Financial Management Flashcards
1
Q
What is the weighted average cost of capital?
A
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.
2
Q
When determining the after tax savings of WACC items, what is included and what is not included?
A
Bonds and L/T Debt are included in the after tax savings.
Common Stock and Preferred Stock do not have tax savings.
3
Q
What are incremental costs?
A
Different between two or more alternatives under consideration. Fixed costs don’t matter here.
4
Q
What are relevant costs considered when purchasing a new asset?
A
New asset purchase price and selling price of old asset.
5
Q
What are sunk costs?
A
Costs incurred in the past that cannot be changed by current or future decisions, and are therefore irrelevant to to current decisions.
6
Q
What is the Present Value (PV) of $1?
A
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.
7
Q
What is there Future Value (FV) of $1?
A
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.
8
Q
What is the PV or an ordinary annuity?
A
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.
9
Q
What is the FV of an ordinary annuity?
A
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.
10
Q
What is the FV of an annuity due?
A
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.
11
Q
For present value, what will the future amount be with the higher interest rate?
A
Lower future amount. Since the higher the interest rate, the more that is counted as interest, and the less there is in PV.
12
Q
For future value, what will the future amount be with a higher interest rate?
A
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.
13
Q
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
A
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
14
Q
What is the APR?
A
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)
15
Q
How do you calculate the effective interest rate?
A
Dollar cost of borrowing/net proceeds of borrowing
16
Q
What is simple interest calculated on?
A
Computed on the principal only and is not compounded.
17
Q
What is the effective annual percentage rate?
A
Also referred to the annual percentage yield. It’s the annual % rate with compounding on loans the are for a fraction of that year.
18
Q
What is a yield curve?
A
Shows the relationship between time and maturity and bond interest rates.
19
Q
What is the real interest rate?
A
Stated (nominal) rate of interest for a period less the rate of inflation of that period.
20
Q
Solve this example: what is the effective interest rate on this loan?
200,000 loan
12% annual rate
20% compensating balance
A
$200,000 x 12% = $24,000
$200,000 x 20% = $40,000
$200,000 - $40,000 = $160,000
$24,000/$160,000 = 15%
21
Q
How is the market rate of interest on US Treasury Bill calculated?
A
Risk free rate + inflation premium
22
Q
What is not a factor relevant in determining risk premium as a security?
A
EPS
23
Q
What happens to the risk premium when investors expect reduced inflation in the future?
A
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.
24
Q
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?
A
Divide the discount period into days in a year:
45-15 = 30
365/30 = 12.1
12.1 x .01 = .121 (or 12% rounded)
25
What is the market approach to determining fair value?
Info generated by market transactions for identical/similar items. (best approach)
26
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.
27
What is the cost approach to determining fair value?
determines the amount required to acquire or construct a comparable item.
28
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)
29
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)
30
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)
31
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
32
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.
33
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%
```
34
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.
35
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.
36
What are three factors to consider when using option pricing as a valuation technique?
1. Measure the risk of the optioned asset - the larger the standard deviation, the greater the value.
2. Exercise price of option
3. Dividend payments on optioned security - the smaller the dividend the greater the option value.
37
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.
38
What are the two additional factors that the Black Scholes Pricing Model uses in addition to the option pricing model?
1. The use of probabilities - probability that the stock will payoff by the expiration date and the probability that the option will be exercised.
2. Discounting the exercise price.
39
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.
40
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
41
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.
42
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
43
In a common sized balance sheet, each item is measured as as % of the total of what?
Revenues
44
What are the three main business entity valuation techniques?
Market, Income, and Asset
45
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)
46
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.
47
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.
48
What is the P/E Ratio?
Price earnings ratio computed as market price/EPS. Both values are on a per share basis.
49
What are for alternative income approaches for valuing a business entity?
Discounted cash flows, capitalization of earnings, earnings multiple, and free cash flow.
50
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.
51
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
```
52
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.
53
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
54
What are examples of inventory price change risks?
