Financial Management Flashcards
What is the weighted average cost of capital?
Rate of return of each source of capital weighted by its share of the total capital.
- % of total capital is determined for each source
- % of each is multiplied by the cost of capital for that source of capital
- % resulting weighted costs fo capital are summed to get the WACC.
When determining the after tax savings of WACC items, what is included and what is not included?
Bonds and L/T Debt are included in the after tax savings.
Common Stock and Preferred Stock do not have tax savings.
What are incremental costs?
Different between two or more alternatives under consideration. Fixed costs don’t matter here.
What are relevant costs considered when purchasing a new asset?
New asset purchase price and selling price of old asset.
What are sunk costs?
Costs incurred in the past that cannot be changed by current or future decisions, and are therefore irrelevant to to current decisions.
What is the Present Value (PV) of $1?
Value now (at the present) of a SINGLE AMOUNT to be RECEIVED in the future. The amount to be received in the future is discounted using an interest rate to get the PV of that amount.
What is there Future Value (FV) of $1?
Value at some FUTURE date of a SINGLE AMOUNT INVESTED now. It is the amount that will accumulate as a result of compounding of interest on the single amount invested at the present.
What is the PV or an ordinary annuity?
Value NOW of a SERIES OF EQUAL AMOUNTS to be RECEIVED at the END of the EQUAL INTERVALS over some future period. Equal amounts to be received a the END of a # of EQUAL PERIODS are discounted using an interest rate to get the PV of those amounts.
What is the FV of an ordinary annuity?
Value at some FUTURE date of a serials of EQUAL AMOUNTS to be INVESTED at the END of the EQUAL INTERVALS over some period of time. It is the amount hat will accumulate as a result of the amounts invested at the END of each period and the compounding interest on those amounts.
What is the FV of an annuity due?
Value at some future date of a SERIES of EQUAL amounts to be INVESTED at the BEGINNING of EQUAL intervals over some period of time. The amount that will accumulate as a result of the amounts invested at the beginning of each period and the compounding interest on those amounts.
For present value, what will the future amount be with the higher interest rate?
Lower future amount. Since the higher the interest rate, the more that is counted as interest, and the less there is in PV.
For future value, what will the future amount be with a higher interest rate?
Higher future amount. Since FV is computed as principal and compounded interest, the higher the interest rate, the greater the amount of interest earned each period - therefore the greater the acc future amount.
Solve the following problem:
Year 1 - 30,000 reduction in costs
Year 2 - 30,000 reduction in costs
Year 4 - 20,000 reduction in costs.
PV of annuity
Perido 1 - 0.88
Perido 2 - 1.65
Perido 3 - 2.32
Since only the PV of an annuity is given, correct answer can only be determined by converting values into annuities. So, since the values are not equal for every year (and therefore not an annuity) so convert them in to 2 series of equal payments.
Year Stream 1 Stream 2. Stream 3
- 20,000 10,000 = 30,000
- 20,000 10,000 = 30,000
- 20,000
- 10,000 annuity for 2 years: $10,000 (1.65) = $16,500
- 20,000 annuity for 3 years: $20,000 (2.32) = $46,400
Total Cost Savings = $62,900
What is the APR?
Effective interest rate for a fraction of the year grossed up to the annual rate (Effective interest rate for fraction of year x that fraction of the year)
How do you calculate the effective interest rate?
Dollar cost of borrowing/net proceeds of borrowing
What is simple interest calculated on?
Computed on the principal only and is not compounded.
What is the effective annual percentage rate?
Also referred to the annual percentage yield. It’s the annual % rate with compounding on loans the are for a fraction of that year.
What is a yield curve?
Shows the relationship between time and maturity and bond interest rates.
What is the real interest rate?
Stated (nominal) rate of interest for a period less the rate of inflation of that period.
Solve this example: what is the effective interest rate on this loan?
200,000 loan
12% annual rate
20% compensating balance
$200,000 x 12% = $24,000
$200,000 x 20% = $40,000
$200,000 - $40,000 = $160,000
$24,000/$160,000 = 15%
How is the market rate of interest on US Treasury Bill calculated?
Risk free rate + inflation premium
What is not a factor relevant in determining risk premium as a security?
EPS
What happens to the risk premium when investors expect reduced inflation in the future?
A lower risk premium will be assessed on a an investment. An expected reduction in inflation in the future would be reflected in a lower L/T rate of return.
