exam Flashcards
explain the process of doing CVP with more than one product
work out the proportion of each product out of the total as a decimal.
work out the contribution margin for each of the products.
multiply each of the contribution margins by the sales mix decimal proportion worked out in the first step.
add the dollar amounts this gives of all the products to get the weighted average contribution margin per unit.
put this WACM on the bottom of the formula instead of P-V and work out breakeven.
Take the decimal proportions of the total breakeven units to find out how many there are of each.
what are the assumptions and limitations of CVP analysis
- Linear revenue and cost functions
- Production = sales (i.e. we can sell everything we produce)
- Fixed and variable costs can be identified
- The sales mix is known
Selling price is known and constant
what is a budget
a plan showing how resources are to be acquired and used over a specified time interval
what are the advantages of budgets
- Helps to identify future problems and opportunities
- Compel management planning which the whole organisation has to partake in
- Provides a measure for comparing actual performance
- Promotes communication and coordination
what are human factors in budgeting
If managers are held accountable for the budget, they should only be accountable for the performance they can control and should participate in setting targets (although there is a tendency to set them at a level you think you can easily meet then).
what is included in the operating budget
sales budget
(production costs) production budget, direct materials purchases budget, direct labour budget, overhead budget
= cost of goods manufactured budget
(period costs) selling and administrative budget
= budgeted income statement
what types of financial budgets are there
cash budget, budgeted balance sheet, capital expenditures budget
what should you consider when projecting sales
- Past experience
- Pricing policy
- Market research
- Economic conditions
- Industry outlook
- Market share
where can you find examples of all the different budgets to follow??
your notes babes
what things go into a cash budget
beginning cash balance, plus cash collections including cash and credit sales = total cash available, less disbursements = total cash needs, = cash deficiency/surplus or closing balance
all non-financial information in statements is?
voluntary
formula: environmental burden = population x affluence x ?
technology
what are the two paradigms for environmental thinking
dominant social paradigm - growth, materialism is good
new environmental paradigm - nature is good
what are the beliefs of promethean optimists
- We need economic development to create surpluses to share back out in order to afford environmental protection
- They believe in infinite possibilities through substitution - the stone age ended because oil was more efficient, oil will become uneconomic and we will just substitute it for something else
what is the counter position of the promethean optimists
survivalism, new environmental paradigm - - We live in a world of finite ecosystems and resources so we can’t simply go on forever the way we have existed in the past
- There are reports telling us the state of the planet is dire - Some have referred to this as the planetary boundaries
what are the three aspects of the triple bottom line?
social, environmental, economic
scale can swamp ?
efficiencies, eg: 6 times better fuel consumption but 600 times more cars
sustainability is not about incremental reform, it is about ?
radical redesign
define tax
a compulsory transfer of resources from the private to the public sector
what is Oliver Wendell Holmes say about taxes
“taxes are the price we pay for civilized society”
80% of government revenue comes from?
taxation
what type of tax does most (49%) of tax revenue come from
individual income tax
what is the marginal tax rates
if i earn another dollar what tax rate would i be subject to on that dollar
what is the average tax rate
total tax paid/income
why do we need taxes?
- To finance government
- To provide public goods
- To redistribute income
To effect fiscal policy
what is involved in the interdisciplinary nature of taxation
accounting, law, economics and psychology, political science
what are the olden days random types of taxes
the window tax, hearth tax, candle tax, brick tax, hat taxes
what are the current pieces of legislation for taxation
Income Tax Act 2007, Tax Administration Act 1994, Taxation Review Authorities Act 1994 and the Goods and Services Tax Act 1985.
a persons tax liability is determined by
Gross income - deductible expenses = net income x tax rate
what is income
- Salary and wages
- Rent
- Dividends from companies
- Interest
Profits from carrying on a business
are illegal activities taxed
yes
do taxes differ between countries?
yes
what is the main goal of firms
to maximise shareholder value
“a dollar today is worth ?