1. Increase in the market price of inputs to the production process.
2. Decrease in the market price of inventory already under a higher purchase price contract.
3. Decrease in the market value of inventory held for re-sale that would required a write down of lower cost or market.
55
What are examples of Foreign Currency Exchange Risk?
Revenues, Expenses, Assets and Liabilities may be adversely affected when converted to the domestic currency.
1. Transaction Risk - Less money received on investments receivables and more money will be owed on payables.
2. Translation Risk - Asset/Revenue accounts of foreign subsidiaries will convert to fewer dollars or Liabilities/Payables will convert to more dollars.
56
What is Interest Rate Risk?
1. An increase in the market rate of interest will cause a decrease in the value of outstanding fixed rate interest debt investments.
2. The cost of interest expense on outstanding variable rate of interest debt will increase.
57
What is default risk?
Borrower will fail to make interest payments or principal repayment when due.
58
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.
59
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.
60
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.
61
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.
62
What is a Swap Contract?
Contract between buyer and seller who agree to exchange cash flows (typically related to interest), currencies, commodities, or risk.
63
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.
64
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.
65
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.
66
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.
67
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.
68
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.
69
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.
70
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.
71
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.
72
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.
73
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.
74
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.
75
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)
76
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.
77
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.
78
What is the correct calculation for the payback approach?
Divide the initial cost of the property by the undercounted estimated annual cash flows.
79
Which capital project valuation approach is primarily concerned with the relative economic ranking of projects?
PPI (Profitability index approach)
80
What is the equation for the Accounting Rate of Return Approach?
(Avg. Annual Incremental Revenues - Avg. Annual Incremental Expenses) / Initial or Avg. Investment
81
What expenses are explicitly recognized under the ARR approach?
Depreciation and Income Taxes - they are deducted from the incremental revenues
82
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.
83
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%
84
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).
85
```
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%
86
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
87
What are the advantages of the NPV Approach?
1. Recognizes the time value of money (PV of future CF)
2. Relates project rate of return to cost of capital
3. Consideres entire life and results of project
4. Easier to computer than IRR
88
What are the disadvantages of the NPV Approach?
1. Requires estimation of cash flows over the entire life, which could be very long
2. Assumes CF resulting from new revenues or cost savings are immediately reinvested at the hurdle rate.
89
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
90
How is working capital recognized using the NPV approach?
Recovery of working capital at the end of the project recognized at present value.
91
```
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
92
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
93
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.
94
```
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
95
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
96
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.
97
How do you solve for the IRR?
Annual cash inflow (or savings) X PV factor = Investment Cost
OR
PV Factor = Investment cost/Annual cash inflow or savings
98
What are the advantages of the IRR?
1. Recognizes time value of money
2. Considers the entire life and results of the project.
3. Meaning of resulting rate is intuitive
99
What are the disadvantages of the IRR?
1. Difficult to compute.
2. Requires estimation of CF over the entire life of project which could be long
3. Assumes immediate reinvestment of cash flow resulting from new revenues or cost savings at the project's IRR
4. Limited usefulness when comparing different size projects
100
How is IRR different from NPV?
IRR assumes immediate reinvesting of cash flow resulting from new revenues or cost savings at project's IRR. NP assumes reinvestment at the hurdle rate.
101
Solve the following IRR Approach Illustration:
Initial Cash Outlay: $37,500 (no RV)
Expected Cash Inflow = $10,000/year for 5 years
PV Table for 5 periods:
8%. 10%. 12%. 14%. 16%
3.993. 3.791. 3.605. 3.433. 3.274
First, the PV factor = Initial cost/Expected cash flow
=$37,500/$10,000
Then, look up PV Factor on PV table to get rate of return on the project.
3.750 falls between 10% and 12%. So the discount rate would be between 10% and 12%.
102
What does the IRR equate?
The PV of a project's expected cash flows to the PV of the projects expected costs/initial investment.
103
How is the IRR on a project defined?
As the discount rate at which the NPV of the project equals zero.
104
If the project has a positive NPV under the IRR method, why does the discount rate (IRR) be greater than the hurdle rate?
