Financial Mngmt, Cap Budget Flashcards
Cost of debt is currently 8% based on 40% debt ratio. Stock issuance would require 10% return. What is cost of capital?
Debt ratio is .40 x .08 = .03
Equity is .60 x .10 = .06
CoC = 9.2%
What are the 3 theories on the reason for differences in yields?
Liquidity preference, market segmentation, and expectations
Cash Conversion Cycle
Number of days from when you pay for inputs to when collect cash from the sales. try to shorten to minimize financing (net operating cycle)
= ICP + RCP - PDP [2-4]
Inventory Conversion Period
Days to convert inventory to sales
ICP=Avg Inv/CGS per day [1-3]
AR Collection Period
Days to collect AR
RCP=Avg AR/Avg credit sales per day [3-4]
AP Deferral Period
Days from buying inventory and paying for it
PDP=Avg payables/purchases per day (or CGS/365)
[1-2]
The number system for cash conversion cycle..
1- Receive inputs from suppliers
2- Pay suppliers
3- Sell finished product on credit
4- Collect receivables
AR Turnover
Net credit sales/Avg AR
Days sales in Avg AR
360/AR Turnover
Reorder point calculation
Avg daily demand (usage in units per day) x Avg lead time = reorder point w/out safety stock \+ safety stock = reorder point w/ safety stock
Economic order quantity (EOQ)
= square root of (2xAxP)/S
A= Annual usage of inventory (demand)
P= Cost of placing an order (order cost)
S= Cost of storing unit for one period (carrying cost per unit for 1 year)
* The order size that minimizes order and carrying costs
JIT characteristics
Order as needed to minimize non-value added costs
- when costs of storing are high (non value)
- lead times are low
- needs for safety stock are low, good relationships
- costs per purchase order are low
- “pull” system
Backflush Approach
Delayed, or Endpoint costing:
- Don’t record production charge until FG or sales
- Standard costs used to allocate man costs to FG
- Usually used with JIT
- Simple accounting, have standard cost for each product, would have same results using sequential tracking
Inventory Turnover
CGS/Avg Inventory
Days supply in Inventory
360/Inventory Turnover
FV factor =
1/PV
What are the 4 capital budgeting techniques
- Payback period
- Internal rate of return
- Accounting rate of return
- Net present value
Payback period
Initial investment/After tax net CF’s = # of years
- No discounted unless question says so
- Salvage value is collected at the end of the asset life, it is used in calculation only if payback period extends that long or beyond
Internal Rate of Return
PV factor = Investment/annual cash flows
* Rate at which NPV=0, if IRR
Accounting rate of return
ARR= Accounting income (include dep and taxes)/Avg Investment (Carrying amount minus depreciation)
- Ignores time value of money
- If you’re given CF, need to add back depreciation and non-cash items to get N/I
Net Present Value
= PV of future CF’s - Required investment
* Discount the PV of both inflows and out and then subtract them
Excess PV index (profitability index)
PV of annual after tax CF/Initial cash invested in project
* Use to rate and order projects
Depreciation Tax shield calculation
Tax rate x depreciation
Annual Financing Cost (AFC)
*Cost of not taking the discount
= (Discount %/ 100 - discount)x(365 / total pay period, or net - discount period, or first num)
Compensating Balances actual interest rate
- Increases the effective interest rate paid on the net part of the loan
= Interest paid / Net funds available (principal-compensating balance)
Current Yield
Fixed interest rate / Current selling price of the bond
* Not take into account that principal repayment will not be selling price but face value
YTM (effective rate)
Rate at which PV of CF will equal current selling price of bond
YTMcurrent yield = discount
Advantages of debt financing
- Interest is tax deductible
- Fixed obligation
- No control given up
- Less costly than equity
Disadvantages of debt financing
- Predetermined payments independently of performance
- High debt levels increase risk business will fail
Operating Leverage (DOL)
= % change in EBIT / % change in sales volume
- small change in sales causes a relatively large change in EBIT
or. .. CM/EBIT
Degree Financial Leverage (DFL)
% change in EPS / % change in EBIT
(small change in EBIT causes a relatively large change in common shareholders’ return, or..
