MCQ Flashcards
Net Present Value Negative
Discount Rate > Internal Rate of Return
Use of Message Encryption Software
Increases system overhead
Translates plain text to ciphertext using key (fixed length string of binary digits) and algorithm combining key and text by blocks
Single key or
asymmetric/public key infrastructure (PKI) using two keys
Does NOT
guarantee secrecy,
reduce need for password changes, or
require manual distribution of keys
decreases bank reserves
Sale of gov’t securities by Federal Reserve
also increases interest rates
decrease in potential money supply
increases in bank reserves
Purchase of gold by the Federal Reserve
decrease in currency held by public
increase in Fed Res float
Fed Res loans to member banks
Short term vs. long term credit
obtained quicker
more flexible
less costly (yield curve) (l/t prepayment penalties are NOT the reason)
riskier (more frequent need to renew)
spontaneous credit
no cost
requirement of compensating balances
increase effective cost of debt
learning curve anaylsis
labor becomes more skilled and efficient
reduces cost
used to mathematically estimate future time to produce units
Calculate residual income
Capital Turnover (4) = Sales (400K) /Invested Capital
Operating Income (40K
Less Imputed Interest on Invested Capital
10% x 100K)
= Residual Income (30K)
3 ways to configure a wide area network (WAN)
Centralized (all devices ink to mainframe)
Decentralized (LAN for each dept)
Distributed Data Processing (DDP) (local processing & corporate mainframe)
Sequential data
can only be accessed after all preceding records passed
impossible to edit in real time (online)
conservative working capital policy
minimize risk
low ratio of current liabilities to long term financing
high current ratio
longer operating cycle
financial leverage
how well the owners of common stock are able to get money from other sources (debt and/or preferred stock) to fund operations
profits made from these resources will be greater than the cost of the financing so that net income attributable to the common stockholders is increased
using other people’s money to make money for owners
extent of debt and preferred stock
DFL = EBIT/(EBIT - Interest-(Pref Div/(1 - TR))
DOTL = DOL X DFL
DFL = Change in NI (after tax)/Change in Operating Income (EBIT)
financial leverage and purchase of treasury stock
decreases SHE
increases debt-to-equity
increases financial leverage
economic exposure
impact of exchange rate fluctuations on firm’s cash flow
running open systems
increase vendors and price competition
scale to precise size
reduce reliance on proprietary components
reduce integration into existing systems
absorption costing
variable and fixed manufacturing costs = product costs
S&A costs = period costs
required by GAAP
variable/direct costing
include only variable manufacturing costs (not fixed)
Advantages of NPV method
TMV (compounding returns)
perfect mkt = correct decision
correct ranking of mutually exclusive projects
absolute value
Disadvantages:
difficult to determine discount rate
cash flow assumptions
deflation
sustained decline in general price level
increased purchasing power of money
increase money supply = decrease exchange rate = decrease demand = increase price = inflation
material efficiency
material usage (quantity) variance
less = favorable more = unfavorable
difference between budgeted cost of materials used and the budgeted cost of materials that should have been used
If someone purchases a call option, he or she expects
prices to rise during the option period.
a put option is purchased if the price is expected to
decrease over the option period.
The excess present value index, or profitability index,
present value of future net cash inflows/
discounted (net) initial investment
NPV/initial invesment + 1
OR
PV benefits/Cost
index number NOT a dollar amount.
the excess present value is particularly useful in evaluating:
different-sized projects when
capital budgeting funds are limited.
project screening not ranking
goal of management in a corporation
maximize shareholder wealth (maximize share price)
NASDAQ market makes it a requirement that all listed companies have audit committees
composed entirely of independent directors
who are also financially literate
COSO
internal control framework
Committee of Sponsoring Organizations of the Treadway Commission.
“COSO is recognized the world over for providing guidance on critical aspects of organizational governance, business ethics, internal control, enterprise risk management, fraud, and financial reporting.”