Because the IRR determines the discount rate, which equates the PV of future cash inflows with the cost of the Investment.
105
How do you calculate the PI (Profitability Index)?
PV of cash inflows/project cost OR
| NPV/project cost
106
What does the PI compute?
Computes the expected return for each dollar invested.
107
How does the payback period rank a project?
On how quickly the invested capital is recovered. Uses nominal values. Does not rank in terms of economic value and only considers outcome up to the initial investment.
108
When is the payback period approach useful in ranking projects?
When liquidating is a concern.
109
How is the discounted payback period approach the same as the payback period approach?
Does not rank in terms of total economic value - just up to the amount invested and is useful for ranking when liquidity the major concern.
110
How is the discounted payback period approach different from the payback period approach?
Ranks projects on how quickly invested capital is recovered using discounted CF.
111
How does the accounting rate of return rank projects?
Ranks based on annual incremental accrual based NI as a % of initial investment. The higher the %, the higher the ranking. It ignores time value of money. And uses accrual accounting values, not cash flows.
112
How does the NPV approach rank projects?
Ranks based on their relative NPV. The higher the NPV, the higher the rank. It recognizes time value of money - so its ranking projects in comparable dollars. Projects with a -NPV are not considered. However, it fails to consider differences in initial project costs.
113
How does the IRR approach rank projects?
Ranks based on relative IRR. Higher the IRR, the higher the ranking.
114
How is the IRR approach similar to the NPV approach?
Recognizes time value of money, but fails to consider the differences in initial project costs.
115
How does the PI approach rank projects?
Ranks based on NPV of each project as a % of initial investment cost of each. The higher the PI index, the higher the ranking. Recognizes the time value of money so the rankings are in terms of comparable dollars. Also takes into the account fo the cost of each project.
116
What method would be used to rank projects competing for limited capital investment funds (also known as capital rationing)
PI since it is specifically designed to rank projects by taking into account both the time value of money and the initial cost of each project.
117
What minimum hurdle rate should be used in evaluating a project when using the NPV approach and provided the proportion of capital structure and after tax cost of capital?
Equal to or grater to the WACC
118
What does the concept and measurement of financial structure include?
Includes the concept and measurement of capital structure plus current liabilities.
119
What does the financial structure of a firm include?
- All items of liabilities and equities used to finance the firms assets
- Sum of liabilities and S/H equity which equals total assets
120
What does the capital structure of a firm include?
Only L/T liabilities and S/H equity.
121
What can A/P, A/R and Inventory all provide?
S/T Financing
122
Both pledging A/R and Factoring A/R are considered means of what?
S/T Financing
123
What does it mean to pledge receivables?
Used in collateral in a financing agreement with a lender.
124
What does it mean to factor receivables?
Receivables sold at a discount for cash to a factor.
125
Why are S/T notes the least likely to be restructured as to the use of proceeds?
As a form of S/T financing, S/T notes usually provide cash which often may be used for various asset and expense purposes
126
Solve for the effective rate of interest:
$20,000 on year note
6% interest
10% compensating balance
1. $20,000 x 6% = $1,200
2. Net proceeds is ($20,000 - (10% x $20,000) = $18,000
The remaining $2,000 must be maintained as a compensating balance.
Effective rate of interest = $1,200/$18,000 = 6.67%
127
What does the following mean? 2/10, net 40
2 - 2% discount
10 - you will receive the 2% discount if you pay within 10 days
40 - it's due in 40 days with no discount
128
What is the calculating for determining the annual interest rate for forgoing the cash discount?
[Discount %/(1-Discount %)] x [360/(40-10)]
129
Solve the following for the annual interest rate of forging cash discount of 2/10, net 40.
[.02/(1.00-.02)]x [360/(40-10)]
[.02/.98] x [360/30]
.02041 x 12 = .2449 = %24.49%
130
What is a revolving credit agreement?
Formal legal commitment, usually by a bank. to extend credit up to some maximum amount to a borrower over a stated period.
131
What would be used to assure a foreign supplier of payment?
