Finc Mgmt B3 - Financial Decisions Flashcards
In a cash flow problem with a LOC and interest payments, remember:
- interest is paid in the month after use of the LOC
- any cash after netting cash in and cash out should first be applied to the LOC and then it can be ending cash
- ending cash is where you begin the next month
- make sure to calc interest on all LOC amounts for previous months
- interest payment is a cash outflow and if there is no money left at month end you must borrow on the LOC
The cost of debt most frequently is measured as
actual interest rate - tax savings
A financial lease has
a duration that corresponds to the useful life of the asset and payments that amortize the cost of the asset while providing the lessor an interest return
Cost of Preferred Stock =
(annual dividend per share x par value ) / (stock sales $ - issuance costs)
When interest rates decline, bond prices
increase
Advantages of short term credit:
- funds can be obtained quickly
- financing with this credit usually results in lower interest costs
- there are some spontaneous sources of funds (i.e. trade credit)
- some of this debt is interest free (ex. wages payable)
Disadvantages of short term credit:
- interest rates vary quickly
- this type of debt is more risky
Advantages of long term credit:
- interest rates tend to be more stable
Disadvantages of long term credit:
retirement will probably contain a prepayment penalty
Short term vs long term credit:
- short term can generally be obtained more quickly
- generally short term is more flexible
- short term is generally less costly as shown by the yield curve
- prepayment penalties are generally associated with long term but are not the basic reason for higher cost with ong term
- short term holds more risk due to the need to renew more often
The type of bond most likely to maintain a constant market value is a
floating rate bond
Advantages of long term debt:
- fixed interest rates for the life of the loan protect the firm from changing interest rates
- interest expense is tax deductible
- lower risk, thus the yield required by long term debt providers is lower
- control of the firm is not shared by long term debt holders
Advantages of common stock:
- a period of low profit or loss, common dividends do not have to be paid
- there is no maturity for common stock since it represents permanent ownership
- common stock increases the equity position of the corporation and can provide a basis for increasing debt
Both debt and equity security holders have an ownership interest in the corporation. Fact or Fiction?
Fiction
Both debt and equity securities have an obligation to pay income. Fact or Fiction?
Fiction
Debt is
a form of financing that increases the liabilities of the firm
Equity securities are
an ownership interest
Buyers of bonds must pay the seller the interest accrued from the last interest payment date to the date of issue in advance. =
face value + (face value x rate x % of year)
Short term interest rates are generally
lower than long term rates
*less risk involved in the shorter term
When a corporation is earning excess profits,
participating preferred stock acts more like equity than cumulative preferred stock
*because the stock does not receive a fixed % like debt. when excess profits are earned, the participating receive additional dividends
Cost of common equity under Dividend Growth Model =
(Dividend / Price) + Growth %
- no taxes
Cash proceeds from factoring AR =
Face amount - % reserve x face - % comm x face = Net amount available x Interest % x # days out of 360 = Interest $ Net amount - Interest $ = Cash proceeds
Preferred stock and long term bonds are similar from the standpoint of the issuing firm because
interest and dividend payments are fixed
WACC =
(% debt x int % x (1-tax %))
+ (% c/s x int %)
+ (% p/s x int %)
Line of credit is
an agreement between a small firm and a bank that permits the firm to borrow varying amounts of funds as needed over a specified time period
Letter of credit is
an international financing tool that guarantees payment to an international supplier upon safe arrival of goods by issuing a loan to the purchaser
Bond interest payment =
Stated rate of interest x Par value
The primary objective of variable interest rate loans is to
reduce the impact of rate changes on both parties
Everything else being equal, a noncallable bond will be priced in comparison to a callable bond so that the noncallable bond will provide
a lower yield
Variable rate loans can be used to reduce the risk associated with changes in interest rates during the term of the loan. the greatest level of risk relates to
long term loans
XYZ Lawn Care provides a variety of lawn care supplies and services. Sales and series vary greatly by season and are affected by changes in weather conditions. The financing method that would likely result in meeting XYZ’s cash needs at the lowest cost is
line of credit
Larson Corp issued $20 million of long term debt in the current year. The major advantage to Larson with the debt issuance is
the relatively low after tax cost due to the interest deduction
A secured bond issue is one that
provides bondholders with a pledge against certain assets
The covenant that obliges the borrower to repay the bonds if a large quantity of common stock is held by a single investor and the bond rating is downgraded is
a poison put clause
The covenant that requires a corporation to maintain, at all times, some minimum level of working capital is
an affirmative covenant
Variable rate loans reduce the potential interest rate risk of
both borrowers and lenders
Letters of credit are often to facilitate international trade. The basic purpose of the letter of credit is to reduce risk to the
exporter
Effective interest rate of loan with compensating balance =
Annual Interest Expense / (Full loan amount - Compensating Balance)
