Definitions Flashcards
Change in accounting principle
Occurs when entity:
1) adopts a generally accepted principle different from one previously used
2) changes method of applying a principle, or
3) changes to a new principle when the old one is no longer accepted
Requires retrospective application, so balance sheet is adjusted at beginning of period to reflect cumulative prior period changes
Change in accounting estimate
Results from new information and a reassessment of the future benefits and obligations represented by assets and liabilities
Requires prospective application, or only the current and future periods
Accounting error
Either:
1) mathematical mistake
2) mistake in application of gaap
3) oversight or misuse of facts when statements were prepared
Requires prior period adjustment by restarting prior period (to ensure consistency and comparability)
CAPM formula and use
Req rate of return = Rf + Beta(Rm - Rf)
Quantifies required return by relating the risk of the security to the average return available in the market.
Challenges: hard to estimate risk free rate, and should only be used for single period (1 year or less)
Covariance of a two stock portfolio
Correlation coefficient x standard deviation 1 x standard deviation 2
A measure of the two stocks’ mutual volatility
Formula - cost of not taking trade discount
Discount % / (100% - discount) x (days in year / (total payment period - discount period))
An annualized cost. Shows the effective rate paid to finance the full amount over the full credit term.
Usable funds formula
Invoice amount x (1.0 - discount %)
Effective interest rate on loan
Net int expense / usable funds
Is the ratio of the amount the firm must pay to the amount the firm can use
Simple interest loan
Occurs when interest is only paid at end of loan term. Stated nominal rate equals effective rate.
Discounted loans
Requires interest to be paid at beginning of loan.
Loan amount = usable funds / (1.0 - stated rate)
Interest expense = loan amount x stated rate
Effective interest rate = stated rate / (1.0 - stated rate)
Loan with compensating balance
When bank requires borrower to maintain a balance during the loan term
Loan amount = usable funds / (1.0 - compensating balance rate)
Effective rate = stated rate / (1.0 - compensating balance rate)
If loan is offered on discounted basis:
Effective rate = stated rate / (1.0 - stated rate - compensating balance rate)
Constant growth dividend discount model
Expected div per share / (discount rate - div growth rate)
Used when dividend growth is expected to be consistent. If calculation is higher than current stock prices stock is undervalued
Expected div = last div paid x (1 - growth rate)^t
t = time periods
Calculating stock value with variable dividend growth
Two stage discount model.
1) calc and sum PV of dividends in high growth stage
2) calc the PV of the stock based on street growth, back to year 1
3) sum 1 and 2
Preferred stock valuation
Dividend per share / cost of capital
Component costs of capital (used for WACC
Debt = effective rate x (1.0 - marginal tax rate)
Pref stock = cash dividend / mkt price of pref stock
Common stock = cash dividend / mkt price of common stock
Retained earnings is same as CS
WACC calc (no pref stock)
(Mkt value of equity/(D+E) x cost of equity) + (mkt value of debt/(D+E) x cost of debt) x (1 - tax rate)
Marginal cost of capital
Weighted average cost to the firm of the next dollar of new capital raised after existing internal sources are exhausted
Cost of new debt, new pref stock, and new common stock
Debt = Annual interest / net issue proceeds
Pref stock = next dividend / net issue proceeds
CS = (next dividend / net issue proceeds) + dividend growth rate
Long vs short position
Long = whenever entity benefits from rising price
Calculate benefit of speeding up cash collections
(Daily cash receipts x days of reduced float) x opportunity cost of funds
Subtract cost to get total benefit/(loss)
4 steps to making disinvestment decision
- Identify fixed costs eliminated by decision
- Determine revenue needed to justify continuing ops. In short run, this should at least equal variable cost of production or continued service.
- Establish opportunity cost of funds received upon disinvestment.
- Determine whether the carrying amount of the asset(s) is equal to economic value. If not, reevaluate decision using current fair value rather than carrying amount.
Price elasticity of demand
measure of change in demand relative to change in price
-always positive value
> 1 means relatively elastic (small change in price results in large change in demand)
= 1 means unitary elasticity. One for one change in both demand and price.
< 1 means relatively inelastic. Large change in price results in small change in demand.
Infinite = demand is perfectly elastic. Results for market in pure competition - single seller demand goes to 0 with any decrease in price.
= 0 means perfectly inelastic. Demand is the same regardless of price.
5 types of risks
- Hazard risks - insurable risks (natural disasters, death, sabotage, impairment of assets, terrorism)
- Financial risks - risk related to interest rates, FX, commodities, credit, liquidity, and markets.
- Operational risks - related to everyday, ongoing operations. Risk of loss from inadequate or failed internal processes, people, and systems. Includes legal and compliance risks.
- Strategic risks - includes global economic risk, political risk, regulatory risk, and risks related to global market conditions. Also reputation risk, leadership risk, brand risk, and changing customer needs.
- Business risk - risk that company will have lower than expected profits.
5 step in risk management process
- Identify risks that could have impact on organization.
- Assess risk probability and potential impact.
- Prioritize risks - large orgs may appoint a committee to review risks and allocate resources
- Formulate response - committee proposes response strategies, and communications sent out to relevant team members
- Monitor risk responses - someone close to the operations (ex. manager) must monitor, and internal audit should also review effectiveness.
