Financial Management Week 5 Flashcards
What does WACC stand for within financial management?
Weighted Average Cost of Capital
What is the formula for WACC ?
WACC = Cost of Debt * (1 - Tax Rate) * [Debt / (Debt + Equity)] + Cost of Equity * [Equity / (Debt + Equity)]
What factors influence the capital structure decision?
- Taxes
- Stability of cash flows and earnings
- Financial and operating flexibility
- Type of assets
What are the most important factors in the Cost of Debt?
- Current interest rate on US treasury bonds with the same maturity
- Default risk
What is the formula for the Cost of Debt?
Cost of Debt = Treasury Bond Rate + Default Premium
How are Bonds Rated within financial management?
- A3, A2, A, B3
- B2, B, C3, C2, C
What rated bonds are Junk or Speculative Bonds?
B2, B, C3, C2, C
What are the most important factors in the Cost of Equity?
- Current interest rate on long-term U.S. Treasury bonds
- Risk of equity
What is the formula for the Cost of Equity?
Cost of Equity = Treasury Bond Rate + Risk Premium
What does Beta stand for within financial management?
A measure of market risk for a company’s stock
What do Beta’s value tell you about a company’s stock?
- Betas of one are at an average risk
- Betas greater than one are more sensitive to macroeconomic risk
- Betas less than one are less sensitive to macroeconomic risk
What is the formula for Total Portfolio Risk?
Total Portfolio Risk = Avg. Beta * Market Standard Deviation
What does CAPM stand for within financial management?
Capital Asset Pricing Model
What is the formula for CAPM?
Cost of Equity = USA Treasury Rate + Market Risk Premium * Beta
What is CAPM used within financial management?
It provides an estimate of the cost of equity based upon the stock’s beta
What does Market Risk Premium stand for within financial management?
The average difference in the rate of return on stocks and long-term USA Treasury bonds
What are the most popular firm evaluation methods within financial management?
- Discounted Cash Flow (DCF)
- Comparables
What does DCF stand for within financial management?
Discounted Cash Flow
What does EBIT stand for within financial management?
Earnings Before Interest and Taxes
What is the “CFₜ” in the formula CFₜ = EBITₜ * (1 - T) + DEPRₜ - CAPEXₜ - ΔNWCₜ?
Free Cash Flow at time t
What is the “EBITₜ” in the formula CFₜ = EBITₜ * (1 - T) + DEPRₜ - CAPEXₜ - ΔNWCₜ?
Earnings Before Interest and Taxes at time t
What is the “T” in the formula CFₜ = EBITₜ * (1 - T) + DEPRₜ - CAPEXₜ - ΔNWCₜ?
Corporate Tax Rate
What is the “DEPRₜ” in the formula CFₜ = EBITₜ * (1 - T) + DEPRₜ - CAPEXₜ - ΔNWCₜ?
Depreciation at time t
What is the “CAPEXₜ” in the formula CFₜ = EBITₜ * (1 - T) + DEPRₜ - CAPEXₜ - ΔNWCₜ?
Capital Expenditures at time t
What is the “ΔNWCₜ” in the formula CFₜ = EBITₜ * (1 - T) + DEPRₜ - CAPEXₜ - ΔNWCₜ?
Increase in Net Working Capital at time t
What does TV stand for within financial management?
Terminal Value
What are some weaknesses in the DCF formula?
- One point estimate
- Beta estimation from companies
- Terminal values play a crucial role
- Changing capital structures or effective tax rates
- DCF method assumes the capital structure and effective tax rates are both incorporated in the discount rate (WACC) and assumed to be constant
What are some weaknesses in the Comparables Method?
- Financial information often unavailable for private companies
- Valuation may be misguided
If you are valuating public market Comparables, what must you remember after getting you valuation?
Reduce your valuation by 20%-25% to discount for liquidity
What are the strengths in using Comparables within financial management?
- Quick to use
- Simple to understand
- Commonly used
- Market based
What are the weaknesses in using Comparables within financial management?
- Private companies comparable difficult
- If public company Comparables use liquidly discount
What are the strengths in using DCF within financial management?
- Theoretically Sound
What are the weaknesses in using DCF within financial management?
- Cash flows difficult to estimate
- WACC assumes constant capital structure
- Sensitive to terminal growth assumptions
What does EVA stand for within financial management?
Economic Value Added
What does MVA stand for within financial management?
Market Value Added
What does Opportunity Cost of Capital stand for within financial management?
Opportunity Cost of Capital is the rate of return you can earn on securities in the capital markets with the same risk as your investment project
What is the formula for Opportunity Cost of Capital?
Opportunity Cost = Rate of Return on Securities of Capital with the Same Risk
What does TC stand for within financial management?
Total Capital
What does Capital Charge stand for within financial management?
Capital Charge measures the opportunity cost of money for your investment project
What is the formula for Capital Charge?
Capital Charge = r * TC
What is the “r” in the formula Capital Charge = r * TC?
Rate of Return
What does ROS stand for within financial management?
Return On Sales
What is the formula for ROS?
ROS = NOPAT / Sales
What does NOPAT stand for within financial management?
Net Operating Profit After Tax
What is an alternative to using Total Capital within financial management?
Total Capital = Net Assets
What does CT stand for within financial management?
Capital Turnover
What is the formula for CT?
CT = Sales / TC
What does ROTC stand for within financial management?
Return on Total Capital
What is the formula for ROTC?
ROTC = NOPAT / TC
What is the formula for MVA?
MVA = Market Value of Equity - Book Value of Equity
What is the formula for Economic Profit?
Economic Profit = Accounting Profit - Capital Charge
What are the main ways a company can improve it’s economic profits and increase it’s stock price?
- Manage: Increase efficiency of existing operations and thus improve the spread between r* (Total Capital) and r (Cost of Capital).
- Build: Invest in businesses and projects with positive spreads
- Harvest: Withdraw capital from operations or activities where r* (Total Capital) is less than r (Cost of Capital).
What metric do many companies use to determine performance-based compensation within financial management?
Economic Value Added (EVA)
How do you measure a stock risk within financial management?
The stock’s Beta value
