What does the Break-Even Analysis measure?
Level of sales required to get an operating profit of $0
Contribution Margin
Selling price – variable costs
Operating Leverage
The degree to which fixed costs comprise the cost structure
High Operating Leverage vs. Low Operating Leverage
High – indicates increased risk since a decline in sales results in a higher decline in operating profit
Low – lower profitability compared to high, but less risky
Is a higher Degree of Operating Leverage more or less risky?
More risky
Financial Leverage
The impact of interest expense on overall profitability
Purpose of Each Type of Ratio
- Liquidity or Working Capital Ratios
- Efficiency or Asset Management Ratios
- Debt Management Ratios
- Profitability or Performance Ratios
Liquidity or Working Capital Ratios – the ability to meet financial obligations and indicate if cash is used effectively
Efficiency or Asset Management Ratios – how effectively assets are used
Debt Management Ratios – the degree of indebtedness and the ability to service debt
Profitability or Performance Ratios – profitability in relation to revenue and investment
Alternative to using Period-End Balances for Financial Ratios
You can use average balances from the beginning and end of the period
May not be effective if the business changes drastically
Turnover Ratios measure what?
Asset efficiency
Which ratio is also known as the cash profit margin?
Cash Conversion Efficiency
Three Benefits of Debt
(Chapter 9 - FP&A)
Cost is generally less than equity
Interest is generally tax deductible
Financing with debt does not dilute earnings
Is the cost of debt or equity usually more?
Equity
Equity for Capital considerations is comprised of what?
Preferred and Common Equity
When would you want to use Debt to Tangible Net Worth?
Companies with high percentage of intangibles due to difficulty in valuing and higher risk
When would EBITDA be used instead of EBIT for the Times Interest Earned ratio?
Firms that have high depreciation expenses
What is the reasoning behind the Fixed-Charge Coverage Ratio?
Fixed charges represent additional risk and therefore should be included
Adjusted EBITDA
Useful for comparisons and will remove nonrecurring items
Three Downsides to ROIC Calculation
Assumes no cost for capital acquired from shareholders
May reject positive NPV projects that increase ROIC
Misleading performance when earnings vary greatly from period to period
Downsides to Residual Income Calculation
Only reflects absolute profit; no indication of capital required to obtain that profit
Does not account for the degree of leverage a firm has
EVA vs. RI
EVA is done on an after tax basis while RI is based on a pretax performance
EVA is more widely accepted for assessing performance
Do firms generally use Economic Value Added (EVA) or Residual Income (RI) to assess performance?
EVA
Free Cash Flow vs. Free Cash Flow to the Firm for Cash Availability
Free Cash Flow = creditors and shareholders
FCFF = long-term capital (bondholders and shareholders)
Service Industry Ratios Commentary
- Investment in buildings and fixed assets?
- Debt levels?
- Balance sheet?
- SG&A size?
- Investment in buildings = little
- Debt levels = low
- Balance sheet = high level of current assets; low level of fixed assets
- SG&A = larger
Comparing between companies, especially those in a peer group, is known as what?
Comparative analysis or benchmarking
Benefits to Ratios
(Review & Familiarize)
Easily computed
Information is easily obtained
Facilitate trend or historical analysis
Comparison between companies
Downsides to Ratios
(Review & Familiarze)
Historical performance only
Should not be used in isolation
Summarize accounting information, not economic value
No qualitative values
Different accounting methods impacts comparability
Common-Size Financials Statements
(Also, how are the I/S and B/S assessed?)
Allow for comparisons of companies of different sizes
Income Statement = Percentage of Revenue
Balance Sheet = Percentage of Total Assets
The Fixed-Charge Coverage Ratio is based on which other ratio?
Times Interest Earned
Flotation Costs
The costs of issuing a security (usually the underwriting costs) not related to direct interest or equity costs
i.e. they are not ongoing
Equity Capital
The invested capital of an organization
Common Equity + Preferred Equity + Retained Earnings
Economic Value Added (EVA)
A performance measurement ratio that isolates the funds available to all suppliers of capital and then relates that total to the amount of capital supplied
Funds from common equity can be raised from which two sources?
Issuing new shares
Retained Earnings (investors will expect to have a high rate of return for funds reinvested in the business)
If a business is already profitable and wants to increase its profits more rapidly, what should the business do:
A. Invest in more variable costs
B. Invest in more fixed costs
B - As the company is already profitable, investing in fixed costs will result in higher profits once fixed costs have been covered.
This is also more risky, but also provides the better reward.