Solve this example: A company wants to approximate the 12% annual interest rate based on a 365 day year it pays on its working capital loan. Show why the terms of 1%, 15, net 45 work?
Divide the discount period into days in a year:
45-15 = 30
365/30 = 12.1
12.1 x .01 = .121 (or 12% rounded)
What is the market approach to determining fair value?
Info generated by market transactions for identical/similar items. (best approach)
What is the income approach to determining fair value?
Convert future amounts to current amounts. Specifically the use of discounted cash flows to determine the current value of those flows.
What is the cost approach to determining fair value?
determines the amount required to acquire or construct a comparable item.
What are the hierarchy’s of inputs use for determining FV?
Level 1 - quoted prices in active markets/identical items (observable)
Level 2 - quoted prices in inactive markets for similar (but not identical) items
Level 3- unobservable inputs (assumption/estimates)
What is CAPM?
Capital Asset Pricing Model. It is an economic model that determines a measure of relationship risk and expected return. It incorporates the time value of money and the element of risk (beta)
What is the CAPM formula?
RR = RFR + (beta(ERR - RFR)
RR - Required Rate for Return
RFR - Risk Free Rate (U.S. Government Bonds)
Beta - Risk Measure
ERR - Expected Rate of Return (benchmark for class of asset being valued)
What does a beta = 1, >1, and <1 stand for?
Beta = 1 - Asset being valued moves in line with benchmark
Beta <1 - Asset is volatile, more systematic risk
Beta < 1 - Less volatile, less systematic risk
In general, what does BETA measure?
In general, beta measures volatility of an asset against the class of asset being valued. For example, for the stock, the asset class would be the market the stock is traded.
Solve the Required Rate of Return with the following information:
U.S. Government Bond (RFR) - 2%
Beta - 1.4
Expected Rate of Return - 9%
RR = .02 + 1.4(.09 - .02) RR = .02 + 1.4(.07) RR = 11.8%
A graph that plots data would show what?
The relationship between the return of an individual asset and the return of the entire class of that asset, as reflected in the benchmark return for that class.
What is an option for an asset?
contract that entitles owner to buy or sell an asset at a stated price within a specific period.
What are three factors to consider when using option pricing as a valuation technique?
- Measure the risk of the optioned asset - the larger the standard deviation, the greater the value.
- Exercise price of option
- Dividend payments on optioned security - the smaller the dividend the greater the option value.
What is the Black Scholes Pricing Model?
Developed for specific circumstances an European call options. It assumes the stock pays no dividends, stock prices increase in small increments, and the risk free rate of return is assumed constant.
What are the two additional factors that the Black Scholes Pricing Model uses in addition to the option pricing model?
- The use of probabilities - probability that the stock will payoff by the expiration date and the probability that the option will be exercised.
- Discounting the exercise price.
What does the Black Scholes model not do?
It does not accommodate for options when the price of the underlying stock changes significantly and rapidly.
What is the current value of the 100 stock options using the following information (option pricing):
Allen was granted option to buy 100 shares of stock. Options expire in 1 year and have an exercise price of $60/share. Analysis determines that the stock has an 80% probability of selling for $72.50 at the end of the 1-yr option period and 20% probability for selling for $65 by end of year. The costs of funds is 10%
$72.50 is $12.t0 above the selling price.
$65.00 is $5.00 above selling price.
(80% x 12.50) + (20% x 5.00) / 1.10
1.10 = 1 + 10% cost of funds.
$11.00/1.10 = $10.00
$10.000 x 100 shares - $1,000
When does the value of a stock option generally increase?
The longer the time to expiration, the higher the risk free interest rate, and the higher the volatility of the stock.
In a common sized balance sheet, each item is measured as a % of the total of what?
Assets/Total Assets
Liabilities or Equity/Total Liabilities and Equity
In a common sized balance sheet, each item is measured as as % of the total of what?
Revenues
What are the three main business entity valuation techniques?
Market, Income, and Asset
How do you value a business entity using the market approach?
Compare to highly similar/highly comparable entities. You can compare public to non-public with some adjustments (i.e. for controlling/non-controlling interests)
How do you value a business entity using the income approach?
NPV of benefit stream generated by the entity. The NPV is the entity value calculated using the discount rate. The discount rate is based on the Rate of Return needed to attract investor funding given the level of risk.
How do you value a business entity using the asst approach?
Sum of the FV of each individual asset and liability. FV is determined by either the income, market, or cost approaches. Appropriate for valuing an entity in liquidation or for company with little to no cash flow.
