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Understanding Corporate Finance > Final Study > Flashcards

Final Study Flashcards

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1
Q

When did the SEC get created?

A

1934

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2
Q

What is the primary objectives of the SEC?

A

To regulate all companies that have publicly traded securities.

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3
Q

What does the SEC publish on a periodic basis?

A

ASRs (Accounting Series Releases)

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4
Q

What organization has the SEC granted authority to monitor accounting standards?

A

FASB (Financial Accounting Standards Board)

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5
Q

Define: Accounting Periods

A

The rule that financial reports should be prepared periodically and cover periods of equal length. Companies may choose the time of year they desire their accounting periods to end.

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6
Q

Define: Matching

A

Firms should include all expenses incurred to realize the revenues that they report.

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7
Q

Define: Conservatism

A

Frims should report the lowest figure when uncertainty exists

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8
Q

Define: Understandibility

A

The information contained in reports should be written at a level that the reader with reasonable conprehension of business practices can understand.

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9
Q

Define: Relevance

A

Reports should contain information that is relevant to the decisions at hand.

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10
Q

Define: Reliability

A

Information provided should be complete and verifiable.

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11
Q

Define: Consistency

A

Firms should strive to use consistent accounting methods so their statements can be compared over time.

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12
Q

What are the 5 requirements that all firms must report?

A

The financial position at a period’s end, the cash flows of a period, the earnings for a period, the comprehensive income for the period, and the investments and distributions to owners for the period.

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13
Q

Define: Balance Sheet

A

the report that records a firm’s assets, liabilites, and owner’s equity at a point in time.

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14
Q

Does the balance sheet report over a period or at a point in time?

A

At a point in time.

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15
Q

What is the formula for Assets, Liabilities, and Owner’s Equity?

A

Assets = Liabilities + Owner’s Equity

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16
Q

When do firms normally end their fiscal years?

A

Firms will end their fiscal year when they are in their most favorable financial position .

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17
Q

What is a comparative balance sheet?

A

A balance sheet that shows multiple years.

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18
Q

What are the other names for an Income Statement?

A

Statement of Earnings or Profit and Loss statement

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19
Q

Define: Income Statement

A

The report that records a firm’s earnings for a period and shows factors that influenced those earnings.

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20
Q

Does the income statement report over a period or at a point in time?

A

Over a period

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21
Q

What is the intent of an income statement?

A

To match a companies expenses with its revenues for an entire reporting period

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22
Q

Define: Net Income

A

The difference between the firm’s revenues and expenses.

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23
Q

What are some other names for Net Income?

A

Net Profit, Net Earnings, Profit after Tax

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24
Q

Are companys’ Net Income and Cash flow the same thing?

A

No, they are rarely the same number and they are not synonymous.

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25
Q

What are two noncash expenses?

A

Depreciation and amortization

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26
Q

Do noncash expenses reduce net income or a firm’s cash position?

A

They reduce a firm’s net income because they are expenses but do not require a transfer of cash.

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27
Q

Are all cash outlays represented as expenses?

A

No, purchases of inventory or property, plant and equipment are not expenses,

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28
Q

Define: Operating Income

A

The firm’s income after operating expenses from the main line of business before the inclusion of income from investments but before interest or taxes have been deducted.

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29
Q

Define: Earnings Before Interest and Taxes

A

The firm’s total income from all sources before interest and taxes have been deducted.

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30
Q

Define: Earnings before Tax

A

The Firms EBIT, less interest charges

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31
Q

Define: Gross Margin

A

Net Income minus the cost of goods sold or the cost of sales

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32
Q

What is another name for Gross Margin?

A

Gross Profit

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33
Q

Define: Gross Profit

A

Net Income minus the cost of goods sold or the cost of sales

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34
Q

Define: Statement of Owner’s Equity

A

Report that describes all changes in the owners’ equity account.

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35
Q

Define: Treasury Stock

A

Outstanding shares that have purchased by the company but not retired

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36
Q

Does the statement of Owners’ Equity report over a period or at a point in time?

A

Over a period.

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37
Q

Define: Statement of Cash Flows

A

Report that the inflow and outflow of cash for a firm.

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38
Q

What are the three major headings for the Statement of Cash Flows

A

Cash Flow from Operating Activities, Cash Flow from Investing Activities, and Cash Flow from Financing Activities

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39
Q

What does Cash Flow from Operating Activities Show?