Letter of credit which is a conditional commitment to pay a 3rd party in accordance with specified terms.
132
What does it mean to factor without recourse?
Buyer (factor) bears the risk associated with collectibility unless fraud is involved
133
What does it mean to factor with recourse?
Buyer (factor) has recourse against the selling firm or some or all of the risk associated with uncollectability
134
What is a terminal warehouse agreement?
Inventory used as collateral is moved to a public warehouse where its held as security.
135
Nexco is seller and Factoro is the factor (buyer)
Value of receivables to be held in reserve for contingencies: 10%
Interest rate on amounts provided: 12% (annual)
Factor fee on total receivables factored: 2%
Amount factored: $200,000 of A/R due in 30 days
Question 1: If $10,000 of those A/R are reversed because the related goods were returned or allowances granted, which one of the following is the amount that Nexco will receive from Factors at the end of the 30 day period?
Question 2: No receivables reversed. How much will Nexco receive from Factoro at the time the accounts are factored?
Question 1: Amount held in reserve was $20,000
$10,000 of A/R reverse.
So Factoro would only pay Nexco the remaining $10,000
Question 2: $200,000 - $20,000 reserve - $4,000 factor fee = $176,000
Charge interest against remaining amount: $176,000 x 1%
The 1% is 1/12th of the 12%.
$176,000 - (176,000 x 1%)
$176,000 - 1,760 = $174,240
136
Why would leasing an asset make more sense?
If the NPV of purchasing an asset is not positive, it is not economically feasible to purchase it, leasing may make more sense.
137
In a NN lease, the lessee assumes what costs?
Executory costs (insurance, taxes, maintenance, etc) of the asset and the RV
138
Solve for the following Lease vs. Buy for someone who wants to be an UBER driver:
Purchase:
Vehicle Cost: $18,000, 5 yr life, no RV
Tax Deductible Depreciation: $3,000/year
Maintenance Cost: $500/year
$18,00 in his savings that earns 2%/year
Routine Operating Costs Would be Same Under Purchase or Lease: $6,000/year
Lease:
Tax Deductible Lease Expenses: $5,000/year payable at the beginning of each year.
Tax Rate: 25%, cost of borrowing is 8%
PV of ordinary annuity: 3.993
PV of annuity due: 4.312
Purchasing:
1. Initial cash outflow to purchase vehicle: ($18,000)
2. Depreciation Tax Shield:
3,000/year x 25% = $750/year
$750 x 3.993 (ordinary annuity) = $2,995 savings
3. Maintenance Cost
$500/year x 3.993 = ($1,997) outflow
4. Opportunity cost of Savings
$18,000 x 2% = $360/year
$360/year x 3.993= ($1,437) outflow of lost income
PV of Purchasing = ($18,439) outflow
Leasing:
```
1. Lease payments:
$5,000/year x 4.312 = ($21,560)
2. Tax Depreciation Shield
$5,000/year x 25% = $1,250
$1,250/year x 3.993 = $4,991 savings
```
PV of Leasing = ($16,569) outflow
It would be better to Lease. Also, the 6,000 is a wash because it's the same expense under Leasing and Purchasing.
139
Describe what a bond is?
A bond is a promissory note that pays a fixed amount of interest and then the face value at maturity.
140
What is Par/Face Value?
Bond Principal
141
What is the coupon rate?
An annual rate of interest.
142
What type of bond is most likely to maintain a constant market value?
Floating rate bond. Rate of interest paid on floating rate bonds varies with changes in some underlying benchmark. (the market)
143
What is the market price of a bond?
Whether issued at par, premium, or discount will be the PV of the principal amount plus the PV of future interest payments, all at the market (effective) rate of interest.
144
What are debenture bonds and what is the usual rate of interest on debenture bonds?
Unsecured bonds. And because they are unsecured, they are likely to have a higher coupon rate (interest rate) than comparable secured bonds.
145
What are Eurobonds?
Issued in a currency other than the currency of the country in which they are issued. I.e. US denominated bond is issued in EEU country would be Eurobonds
146
Why are Eurobonds usually less expensive?