What is the P/E Ratio?
Price earnings ratio computed as market price/EPS. Both values are on a per share basis.
What are for alternative income approaches for valuing a business entity?
Discounted cash flows, capitalization of earnings, earnings multiple, and free cash flow.
Solve this example for capitalization of earnings, an alternative approach to the income approach:
An entity expects to earn $100,000 and the rate of return required for the level of risk is 20%. Assume a 4% growth rate and a 3% inflation rate.
Capitalized Value = Expected Earnings/[Discount Rate - (Growth Rate + Inflation Rate)]
Capitalized Value = $100,000/[.20-(.04+.03)]
Capitalized Value = $100,000/.13
The value of the business would be: $768,231.
What is the formula for the alternative income approach for valuing an entity called the free cash flow:
Net Income \+Depreciation/Amortization -Capital Expenditures \+/- Changes in Working Capital =Free Cash Flow
What is the main goal for hedging and derivatives?
Offsetting transactions so that the loss on one transaction will be offset by a gain of another. Hedging is the concept. Derivatives is the tool.
What are examples of hiding items?
Recognized Asset: A/R, Investments, Inventory
Recognized Liabilities: A/P, Interest Payable
Firm Commitments: Executed contract to buy/sell a good/service, but not yet recognized.
Planned Transaction: Budgeted revenue/expense
What are examples of inventory price change risks?
- Increase in the market price of inputs to the production process.
- Decrease in the market price of inventory already under a higher purchase price contract.
- Decrease in the market value of inventory held for re-sale that would required a write down of lower cost or market.
What are examples of Foreign Currency Exchange Risk?
Revenues, Expenses, Assets and Liabilities may be adversely affected when converted to the domestic currency.
- Transaction Risk - Less money received on investments receivables and more money will be owed on payables.
- Translation Risk - Asset/Revenue accounts of foreign subsidiaries will convert to fewer dollars or Liabilities/Payables will convert to more dollars.
What is Interest Rate Risk?
- An increase in the market rate of interest will cause a decrease in the value of outstanding fixed rate interest debt investments.
- The cost of interest expense on outstanding variable rate of interest debt will increase.
What is default risk?
Borrower will fail to make interest payments or principal repayment when due.
Describe what derivatives are.
They are the in strident for hedging. They have an underlying and notional amount. The underlying amount is the specified price. The notional amount is the specified unit of measure. Little to no initial net investment is required. Terms require or permit cash settlement and not for the actual delivery of the goods/services.
What is a Future’s Contract?
Contract for the delivery or receipt of a commodity, foreign currency, security investment, or other asset in the future at a price set now. A clearinghouse is used for these transactions and they are settling daily.
What is a Forward Contract?
Similar to a future’s contract except they are executed directly between 2 parties. They can be customized to any item, quantity, and delivery date. They are only settled at the END of the contract.
What is an Options Contract?
Buyer has the the right to buy (call) or sell (put) a particular asset in the future at prices set now (strike price). The buyer will exercise the option only if it economically feasible.
What is a Swap Contract?
Contract between buyer and seller who agree to exchange cash flows (typically related to interest), currencies, commodities, or risk.
What type of contract could a firm enter into should there be risk to a firm for a commitment to purchase inventory?
Enter into a futures contract to sell comparable inventory at a price set now and to sell in the future. So, if there is a decease in the market price, there is a loss on the value of inventory under the fixed price, but a gain on the value of the futures contract to sell the comparable inventory. This contract provided for a sale at the higher price before the price decline.
What type of contract could a firm enter into should there be a risk to existing inventory to the decline of market price which would result in a write down of lower of cost or market?
Enter into a forward contract or put option to sell comparable inventory. So, if the value of the inventory declined, the lower of cost or market write down would result in a loss. But the gain on the value of a forward contract or put option to sell inventory (at a higher price before the decline), would offset the loss.
Solve this example: A firm acquired inventory at a cost of $100,000 that it expects to sell in 4-6 months. The firm is concerned with a decline in the market value of inventory prior to the sale. To hedge the possible decline, it enters into a forward contract to sell comparable inventory at the end of 3 months. The forward price is $100,000. At the end of the 3 months the market price is $80,000. What is the net G/L on this transaction?
$20,000 loss on the LCM write down ($100k - $80k)
$20,000 gain on the sale ($100k selling price - $80K)
Net G/L = $0
Note: the party probably doesn’t want the inventory anymore and will settle the contract in lieu of delivery of inventory.