A

Net Income plus noncash expenses with other adjustments

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40
Q

What does the Cash Flow from Investing Activities Show?

A

The cash flow from investing activities and presents cash flows related to purchase and sale of property, plant, and equipment and other non-current investments.

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41
Q

What does the Cash Flow from Financing Activities Show?

A

The effects of financing activities such as issuance and repayment of debt, stock and payment of dividends.

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42
Q

Are Dividends a use or source of cash?

A

Use.

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43
Q

What are the three types of ratios that analysts use?

A

Operating Performance Ratios, Liquidity Ratios, Financial Strength Ratios

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44
Q

What do Operating Performance Ratios show?

A

They measure a firm’s profitability and asset usage.

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45
Q

What do Liquidity Ratios show?

A

They measure a firm’s ability to meet short term financial obligations and its skill in managing working capital.

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46
Q

What do Financial Strength Ratios show?

A

They measure a firm’s risk that is associated with the way a company has packaged its debt and equity trhat it uses to finance its assets.

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47
Q

Define: Profit Margin

A

Indicates a firm’s ability to convert its sales into earnings. Also called Return on Sales

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48
Q

Define Return on Sales

A

Indicates a firm’s ability to convert its sales into earnings. Also called Profit Margin

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49
Q

Profit Margin Formula

A

Net Income / Net Sales

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50
Q

Return on Sales Formula

A

Net Income / Net Sales

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51
Q

What kind of ratio is Profit Margin?

A

Operating Performance Ratio

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52
Q

What kind of ratio is Return on Sales?

A

Operating Performance Ratio

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53
Q

Define: Gross Margin Ratio

A

The average percentage by which a sales price of a company’s goods or services exceeds the cost of those goods or services

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54
Q

Gross Margin Ratio

A

Net Sales (Costs of goods Sold) / Gross Margin

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55
Q

What kind of ratio is the Gross Margin Ratio?

A

Operating Performance Ratio

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56
Q

Define: Asset Turnover

A

The firm’s ability to generate sales through its assets

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57
Q

What kind of ratio is Asset Turnover?

A

Operating Performance Ratio

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58
Q

Define: Return on Assets (ROA)

A

The best indicator of a firm’s asset usage. Also called ROI (Return on Investment)

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59
Q

ROA (Return on Assets) Formula

A

Profit Margin * Asset Turnover

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60
Q

What kind of ratio is ROA (Return on Assets)

A

Operating Performance Ratio

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61
Q

What kind of ratio is ROI (Return on Investment)

A

Operating Performance Ratio

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62
Q

Are analysts more interested in points of time or periods of time?

A

Normally analysts are interested in periods of time for comparison sake. It is best to use years worth of data for comparison.

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63
Q

What are qualifications for companies to be compared?

A

They must be of similar size, with similar accounting methods, in the same kind of business, and the strategies of the company must be known.

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64
Q

Define: Horizontal Percentage Changes

A

Differences from year to yhear in discrete components of financial statements.

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65
Q

Define: Vertical Percentage changes

A

A benchmark is chosen (normally sales) and other components are expressed against that benchmark

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66
Q

Is it better to use Horizontal Percentage Changes, Vertical Percentage changes, or both?

A

Both, because it gives insight into the company.

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67
Q

Define: DuPont Formula

A

Represents a snapshot of every key ingredient of a firm’s financial position

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68
Q

DuPont Formula

A

(Net Income/Sales) * (Sales/Assets) * (Assets/Equity)

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69
Q

What does the duPont Formula (methodology) allow you to isolate?

A

The factors that are responsible for the ROE.

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70
Q

Define: Sustainable Rate of Growth

A

the extent a company can grow without having to obtain outside financing.

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71
Q

Sustainable Rate of Growth Formula

A

(Sales/Total Assets) * (Net Income/Sales) * (Total Assets/Total Debt) * (1- Payout Ratio)

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72
Q

Define: ROE (Return on Equity)

A

The return on investment for the firm’s shareholders

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73
Q

ROE (Return on Equity) Formula

A

(Net Income Available to Shareholders)/(Average Owner’s Equity)

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74
Q

What is Net Income Available to Shareholders?

A

Net Income - Interest - Taxes - Dividends paid to preferred stockholders

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75
Q

Define: P/E (Price/Earnings) Ratio

A

The market price of a company’s stock divided by the EPS

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76
Q

Define: EPS (Earnings Per Share)

A

The Company’s net income divided by the average number of common stock outstanding during the year.