Risk appetite in an ERM system
refers to the level of risk an entity is willing to accept in reaching its goals
is related to the organization’s overall culture and strategy.
risk tolerance
refers to a specific level or range of variation that is acceptable in reaching particular objectives
Investment risk from investment activity
Price risk refers to the risk that a security or portfolio of securities will decline in value and can be mitigated through diversification and hedging activities.
Credit risk refers to risk of default by a borrower or issuer of a debt security in which the company has invested.
Liquidity risk refers to exposure to loss resulting from the lack of marketability or liquidity of an investment.
An outside director
a member of the board
who is not otherwise employed by or engaged with the organization, and
does not represent any of its stakeholders
contribution margin ratio
contribution margin per unit
/sales revenue per unit
additional sales x contribution margin ratio = additional net sales
less additional S&A (fixed) expenses
= net decrease/increase in pretax profit
calculate $ and % change adjusted for inflation
prior $ X (CPI current/CPI prior)
current $ less adjusted $ (above)
difference (above)/current $ = % change adj for inflation
effective rate of interest and compensating balance
actual interest at stated rate
/available principal (loan proceeds less compensating balance)
annual after tax cost of bonds sold at a discount
stated interest
/discount price
x 1-tax rate
opportunity cost of holding cash balances
average cash balance
x opportunity cost %
Section 302 of the Sarbanes-Oxley Act
requires that CEOs and CFOs
certify that the periodic statutory financial statements
were reviewed before being signed.
Annual percentage rate (APR)
periodic rate times the number of periods per year
requirement established by the New York Stock Exchange for the companies that are officially listed on that exchange
To help ensure that companies operate with some level of moral guidance,
a code of conduct must be adopted.
To help outsiders evaluate the company’s commitment to ethical principles
that code of conduct must be made public.
financial intermediaries include
Commercial bank Savings and loan Mutual savings bank Credit union Mutual fund Pension fund Life insurance company
Stock exchanges
require a physical/tangible location
NYSE and AMEX are national exchanges.
Boston is a regional exchange.
NASDAQ
computer based trading network
lacks a single physical location
NOT an exchange
yield curve
a graph of the relationship between bond yields and maturity
upward sloping curve
provides investors with a higher return to compensate for taking greater risk by investing in longer maturity bonds
Nominal and stated rates
different names for the rate quoted in the contract
APR
periodic rate times the number of periods per year
Effective annual rate (EAR)
annual rate of interest actually being earned or charged
open end fund
often referred to as a mutual fund
size changes based on investor demand
fund where investors buy shares from and sell shares to the fund at the fund’s net asset value (NAV)
Treasury bill
is a short-term debt obligation backed by the U.S. government with a maturity of less than one year
T-bills (as they are often called) are sold in denominations of $1,000 up to a maximum purchase of $5 million.
Treasury note
has a maturity from one to ten years
Treasury bond
has a maturity great than ten years
Spot market
purchase and sale of commodities for current delivery
nominal risk free rate of interest
function of two factors
real rate of interest and
an inflation premium
Money market
market for securities with a maturity of one year or less.
Capital market
is for longer term investment products.
open end fund
often referred to as a mutual fund
fund where investors buy shares from and sell shares to the fund at the fund’s net asset value (NAV)
closed end fund
a fixed number of shares are issued to investors and they trade with each other on the secondary market at prices that often differ from the fund’s NAV
NYSE Specialist
NYSE member acting as a dealer in a small number of securities on the exchange
makes a market in a stock on the NYSE
In the OTC market the same function is provided by market makers.
call option
gives the holder the right to purchase a security at a specified price for a certain period of time (often three months or less)
London Interbank Offered Rate (or LIBOR)
average interbank borrowing rate
derived from quotations provided London banks and calculated by the British Bankers’ Association.
This rate is generally compared to the U.S. Federal fund rate.
nominal risk free rate of interest is a function of two factors
real rate of interest and an inflation premium
Federal Reserve has purchased a large quantity of US government securities
Federal Reserve Bank deposits can be used to buy government securities as a way of raising the supply of money.