What type of contract could you enter into in there is a risk that a receivable denominated in foreign currency will be worth less due to a change in the exchange rate?
Forward contract to sell foreign currency units when received a price set now. Upon collection of the receivable, you receive the foreign currency units to settle the contract. You also receive # of dollars provided by the forward contract regardless of current exchange price.
How could you hedge the risk of market rate interest changes on a variable rate loan where there is a risk for the increase in interest rates?
Could enter into an interest rate swap agreement and exchange variable rate interest receipts for fixed rate interest payments. Entity would make a higher fixed rate payment to a counterpart - and in return receive a variable rate payment from the counterpart.
If interest rates go up, you will receive a higher interest from the counterpart which will be offset by higher fixed interest payments. If the market rate doesn’t go up, you still have limited your loss.
How could you hedge the risk of credit default?
Credit default swap. Entity pays a fee for a buyer to assume the credit risk. If the creditor fails, buyer of debt compensates for the loss.
What are some costs associated with financial hedging?
Hedging costs may be unnecessary, may lose the gain if market moves in the opposite direction, difference between forward and spot prices, contract related fees, and internal admin costs of hedging.
What are some costs associated with financial hedging?
Credit risk - counterpart fails to meet the contractual obligations. (This risk is reduced when the contract is done through an exchange)
Market Risk - Market will change contrary to predictions.
Basis Risk - hedged item and hedging instrument do not move in opposite directions.
What does it mean when a derivative is used for speculation?
No item is hedged, and there is not intent to hedge, but it is used for profit only. For example, an investor may enter into a derivative contract if he believes the stock price will go up. He could buy an option contract (call) to purchase in the future for a price set now should it be economically feasible.
In countries where currency rates are likely to fall, a firm should NOT encourage what and why?
Should NOT encourage the trading of the trade credit wherever possible. There are A/R’s and therefore they would be worth less when they came do should the currency decrease.
Fill in the blanks and then explain why: The buyer of a forward contract will _____ when price increases, and the seller of a forward contract will ____ when the price increases.
Buyers of forward contracts will gain when the price increases because the buyer will be purchasing the contracted asset at the lower contract price. The seller of the forward contracts will lose when the price increases because the seller misses out on the higher price of the asset - they are locked into the lower price.
Whet are you two options fo hedging a net receivable denominated in British pounds by a US company?
Could purchase a put (sell) option or a froward contract to sell British pounds. These hedge against the risk that the receivable is worth less do you a depreciation in the foreign currency.
A company has recently purchased some stock of a competitor as part of a L/T plan to acquire the competitor. However, it is concerned that the market price of this stock could decrease in the short run. How can the company hedge against a possible decline in the stock market price?
Purchase a put option on the stock. The put option would give the company an option to sell the stock at a specified price in the future. If the price of the stock declines, the value of the put option will increase by the like amount (because you’re selling it at a higher price than the stock currently is)
Firm has a large amount of variable rate financing due in a year. Management is concerned about the possibility of increases in S/T rates. What could hedge against this risk?
Selling treasury notes in a futures contract. If interest rates increase, value of the Treasury notes contract will decline, which would enable the firm to acquire notes at the new lower value and sell them at a higher futures contract price - resulting in a gain - offsetting the increase in S/T interest rates on the financing.
American imported of English clothing has contracted to pay an amount fixed in British pounds 3 months from now. Importer worries that the US dollar may depreciate sharply (making the payable more expensive). How could he hedge against this risk?
Buy pounds in the forward exchange market. Buying pounds now through a forward contract would lock in the dollar cost of the pounds needed to pay the obligations when it comes due, and protect against the depreciation of the dollar against the pound.
What is the correct calculation for the payback approach?
Divide the initial cost of the property by the undercounted estimated annual cash flows.
Which capital project valuation approach is primarily concerned with the relative economic ranking of projects?
PPI (Profitability index approach)
What is the equation for the Accounting Rate of Return Approach?
(Avg. Annual Incremental Revenues - Avg. Annual Incremental Expenses) / Initial or Avg. Investment
What expenses are explicitly recognized under the ARR approach?
Depreciation and Income Taxes - they are deducted from the incremental revenues
When there is a residual or salvage value, how is the “initial” investment calculated.
It is calculated as the AVERAGE initial investment. Initial investment + RV/SV / 2 to get the average.