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77
Q

EPS (Earnings Per Share) Formula

A

(Net Income Available to Shareholders)/(Average Common Shares Outstanding)

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78
Q

P/E (Price/Earnings) Ratio Formula

A

Stock Price/EPS

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79
Q

Define: Payout Ratio

A

The percentage of earnings per share that a company distributes in the form of dividends.

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80
Q

Payout Ratio Formula

A

Dividends/Net Income

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81
Q

Define: Times Interest Earned

A

How many times over a firm’s earnings could pay for the interest obligations of a firm.

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82
Q

Times Interest Earned Formula

A

EBIT (Earnings before Interest & Taxes) / Interest Obligations

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83
Q

What kind of ratio is ROE (Return on Equity)?

A

Operating Performance Ratio

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84
Q

What kind of ratio is Payout Ratio?

A

Operating Performance Ratio

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85
Q

What kind of ratio is P/E (Price/Earnings) Ratio?

A

Operating Performance Ratio

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86
Q

What kind of ratio is EPS?

A

Operating Performance Ratio

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87
Q

What kind of ratio is Times Interest Earned?

A

Operating Performance Ratio

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88
Q

Define: Current Ratio

A

The company’s ability to meet short term obligations and unforeseen needs.

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89
Q

Current Ratio Formula

A

Current Assets/Current Liabilities

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90
Q

What kind of Ratio is the Current Ratio?

A

Liquidity Ratio

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91
Q

Define: Quick Ratio

A

A variation of the current ratio that only uses assets that are readily converted into cash.

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92
Q

Quick Ratio Formula

A

(Cash + Marketable Securities + Accounts Receivable)/Current Liabilities

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93
Q

What kind of ratio is the Quick Ratio?

A

Liquidity Ratio

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94
Q

Define: Receivables Turnover

A

How quickly a company ordinarily converts accounts receivables into cash.

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95
Q

Define: Days Sales Outstanding

A

Converts the recievalbes turnover figure into the number of days

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96
Q

Receivables Turnover Formula

A

Net Sales/Average Accounts Receivables

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97
Q

DSO (Days Sales Outstanding) Formula

A

Number of Days in a Period(Normally 365)/Receivables Turnover

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98
Q

What kind of ratio is Receivables Turnover?

A

Liquidity Ratio

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99
Q

What kind of Ratio is DSO (Days Sales Outstanding)?

A

Liquidity Ratio

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100
Q

Define: Inventory Turnover

A

How well a company is managing its working capital account. OR how long it takes for a company to buy inventory and turn it into a finished good.

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101
Q

Inventory Turnover Formula

A

Cost of Goods Sold/Average Inventory

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102
Q

What kind of ratio is Inventory Turnover?

A

Liquidity Ratio

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103
Q

Define: Days Inventory

A

Turns the Inventory turnover into number of days

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104
Q

Days Inventory Formula

A

Number of Days in a Period(Normally 365)/Inventory Turnover

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105
Q

Define: Operating Cycle

A

Estimates how long it takes a business to complete the purchase of inventory, the conversion of inventory to finished goods, the sale of finished goods, and collection of accounts receivable.

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106
Q

What kind of ratio is Days Inventory?

A

Liquidity Ratio

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107
Q

What kind of ratio is Operating Cycle?

A

Liquidity Ratio

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108
Q

Operating Cycle Formula

A

DSO+ Days Inventory

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109
Q

Define: Accounts Payable Turnover

A

How far a company is stretching its payable obligations

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110
Q

Accounts Payable Turnover Formula

A

Purchases/Average Accounts Payable

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111
Q

Why is it difficult to get the Accounts Payable Turnover?

A

Not all companies provide data about their purchases. Instead analysts will use the cost of goods sold plus the changes in inventory

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112
Q

What kind of formula is Accounts Payable Turnover?

A

Liquidity Ratio

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113
Q

Define: Days Payable

A

The approximate number of days that it takes for the accounts payable turnover.

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114
Q

Define: Debt to Total Assets

A

Calculates the percentage of a company’s assets that are being provided by creditors

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115
Q

Debt to Total Assets Formula

A

Total Liabilities/Total Assets

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116
Q

What kind of ratio is Debt to Total Assets

A

Financial Strength Ratio

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117
Q

Define: Debt to Capitalization

A

Shows the long term debt in terms of all equity and debt

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118
Q

Debt to Capitalization Formula

A

Long Term Debt/(Total Equity + Long Term Debt)

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119
Q

What kind of ratio is Debt to Capitalization?