EBIT / (EBIT-interest)
Cost of Debt
After tax cost of interest payments measured by YTM
- YTM x (1 - effective tax rate)
- (Interest exp x (1-tax rate)) / Avg market
CAPM
Capital asset pricing model: risk v. expected return
= Risk Free interest rate + [(expected-risk free rate)xbeta]
6 ways to measure cost of equity
CAPM Arbitrage Bond Yield Plus Dividend Yield Plus Cost of New Common Stock Weighted Avg Cost of Capital
Dividend Yield Plus growth
= (Next expected dividend/current stock price)+expected growth in earnings
Cost of New Common Stock
= Next expected dividend / (current stock price - flotation costs) + expected growth in earnings
* Must cover costs of issuing securities
WACC
Weighted Avg Cost of Capital
- Lower required rates of return mean lower WAAC
- Low debt to equity ratios means lower WAAC and rely more on debt
Residual Income
= Operating profit - Interest on investment (invested capital x required rate of return)
Economic Value Added
= Net Operating profit after taxes (NOPAT) - cost of financing (Capital invested x WAAC)
Return on Assets
= Net income / Avg total assets
Return on Equity
= Net income / Avg common stockholders’ equity(total sock equity - preferred stock liquidation value)
Debt to Equity
Total debt / Total equity
SD measures…
Coefficient measures…
Volatility
Risk
Unsystematic risk is…
systematic risk is..
Avoidable
Unavoidable
Beta measures..
How volatile the investment is relative to the overall market (how quickly stock changes when market sways) - systematic risk
Coefficients of variation in Hedges against risk..
-1
The closer to 0, the less of a relationship there is. +1 means they act the same. -1 means they act in opposite manner
Calc Compensating balances using only interest rates given
Interest rate=Interest paid/(Principal-Comp bal)
= .11 / (1 - .10)
where 11% is proposed rate and 10% is comp rate
Which capital budgeting methods is depreciation expense ignored?
When income taxes are ignored, depreciation expense is excluded from calculations of NPV, IRR, and payback methods
When income taxes are ignored, depreciation is INCLUDED when calculating the accounting rate of return
The discount rate (hurdle rate of return) must be determined in advance for the…
NPV method
What is an internal rate of return?
A time-adjusted rate of return from an investment
Sales = 750,000 Asset turnover = 1.5 times Return on sales = 8% Imputed rate = 12% What is the residual income for year 1?
Residual is Profit reduced by required return on assets
Profit = 750,000 x 8%= 60,000
Assets= 750,000/ 1.5= 500,000 x 12%= 60,000
Therefore, NO residual income
Price Earnings Ratio
Common stock price per share/EPS
Which of the following factors would not be relevant when determining the risk premium on a specific security?
EPS - while dependent on profitability, the denominator is dependent on number of shares, so 2 with similar earnings and risk but with diff shares could have vastly diff EPS
Where are gains/losses reported for CF hedges?
The effective portion is recorded in OCI and ineffective portion in income
ROI
Net income / Avg assets or Avg invested capital
**Measures profitability in relation to avg capital invested. Could be profitable but decrease company’s overall ROI
Total Asset Turnover
Sales / Avg total assets
Credit Default Swaps protect…
The buyer against bond defaults (not interest rate changes)
Invest 100,000 in prop, sell for 120,000 in one year. 10% rate. What is NPV?
120,000 / 1.10 = 109,091 - 100,000 = 9,091
Explain depreciation tax shield
Incremental earnings on project have related incremental tax liability. Depreciation reduces incremental earnings and thus tax liability. Shield part of the inflow from taxation ONLY WHEN taxes are a factor in the problem
Explain the concept behind economic order quantity
The purchase order size that minimizes the total of inventory order cost and inventory carrying costs
Factoring receivables generally improves..
AR turnover ratio
Profitability index =
PV of cash inflows / initial cost of a project
**Used to compare projects with positive NPV that differ in size
Credit risk is..
