Financial Management (11-21%)

Question 1

What is Capital Structure?

Answer 1

how a firm uses different sources of funds to finance its operations and growth - some combination of debt and equity

Question 2

What is Cost of Capital?

Answer 2

refers to opportunity cost of using capital in a project or investment compared to another - which produces higher return?

Question 3

How do you calculate the Cost of Capital?

Answer 3

average cost of capital = taking relative weighted costs of different capital sources (rate of return required by either investors or lenders), to arrive at weighted average cost - then used to evaluate future projects or investments

Question 4

What is Asset Structure?

Answer 4

how a business uses assets to generate earnings - primary metric is return on assets (net income/total assets)

current assets - provide liquidity
long-term assets - geared towards generating earnings

Question 5

What are Loan Covenants?

Answer 5

restrictions/requirements placed on loan/line of credit by lender - if borrower does not meet requirements, loan is due immediately

• meeting certain ratios (debt to equity, working capital)
• limits on taking additional debt
• requirements on collateral attached to loan

Question 6

What is a Growth Rate?

Answer 6

used to evaluate entire business, business’ earnings or sales, expenses, or even entire economies

growth rate = (end value-beg value/beg value) x 100

Question 7

What is Profitability?

Answer 7

extent to which business generates a profit - common measures: profit margin, return on assets, return on equity

different measures of profit margin:

• GROSS MARGIN: (revenue-COGS)/revenue
• CONTRIBUTED MARGIN: (revenue-variable expenses)/revenue
• OPERATING MARGIN: operating income/revenue
• PRE-TAX MARGIN: earnings before tax/revenue
• NET PROFIT MARGIN: net income/revenue

Question 8

What is Leverage?

Answer 8

amount of debt business uses to buy assets - ratio of debt to equity used to acquire assets - can result in business earning a greater return on investment by using existing assets

the more leverage used, the more risk - as a business takes on more and more debt, chances increase they will not be able to pay all back

debt also has tax advantages - interest expense is deductible

Question 9

What is Working Capital?

Answer 9

difference in a firms current assets and current liabilities - objective is to meet operating needs of company (purchasing inventory) and having enough cash to meet obligations as they become due

Question 10

What are Working Capital Ratios?

Answer 10

• liquidity ratios:
• working capital (CA-CL)
• current ratio (CA/CL)
• quick ratio (CA-Inv,Prepaids/CL)
• times interest earned (NI+Interest+FIT/Interest)
• average collection period (365xAvg AR/Credit Sales)
• operational ratios:
• cash conversion cycle (Days AR O/S + Days Inv O/S - Days AP O/S)
• receivable turnover (Credit Sales/Avg. AR)
• inventory turnover (COGS/Avg. Inv)

Question 11

What is Inventory Management?

Answer 11

main objective - to determine and maintain optimal amount of all inventories

cost of carrying inventory directly related to how much inventory should be kept on hand - if cost of carrying rises, should carry less

Question 12

What is a Just in Time (JIT) Inventory System?

Answer 12

aimed at increasing efficiency and eliminating unnecessary costs be reducing inventory on hand but it requires more frequent deliveries from suppliers - increases chances of running out of inventory, but also lowers inventory carrying costs

usually vendors will guarantee free from defects so that purchaser does not need to inspect upon delivery

Question 13

What is Economic Order Quantity Formula?

Answer 13

method that aims to determine order size that will minimize total inventory cost - both order cost and carrying cost assumed to be constant - also assumed that periodic demand is known to be feasible

square root of: 2 (setup costs x demand rate) / holding costs
  \_\_\_\_\_
/ 2(SxD)
   \_\_\_\_
      H

Question 14

What is AP Management?

Answer 14

managing AP (specifically to vendors) can have big impact on profitability and cash flow - most important thing is that pay bills on time - improves relationships and will result in favorable discounts and credit terms

Question 15

What is Cash Management?

Answer 15

trying to make sure do not have too much cash or not enough cash - too much cash is inefficient use of resources - too little cash causes obvious problems

zero-balance account is a cash management tool - removes any excess cash at end of each day, moves to another account - also used for specific purposes, account exclusively for paying payroll checks

Question 16

What is AR Management?