A

Financial Strength Ratio

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120
Q

Define: Debt to Equity

A

The proportion of borrowing to equity in the capital structure.

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121
Q

Debt to Equity Formula

A

Total Liabilities/Total Equity

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122
Q

What kind of ratio is Debt to equity?

A

Financial Strength Ratio

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123
Q

Define: Forecasting

A

Making observations from the surrounding world and making projections.

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124
Q

Define: Pro Forma Financial Statements

A

Financial statements based on projections in order to plan for future endeavors.

125
Q

Are Pro Forma Statements accurate?

A

Pro Forma statements are only as accurate as the assumptions they are built on. These should be tested when possible

126
Q

When Pro Forma Statements are created, do analysts use single assumptions, a few assumptions or many assumptions?

A

Analysts try to make many assumptions that are as confident and accurate as possible

127
Q

What are the three steps to creating Pro Forma Statements?

A

Qualitative Step (identifies key assumptions), Quantitative Step (Comparative techniques), and testing the assumptions

128
Q

Where is the best place to start for the Qualitative Analysis step?

A

Assess factors that may impact the industry as a whole and test them.

129
Q

What are the Industry Qualitative Factors?

A

Industry Definition, Sales Influence, and Cost Structure

130
Q

What are the Company Qualitative Factors?

A

Company Definition, Sales Influence, and Cost Structure

131
Q

What is the the best way to define critical variables that influence a firm’s future performance?

A

Consider a firm’s management, strategies, facilities, size, product line, and cost structure.

132
Q

Define: Time Horizons

A

A point in the future where projections might lose credibility.

133
Q

Is it easy or difficult to establish a projections horizon?

A

Difficult because accuracy diminishes with the length of time, and different projections may have different horizons and the horizons will have to be the same.

134
Q

What are the two mathmatical objectives of Quantitative Analysis?

A

Determine how a company has performed in the past, and to use that as a foundation with assumptions to project the future.

135
Q

What are some companys that publish industry surveys?

A

Robert Morris Associates, Standards & Poor’s, and Value Line (and others)

136
Q

What do Industry surveys show?

A

the key ratios for an industry

137
Q

What should you obtain at minimum to assist with Historical Evaluations?

A

A industry’s historical sales growth, asset usage skill, profitability, return on equity, dividend policy, liquidity, and capital structure.

138
Q

What purpose(s) the Industry Survey information serve?

A

Analysts can test assumptions they made during the qualitative analysis, and they can quantify the industry’s record

139
Q

After obtaining the industry information, what should an analyst collect?

A

The company’s analysis with the same information.

140
Q

Should an analyst get vertical or horizontal methods for a company?

A

Both if possible.

141
Q

Once an analyst has the Industry Survey information and the company’s analysis, what is the next step?

A

To compare the two to see if there are similarities or differences.

142
Q

What is a caveat to projecting statements?

A

Large assumptions must be made and tested, and not all the results may be of great accuracy.

143
Q

What is normally decided first when projecting statements?

A

Sales growth records

144
Q

What is developed after the Sales Growth records?

A

Income statements using the desired vertical percentages.

145
Q

What Cash Flow portion is Net Income a part of?

A

Cash Flow from Operating Expenses

146
Q

What statement fulfills a firm’s requirement to disclose its earnings for a period?

A

Income Statement

147
Q

What ratios measure a firm’s profitability and asset usage?

A

Operating Performance Ratios, Liquidity Ratios, Financial Strength Ratios

148
Q

What ratio shows the average percentage by which sales price exceeds the cost of goods sold?

A

Gross Margin

149
Q

What Cash Flow portion is Depreciation a part of?

A

Cash from from Operating Activities

150
Q

What does a working capital position measure?

A

The current assets less the current liabilities at any given time.

151
Q

What benefits do a company get when they reduce investments in inventory?

A

Less dependence on short term credit (paying it back), and improving cash flow

152
Q

What hazards can arise if a company reduces its investment in inventory?

A

They can lose sales if they overly restrict the amount of inventory.

153
Q

What ratio is the best indicator of a firm’s ability to manage its assets?

A

ROA (Return on Assets)

154
Q

What does Sustainable Growth Calculation Measure?