The risk that the counter-party to a contract will fail to honor its obligations
Disadvantages to internal rate of return
CF’s are assumed to be reinvested at the rate earned by the project and IRR is more difficult to use
Cost of debt
Interest expense x (1-tax rate)
/ Avg market value of debt (bonds)
Dividend Yield
Dividend yield= dividend per share/selling price
Why would a firm generally choose to finance temporary assets with short-term debt?
Matching the maturities of assets and the related liabilities reduces risk.
Cost of Preferred Stock
Preferred dividends/Avg market of p/s
Cost of common stock
(Dividends on common/Avg market of common)
+ Expected growth rate in dividends
When income tax are ignored, depreciation is excluded from calc for the…
NPV
IRR
Payback
Expected c/s dividend
EPS x c/s payout rate
How to decrease market vale per share of c/s?
Stock dividend
Calc to figure out price of a stock
P/E ratio x EPS (Net income/shares out)
Best method for comparing capital projects if capital rationing used…
Profitability index best for independent initial ranking
Materials Requirements Planning
MRP is forecast based planning and inventory control to ensure materials are available when needed
Operating profit equals
EBIT or..
Net income + interest + taxes
What is the typical reason for a corporation to use warrants?
make a corporation’s securities attractive to a wider range of investors, increasing the supply and decreasing the cost of capital.
What is the effect of a stock dividend?
Decreases future earnings per share (A stock dividend increases the quantity of outstanding stock. Future EPS will be less than it would otherwise be, as earnings are spread over more shares. A stock dividend effectively moves equity from retained earnings to paid-in-capital)
A company purchases inventory on terms of net 30 days and resells to its customers on terms of net 15 days. The inventory conversion period averages 60 days. What is the company’s cash conversion cycle?
It is the sum of the inventory conversion cycle (60 days) plus the receivables collection period (15 days) less the payables deferral period (30 days) = 45 days
Cost of Retained Earnings
Cost of c/s [dividends/price + growth] x (1-stockholders marg tax rate)
Debt ratio
Total debt / Total assets
** Measures a company’s leverage
Operating assets =
Sales / Capital turnover ratio
Times interest earned
EBIT/Interest expense
Life Cycle of products, industry, entity
- Infancy - little direct competition, higher promotional expenses, high resources to start in new market (experimentation phase)
- Growth - sales increase, attract direct competitors, may need to reinvest profits dramatically
- Maturity - rates of increase slow down, more competition, fund next generation or pay out
- Decline- sales decreases as replacement products evolve
When there are products competing for a scarce resource, for short run profit maximization..
the company should produce and sell the product that has the greater contribution margin per unit
Incremental profit
= Incremental sales - incremental costs
Safety Stock
Extra inventory on hand to avoid a stock-out in case lead time demand was higher than average
Max demand during lead time less expected demand during lead time
After tax Payback example: 1,000 investment, 250 CF, 200 depreciation /yr, 25% tax rate
Depreciation tax shield= 200 x 25%= 50
CF with taxes = 250 x 75% = 187.50
Payback= 1,000/237.50 = 4.21 years
How will financing long term assets with short term debt affect the entity?
Adversely: when rates go up they need to refinance ST debt at new higher rate to keep long term assets funded.
- Also, the return on the asset may decrease when rates increase
- Match maturities of ST assets with ST debt -extra costs paid on new ST debt will be compensated by extra returns earned on new ST asset bc higher rates apply to both borrowing and investing
Advantages and Disadvantages of NPV
Ad: CF over life used, including residual sales; TVM is used; CF reinvested at cost of cap
Dis: Doesn’t est rate of return, merely tests against hurdle rate; more difficult to use; difficult to apply to strategic investments with unidentifiable CF’s
Financial and Business Risk
Financial- additional risk owners bear due to decision to carry debt
Business- riskiness of operations without any debt (the risk inherent in operations)
Floating Rate Bonds
Has a variable interest rate. The interest rate is reset to equal the current market interest rate. Therefore, the market value of the bond itself will remain constant since that set price will always yield the current market rate.
Expected return on stock (given price info)
Dividends + expected increase in price (or cap gains)
/ current market price
