Financial Management (21%) Flashcards
A cost that has been incurred in the past, cannot be changed by current decisions, and is irrelevant to making current and future replacement decisions.
SUNK cost (i.e. original cost of machine and related accumulated depreciation)
Another way to say Cost of Capital
Rate of Return, companies will always seek to minimize the required rate of return (cost of capital) needed to attract shareholder investment in the corporation.
Opportunity Cost Defined
Opportunity cost is the discounted dollar value of benefits lost from an opportunity as a result of choosing another opportunity.
Remember that the gain on sale of the old item will be rolled into the disposal cost and is a SUNK cost.
Incremental Cost Defined
Incremental costs are those that are different between two or more alternatives under consideration. Remember that fixed costs are present regardless of which option is chosen and should not be considered when calculating incremental/differential cost.
Definition of Ordinary Annuity and Ordinary Annuity Due
OA = equal payments made at the end of each period.
OAD = equal payments made at the beginning of each period.
Present Value vs. Future Value
For present value, the higher the interest or discount rate, the lower the present value of a future amount. Since the higher the interest or discount rate, the more that is counted as interest, the less there is in present value.
For future value, the higher the interest rate, the greater the future value of a present amount. Since future value is computed as principal plus compounded interest, the higher the interest rate, the greater the amount of interest earned each period and, therefore, the greater the accumulated future amount.
Stated Interest Rate (nominal rate) and Real Interest Rate
What is difference between Real Interest Rate and Real Risk Free Interest Rate?
The stated interest rate (also called the nominal or quoted interest rate) is the annual rate specified in the loan agreement or comparable contract; it does not take into account the compounding effects of frequency of payments or the effects of inflation.
Real interest rate—as contrasted with nominal interest rate, refers to the rate of interest after taking into account the effects of inflation on the value of funds received. The calculation of the real interest rate (RIR) is: RIR = Nominal int. rate - inflation rate
The Real Risk Free Rate is the basic component of interest or another way of saying nominal.
Simple Interest and Compound Interest
Original principal only; no compounding in the interest computation.
Compound interest provides that interest be paid not only on the principal, but also on any amount of accumulated unpaid interest. Compound interest pays interest on interest; simple interest does not.
Compound Interest Formula (same as Future Value of $1 formula)
Compound interest and future value of $1.00 calculations are performed in the same manner. Both account for interest being paid on accumulated interest. For multiple period calculations either the formula above or a future value of $1.00 table can be used.
If asked to calculate the CI, formula attached with facts below.
- P = principal amount (the initial amount you borrow or deposit)
- r = annual rate of interest (as a decimal)
- t = number of years the amount is deposited or borrowed for.
- A = amount of money accumulated after n years, including interest.
- n = number of times the interest is compounded per year
Effective Interest Rate
The effective interest rate is determined as the full cost of a loan divided by the net cash proceeds.
Remember in calculating the proceeds, take into account the discount if any, compensating balances, origination fees etc.
Interest Cost = P x R x T EIR = (Int. Cost / P) / T
Annual Percentage Rate (APR)
One step past EIR, The annual percentage rate of interest is the annualized rate for a loan that is for less than a full year. NO COMPOUNDING
I = P x R x T (where T is length of loan, i.e. 1 quarter is 90/360)
going off example above, the APR is EIR x 4 for the full year APR.
Effective APR
The EAPR will always be higher than the APR due to compounding. The EAPR, also called the annual percentage yield, is the APR with compounding on loans that are for a fraction of a year.
As discussed under compounding, the assumption is that interest is paid on interest that would accumulate for each period during the year.
The formula for computing the effective annual percentage rate (EAPR) is: (1+I/P) P − 1
“2/10, net 30” Defined
Credit terms of “2/10, net 30” mean that the debtor may take a 2% discount from the amount owed if payment is made within 10 days of the bill, otherwise the full amount is due within 30 days.
The 2% discount is the interest rate for the period between the 10th day and the 30th day; it is not the effective annual rate of interest.
GAAP Fair value is…
Price received to SELL an asset or paid to transfer a liability. It is NOT an entry price.
U.S. GAAP Fair Value Hierarchy of Inputs
- Level 1 = highest quality inputs (unadjusted quoted prices for identical item in active market)
- Level 2 (quoted prices for similar (not identical) item in active market, quoted prices for identical item in non-active market)
- Level 3 = lowest quality (and typically not visible) inputs (entity assumptions and internal data)
Fair Value Framework approaches to developing FV
Market Approach
Income Approach (discounted cash flows)
Cost Approach (replacement cost)
Beta
Beta is the covariance of the asset’s returns with the returns of the overall portfolio. Therefore, it measures the systematic risk of the investment. Measure of volatility of an asset when compared to a benchmark for a whole class of that asset.
b = 1, asset moves in line with benchmark
b > 1, asset moves more than benchmark
CAPM Assumptions and Limitations
- Assumes there is both an asset class and benchmark for asset being valued.