When more money is available, it is easier to obtain and interest rates usually fall.
private placement
SEC permitted issuance
allows the sale of securities with only a limited amount of registration and disclosure information which will save the company money
Price risk from investment activity
refers to the risk that a security or portfolio of securities will decline in value.
can be mitigated through diversification and hedging activities
Credit risk from investment activity
refers to risk of default by a borrower or issuer of a debt security in which invested
Translation risk
risk to the firm’s earnings associated with translating its financial statements into functional currencies
Foreign currency transaction (remeasurement) risk
risk of loss associated with effects of changes in currency exchange rates on transactions valued in other currencies
exposes firm to loss if it has a receivable valued in a foreign currency and the value of this currency weakens relative to the U.S. dollar
Transfer pricing
refers to the pricing strategy for products and services bought and sold across international borders between related parties.
closely tied to a firm’s international tax strategy
minimize its overall tax burden by minimizing net income in jurisdictions with higher income tax rates and maximizing its net income in jurisdictions with lower income tax rates
in response, many foreign jurisdictions have implemented tax regulations that are designed to align transfer prices with market prices
money market hedges
firm would borrow a sum of money in a foreign currency at the present time to be repaid by a receivable in that currency to be received at a future date
forward contract hedge
firm will be entitled to purchase and sell
a specific quantity
at a specific future date
of a particular foreign currency, commodity, or financial instrument
currency swap hedge
firm will exchange an obligation to pay cash flows in one currency for an obligation to pay cash flows in another currency.
option contract hedge with European call option
firm will be able to buy, at its option, a certain financial instrument or commodity at a specified date.
foreign currency economic risk
risk associated with the present value of a firm’s cash flows due to changes in foreign currency exchange rates
Foreign currency transaction (remeasurement) risk
risk of loss associated with effects of changes in currency exchange rates on transactions valued in other currencies
Transfer pricing
refers to the pricing strategy for products and services bought and sold across international borders between related parties.
closely tied to a firm’s international tax strategy
minimize its overall tax burden by minimizing net income in jurisdictions with higher income tax rates and maximizing its net income in jurisdictions with lower income tax rates
A rightward shift in the demand curve
means that buyers are willing and able to purchase more of a product at all prices.
Factors that create a shift in the demand curve include: income, prices of related goods, number of buyers, preferences, and expectation of future prices.
four basic categories of normalization adjustments:
Nonoperating adjustments:
Nonrecurring adjustments:
Comparability adjustments:
Discretionary adjustments:
discounted break even period
time required to recover the cash invested in a project.
discount both cash inflows and outflows
break even becomes “the point where discounted cumulative cash inflows on a project equal discounted total cash outflows.”
Structural unemployment
arises because of changes in technology and international competitiveness, which change the skills required to perform jobs and/or change the location of jobs.
Workers laid off due to technological change often find it difficult to obtain jobs without retraining, relocating, or additional education.
IRS Revenue Ruling 68-609 states,
“The 8 percent rate of return and the 15 percent rate of capitalization are applied to tangibles and intangibles, respectively, of businesses with a small risk factor and stable and regular earnings; the 10 percent rate of return and 20 percent rate of capitalization are applied to businesses in which the hazards of business are relatively high.”
However, even the IRS has denounced the use of the treasury method discussed in Revenue Ruling 68-609 as well as a blanket approach to determine discount and capitalization rates.
Frictional unemployment
occurs due to normal labor turnover such as people seeking employment in a higher-paid occupation or another location.
Discount and capitalization rates are not the same.
Capitalization rate is often derived by subtracting a company’s expected long-term annual growth rate from its discount rate;
therefore, a growing company’s capitalization rate is usually lower than its discount rate.
the best set of controls includes
input controls (batch and hash totals, record counts of each run),
preventive controls (proper separation of duties, passwords and user codes), and
recovery methods (backup copies of activity and master files).