Because they are not issued in the currency of the country in which they are denominated, the bonds are normally a less expensive form of financing because of the absence of government regulation.
147
What is the current yield?
Ratio of annual interest payment to price of bonds in the market.
148
What is the current yield in the following example?
$1,000, 6% bond, currently selling for $900.
Calculation : CY = annual coupon interest/current market price
$1,000 x % = $60/$900 = 6.67%
149
How does the market price of bonds change in relation to the market rate of interest?
Inversely. If the market rate in interest increases, the market price of bonds decrease.
150
What price would the following bond have to be sold at in order for the buyer to earn the market rate of interest?
Assume $1,000 bond outstanding that pays 4% (this doesn't change!)
The Market rate of interest goes up to 5%.
So, as a consequence of the market rate of interest increases, the value of the 4% bond goes down. No one will buy 4% bonds for $1,000 when they can get a better rate of interest at 5% for new bonds.
So:
$1,000 x 4% = $40
2. $40/what price = 5%
Solve for the price = $800
151
What is preferred stock?
Class of ownership in a corporation that has a priority claim on its assets and earnings before common stock - generally with a dividend that must be paid out before dividends to common S/H are paid.
152
What is the calculation for Preferred Stock Value?
Annual dividend / Required Rate of Return
153
What is the calculation for the Preferred Stock Expected Rate (PSER)?
Annual dividend / Market Price
154
How is preferred stock like bonds?
Usually do not have voting rights and dividends are limited in amount and expected rate (like bond interest)
155
How is preferred stock like common stock?
Ownership interest, no maturity, does not required dividend, dividend not expensed and not tax deductible.
156
What is the preferred stock value?
PV of expected Cash Flows.
157
What is the preferred stock cash flow?
Dividends
158
What is the PSV based on the following info?
Annual dividend = $4
PS Investors ROR = 8%
PSV = Annual dividend / ROR
PSV = $4/.08
=$50
159
What is the PSER based on the following info?
Annual dividend = $4
Market Price = $52
PSER = $4/$52 = 7.7%
160
What is the PSER based on the following info?
Quarterly dividend on Preferred Stock - $1.60
Current Market Price = $80
Since it provides the quarterly dividend, need to start by multiplying it by 4 to get the annual dividend. $1.60 x 4 = $6.40.
Annual dividend/Market Price
$6.40/$80 = 8%
161
What will issuing preferred stock do to the debt to equity ratio?
Debt to equity ratio will decrease.
162
What is the after tax cost of preferred stock?
Trick question - same as the pre-tax cost. Since dividends on preferred stock are not tax deductible, no adjustment to pre tax cost needs to be made.
163
What is the value of common stock?
PV of expected cash flows
164
What are the cash flows of common stock?
Common dividends
| Common stock appreciation
165
How do you calculate the value of common stock held for less than one year?
PV of dividends expected
| +PV of expected market price at end of 1 yr or less
166
How do you calculate the value of common stock hey for more than one year?
1st year dividend / (ROR - growth rate)
167
What is the common stock value of the following common stock held for more than a year using the following values?
Expected dividend = $2.10
Expected dividend growth rate - 5%
Investor ROR - 8%
```
CSV = 1st year div / (ROR - growth rate)
CSV = $2.10 / (8% - 5%)
CSV = $2.10 / 3%
CSV = $70
```
168
How do you calculate the expected common stock rate of return? (CSER)
CSER = (1st year dividend / Market Price) + Growth Rate
169
What is the expected ROR using the following values?
1st year div = $2.10
Market Price = $70
Growth Rate - 5%
```
CSER = ($2.10/$70) +5%
CSER = 3% + 5% = 8%
```
170
What are some advantages of commons stock?
No maturity date, no security required, no legally required payments.
171
What are some disadvantages of common stock?
Higher cost of capital, additional shares dilute ownership and EPS
172
What is the CSER using the following values?