A

How quickly a company can expand without taking external capital

155
Q

Surveys produced by Robert Morris Associates are used during which phase of Analysis?

A

Quantitiative Analysis

156
Q

When considering a major company decision, what are the two vantage points?

A

How the decision will iompact the firm and the resulting stockholder reaction.

157
Q

Define: Value

A

Value is added to a firm when earnings are enchances, operation or financial risks are reduced, or when efficiencies result as the consequence of a decision.

158
Q

When should management reinvest capital into the business?

A

As long as returns being generated by the business exceed those whicch shareholders could realize by investing their capital elsewhere.

159
Q

How does Management obtain capital for investment?

A

Debt, retained earnings (withheld dividends), and new equity issues.

160
Q

What is management’s return on investment on assets measured in?

A

Earnings or cash flows

161
Q

How do investors receive their returns on investment?

A

Interest payments (lenders/debt holders), dividends or rising stock values (shareholders)

162
Q

How is value being added to a firm’s owner?

A

When the rate of return exceeds the cost of capital they have invested.

163
Q

If Managers cannot find good investment opportunities, what is their duty?

A

To return shareholders capital so they can invest their funds elsewhere.

164
Q

Define: Capital Structure

A

The combination of debt and equity which balance’s a firm’s assets. Also called capitalization.

165
Q

What is another name for Capital Structure?

A

Capitalization

166
Q

Define: Capitalization

A

The combination of debt and equity which balance’s a firm’s assets. Also called Capital Structure.

167
Q

What is another name for Capitalization?

A

Capital Structure

168
Q

What is an important consequence or result of asset acquisition?

A

New Net income, cash flow, or efficiency that outweighs the cost of the acquisition.

169
Q

How are dividends taxed?

A

At a corporate level and at the personal level of the stakeholder.

170
Q

What are some internal considerations that need to take place when looking for new funding?

A

The amount of funding, The structure of the company’s existing capitalization, the company’s future needs

171
Q

What are some external factors that may influence managers?

A

High or low interest rates and the market price of shares.

172
Q

Define: Financial Risk

A

The uncertainty associated with a company’s ability to convert operating income to a given level of earnings per share.

173
Q

What are the most commonly used indicators for financial risk?

A

The capitalization ratios

174
Q

Why does a capital market prefer a certain level of debt?

A

Earnings are higher per share in a capital structure where some debt is present.

175
Q

Define: Dilution

A

The process by which a given level of earnings is spread of a greater number of shares.

176
Q

Which sides of the balance sheet can managers use to add value?

A

Both sides of the balance sheet.

177
Q

When creating value, are both sides considered at the same time or separately?

A

They should be considered separately in order to determine the merits from each side.

178
Q

What is the pattern that an investment/capitalization issue typically follows?

A

Choose an proposal to invest in, a capitalization package for financing the package is created, and then they are both considered together.

179
Q

Define: Present Value

A

the value in the present of a sum of money, in contrast to some future value it will have when it has been invested at compound interest.

180
Q

What are some variables common to all investments?

A

Size, duration, return and timing of the return.

181
Q

Why are investments that provide cash flow sooner preferred?

A

Because they allow for the reinvestment sooner and money has a different value over time

182
Q

Define: Accumulated Value

A

The sum of the payments received up to a future time. Also called Future Value

183
Q

Define: Future Value

A

The sum of the payments received up to a future time. Also called Accumulated Value

184
Q

Future Value Formula

A

(1+Periodic Interest Rate)^number of periods * Initial Investment

185
Q

Define: Discount Factor

A

the rate that an investor believes he can enjoy whether or not an investment is chosen.

186
Q

Present Value Formula

A

FV / (1+Interest Rate)^Number of periods in the future

187
Q

What is the rule of 72?

A

The rule that bankers used to determine (in approximate terms) what combination of interest rate and years would cause an investment to double.

188
Q

If an investment pays out over multiple years, how is that calculated?

A

The years must be calculated seperately then added up in order to get the present value

189
Q

Is the present value equation a rearrangement of the future value equation?

A

Yes

190
Q

True/False: A major tenet of finance is to match short-term assets with short-term borrowings and long-term assets with long-term borrowings.

A

TRUE

191
Q

If the financial risk of a firm decreases, what will happen to the stock price?