A company can finance an equipment purchase via lease financing or loan financing. A factor that would not be considered when comparing the two methods is
the capacity of the equipment
The Aida company plans to issue bonds with a maturity of $1,000,000 and a stated rate of interest of 10%. If the effective rate of interest aka YTM is 9% then the bond is
issued at a premium
A spontaneous source of financing for a firm is
A/P
Sales-type lease is
- a type of capital lease
- Fair Value is different than the carrying amount
- involves real estate
- transfer of ownership occurs at end of the term
NPV as used in investment decision making is stated in terms of
CFs
The original cost of equipment is ________ and _______ be considered in a replacement decision
sunk cost; should not
A project should be accepted if the PV of CF from the project is
greater than the initial investment
The decision making model that equates the initial investment with the PV of future CF is
IRR
The method to use if capital rationing needs to be considered when comparing capital projects is called
profitability index
Relevant costs are
expected future costs that are important or pertinent to the decision under consideration and will be affected by the decision
Relevant costs include the
- initial investment required
- future net cash inflow or net savings in cash outflow
- disposal cost or salvage value of old equipment and the new equipment
Relevant costs do not include
sunk costs, depreciation, gain/loss on sale
Technical analysis involves
analyzing past market data of price and volume movements to attempt to determine future price movements of individual securities
Weak Form of the efficient market hypothesis suggests
that information about past prices would not be of use in predicting future performance and therefore technical analysis would not be a viable technique to use
Fundamental analysis uses
factors specific to a firm in an attempt to find undervalue securities (i.e. F/S, ratios, projected earning growth, and dividend yield)
Efficient market beliefs (3)
weak form
semi-strong form
strong form
Weak form efficient market suggests
information about past prices would not be of use in predicting future performance
Semi-strong form efficient markets suggest
all publicly available information is incorporated in market prices
Strong form efficient market suggests
all available information is incorporated in current market prices
Inventory Turnover =
COGS / Average Inventory
COGS =
Revenue - Gross profit
A company uses it’s company-wide cost of capital to evaluate new capital investments. If there are multiple operating divisions each having unique risk attributes and capital costs the implication is that
high risk divisions will over invest in new projects and low risk divisions will under invest in new projects
NPV =
-Initial Investment + (After tax savings x PV of an annuity factor)
NPV is also =
-Initial Investment + (Annual inflow x PV of an annuity factor) + (Salvage value x PV of single sum)
The calculation of depreciation is used in the determiniation of NPV of an investment because
Depreciation increases CF by reducing income taxes
When estimating CF for use in capital budgeting, depreciation is
utilized in determining the tax costs or benefits
The metric that equates the PV of project’s expected cash inflows to the PV of the projects’s expected costs is
IRR
The following represents the residual income that remains after the cost of all capital, including equity capital, has been deducted
Economic Value Added (EVA)
Free Cash Flow (FCF) =
Operating CF - Capital Expenditures
Net Operating Capital =
Current Assets - Current Liabilities
NPV =
-Initial Investment - (sum of CF / 1+r^n)
Payback method
provides the years needed to recoup the investment in a project
Payback method =
Net investment / annual cash flows
IRR is defined as
the discount rate at which the NPV = zero
Fact or Fiction? Opportunity cost is recorded as a normal business expense
Fiction; these are not recorded in the accounting records
Fact or Fiction? The ARR considers TVM
Fiction; ARR does not use TVM
Fact or Fiction? A strength of the payback method is that it is based on profitability
Fiction; payback only considers the cash flow until investment is returned and ignore profitability
Fact or Fiction? Capital budgeting is based on predictions of an uncertain future
Fact
Carrying costs ____ as the size of the order increases
increase
Setup or ordering costs ______ as size of production run increases
decrease
Lower setup costs result in _______ lot sizes
decreased
*less expensive to produce a smaller lot
Increased carrying costs result in ______ lot sizes
decreased
*the greater cost of carrying inventory means fewer units will want to be produced
Economic Order Qty (EOQ) =
Square Root of [(2 x Demand x Setup cost) / (Cost per unit x Carrying cost )]
A strength of the Payback method is
it is easy to understand
All CF occurring after the payback period are
ignored
Risk adverse investor is
one who is willing to take risk but believes that they will be reasonably compensated for the level of risk being taken
Treynor index is
based on the premise that ther are 2 components of risk:
- risk produced by fluctuations in the market
- risk produced by fluctuations of individual stock
Sharpe measure is
a measurement that uses the standard deviation of the portfolio rather than beta
Jensen measure is
a measurement of the absolute value of performance of a portfolio on a risk adjusted basis
Treynor index =
(Portfolio return - Risk Free rate) / Beta
Profitability index =
PV of Cash Flow After Initial Investment / Initial Investment
Assumptions of EOQ include:
- periodic demand for the good is known
- total carrying costs vary with qty ordered
- costs of placing an order are unaffected by qty ordered
- purchase costs per unit are not affected by qty discounts
NPV =
-Initial Investment + (Annual inflow x PV of annuity) + (Single sum x PV of $1)