Stock price at $50/share
$5 dividend
Expected to trade at $60/share in one year
CSER = (1st year dividend / Market Price) + Growth Rate
First, solve for the growth rate - ($60-$50)/$50 = 20%
($5/$50) + 20%
10% + 20% = 30%
173
What must a crowdfunding take place through?
SEC registred broker or funding portal
174
What is an investor limited in the amount that can be invested through crowdfunding during a 12 month period?
$100k
175
What is a firm limited to in the amount that can be invested through crowdfunding during a 12 month period?
$1m
176
S/T debt vs L/T debt when it comes to financial flexibility?
S/T financing generally offers greater financial flexibility than L/T financing.
177
S/T debt vs L/T debt when it comes to interest rates?
S/T financing generally has a lower interest rate than L/T financing.
178
S/T financing DOES NOT have a lower risk of what compared to L/T financing?
Illiquidity
179
What is the hedging principal?
Maturity structure of entity's financing should be consistent with cash flows produced by asset being financed. Therefore, assets providing S/T benefits should be financing with S/T financing and vice versa.
180
Funding a permanent expansion in A/R by issuing L/T bonds is an example of what?
The hedging principal.
181
When would a company be encouraged to replace outstanding fixed rate bonds with S/T borrowings?
If interest rates have declined over the last 5 years, a company can currently borrow at a lower interest rate than the older fixed rate debt.
182
How is the after tax cost of new debt calculated?
Before tax cost of debt x (1 - tax rate)
183
What is a zero balance account?
Cash management technique that permits control over cash outflows by using a checking account that has a zero real balance because payments from the account exactly equal deposits.
184
What is the net annual benefit of the following?
Daily cash receipts are $100,000 and collection time is 4 days. Bank has offered to reduce the collection time on firms deposits by 2 days using a lockbox and $500 monthly fee. Money market rates are to average 6% during the year.
($100,000 cash receipts x 2 day benefit) x 6% money market rate = $12,000 savings
Net Annual Benefit = $12,000 savings - ($500 cost x 12) = $6,000
185
Do pre-authorized checks and pre-authorized debt/credit cards benefit cash receipts or cash payments for an entity?
Cash Receipts.
186
What is the market for short term securities?
Money Market
187
What is liquidity risk?
Associated with the ability to sell an investment in a short period of time without having to make price concessions. The risk is the inability to sell for cash in the S/T or the inability to receive FV in was in the S/T.
188
What does the following mean:
2/10, n/30
2% discount if paid within 10 days
189
What is the overall objective of A/R?
Maximize profits. It is not to minimize uncollectible accounts.
190
Firm is going to be incorporating discounts on receivables. Credit sales are expected to remain unchanged at $1M. The 2% discount is expected to be taken on 40% of the A/R amounts. Average A/R would likely decrease by $30,000. Firm has the opportunity cost of 15% associated with the use of cash.
Estimated $400,000 A/R accounts would take advantage
(40% x 1M)
Discount:
2% x $400,000 = ($8,000) discount
$30,000 x 15% opportunity cost = benefit obtained with the reduction in working capital required for carrying average A/R. This equals a $4,500 benefit.
$4,500 benefit - $8,000 cost = ($3,500)
191
What is supply push inventory management?
Goods produced in anticipation of their sale.
192
What is JIT (just in time) inventory management?
Delivery only when needed. Uses demand pull - goods are produced only when and as needed by end user.
193
How do you calculate total inventory admin cost?
Total order cost + Total carrying cost
194
What is the EOQ and how is it calculated?
Economic Order Quantity - it's a model that determines order size.
Total order cost = # of orders x per order cost OR
(Total units/order size quantity) x per order cost. OR
(T/Q) x O
195
How is the re-order point calculated?
Delivery time stock + Safety Stock
196
Annual use equally over 50 weeks = 300,000 units
Delivery time = 2 weeks
Safety stock = 1,000 units
What is the re-order point?
Weekly usage = 300,000 units/50 weeks = 6,000/units per week
Re-order point = Delivery time stock + safety stock
RP = 6,000/week x 2 weeks = 12,000 units + 1,000 unties a safety stock = 13,000 units = re-order point
So, inventory should be re-ordered when it drops to 13,000 units on hand.