A

It will rise

192
Q

Define: Capital Investments

A

Investments that provide returns for a period greater than one year

193
Q

What are some examples of Capital Investments?

A

Property, plant or equipment; marketing campaigns; research and development, or permanent additions to working capital

194
Q

What is the most popular way to evaluate capital investments?

A

Capital Budgeting

195
Q

What are the 4 steps of capital budgeting?

A

generation of investment ideas, evaluation and ranking of alternatives, selection of investments, and continuing appraisal of previous investment performance.

196
Q

Are generating alternative investing ideas more or less important than scrutinizing the current ideas?

A

They are more important because creative companies will be more successful.

197
Q

Define: Relevant Cash Flows

A

Costs and benefits which only exist if an investment is implemented. Also called Incremental Cash Flows

198
Q

Define: Incrimental Cash Flows

A

Costs and benefits which only exist if an investment is implemented. Also called Relevant Cash Flows

199
Q

Define: Sunk Cost

A

A cost a company will have to bear even if the investment is not understaken or fails. This flow should not be considered an incremental cost during analysis

200
Q

Define: Acquisition Costs

A

Cash payments that are required for ownership and any subseqient expenditures required to extend the life of the asset.

201
Q

What can purchase price be offset by?

A

Discounts, trade ins, or other means.

202
Q

What can purchase price be increased by?

A

Installation charges or freight charges

203
Q

Define: Operating Costs

A

The peridodic (usually annual) cost of using the asset. These are normal reoccuring costs.

204
Q

Is an overhaul an operating cost or an acquisition cost?

A

It is an acquisition cost because it is not a periodic cost of using the asset.

205
Q

The benefits of investments are thought of as?

A

Sources of cash. These may be operating cost savings, additional revenues, tax savings, cash proceeds from the sale of an asset, or the predicated salvage value of the new asset.

206
Q

Can taxes provide costs of benefits?

A

They can provide either. The sale of an asset will be subject to taxes if the asset is sold for any price other than book value. If sales price exceeds book value, then it is considered income and taxed. If the sales price is less than book value, it is considfered a loss and taxed at an appropriate rate.

207
Q

Net Book Value of an Asset Formula

A

Purchase price + Improvements - Depreciation

208
Q

When are tax complications avoided?

A

When a firm retains the old asset and a new asset is bought.

209
Q

Define: Investment Tax Credits

A

A credit equal to a certyain percentage of the cost of the investment. This was enacted by congress to stimulate the economy.

210
Q

Define: Differential Analysis

A

A technique widely used to identify incrimental benefits and costs.

211
Q

How is the differential analysis generally displayed?

A

A table showing the potential areas impacted (revenues, operating expense, utilities, maintenance, salaries, insurance, depreciation)

212
Q

When performing differential analysis what is important?

A

To choose a reference point for comparasins. Normally the reference point is the company as it is before any investments take place.

213
Q

What is the most important practice when capital budgeting?

A

Consistency.

214
Q

Tax consequences of the capital gain on the sale of the old asset is

A

A cost

215
Q

Is depreciation added or subtracted from Net Income to determine cash flow?

A

Added

216
Q

Define: Useful Life

A

The estimated economic life of an asset.

217
Q

How are time horizons normally chosen?

A

Arbitrarily but later they must conform to the period of time an analsyst can be confident in the predicted figures.

218
Q

Define: Depreciable Life

A

The number of years that a company will depreciate the new asset.

219
Q

When a new asset is compared to an old one, how is the time horizon changed?

A

The time horizon must be shortened to match the older assets.

220
Q

What is done after a time horizon is compared for new assets and old assets?

A

The residual cash flows for the new asset must be estimated.

221
Q

What is year zero defined as on Investment charts?

A

The moment the investment is implemented

222
Q

Define: Salvage Costg

A

The cost of the new value at the end of its useful life

223
Q

Is salvage cost shown as a cash inflow or a cash outflow?

A

Inflow

224
Q

How can investments be ranked?

A

They are numerically ranked through the comparisons of their retursan. Most are based on Present Value

225
Q

Define: Payback

A

The number of years that will pass before returns equal the original investment. Also called Break-even analysis.

226
Q

What is another name for payback analysis?

A

Break-even analysis

227
Q

What is another name for break-even analysis?

A

Payback analysis

228
Q

Payback Formula

A

Investment/Annual Cash Inflows

229
Q

If the investment does not return regular equal installments, how can you find the payback?