Answer 16

goal is to maximize profits not sales - granting credit policy too loose, will result in bad debt - policy too tight, risk losing credit sales

the more times can turnover AR in a year, shows how efficient at collecting cash on credit sales and fewer credit sales being written off - higher AR turnover ratio better - average collection period number lower better

can factor AR, to sell AR to third party at discount to receive cash sooner - accepting credit cards is a way of factoring too - risk is on CC company

Question 17

What are the 3 levels of determining fair value?

Answer 17

1 - OBSERVABLE QUOTED market prices for IDENTICAL A/L in active market (highest level/most reliable)

2 - OBSERVABLE QUOTED prices for SIMILAR A/L in active market

3 - UNOBSERVABLE - only be used when no observable inputs (lowest level)

Question 18

What are the 3 main approaches to determining fair value?

Answer 18

MIC

• MARKET APPROACH - uses prices and other relevant information generated by market transactions involving A/L identical/comparable to those being valued
• INCOME APPROACH - uses valuation techniques to convert future amounts of economic benefits or sacrifices of economic benefits to determine what future amounts worth
• COST APPROACH - determines what would cost to construct replacement item
• valuation based on exit price (NOT entry price) - would receive to sell an asset or paid to transfer liability

Question 19

What is Option Pricing?

Answer 19

Black Sholes Model - mathematical formula for valuing stock options - advantages and disadvantages

advantages:

• discounts exercise price
• uses probability option will be exercised
• uses probability price of stock will pay off within time of expiration

disadvantages:

• assumes stock does not pay dividends
• assumes risk-free rate of return used for discounting remains constant
• assumes option can be exercised only at expiration date

Question 20

What is Binomial Option Pricing?

Answer 20

price tree and probable values are calculated based on volatility, expiration dates, and probabilities

Question 21

What is the Capital Asset Pricing Model (CAPM)?

Answer 21

evaluates relationship between risks and expected return for assets, but usually stocks - uses risk-free rate of return and beta

RISK-FREE RATE OF RETURN - hypothetical rate for return for ‘no risk’ and based on 3-month US treasury bill

BETA - measure of how volatile investment is compared to rest of market/comparable items - 1 means equal - 0.50 means half as volatile - 2 means twice as volatile

Question 22

What is Dividend Discount Model?

Answer 22

used to predict dividends and discounts them back to present value - if PV of dividends on per share basis greater than current share price, stock is considered undervalued and good investment

Question 23

What are the 3 main approaches to valuing a business?

Answer 23

MIA

• MARKET APPROACH - business compared to other similar businesses with similar characteristics in same industry/market
• INCOME APPROACH - FV derived from business income streams - net present value of cash flows, or discounted cash flow model
• ASSET APPROACH - FVs of individual assets of business added up & equal value of business - commonly used when business liquidated to pay its debts

Question 24

What are the 5 main approaches to comparing potential investments?

Answer 24

PENIC

• Payback period approach
• Economic value added
• Net-present value
• Internal rate of return
• Cash flow analysis

Question 25

What is the Payback Period Approach for comparing potential investments?

Answer 25

determines how many years will take to recover initial project investment cost

take upfront project cost, divide by expected annual cash flows - if project cost will be recovered in specified time, would accept project - if not, would reject project

Question 26

What is the Net-Present Value Approach for comparing potential investments?

Answer 26

compares PV of expected cash flows of project to initial cash investment in project

if NPV is zero or positive, project considered economically feasible

Question 27

What is Economic Value Added (EVA)?

Answer 27

metric to measure economic profit and is form of measuring residual income

EVA = net operating profit after taxes (NOPAT) - (invested capital X weighted avg cost of capital)

or = NOPAT - required return

Question 28

What is Discounted Cash Flows (DCF)?

Answer 28

method of discounting future cash flows to PV on per-share basis to compare current share price to see if potential investment is undervalued or overvalued by market

Question 29

What is Internal Rate of Return (IRR)?

Answer 29

method determines discount rate that would make NPV of after-tax cash flows equal to zero - any potential investment/project that returns IRR greater than zero, has value

solving for discount rate - can only be calculated using specific function made for calculating IRR or by using trial and error