Financial Management Flashcards
Opportunity Cost
Discounted dollar value of next best benefit lost from an opportunity not taken as a result of choosing another opportunity. The revenue lost from an alternative not selected is an opp cost associated with the alternative that is selected.
Differential Costs
costs that are different between two or more alternatives.
Cost of capital
cost of long term funds -debt/equity used to finance an operation. Major LT sources of capital funding include LT debt, pref stock, comm stock
Cost of debt
rate of return that must be paid to attract and retain lenders’ funds
WACC
Weighted average cost of capital.
Rate of return of each source of capital weighted by its share of the total capital.
Calculation of WACC
- percent of total capital is determined for each source
- percent of each is multiplied by the cost of capital for that source of capital.
- resulting weighted costs of capital are summed to get the WACC.
Effective Interest Rate
The annual interest rate implicit in the relationship between the net proceeds of a borrowing (or other arrangement) and the dollar cost of the borrowing (or other arrangement).
Dollar cost of borrowing / Net proceeds of borrowing
Define “stated rate (of interest)” - also what is it also known as?
Nominal rate or quoted rate
The annual rate of interest specified in a debt instrument or other contract/agreement; it does not take into account the compounding effects of payment frequency.
Define “effective annual percentage rate” (also called the “annual percentage yield”).
Annual percentage rate with compounding on loans that are for a fraction of a year
what is the amount of interest specified in the loan contract called
the stated rate
Effective rate of the loan
net cost of the loan / net proceeds from the loan
Annual Percentage rate
annualized rate for a loan that is less than a full year
what does a yield curve show?
the relationship between time to maturity and bond interest rates
Real interest rate
the stated (nominal) rate minus the rate of inflation for that period
What would be the interest rate on a US treasury bill
the risk free rate plus the inflation premium .
US treasury bills are considered free of default risk, liquidity risk, and maturity risk
Market approach
info generated by market transactions for identical/similar items
income approach
converts future amounts of benefit or sacrifice to determine the current value
cost approach
determines the amount required to acquire or construct a comparable item
Capital Asset Pricing Model
an economic model that determines the relationship between risk and expected return and uses that measure in valuing securities, portfolios, capital projects, and other assets
CAPM formula
Required rate of return = Riskfree rate of return + Beta (Expected rate of return - riskfree rate of return)
Beta > 1
asset being valued moves greater than benchmark. the asset is more volatile than the entire class.
Beta < 1
asset being valued moves less than benchmark. the asset is less volatile than the entire class.
Beta = 1
The individual asset being valued changes in the same proportion as the entire class of the asset being valued; the asset has average systematic risk for the entire class.
Option
a contract that entitles the holder to buy or sell an asset at a stated price within a specified period. financial options are a form of derivative instrument
American style option
the option can be exercised any time prior to expiration
European style option
the option can be exercised only at the maturity/expiration date
why is the Black scholes pricing model unique?
uses probabilities
discounting of the exercise price
Binomial option pricing model
uses a tree diagram to estimate values at a number of time points between the valuation date and the expiration date
a method that can be generalized for the valuation of options.
what are some limitations of the black scholes model
It is appropriate only for European call options, which permit exercise only at the expiration date.
It assumes options are for stocks that pay no dividends.
It assumes options are for stocks whose price increases in small increments.
It assumes the risk-free rate of return remains constant during life of the option.
It assumes there are no transaction costs or taxes associated with the options.
What are some major advantages of the original Black-Scholes option pricing model?
It assigns a probability factor to the likelihood that the price of the stock will pay off within the time to expiration.
It assigns a probability factor to the likelihood that the option will be exercised.
It discounts the exercise price to present value.
what is the black scholes option pricing model
a mathematical formula for valuing stock options, which are derivative instruments (and certain other instruments). The original model was developed to value European-style options, which permit exercise only at the expiration date of the option.
Identify four major types of items that are hedged (i.e., hedged items).
Inventory/commodity prices
Foreign currency exchange rates
Interest rates
Default (Credit) risk
Which one of the following U.S. GAAP approaches to determining fair value converts future amounts to current amounts?