Magnetic ink character recognition
is most often used by banks to read the magnetic ink on checks and deposit slips.
prevent the viewing of sensitive data on an unattended data terminal
Automatic log-off of inactive data terminals
Structural unemployment
arises because of changes in technology and international competitiveness, which change the skills required to perform jobs and/or change the location of jobs.
Cyclical unemployment
occurs during declines in the business cycle, and unemployment should be reduced as the economy recovers.
Accounting rate of return
Increase in income ÷ Required investment
Accounting rate of return is a nondiscounted method of computing the rate of return of an investment.
It is based on accrual accounting and has the measurement of profitability as the goal.
The limitation of this method, however, is that it ignores the time value of money.
(Net cash inflow - Depreciation) ÷ Investment or
net income ÷ investment.
There is some controversy about the denominator—the most commonly used amount is the initial cost of the investment, but some advocate the use of an average investment.
Sensitivity analysis in capital budgeting projects.
involves testing the effects of various assumptions.
Adjusting the required rate of return in capital budgeting projects.
involves increasing the rate for more risky projects
adjusting estimated future cash flows in capital budgeting projects.
make them more conservative for more risky projects
Section 302 of the Sarbanes-Oxley Act requires
CEOs and CFOs certify that the periodic statutory financial statements were reviewed before being signed.
Break even units
Total fixed costs / (Selling price per unit - Variable cost per unit)
Manufacturing Cycle Efficiency
Manufacturing or Process Time /Time from Start of Manufacturing to Delivery
Accounting rate of return
Increase in income ÷ Required investment
Sensitivity analysis
involves testing the effects of various assumptions.
The CAPM formula
is E(R) = RF + B [RM-RF]
E(R) = expected return on the security RF = risk free rate of return (4%) RM = the return on the market (10%)
E(R) = 4 + 1.5 [10-4] = 13%
adjusting estimated future cash flows
make them more conservative for more risky projects
Prime cost consists of
direct material and direct labor.
Both of these are variable costs
value or price of stock given annual dividend and required rate of return
dividend divided by the required rate of return
a low discount rate for a cash flow in a quicker period of time
will lead to a high present value
Quarterly compounding requires
one fourth the interest rate and
four times the periods
The CAPM formula
is E(R) = RF + B [RM-RF]
E(R) = expected return on the security RF = risk free rate of return (4%) RM = the return on the market (10%)
E(R) = 4 + 1.5 [10-4] = 13%
statistical measure for two investment alternatives that have different expected returns and standard deviations
Coefficient of variation
When projects have different expected returns, the project with the lower coefficient of variation is preferred.
When two investments have the same expected return,
the project with the lower standard deviation is preferred.
Bond ratings
By firms such as Moody’s or Standard and Poor’s
Measure default risk
Highest rating is AAA.
BBB and above are investment grade.
Below BBB are high yield/junk bonds.
security market line (SML)
graphs the relationship between .
expected return and risk
as measured by the beta coefficient.
The beta coefficient measures systematic risk.
The equation for the SML is the capital asset pricing model (CAPM): E(R) = RF + B [RM-RF]
The internal rate of return (IRR)
Profit rate from the investment.
Specific discount rate that makes the present value of the inflows equal to the net investment and forces the NPV to be equal to zero
IRR needs to be higher than the cost incurred to get the capital that is used to make the investment.
project’s payback period
Initial Investment/Annual Cash Flow
does not adjust for the time value of money
how long in years or months it takes the firm to recoup its initial cost (focus is liquidity, rapid cash recovery)
point where sum of future UNDISCOUNTED cash flows exceeds net investment
depreciation expense is a noncash expense that is subtracted from profit to arrive at net income.
add noncash depreciation back to net income per year
WACC four weighting systems
book values (balance sheet)
market value
optimal/target capital structure weights
marginal weights
(assign capital weights in percentages funds were actually raised, i.e. project funded using only debt,
debt weight 100)
Future value problems can be solved without financial calculators or tables.
The future value of a single sum is
amount times
one plus the interest rate
raised to the power of the number of periods.