more than a dollar tomorrow”
what is FVIF
future value interest rate factor, (1+r)^n
what is pvif
present value interest rate factor, 1/(1+r)^n
how do you rearrange present/future value to get n
use natural logs to multiply each side by them and bring the n out the front
what is an annuity
a stream of equally spaced, even (equal) cash flows for a finite period
what is a perpetuity
a stream of even cash flows that extends to infinity
what is multiple uneven cash flows
a stream of (usually) equally spaced, uneven cash flows for a finite period of time
what is an ordinary annuity
first cash flow occurs at the end of the first period eg: interest earned on savings
what is an annuity due
first cash flow occurs at the beginning of the first time period eg: premiums paid on an insurance policy
what is an amortised loan
these are loans paid off in equal instalments over time
reducing the balance of amortised loans through annuity payments is called?
amortisation
at the beginning of the loan more of the payment is going towards ___ than the ____
interest , principle
what are the steps to work out amortised loans
Step 1: Find the required annual payment
Step 2: Find the interest paid in year 1
The borrower will owe interest upon the initial balance at the end of the first year. Interest to be paid in the first year can be found by multiplying the beginning balance by the interest rate.
Step 3: Find the principle repaid in year 1
Principle repayment = payment - interest
Step 4: Find the ending balance after year 1
Subtract the amount paid towards the principal from the beginning balance.
what is the stated (quoted) rate
APR (annual percentage rate)/m (number of compounding periods)
periods, n, is given by?
m * y
what is the effective annual rate
The effective annual rate is a comparable measure that reflects the number of times per year that interest is paid or compounded (m). We do not use this in TVM calculations, but rather for comparing rates if they are compounded differently
what is capital budgeting
the process of evaluating and selecting long-term investments that are consistent with the firms’ goal of maximising owner wealth.
what is capital expenditure
an outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year
what is an individual project
cf’s are unrelated to one another, the acceptance of one does not eliminate the other from further consideration
what is a mutually exclusive project
projects compete with one another so the acceptance of one eliminates the other from further consideration
what is the accept-reject approach
evaluating capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criterion
what is the ranking approach
ranking projects on the basis of some predetermined measure such as the rate of return
what is unlimited funds
where a firm is able to accept all independent projects that provide an acceptable return
what is capital rationing
where a firm has a fixed number of dollars available for capital expenditure and numerous projects compete for these dollars
what is the payback period method
This method is widely used as it is very simple to calculate. It shows the time required for a firm to recover its initial investment in a project.
what is the decision criteria for the PP method
The length of the maximum acceptable payback period is determined by management. If the payback period is less than the maximum acceptable payback period, accept the project. If it is more than the acceptable benchmark, reject the project.
what are the pros and cons of the payback method
The advantages of the payback period method are that it is simple and intuitive. It deals with cash flows as opposed to accounting profits (distorted by accruals) and can be viewed as a method of risk exposure.
It’s disadvantages are that it is merely a subjective, arbitrarily determined number. It also ignores the TVM and fails to recognise CF’s that occur after the Payback Period.
what is the net present value method
This is found by subtracting a project’s initial investment from the present value of its cash flows, discounted at a rate equal to the firm’s opportunity cost of capital.
what is the decision criteria for the net present value method
If NPV is greater than $0 we accept the project. If it is less than $0, reject the project. If NPV = $0 we can say it is still good as we cover our costs but no more and we get a gain in size. If NPV is greater than $0 the firm will earn a return greater than the cost of its capital and this should increase the market value of the firm and the wealth of its owners.
what are the pros and cons of the npv method
The advantages of NPV are that it considers all free cash flows as opposed to accounting profits, it recognises TVM and it is consistent with the overall goal of maximising shareholder value.
It’s disadvantages are that it required detailed long-term forecasts and estimates of the firms opportunity costs of capital which are not easy and make the approach harder to apply.
what is the profitability index
just a variation of NPV
what is the decision criteria for PI
invest when the index is greater than 1
what are the pros and cons and pitfalls of the PI
The pitfalls of the index are that while NPV and PI will always agree, PI can lead to incorrect selection of projects as it may pick a small project over a bigger one. In the case of conflicting rankings, always follow NPV!