- Assumes all investors have equal assets to all investments of class being valued and all use one time-period horizon.
- Assumes asset risk measured solely by variance of the asset being valued from asset class benchmark.
- Assumes no external cost or restrictions on borrowing.
- Uses historical data
kS (CAPM) = kRF + (kM − kRF)bi
CAPM is widely used, but primarily for:
- Securities Analysis
- Capital Budgeting
- Setting Fair Compensation for Regulating Monopolies
The risk-free rate of return is a measure of?
The time value of money.
The standard deviation of an investment’s expected return is?
A measure of its risk.
What type of risk does an investment with a beta of 1 have?
Average Systematic Risk
The riskier an investment, the higher the? What does the CAPM model truly measure?
Expected return
The capital asset pricing model (CAPM) measures the relationship between risk and reward.
Black Scholes Option Pricing Model
For Euro call options Stocks pay no dividends Stock prices increase in small increments RFR is assumed constant Uses probabilities Uses discounting
Binomial Option Pricing Model
Uses tree diagram to generate values at number of points between valuation date and expiration date.
True of False: Common-size analysis converts financial statements to percentages
TRUE
True or False: The asset approach to valuing a business is likely to be appropriate in valuing a failing business.
TRUE
P/E Ratio for CS
Market Price / EPS
Income Approach to Valuation of a Business
- Discounted Cash Flow
- Earnings Multiple
- Free Cash Flow
In a common-size income statement, each item is measured as?
A percentage of total revenues.
In a common-size balance sheet, each item is measured as?
A percentage of total assets (or total liabilities plus equity)
Approaches to valuing a going business
- Market
- Income
- Asset
The longer the forecasting time horizon, the more likely the forecasting will use which forecasting method?
Qualitative methods (subjective and long-range)
- Executive Opinion
- Market Research
- Delphi Method
What are the components of the Quantitative Method of business forecasting? Describe them.
- Time Series Models (assumes data patterns in the past will continue unchanged into the future)
- Causal Models (assumes the variable forecasted is related to other independent variables and makes a forecast based on those relations)
ST, Medium and LT Forecasting What Methods are best in what periods?
- ST - Time Series
- Medium - Time Series and Causal
- LT - Causal and Qualitative
Quantitative Forecasting - Causal Model Types
- Regression (linear or non-linear) i.e. trend analysis
- Input / Output Models
- Economic Models
Quantitative Forecasting - Time Series Model Types
- Naive (prior period)
- Simple Mean
- Simple Moving Average (each period weighed equally)
- Weighted Moving Average (assigns subjective weight)
- Exponential Smoothing (weighted avg. procedure)
- Trend Adjusted Exponential Smoothing
- Seasonal Indexes
- Linear Trend Line
A company invested in a new machine that will generate revenues of $35,000 annually for seven years. The company will have annual operating expenses of $7,000 on the new machine. Depreciation expense, included in the operating expenses, is $4,000 per year. The expected payback period for the new machine is 5.2 years.
- What amount did the company pay for the new machine?
Initial Investment is PP x Annual Revenue amount 5.2 x 32,000 = 166,400
Remember that depreciation is a non-cash expense and should not be included in the 7,000 opex.
Accounting Rate of Return
(Average Incremental Annual Revenue - Average Incremental Expense) / Initial (or avg.) Investment
- Ignores TVM and Cash Flow
- Depreciation (in full) explicitly considered as reduction in income
- Taxes (in full) explicitly considered as reduction in income
The hurdle rate or in other words, a firm’s discount rate is determined by what?
The firm’s WACC, the required return for investors to invest in the corporation
The calculation of depreciation is used in the determination of the net present value of an investment for what reason?
Depreciation increases cash flow by reducing income taxes.
Do not use the full depreciation amount…only the tax impact as an addition to cash flow.
A project should be accepted if the present value of cash flows from the project is?
Greater than 0.
- Investment Cost of a Project Formula
- PV Factor Formula
- Investment Cost = Annual Cash Inflow (or savings) x PV Factor
- PV Factor = Initial Cost / Annual Savings
What will increase/decrease the internal rate of return?
Remember the formula for a PV Factor:
Initial Investment in Project / Annual Savings
Anything (such as reduced tax credits on an asset) that increases the cost of the asset/project, will increase the numerator in the formula above and hence lower that internal rate of return (or the discount rate).