Income approach. Specifically, the use of discounted cash flows to determine the current value of those flows is an example of the income approach to determining fair value.
Common-size financial statements are useful in making comparisons
Between Entities and Over time.
Common-size financial statements are prepared by converting each amount to a percentage of a total amount on each financial statement. For example, revenues and expenses are converted to a percentage of total revenues.
What are the elements in the capital asset pricing model formula?
Risk free rate of return
Expected rate of return
A measure of volatility for the item being valued
What are income approaches to the valuation of a business?
Discounted Cash Flows
Earnings multiple
Free Cash Flow
Market Approach
(also Called the Sales Comparison Approach)—Uses prices and other relevant information generated by market transactions involving assets or liabilities that are identical or comparable to those being valued.
Income Approach
Uses valuation techniques to convert future amounts of economic benefits/sacrifices of economic benefits to determine what those future amounts are worth as of the valuation date.
Typically converts future cash flows or earnings amounts using models, including:
Discounted cash flows
Option pricing models
Earnings capitalization models
Cost Approach
Uses valuation techniques to determine the amount required to acquire or construct a substitute item (replacement cost or reproduction cost).
Use of this approach is more limited than the market approach or the income approach.
Use would be especially appropriate for valuing specialized types of assets.
Define Risk Premium
The rate of return expected above the risk free rate based on the perceived level of risk inherent in an investment/undertaking
Risk free rate of return
The rate of return expected assuming virtually no risk; rate of return expected solely for the deferred current consumption that results from making an investment. In the U.S., it is measured by the rates paid on U.S. Treasury obligations.
When used in evaluating capital projects, the weighted average cost of capital is called…
the hurdle rate
Payback Period Approach
determines the number of years needed to recover the initial cash investment in the project and compares the resulting time with a pre-established maximum payback period. If the expected payback period for a project is equal to or less than the pre-established maximum, the project is deemed acceptable; otherwise, it would be considered unacceptable.
Calculation of payback period approach
Initial investment / Annual cash inflow of a project
Discounted Payback Period Method
a variation of the payback period approach, which takes the time value of money into account. It does so by discounting the expected future cash flows to their PV and uses the PVs to determine the length of time required to recover the initial investment.
Does the payback period method consider time value of money?
no
Does the discounted payback period method consider time value of money?
Yes
will the discounted payback period method use future value factors or PV factors to determine the value of cash flows
PV
Accounting rate of return
also called the Simple Rate of Return
Assesses a project by measuring the expected annual incremental accounting income from the project as a percentage of the initial (or average) investment.
the accounting rate of return (ARR) would be calculated as:
ARR = (Average Annual Incremental Revenues − Average Annual Incremental Expenses) / Initial (or Average) Investment
Net Present Value Approach
Assesses projects by comparing the present value of the expected cash inflows (revenues/savings/residual value/etc.) of the project with the expected cash outflows (initial cash investment/other payments) of the project.
Advantages of the NPV approach
Recognizes the time value of money (i.e., present value of the future cash flows)
Relates project rate of return to cost of capital
Considers the entire life and results of the project
Easier to compute than the internal rate of return method (the other major discounted cash flow method)
Disadvantages of NPV method
It requires estimation of cash flows over entire life of the project, which could be very long.
It assumes cash flows are immediately reinvested at the discount rate.
How is the NPV determined
It is the difference (net) between the present value of expected cash inflows from a project and expected cash outflows, including the initial cost of the project.
The net present value method of evaluating capital projects assumes that new cash inflows or savings will be immediately reinvested at the ___ rate of return
Discount rate used in the NPV calculation. This is usually the cost of capital.
hurdle
The discount rate (hurdle rate of return) must be determined in advance for the
NPV method
Internal rate of return approach
also called the Time Adjusted Rate of Return.
Evaluates a project by determining the discount rate that equates the present value of the project’s future cash inflows with the present value of the project’s cash outflows. The rate so determined is the rate of return earned by the project.
IRR calc
NPV =0
Future annual cash inflows x PV factor = Inv cost
rearranged equation:
PV factor = inv cost / future annual cash inflows
IRR advantages
- TVOM
- considers entire life and results of project
Describe the modified internal rate of return (MIRR) approach to capital project evaluation.