The advantages and disadvantages of the Profitability Index are the same as for the NPV.
what is the internal rate of return
This is the rate of return that the firm will earn if it invests in the project and receives the given cash flows.
what is a net present value profile
These are graphical depictions of a projects NPV’s for various discount rates. They are downward sloping and help us to visualise things and make decisions.
when will IRR and NPV agree and disagree
IRR and NPV will agree where cash flows are conventional (i.e. after the initial investment is made (cash flow), all the cash flows in each future year are positive (inflows). Where different accept/reject decisions can be created is if the projects are mutually exclusive or if a project has unconventional cash flows.
describe incremental cash flows
These are the additional after tax cash flows (outflows or inflows) expected to result from a proposed capital expenditure.
what are the major cash flow components
- Initial Investment - the amount we spent today
- Operating Cash Flows - the incremental after-tax cash inflows resulting from the implementation of a project during its life
- Terminal Cash Flows - the after-tax non-operating cash flow occurring in the final year of a project, usually in relation to the liquidation of the project
what is an expansion decision
Expansion involves expanding current business activities and doing something new. The after-tax cash outflows and inflows associated with the project are the initial investment, operating cash flows and terminal cash flows.
what is a replacement decision
Replacement decisions are more complicated to work out. The firm must identify the incremental cash inflow and outflows that would result from the replacement eg: of a machine.
what are sunk costs
Sunk Costs are expenses made in the past which have no effect on future cash flows. They should not be included in a project’s incremental cash flows as these costs have already been decided in the past, and we should only include future decisions.
what are opportunity csots
Opportunity Costs are cash flows which could be realised from the best alternative use of an owned asset. Opportunity costs should be included.
what are cash flows diverted from existing products
You must be aware of cash flows diverted from existing products by introducing a new one (the cannibalisation effect). An example of this effect is reduction in the sales of coke when coke zero was produced.
what are synergistic effects
Synergistic effects are sales that wouldn’t have happened without an existing project. An example is a warranty is unable to be sold without the sale of a car first.
are overhead costs included
We only include overhead costs when they change due to the project. If they don’t change they will occur whether the project happens or not, so in this case, they shouldn’t be included.
do we include interest payments
no
do we include changes in net working capital
yes
what is initial investment
The cost of a new asset is the net outflow necessary to acquire a new asset. Installation costs are any added costs to get the asset in the right place. The installed cost is the cost plus the installation cost and is the depreciable value for the asset.
what are the after tax proceeds from the sale of an old asset
These are the difference between the old assets sale proceeds and any applicable taxes or tax refunds. The proceeds from the sale of the old asset are cash inflows, net of any removal or clean up costs, resulting from the sale.
To find the tax on the sale of an old asset we need the book value (installed cost - accumulated depreciation). To get the tax value we take (sale price - book value) x company tax rate.
what are changes in net working capital
The NWC is the amount by which a firms’ current assets exceeds its current liabilities. The change in NWC is the difference between a change in current assets and a change in current liabilities.
what are operating cash flows
These are benefits expected to result from proposed capital expenditures and are measured on an after-tax basis. They must be on a cash flow rather than accounting profit basis. We are only concerned with the change in operating cash flows that result from a project so we must use incremental cash flows. We may have to convert accounting information into cash flows by adding back on depreciation and other non-cash charges.
describe cash flow vs accounting income
If we only look at accounting information we don’t notice the investment at t = 0. Depreciation is a non cash expense but has a real cash effect. This can lead to incorrect investment decisions.
what are terminal cash flows
This is cash flow resulting from termination and liquidation of a project at the end of its economic life. This is an after-tax cash flow and occurs in addition and in line with the final operating cash flow.
what is salvage value
The proceeds from the sale of the new and old asset, often called the “salvage value,” represent the amount net of any removal or clean up costs.