A

Adding each years return successively until a figure is obtained that equals the original investment.

230
Q

What is the advantage of the payback calculation?

A

It tells a firm when they can predict when the cost of investment will be recovered so that funds can be employeed elsewhere

231
Q

What is a drawback of Payback and break-even analysis?

A

It does not recognize the magnitude of returns past the payback date

232
Q

Define Benefit/Cost Ratio

A

The ratio of incremental cash flows to the acquisition costs

233
Q

What is the drawback of Benefit/Cost ratio?

A

It fails to compensate for the time value of money

234
Q

What are discount factors varied to compensate for?

A

Risk

235
Q

Define: Hurdle Rates

A

Discount factors that firms employ.

236
Q

What is the most commonly used hurdle rate?

A

The approximate risk to the firm itself.

237
Q

Do firms normally rely on a single or multiple hurdle rates?

A

Single hurdle rate and rely on managers opinions of present values to select investments.

238
Q

If an investment is perceived as less or more risky, how will the hurdle rate change?

A

More risk = higher hurdle, lower risk = lower hurdle

239
Q

Define : Present Value Payback

A

Same as payback but uses Present Value in the denomiator

240
Q

Present Value Payback Formula

A

Initial Investment/PV of Annual Cash Flows

241
Q

What is a drawback of Present Value Payback?

A

It does not recognize the magnitude of returns past the payback date

242
Q

Is it better to use a singular or multiple methods when ranking investments?

A

It is better to use multiple methods, but Present Value based methods are superior to others.

243
Q

What does an investment with positive NPV create?

A

Value

244
Q

What qualitative assesments must take place when determining investments.

A

The impact on personnel, the community, the environment, and the law.

245
Q

Define: Present Value Index

A

Identical to Benefit/Cost Ratio but uses Total Present Value in the numerator

246
Q

Present Value Index Formula

A

Total PV of Annual Cash Flows/Initial Investment

247
Q

Define: Net Present Value

A

the present value of a company’s future cash flows minus the initial investment

248
Q

Net Present Value Formula

A

Present Value of Annual Cash Flows - Initial Investment

249
Q

Define: Internal Rate of Return

A

the discount factor necessary to make an investment’s NPV equal 0

250
Q

How is Internal Rate of Return normally calculated?

A

Through Trial and Error manually or through computers and financial calculators

251
Q

Why are IRR calculations popular?

A

they describe an investment’s returns in a way that can be compared to the firm’s hurdle rate.

252
Q

What calculations are Hurdle Rates used in?

A

Present Value Calculataions or benchmarks that are used to judge internal rates of return

253
Q

Why aren’t hurdle rates static?

A

Hurdle rates are normally varied to compensate for risk.

254
Q

Define: Opportunity Cost

A

Average hurdle rate. Also called Cost of Capital

255
Q

Define: Cost of Capital

A

Average hurdle rate. Also called Opportunity Cost

256
Q

Define: Operational Risk

A

The risk associated with a companys ability to produce and market its products

257
Q

Define: Risk of Illiquidity

A

An investors lack of access to funds will prevent participation in a better investment

258
Q

What does the capital market set prices based on?

A

The markets perception of how a company is doing.

259
Q

Define: Efficient Market

A

At any given moment, the prices of securities reflect all that is or can be known about a company’s future.

260
Q

Why does the Efficient market theory exist?

A

Because at any time there are hundreds of analysts attempting to find value to exploit.

261
Q

How do Debt Markets price their funds?

A

Based on the risk they perceive a firm has.They will set their return requirements based on a firm’s operational risk, financial risk, and the terms of the loan.

262
Q

Do long term loans or short term loans have a greater probility that a better opportunity will come along for investors?

A

Long Term Loans

263
Q

Cost of Capital Formula

A

(%Debt * Cost of Debt) + (%Equity * Cost of Equity)

264
Q

Where do you get the data for the Cost of Capital Formula

A

The balance sheet to get the percentages of debt and equit.

265
Q

What is a more accurate figure than Cost of Capital?

A

Target Cost of Capital

266
Q

Define: Target Cost of Capital

A

Same as cost of capital but it reflects the future percentages that the company is going to maintain.

267
Q

Define: Marginal Cost of Capital

A

same as cost of capital but is based on the prices that are reflected in the current capital structure. (paid in the past) This means it is based on the prices that a company will have to pay to recreate the target structure

268
Q

What are the two dominant forms of debt?

