Finance Flashcards
How to calculate the cost of capital (WACC)
WACC = Weighting of Debt x after-tax cost of debt + weighting of equity x cost of equity
[(LT debt/(LT debt+Total equity)) x (yield x (1-tax rate))] + [(PS/(LT debt+Total equity)) x COE] + [(CS/(LT debt+Total equity)) x COE]
Cost of debt
Cost of debt: yield rate on long term debt
- long term liabilities such as pension obligations or provisions are excluded
- Fixed rate = market yield, variable rate = currant yield + premium
Cost of equity
Cost of equity:
Preferred:
Total annual preferred dividends paid / Total market value of all preferred shares outstanding
Common:
#1: Risk free return + Risk premium related to risk of investment
#2: Risk free return + (Beta x Market risk premium)
Weighting of debt and equity
Weighting of debt + weighting of equity = 100%
Present Value interest factor (PVIF)
1/(1+i)^n
Quick way to calculate NPV over time
(year 0 net after tax cash flows) + (=NPV(discount rate, years 1 - X net after tax cash flows))
Quick way to calculate NPV mid-year discounting
(year 0 net after tax cash flows) + (=FV(discount rate,.5,,-NPV(discount rate, years 1 - X net after tax cash flows)))
i = discount rate nper= .5 pmt = 0 FV = -NPV
Effective annual interest rate (EAR)
(1+(quoted rate/n))^n-1
n= number of compounding periods per year
PV of a constant growing perpetuity
PV = PMT/(i - g)
g = constant growth rate
Fisher Effect formula - Inflation effect on rate of return (RRR)
(1 + inflation rate) x (1 + nominal rate of return) = (1 + RRR)
Calculate monthly mortgage interest
- effective annual interest rate (EAR) = (1 + i/n)^n-1
2. effective monthly rate= (EAR + 1^(1/12)-1
Discounting an amount by one year compared to discounting over 3 years
One year: PV/(1+discount rate)
3 years: PV/(1+discount rate)^3
Business Lifecycle
Developmental - Seed capital Commercial - Venture Capital Growth - Equity/Debt Maturity - Debt/Equity Decline - Debt
Categories of NPV analysis
Initial investment - including opportunity costs, gain on PV of tax shield
After-tax operating cash flows (incremental)
Working capital
Salvage values - loss on future CCA tax shield
PV of the tax shield on CCA
(Investment x CCA rate x tax rate / CCA rate + discount rate) x (1 + 0.5 x discount rate / 1+ discount rate)
at a .5 rate for regular CCA
PV of tax shield on CCA AII
(Investment x CCA rate x tax rate / (CCA rate + discount rate) x (1 + 1.5 x discount rate / 1 + discount rate)
At a 1.5 rate for Accelerated investment incentive CCA
PV of the tax shield on CCA 100%
(Investment x tax rate) / (1 + discount rate)
100% deduction for manufacturing, processing equipment and clean energy
Working Capital
Working capital dollars = Current Assets - Current Liabilities
Working Capital per Dollar of Sales = working capital / sales
Working capital ratio = Current Assets / Current Liabilities
PV of the lost tax shield on CCA on Salvage
(Salvage proceeds x CCA rate x tax rate) / (CCA rate + discount rate)
formula does not consider recapture, terminal loss, capital gain/loss
NPV Pros/Cons
Pros:
Considers time value of money
Calculates on absolute dollar values, not percentages, therefore user can determine total impact
Possible to use varying discount rates which is useful in addressing risk
Limitations:
Long-term cash flow forecasting may be difficult
It assumes cash flows occur at the end of the period
IRR - Rules for acceptance
Internal Rate of Return
If the IRR is greater than the discount rate appropriate for the project, then the project should be accepted. If the IRR is less than the appropriate discount rate, then the project should be rejected.
IRR pros/cons
Pros: Considers the time value of money It is easily understood Limitations: If cash flows vary throughout the life of the project there can be multiple IRRs It cannot be used to rank projects IRR does not indicate the dollar impact
Payback period with uneven cash flows calc
The last period with a negative cash flow + (the cumulative cash flow at the end of that period / Total net inflow cash in the next period)
ex: 3 years + (11,000 / 19,000) = 3.58 years
Payback period Pros/Cons
Pros:
Simple and easy to calculate/understand
Measures inherent risk assuming the longer payback is an indication of higher uncertainty and risk
Can be used to rank projects
Highlights liquidity
Limitations:
Does not take into account the time value of money which can lead to wrong decisions
Does not take into account cash flows after payback period (they may create a greater NPV than another project)
Does not give any indication that value will be added to the company
To gain protection from creditors an entity must prove its insolvency with one or more of these criteria
- The FMV of assets is less than FMV of liabilities (asset insolvent)
- Unable to pay obligations as they come due (cash flow insolvent)
- Reasonably expected to run out of liquidity prior being able to complete a needed restructuring
Cash Conversion cycle formula
Inventory period + average collection period - average payables period
Operating cycle = Inventory period + average collection period
*Lower = better
AR turnover Ratio
Sales / average balance of AR
Average collection period
(average balance of AR / sales) x 365
OR
365 / AR turnover Ratio
ROI calculation
(Net Income/Sales) x (Sales/Assets)
OR
Net Income / Cost of Investment
Residual Income Calculation
Operating Income - (Required rate of return x Investment)
Calculate NPV with cash flows at the beginning of the period
NPV formula * (1+WACC)
XNPV
Excel formula that calculates the NPV of a series of cash flows that occur at irregular intervals.