what are the taxes on terminal value
When net proceeds from the sale exceed book value we will minus tax and pay it. When net proceeds from the sale are less than book value we add tax as a tax rebate.
define risk
Risk is a measure of the uncertainty surrounding the return that an investment will earn, or more formally, the variability of returns associated with a given asset.
define return
Return is the total gain or loss experienced on an investment over a given period of time.
risk and returns are ____ related
positively
the higher the risk the _____ the return must be for us to invest
higher
what is the expected rate of return
the average of all possible outcomes, where those outcomes are weighted by the probability that each will occur
what does it mean to be risk adverse
Most people are risk adverse. These people would require an increased return as compensation for an increase in risk. This DOES NOT mean they won’t take any risks.
what does it mean to be risk neutral
Risk Neutral investors choose the investment with the greatest return regardless of the risk.
what does it mean to be risk neutral
Risk Neutral investors choose the investment with the greatest return regardless of the risk.
what does it mean to be risk seeking
These investors choose the highest risk investment even if it has lower returns
what is scenario analysis
This is where we assess risk using several possible alternative outcomes to obtain a sense of the variability between the results.
what is range
This is a measure of the asset’s risk which is found by subtracting the return associated with the pessimistic (worst) outcome from the return associated with the optimistic (best) outcome. The larger the range the more risky.
what is the expected value of return
This is the average return that an investment is expected to produce over time.
what is the standard deviation
This is the most common statistical measure of an assets risk. It measures the dispersion of returns around the expected value (or mean).
what is variance
This is the average value of squared deviations from the mean, standard deviation squared. Conversely, standard deviation is the square root of the variance.
the higher the standard deviation the higher the?
risk
what is diversification
is a strategy designed to reduce risk by spreading a portfolio across multiple investments, because prices of different assets do not move exactly the same.
what is unique risk
are risk factors affecting only a specific firm, aka “non-systematic risk, firm specific risk, idiosyncratic risk or diversifiable risk.”
what is standard deviation risk wise
total risk (unique risk + market risk)
what is market risk
includes economy wide sources of risk that affect the overall stock market, such as an economic downturn, and are also known as “systematic risk or non-diversifiable risk.”
what is a portfolio
a collection of assets
describe correlation of assets
This varies between -1 and 1 and measures the degree to which assets vary in the same direction. Perfectly positive correlation is where M going up by 1% causes N to go up by 1% also. Perfectly negative correlation is where M going up by 1% causes N to go down by 1%. Zero correlation gives diversification benefits.
describe diversification in relation to correlation
To reduce risk it is best to diversify by combining assets that have the lowest possible correlation. This reduces the overall variability of a portfolio’s returns.
we can never diversify away?
market risk
we can diversify away?
unsystematic risk (unique risk)
what does the capital asset pricing model (CAPM) do?
links risk and return for all assets. it is used to estimate the required returns on assets (discount rate). it measures how much additional return an investor should expect from taking a little extra risk
what is market risk given by
the beta coefficient
the beta coefficient for the entire market is?
1
we calculate the beta coefficient by which method?
rise over run
we calculate beta for a portfolio by?
the amount invested in the asset times it beta and add up all the assets - this uses weighting by the amount invested
what is the required rate of return
The investors required rate of return is the minimum rate of return necessary to attract an investor to purchase or hold a security.
what is the equation in words for the investors required rate of return
= risk free rate of return + risk premium
what is the risk free rate of return
The risk free rate of return is the required rate of return for risk free investments, typically measured by the US Treasury bill rate.
what is the risk premium
The risk premium is the additional return we must expect for acquiring risk. As the level of risk increases, we will demand additional expected returns.
what is the market risk premium
This is the risk premium of the market portfolio. It is the difference between the market return and the return on risk free treasury bills. It compensates investors for market risk.