A

Loans and Bonds

269
Q

Is cost of debt calculated before or after taxes?

A

After Taxes. Interest payments are tax deducitible.

270
Q

Define: Bonds

A

Long term securities that a firm issues to investors in return for capital.

271
Q

What is the most common unit of issued bond?

A

$1000 bond

272
Q

Define: Coupon Rate

A

The interest on a bond.

273
Q

To calculate the yield to maturity of a bond, you are using which of the following capital budgeting techniques?

A

IRR

274
Q

The call price of a bond is also referred to as

A

Strike Price

275
Q

How can firms generate equity?

A

Earnings, issuance of stock

276
Q

What is the YTM calculated from?

A

The investor’s perspective.

277
Q

Define: Yield to Maturity (YTM)

A

The return that is earned on a bond

278
Q

If a bond is valued at part, what is its YTM equal to?>

A

Coupon Rate

279
Q

If the market falls, will the market discount or mark up bonds with high interest rate?

A

Mark up

280
Q

How does the market impact bonds?

A

As the market rises above the rate, the bonds will lose value and be discounted. As the market falls below the rate, the bonds will gain value and will inflate in price.

281
Q

The Capital Asset Pricing Model relates historical returns of a company to?

A

The market as a whole

282
Q

Cost of Equity Formula

A

Projected EPS/Stock Price

283
Q

What is the fundamental assumption underlying dividend discount models?

A

The maximum price that investors are willing to pay for a stock is the present value of the future dividends they will receive.

284
Q

What are the two methods for quantifying the returns that investors expect?

A

Dividend Discounts and Risk Premium Assessments

285
Q

True/False: Changing YTMs does not change the value of a bond.

A

True! Market changes the value and that in turn changes YTM.

286
Q

Define: Call Provision

A

Permits a firm to repurchase bonds at their market value or par value (if the market value reaches a certain point)

287
Q

What is the call price also called?

A

Strike Price

288
Q

Cost of Debt Formula

A

(1-Tax Rate) * Interest Rate

289
Q

Growth Rate Formula

A

(1-Payout%) * ROE

290
Q

Define: Risk Premiums

A

Returns that investors require in excess of the returns that are available in risk-free assessments

291
Q

What are some “risk free” investments

A

US Government securities: Treasury Bills and Bonds

292
Q

Total Required Return Formula

A

Risk Free Rate + Risk Premium

293
Q

What is the best way to define a risk premium to use?

A

Guess!

294
Q

What does the Capital Asset Pricing Model quantify?

A

A company’s risk premium by relating the historical returns of that company or the industry that it competes, to the performance of the market as a whole.

295
Q

Define: Beta

A

a variable that measures the magnitude of covariance in stock performance and the total stock market

296
Q

CAPM Formula

A

Risk Free Rate + Beta*(Market Return-Risk Free Rate)

297
Q

What does a Beta of 1 mean?

A

The company has risk equal to the average stock market so it will move in the same direction as the market at the same rate

298
Q

What does a Beta of less than 1 mean?

A

The stock value will move in the same direction as the market, but not move as far

299
Q

What does a Beta of greather than 1 mean?

A

The stock value will move in the same direction as the market, but move farther

300
Q

Is Risk increased or decreased as a beta rises?

A

Greater

301
Q

What are the two solutions to finding a market return proxy?

A

An estimate could be made or the historical performance of the market can be used.

302
Q

Define: Preferred Stock

A

Provide the holder with ownership in a firm, without exposure to risks that common shareholders have.

303
Q

Why are Preferred stocks attractive to investors?

A

They provide a relatively safe and predictable return

304
Q

What does preferred stocks not provide?

A

They do not have voting rights, and they do not benefitr from high returns of a profitable year

305
Q

Cost of Preferred Formula

A

Preferred Dividends/Preferred Equity of Capital Structure

306
Q

Define: Convertibles

A

instruments that can be converted to common stock. This may occur with our without the investor’s approval.

307
Q

When are call provisions enacted?

A

When the par value of bonds increase to a certain value (also known as strike price)

308
Q

Cost of New Equity Formula:

A

Next Year’s Dividend/StockPrice*(1-Fee%) + Growth Rate

309
Q

Cost of New Debt Formula:

A

(Interest on Coupon Payment/Proceeds Debt Issue) * (1-Tax Rate)

Understanding Corporate Finance (1 decks)

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