Solve this example for the ARR: Firm is negotiating the purchase of equipment that would cost $100K with the expectation that $20k/year cold be saved in after tax cash costs if acquired. Estimated useful life is 10 years. No RV. Depreciated straight line.
Average Annual Income = $20,000 (same every year)
Average Annual Income Expense = $100k/10 years = $10,000 in depreciation a year
There is no RV, so the denominator is just the initial investment.
($20k - $10k)/$100k = $10k/$100k = 10%
How would you describe ARR?
It is a method of evaluating potential capital products that takes into account depreciation expense that was non-deductible for tax purposes. It considered the entire life of product and assumes that the incremental net income is the same each year (hence the average).
Solve the example for ARR: New Machine Cost: $66k Salvage Value: $16k Expected Life: 6 years Annual incremental income before tax: $7,200 Tax Rate: 30%
First, find the after tax cost of the investment. There is no mention of depreciation here, so tax is the only expense.
Avg annual incremental income - $7,200 x 70% = $5,040. (same each year, so no need to avg over 10 years)
Second, need to find the average cost of the investment because a salvage value is provided. So, (66,000 + 16,000)/2 = $41,000
5,040/41,000 = 12.29%
Solve the example for ARR:
Cash flow, net of taxes is $3,000 in each of the 10 years
ARR is expected to be 10%
Depreciation is 10 years straight line and a full year of depreciation will be taken in the first year.
What was the initial cost of the investment?
Fill in the missing blanks of the equation:
10% = (Incremental income - Incremental expenses) / Initial investment
10% = (Incremental income - Depreciation) / Initial Investment
10% = (Incremental income - 1/10 of the initial investment) / Initial Investment
When you solve the algebra, you get .10x = 3,000 -.10x where x is the initial investment.
.20x = 3,000 = $15,000
What are the advantages of the NPV Approach?
- Recognizes the time value of money (PV of future CF)
- Relates project rate of return to cost of capital
- Consideres entire life and results of project
- Easier to computer than IRR
What are the disadvantages of the NPV Approach?
- Requires estimation of cash flows over the entire life, which could be very long
- Assumes CF resulting from new revenues or cost savings are immediately reinvested at the hurdle rate.
When with the net investment in a new project using the NPV approach be recognized?
Recognized as a cash outflows at the beginning of the project
How is working capital recognized using the NPV approach?
Recovery of working capital at the end of the project recognized at present value.
Solve the following using the NPV approach? Initial cost of project: $75,000 Estimated periods be benefited: 10 years Estimated annual savings: $15,000 Estimated RV: $5,000 Cost of Capital: 10% PV of $1: 0.386 PV of Annuity: 6.145
PV of Savings = $15,000 x 6.145 = $92,175
PV of RV = $5,000 x 0.386 = $1,930
Total PV = 92,175 + 1,930 = 94,105
Solve the following using the NPV approach for the purchase of a new machine?
$110,000 after tax savings for 10 years
12% return
NPV = $12,0007
PV of $1 at 12% at end of 7 periods = 0.452
PV of ordinary annuity of $1 at 12% for 7 periods = 4.564
What is the cost of the machine?
NPV of a project is determined by subtracting the cost of the investment from the PV of future cash flows.
NPV = (cash flows x PV of annuity) - Investment Cost
12,000 = ($110,000 x 4.564) - Investment Cost
12,000 = 502,040 - Investment Cost
-502,040 -502,040
=490,040 is the investment cost
How does depreciation affect the NPV calculation?
The calculation of depreciation is used in the determination of NPV of an investment b/c it increases cash flow by reducing income taxes.
Solve the following using the NPV approach for the purchase of a new machine? Cost of Machine - $100,000, 6 year life Salvage Value - $20,000 Net Annual Cash Inflows - $25,000 PV of Single Sum - 0.564 Annuity - 4.355 NPV of Machine?
PV of the Salvage Value - $20,000 x 0.564 = $11,280
PV of Net Annual Cash Inflow - $25,000 x 4.355 = $108,875
11,280 + 108,875 - 100,000 = $20,155
What is the after tax cash flow of the following project?
Expected Sales: $1,500
Cash Operating Expenses: $700
Depreciation: $250
Tax Rate: 30%
$1,500 Sales
(700) Operating Expenses
$800 x 70% = $560
Depreciation $250 x 30% tax savings = $75
$560 + 75 = $635
What is the internal rate fo return? (IRR)
Evaluates a project by determining the discount rate that equates to the discount rate that equates to the Present Value of the projects future cash inflows with the present value of projects cash inflow.