Which one of the following forms of short-term financing is least likely to be considered a spontaneous source of funding? Short-term notes payable Accrued taxes payable Accrued salaries payable Trade accounts payable
STNP
Spontaneous financing occurs automatically in the carrying out of day-to-day operations. Financing through the use of short-term notes payable does not occur automatically as a result of carrying out day-to-day operations, but rather requires negotiation with a lending institution, usually a commercial bank, and the execution of a promissory note.
The other forms of payable occur spontaneously as a result of normal business operations.
Inventory Secured Loan Arrangements
- Floating lien agreement – The borrower gives a lien against all of its inventory to the lender, but retains control of its inventory, which it continuously sells and replaces.
- Chattel mortgage agreement – The borrower gives a lien against specifically identified inventory and retains control of the inventory, but cannot sell it without the lender’s approval.
- Field warehouse agreement – The inventory used as collateral remains at the firm’s warehouse, placed under the control of an independent third-party and held as security.
- Terminal warehouse agreement – The inventory used as collateral is moved to a public warehouse where it is held as security.
Define the “Financial Structure” of a firm vs. the “Capital Structure” of a firm.
- Financial Structure is overarch. FS is all the debt and equity of a firm.
- Capital Structure strictly pertains to the Long-term debt and equity position of the firm.
Other names for:
- Working Capital Financing
- Capital Financing
- WCF = Short-term financing
- CF = Long-term financing
Long-term Capital Financing - When to accept a a project using a Financial Lease as opposed to one of the traditional capital budgeting analysis’s.
Project should only be accepted if the traditional capital budgeting analysis measures the project not to be economically feasible AND the leasing based analysis shows the project to be economically feasible or both are feasible but the lease provides a better “return.” Note this lease would be considered a financial lease and NOT operating.
Financial Leases -
Net Lease vs. Net-Net Lease
- NL = lessee assumes costs associated with ownership during period of lease (executory costs, maintenance, taxes, etc.)
- NNL - assumes executory costs plus a pre-established residual value.
What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?
The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt would be to reduce the risk, and therefore the interest rate, on debt being issued.
Debt covenants place contractual limitations on activities of the borrower to help protect the lender.
As such, they reduce the default risk associated with a debt issue and, therefore, reduce the interest rate on that debt.
Long-term promissory notes wherein the borrower, in return for buyers’/lenders’ funds, promises to pay the bondholders a fixed amount of interest each year and to repay the face value of the note at maturity.
Bonds -Indenture - bond contract -Par value - “principal” returned at maturity of the bond. -Coupon - annual interest rate printed on bond and paid on par value.
Security Classifications of Bonds
- Mortgage Bond - secured by pledge of specific property.
- Collaterial Trust - secured by financial assets of the firm.
- Debenture - unsecured, high risk, so firms must have excellent credit rating.
- Subordinated Debenture - bond with claims subordinated to other general creditors in event of bankruptcy.
- Income Bond - with interest payments that are contingent on firm’s earnings.
APR’s for: 2/10, n/30 5/10, n/30
36.7% & 94.74% respectively, formula base below.
Economic Order Quantity
(EOQ = how much to order)
The amount to be ordered is known as the economic order quantity (EOQ).
The EOQ minimizes the sum of the ordering and carrying costs.
The total inventory cost function includes carrying costs (which increase with order size) and ordering costs (which decrease with order size).
When to reorder inventory?
The objective is to order at a point in time so as to avoid stockouts but not so early that an excessive safety stock is maintained. Safety stocks may be used to guard against stockouts; they are maintained by increasing the lead time (the time that elapses from order placement until order arrival). Thus, safety stocks decrease stockout costs but increase carrying costs. Examples of these costs include
Internal Rate of Return (IRR)
How is the IRR related to NVP? see pic
Another discounted cash flow method. The IRR determines the rate of discount at which the present value of the future cash flows will exactly equal the investment outlay (i.e., the rate that results in a NPV of zero).
PV (investment today) = TVMF × Cash flows
Note IRR does NOT recognize salvage value
Consumer Price Index (CPI) = a measure of inflation
CPI is measured as the price that urban consumers paid for a fixed basket of goods and services in relation to the price of the same goods and services purchased in some base period. It is therefore inappropriate for measuring what companies buy. The producer price index (PPI) is the measure used by companies.
- Profitability Index Defined
- The profitability index is a variation on which of the following capital budgeting models?
- The excess present value (profitability) index computes the ratio of the present value of the cash inflows to the initial cost of a project. It is used to implement the net present value method when there is a limit on funds available for capital investments. Assuming other factors are equal, this is accomplished by allocating funds to those projects with the highest excess present value indexes.
- NPV - The profitability index is calculated as the ratio of the net present value of the project to its initial cost.
PI = (NPV / Initial Investment) x 100