197
What are the characteristics JIT inventory?
1. Reducing distance and time between related production operations.
2. Establishing close, L/T relationships with suppliers
3. Reducing Raw Materials safety stock
4. More frequent deliveries.
198
Does a change in safety stock affect a firm's economic order quantity?
No.
199
What is the heeding principal as it relates to currently liabilities management?
Financing L/T needs with L/T funds and S/T needs with S/T funds.
200
Financing L/T needs with S/T funds is too what?
Aggressive
201
Financing S/T needs with L/T funds is too what?
Conservative
202
Three suppliers are offering a firm different credit terms:
1. B Co. offers 1.5/15, net 30
2. C Co. offers 1/10, net 30
3. D Co. offers 2/10, net 60
Firm would have to borrow from a bank at an annual rate of 10% to any take advantage of any cash discounts. What is the best option?
First, find the annual benefit of each plan:
[Discount %/(100%-Discount)]x[360 days/(Total pay period -discount period)
Then, by borrowing from the bank at 10% and taking advantage at the discount, you have to subtract the benefit of each plan less the .10 annual cost of borrowing.
The answer is B Co. and in Cornel notes, solve for each one.
203
What is the calculation for the debt to equity ratio?
Total debt (liabilities) / Owner's Equity
204
What is the calculation for the return on assets?
Divide NI (the return) / Assets
205
What is the calculation for A/R Turnover?
Net credit sales/Avg. (net) A/R
Average A/R = (beginning + end)/2
206
What is the working capital equation?
CA - CL
207
What is the working capital ratio?
CA/CL
208
What is the acid test ratio?
Also known as the quick ratio?
(Cash + (Net) Receivables + Marketable Securities)/Current Liabilities
209
What is the Defensive Interval Ratio?
(Cash + (Net) Receivables + Marketable Securities)/Avg. Daily Cash Expenditures
210
What is the Average Collection Period?
(Days in Year x Avg. A/R)/Credit Sale for Period
211
What is the Times Interest Earned Ratio?
(Net Income + Interest Expense + Income Tax Expense)/Interest Expense
212
What is the Times Preferred Dividends Earned Ratio?
Net Income/Annual Preferred Dividend Obligation
213
Firm has the following:
$1.5m in CA
$500k in CL
$250k inventory level.
Firm plans to issue S/T debt to increase inventory.
What is the largest amount of S/T debt the firm may issue to increase inventory without dropping the current ration below 2.0?
Answer in the question was $500k. Do the calc below to figure out how.
Current Ratio as it stands now = $1.5m/500k = 3
The acquisition of additional inventory using S/T debt will increase both current assets (inventory) and current liabilities (S/T debt payable). So, you have to increase CA by the same amount as CL.
($1.5m + $500k) / ($500k + $500k) = $2m/1m = 2.0
214
A firm has a ratio of 2:1. What would paying down some current liabilities do to the ratio?
Because the company's current ratio is greater than 1:1, an equal dollar decrease in CA and CL will result in an increase in the ratio of remaining current assets and liabilities.
For example, a 2:1 ratio could mean there is $200,000 CA : $100,000 CL.
If the firm pays down $10k of CL:
$190,000/90,000 = 2.11
215
Solve for the Times Interest Ratio:
Income after tax: $5.4m
Interest expense: $1m
Depreciation expense: $1m
40% tax rate.
Times Interest Ratio =
(Net Income + Interest Expense + Income Tax Expense)/Interest Expense
First, you need to calculate the income tax expense:
Income before tax (t) x (1-.40) = $5.4m income after tax
solve for T = $9m
$9m x 40% = $3.6m income tax expense
($5.4m + $1m + $3.6)/$1m = 10
216
Solve for the Quick/Acid Test Ratio:
```
Cash: $5,000
A/R : $10,000
Inventory: $20,000
A/P: $15,000
S/T NP: $5,000
L/T NP: $35,000
```
(Cash + A/R + Marketable Securities)/CL
| $5,000 + $10,000)/($15,000 + $5,000
$15,000/$20,000 = .75
217
How do you calculate A/R Turnover?