The discount rate is determined in advance for
NPV
IRR is most commonly compared to _______ to evaluate whether to make an investment
WACC
________ would decrease the IRR of a proposed asset purchase
Decreasing tax credits on the asset
With IRR:
- increase in cash inflows (decrease in cash outflow) = higher IRR
- earlier cash inflows (later cash outflows) = higher IRR all else being equal
The cash conversion cycle includes the periods
- inventory conversion (DIO)
- payables deferral (DPO)
- average collection (DSO)
Cash conversion cycle =
DIO + DSO - DPO
Inventory conversion cycle (DIO) =
Avg inventory / Avg sales per day
Receivables collection period (DSO) =
Avg AR / Avg sales per day
Payables deferral period (DPO) =
Avg AP / Avg purchases per day
Return on Investment =
Net Income / Invested Capital
A limitation common to payback period, discounted CF, IRR, and NPV is
they rely on forecasting of future data
The capital budgeting techniques that use forecasted CF are
payback period
discounted payback
NPV
IRR
The capital budgeting techniques that use forecasted NI are
ARR
The capital budgeting techniques that use TVM
discounted payback
NPV
IRR
The capital budgeting techniques that may required multiple trial and error calcs
IRR
The capital budgeting techniques that require the company’s cost of capital
discounted payback
NPV
IRR
A limitation of the Profitability index is that
it requires detailed long term forecasts of the project’s cash flows
Division A is considering a project that will earn a rate of return that is greater than the imputed interest charge for invested capital but less than the division’s historical return on invested capital. Division B is considering a project that will earn a rate of return that is greater than the division’s historical return on invested capital, but less than the imputed interest charge for invested capital If the objective is to maximize residual income then
Project A should be accepted and Project B rejected
*residual income deals with imputed interest charges so focus there and not on historical
Project A and Project B have the same initial investment requirements and lives. Project B has a decreasing estimated cash inflow each year. Project A has an increasing estimated net cash inflow each year. The payback period is greater for
Project A
Project A and Project B have the same initial investment requirements and lives. Project B has a decreasing estimated cash inflow each year. Project A has an increasing estimated net cash inflow each year. Project A also has a greater total net cash inflow. The ARR is greater for
Project A
An increase in ________ should cause mgmt to reduce average inventory
cost of carrying inventory
A client wants to know how many years it will take before the accumulated CF from an investment exceed the initial investment without taking the TVM into account. The financial model _______ should be used
payback period
The inventory mgmt technique that focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as WIP and RM is
materials requirements planning
Reward/Risk ratio =
rate of return / measure of risk
Sharpe measure =
(Portfolio return - Risk Free rate) / Standard deviation
Two general rules with PV calcs:
- increases in cash inflows (decreases in cash outflows) will result in higher PV, all else being equal
- earlier cash inflow (later cash outflows) will result in higher PV, all else being equal
An internal rate of return is
a time adjusted rate of return from an investment
Residual income of an investment center is the center’s
income less the imputed interest on its invested capital
Return on Investment (ROI) =
NI / Average Invested Capital
To maximize shareholder wealth, the company should accept projects with returns greater than
WACC
Fact or Fiction? Idle space that has no alternative use has an opportunity cost of zero
Fact
Jensen measure =
Risk free rate + ((Return on market index - RF) x Beta)
B A D Annuity
Beginning > Annuity Due
O A E Annuity
Ordinary Annuity > End
Working Capital =
Current Assets - Current Liabilities
Assets =
Liabilities + Equity
A company has equity of $9,000. Long-term debt is $1,900. Net working capital, other than cash, is $2,500. Fixed assets are $2,200. What amount of cash does the company have?
$6,200
*A=L+E
A = 9,000 + 1,900
A=10,900
WC = CA - CL = 2,500
A = 10,900 - 2,500 - 2,200
A B
--------- ---------
Sales $1,000 $1,500
Cash exp 400 700
Depr. 150 250
Tax % 30% 30%
Which has the largest after-tax cash inflow?
Project B with after tax inflow of $635
*Project A produces taxable income of $450 ($1,000 less $400 less $150). Multiplying taxable income of $450 by a 30% tax rate gives income tax of $135. After-tax cash inflow for Project A is $1,000 sales less cash expenses of $400 and income tax of $135, or $465.
Project B produces taxable income of $550 ($1,500 less $700 less $250). Multiplying taxable income of $550 by a 30% tax rate gives income tax of $165. After-tax cash inflow for Project B is $1,500 sales less cash expenses of $700 and income tax of $165, or $635.
Initial Investment =
Payback period x Net Cash Inflow (aka cash inflows - cash outflows)
Under the efficient market hypothesis, the thought process “you cant beat the market” relates to the
strong form
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?
45 days
*60+15-30
Advantages of using NPV include
- TVM is considered (compounding of returns)
- correct decision advice will be obtain given a perfect market
- correct ranking will be obtained for mutually exclusive projects with similar lives and investments
- an absolute value is obtianed
Disadvantages of using NPV include
- discount rate is difficult to determine
- assumptions related to cash flows have to be made that may or may not be correct
AR Turnover =
Net credit sales / Avg AR
Asset Turnover =
Sales Revenue / Avg Total Assets
Residual Income =
NI - (Imputed % x Invested Capital)
Return on Sales =
NI / Net Sales Revenue