what is the capital asset pricing model (CAPM) formula
required return on asset (rj) = rf (risk free rate of return) + [bj (beta coefficient) x (rm - rf (market risk premium))]
describe equilibrium and how it changes
When expected return is < required return the selling pressure drives the price down. When the expected return > required return the price goes up because everyone wants it and is rushing in so the price gets driven up. Where we can earn more than required return the stock is undervalued and the price gets driven up. We are in equilibrium when the required return is equal to the expected return. This is also known as a fairly valued stock.
what are the limitations of capm
- The CAPM relies on historical data so the betas may or may not accurately reflect the future variability of returns
- Therefore, the required returns specified by the model should only be used as rough approximations
- The CAPM assumes markets are efficient
- Although the perfect world of efficient markets appears to be unrealistic, studies have proven support for the existence of the expectational relationship described by the CAPM in active markets such as the NYSE.
what does rj stand for in the capm formula
required return on asset
what does rf stand for in the capm formula
risk free rate of return
what does bj stand for in the capm formula
beta coefficient
what does rm stand for in the capm formula
market return, return on the market portfolio of assets
what does rm - rf stand for in the capm formula
market risk premium
what is cost of capital
The cost of capital represents the firm’s cost of financing, and is the minimum rate of return that a project must earn to increase firm value. Financial managers are ethically bound to only accept projects that they expect to exceed the cost of capital. The cost of capital is used as a discount rate and depends on a firm’s debt and equity mix (capital structure).
what is the pre-tax cost of debt
The pre-tax cost of debt is the financing cost associated with new funds through long term borrowing. Typically the funds are raised through the sale of corporate bonds (ignoring bank loans).
what are flotation costs
Flotation costs are the costs of issuing and selling a security which involved two components: underwriting (compensation earned by investment bankers for selling the security)
what are administrative costs
administrative (legal, accounting, printing expenses etc.) costs.
what are net proceeds
Net proceeds are the funds actually received by the firm for the sale of a security
what are the 3 ways to find the required rate of return
- Using market quotations: observe the yield to maturity (YTM) on the firm’s existing bonds or bonds of similar risk issued by other companies
- Calculate the cost: find the before tax cost of debt by calculating the YTM generated by the bond cash flows
Approximating the cost
- Calculate the cost: find the before tax cost of debt by calculating the YTM generated by the bond cash flows
how do you find the after tax cost of debt
multiply the pre tax cost by (1 - tax rate)
what are preference shares
Preference shares give preference shareholders the right to receive regular fixed dividends before the firm can distribute any earnings to ordinary shareholders.
what is the cost of ordinary shares
The cost of ordinary shares is the return required on the shares by investors in the marketplace.
what are the two forms of share financing
- Retained earnings or existing ordinary shares
2. New issue of ordinary shares
what are some differences between CAPM and the constant growth model
The CAPM technique differs from the constant-growth valuation model in that it directly considers the firm’s risk, as reflected by beta, in determining the required return or cost of ordinary share equity (compensation for risk).
The constant-growth model does not look at risk; it uses the market price, P0 , as a reflection of the expected risk–return preference of investors in the marketplace.
The constant-growth valuation and CAPM techniques for finding rs are theoretically equivalent, though in practice estimates from the two methods do not always agree.
Another difference is that when the constant-growth valuation model is used to find the cost of ordinary share equity, it can easily be adjusted for flotation costs to find the cost of new ordinary share; the CAPM does not provide a simple adjustment mechanism.
The difficulty in adjusting the cost of ordinary share equity calculated by using CAPM occurs because in its common form the model does not include the market price, P0 , a variable needed to make such an adjustment.
the cost of retained earnings is the same as?
the cost of ordinary share equity
what is share under-price selling
selling the shares below its current market rate to incentivise investors to buy new shares from the firm instead of from the market
what are the 3 steps to calculate WACC
- Calculate the value of each security as a proportion of firm value
- Determine the required rate of return on each security
- Calculate a weighted average of the after-tax return on the debt and return on the equity
when estimating WACC, do you use book values?
no, use market values