Evaluates project treats cash inflows and outflows separately and assume inflows are reinvested at the firm’s reinvestment rate and outflows are reinvested at the firm’s cost of capital.
Describe the internal rate of return (also called time adjusted rate of return) approach to capital project evaluation.
It evaluates a project by determining the discount rate that equates the present value of a project’s cash inflows with the present value of the project’s cash outflows.
Disadvantages of the IRR
It is difficult to compute.
It requires estimation of cash flows over the entire life of project, which could be very long.
It requires all future cash flows be in the same direction, either inflows or outflows.
It assumes cash flows resulting from the project are immediately reinvested at the project’s internal rate of return.
Limited usefulness when comparing projects of different size, life or timing of cash flows.
Under what conditions is the internal rate of return approach (to capital budgeting) not appropriate?
When future cash flows of a project are both positive and negative, the internal rate of return method should not be used because it can result in multiple solutions.
what is the profitability index
provides a way of ranking projects by taking into account both cash flow benefit expected from each project and the cost of each project.
also called the cost/benefit ratio or present value index
How is the profitability index calc? When the present value of future cash inflows is used
PI = PV of Cash inflows / Project cost
How is the profitability index calc? When the NPV is used
PI = Net present value / Project cost
Describe the equivalent annual annuity approach (EAA) to ranking capital projects.
The EAA ranks projects by calculating the constant annual cash flow generated by a project over its entire life as if it was an annuity. The projects are then ranked based on the present value of those cash flows; the higher the cash flows the higher the ranking.
What is the preferred method of ranking economically feasible projects?
The profitability index, which takes into account both the net present value and the initial cost of each project, or the equivalent annual annuity approach.
In what circumstance might the use of the payback period approach be useful in ranking capital projects?
When liquidity issues are a major concern in selecting from a set of projects
In ranking economically feasible projects, what is the primary shortcoming of the net-present-value approach?
It fails to take into account differences in the initial cost of economically feasible projects. Each project is evaluated independently of each other project; therefore, differences in initial cost among projects are not considered.
Financial Structure
All elements of liabilities (current and noncurrent) and owners’ equity of a firm constitute its financial structure.
Describe the components of a firm’s capital structure.
All elements of long-term debt and owners’ equity
what financial instrument provides the largest source of short term financing for small firms
trade credit
It occurs automatically with the purchase of goods and services.
Commercial paper
Short term unsecured promissory notes
- sold by large, highly creditworthy firms
- most are for 180 days or less
- if more than 270, SEC registration is required.
- interest rates typically less than other ST sources
what are some disadvantages of standby credit (short term financing)
- poor credit rating = high interest rate
- usually involves a fee
- compensating balance usually required
Letter of credit
a conditional commitment by a bank or third party in accordance with specified terms and commitments.
Revolving line of credit
a legal agreement between a borrower and a financial institution whereby the fin. inst. agrees to provide an amount of credit to the borrower. Recurring manner - borrower, repaid, borrowed again.
Line of credit
informal agreement
between a borrower and fin. inst. whereby the fin. inst. agrees to a maximum amt of credit that it will extend to the borrower at any one time.
-it is not legally binding on the fin. inst.
Pledging Accounts Receivable
using A/R as security for short term borrowing
Factoring
the sale of A/R
with or w/o recourse
Buyer = factor
Factoring w/o recourse
the factor bears the risk assoc with collectibility (except in case of fraud)
Factoring with recourse
the factor has recourse against the seller for some or all of the risk assoc with uncollectibility of the rec.
Inventory secured loans
when a firm pledges all or part of their inventory as collateral for a ST loan
Floating lien agreement
borrower gives a lien on all of its inventory but retains control of its inventory which it continuously sells and replaces.
Chattel mortgage agreement
lender has a lien against specifically identified inventory
-borrower retains control of that inventory but cannot sell it without lendor approval.
Field warehouse agreement
inventory remains at borrower’s warehouse but under the control of an independent third party
terminal warehouse agreement
inventory is moved to a public warehouse and placed under the control of an independent third party.