FV= current amount x (1 + i)^n
A short cut estimate (very close estimate) for the time it takes for a sum to double in value
Rule of 72
72/interest rate
72/.08* = 9 yrs
*8%
risk premium is comprised of five components:
business risk, financial risk, liquidity risk, currency risk, and country risk
security market line (SML)
graphs the relationship between .
expected return and risk as measured by the beta coefficient.
The beta coefficient measures systematic risk.
The equation for the SML is the capital asset pricing model (CAPM): E(R) = RF + B [RM-RF]
project’s benefit cost (profitability) index
B/C ratio
present value of the cash flows
divided by the net investment.
An index greater than one (or equal to in some cases) means that the project is acceptable.
project’s DISCOUNTED payback period
length of time required for an investment’s DISCOUNTED cash flow to equal its initial cost (net investment)
Modified Internal Rate of Return (MIRR) improves upon the Internal Rate of Return (IRR) technique by addressing what shortcomings of the IRR
MIRR reinvestment rate assumption may be user-modified
IRR assumes reinvestment of each cash flow at the IRR
NPV assumes reinvestment at the cost of capital
.
limitations of IRR (versus a NPV)
Value additivity issue
Multiple roots (answers) issue when cash flow changes from positive to negative
Dealing with mutually exclusive projects
projects the equivalent annual annuity (EAA) technique (sometimes called the equivalent annual cost or EAC) is used to evaluate
calculates present value on an annual basis
allows the analyst to compare projects with different lives
Standard capital budgeting techniques (such as NPV, IRR) are not designed to compare projects with different lives.
times interest is earned
shows how easily an organization can meet its required interest payments
net income for the period less interest and tax divided by the reported interest expense
Earnings before interest exp and taxes/interest expense
EBIT/IE
Projected Profit
Sales - VC* - FC
VC Rate x Sales
opportunity costs
benefits that are passed up
sunk cost
real cost incurred in the past that cannot now be changed
already been spent and cannot be recovered
not considered in the investment decision process
fixed cost
will not increase as production levels increase (within a relevant range)
variable cost
one that will increase as production levels increase
Break even sales
contribution margin (CM) = sales - variable costs ($80,000 - $20,000 = $60,000)
Contribution margin ratio (CMR)
CM/sales revenue
60,000/80,000 = .75
Break even sales:
Fixed costs/CMR
$30,000/.75 = $40,000.
Variable Cost Rate
Variable Costs/Break Even Sales
Projected Profit
Sales - VC - FC
Access time
amount of time it takes for a computer to seek out and find data or, “to retrieve data from memory.”
transmission rate
speed of transmission of data from a remote terminal to a central computer
often measured in baud
Financial leverage
increases when the proportion of fixed payment obligations from interest and preferred dividends increases relative to the “variable” payments to common stockholders.
decrease in preferred dividends increases denominator, so proportionately decreases total FL
Payable-through drafts
legal instruments that look like checks, but they are not drawn on the bank.
drawn on and approved by the issuing company against its demand deposit account.
Concentration banking
company uses a geographically dispersed collection center to speed up the collection process.
For standard variance:
AS QP (ass cupie).
AQAP AQSP SQSP
For overhead variance:
SEV (spending, efficiency, volume)
ABA BSA (aba busy)
two types of business valuation engagements
SSVS 1, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset:
valuation engagement,
calculation engagement
In a valuation engagement,
valuation analyst is free to employ the use of ANY Valuation Approach or method that is professionally deemed appropriate under the circumstances
Financial leverage
increases when the proportion of fixed payment obligations from interest and preferred dividends increases relative to the “variable” payments to common stockholders.