(Net) Credit Sales/Average (Net) A/R
Average (Net) A/R = (Beginning + Ending)/2
218
How do you calculate Number of Days' Sales in Average Receivable?
= 365 (or whatever amount of days provided in the example)/Accounts Receivable turnover
219
How do you calculate the Inventory Turnover?
= COGS/Average Inventory
Average Inventory = (Beginning + Ending)/2
220
How do you calculate Number of Days' Supply Inventory?
=365 (or whatever amount of days provided in the example)/Inventory Turnover
221
How do you calculate Accounts Payable Turnover?
=Credit purchases*/Average Accounts payable
Average A/P = (Beginning + Ending)/2
*if credit purchases not available, use COGS adjusted for changes in inventory
(COGS + Ending inventory - beginning inventory)/Average Accounts Receivable
222
How do you calculate Number of Days' Purchases in Average Payables?
=365 (or whatever is provided in the question)/ Accounts Payable Turnover
223
What is capital turnover?
=Annual sales (or revenue)/Average owner's equity
224
Draw out the operating cycle length?
See notes if need be.
225
What is the average days sales inventory with the following facts?
Net Cash Sales: $3,000
COGS: $18,000
Beg Inv: $6,000
Purchases: $24,000
Avg Days Sales in Inventory = 360/Inventory Turnover
Inventory Turnover = COGS/Average Inventory
To calculate average inventory, you need to find ending inventory:
Beg Inv $6,000 + Purchases $24,000 - COGS $18,000 = $12,000 End Inv
So, $18,000/($6,000 + $12,000)/2
=$18,000/$9,000
=2
Avg Days sales in Inventory = 360/2 = 180
226
How can you find the COGS using Annual sales and the gross annual profit percentage?
COGS = Annual sales x (1-GP%)
227
What is the calculation for the Cash Cycle?
Inventory conversion (DIO) + Accounts Receivable conversion (DSO) - Accounts Payable conversion (DPO)
228
How do you calculate Days Inventory Outstanding (DSO)?
=Average Inventory/COGS per day
229
How do you calculate Days Sales Outstanding (DSO)?
=Average AR/Sales per day
230
How do you calculate Days Payable Outstanding (DPO)?
=Average Payables/COGS per day
231
Solve for the cash conversion cycle using the following information:
```
Receivables: $4m
Inventory: $2.6m
Payables: $3.7m
Sales: $50m
COGS: $45m
```
```
DIO = $2.6m/($45m/365) = 21.08 days
DSO = $4m/($50m/365) = 29.20 days
DPO = $3.7m/($45m/365) = 30.01 days
```
CCC = 21.08 + 29.20 - 30.01 = 20.3 days
232
All fixed rate debt investments have what kind of risk associated with them?
Interest rate risk - risk that market rate of interest will go up, causing the value of outstanding debt (issued at a lower interest rate) will go down. This includes fixed rate domestic, international and US Treasury Bonds.
233
What risk would a firm that utilizes only equity financing face?
Business risk which derives from the relationship between the firm and the environment in which it operates.
234
Describe unsystematic risk.
Company specific risk (also called firm specific and diversifiable risk) Risk includes elements of business risk that can be eliminated through diversification of projects/investments.
235
How are diversifiable risks mitigated?
Engaging in multiple different investments or undertakings so that unexpected/unfavorable outcomes of one will only represent a small portion of all investments/undertakings and will also be offset by favorable outcomes.
I.e. Labor Strikes - these are typically associated with a particular undertaking, plant, firm or industry
236
What is systematic risk most closely associated with?
Elements of macro environment such as interest rate/inflation risk.
237
What part of the firm is associated with firm related business risks?
Products/services, cost structure, financial structure.
238
What part of the firm's environment is associated with the business risk?
General economic conditions, competition, customer demand, technology
239
What does inflation reduce?
Purchasing Power
240
What is liquidity risk?
Asset cannot be sold at FV for cash.