Common stock dividends
are variable, in the sense that there is no fixed, definite amount of dividends that must be paid each year.
must be paid regardless
interest
preferred dividends
A decrease in preferred stock dividends
decreases financial leverage
The formula for total leverage shows that as preferred dividends decrease (increasing the value of the denominator), total leverage decreases.
simple interest method
principal x interest rate x time
two types of business valuation engagements
SSVS 1, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset:
valuation engagement,
calculation engagement
In a valuation engagement,
valuation analyst is free to employ the use of ANY Valuation Approach or method that is professionally deemed appropriate under the circumstances
results are expressed in terms of a conclusion of value and can either be a Single Number OR a Range
premise of value can be either a Going Concern OR Liquidation
In a calculation engagement,
the valuation analyst and the client Agree upon the valuation methods AND Approaches to be used, so NOT free to use any approach or method available.
valuation engagement AND calculation engagement
results are expressed in terms of a conclusion of value and can either be a Single Number OR a Range
premise of value can be either a Going Concern OR Liquidation
estimated net realizable value method to allocate joint costs
Product NRV:
Sales price less Separable Costs
Allocate joint costs
Product NRV/Total NRV x Joint Costs
certainty equivalent net present value
no risk (i.e., the cash flows are certain),
the appropriate discount rate is the risk-free rate.
A Mortgage
B Subordinated
C Senior
D Debenture
A. collateralized
B. junior in standing
C. bondholders first in terms of repayment
D. unsecured
reorder point
inventory level at which an order for the inventory item is submitted
Reorder point = (Avg. Daily Use × Lead time) + Safety Stock
10 days are required to order and receive a part
daily demand for part is 1,000 units
Reorder point = 1,000 units x 10 days
Reorder point = 10,000 units
Correlation
refers to the existence of a reliable relationship between two variables (dependent and independent)
measured by the value of the coefficient of correlation, r
The coefficient of correlation, r, is a measure of the relative relationship (not the variance) between the two variables.
dependent variable - values to predict
independent variable - values used in the prediction
Reliable correlation must exist for regression analysis to be valid.
translation exposure
exposure of a multinational corporation’s consolidated financial statements to foreign exchange fluctuations
dividend irrelevance theory
investors are neutral as to whether returns come from dividends or capital gains
direct contrast to Bird in the Hand theory
Return on investment (ROI)
Net Income / AVG Invested Capital
If the invested capital increases (long-term asset purchase), then ROI will decrease.
Residual income
amount of net income in excess of a minimum desired rate of return on invested capital.
Reported net income - (Desired rate of return × Invested capital)
If invested capital increases, the residual income will decrease.
A Mortgage
B Subordinated
C Senior
D Debenture
A. collateralized
B. junior in standing
C. bondholders first in terms of repayment
D. unsecured
A Best efforts basis
B Private placement
C Rights offering
D Underwriting
A. investment bank sells what it can, in exchange for a commission
B. selling securities to institutional investors rather than the public
C. offering the securities to existing owners first
D. investment bank purchases the entire security offering from the issuer and attempts to resell it to the public at a profit
A lease must be classified as a capital lease if any one of four conditions occurs.
A Transfer of ownership occurs
B A bargain purchase plan option exists
C The lease period is greater than or equal to 75% of the assets life
D The present value of the lease payments is greater than or equal to 90% of the asset’s initial value
Bird in the hand theory
firm’s value is maximized by setting a high dividend project ratio
investors are less certain of receiving future capital gains,
investors value a dollar of current dividend more than a dollar of uncertain capital gains
result in a high firm value
dividend irrelevance theory
investors are neutral as to whether returns come from dividends or capital gains
direct conrast to Bird in the Hand theory
Sinking funds
reduce the risk to bondholders by gradually reducing the amount of debt the firm has outstanding.
to enforce the sinking fund provision, the bonds are often used with a call provision
long-term source of funds considered a hybrid security
Preferred stock
features of bonds (a fixed dividend) and
equity (no maturity)
Indenture
legal document that outlines the obligations of the bond issuer
Covenants
provisions within an indenture detailing things the issuer must do (minimum ratios) or cannot do (issue additional debt without permission)
Warrants
long term options attached to bonds.
advantages of issuing the bonds over issuing CS
use the money to increase income by more than the cost of the interest, this leveraging increases net income without any additional funds from the owners.
interest expense is tax deductible so that its cost is reduced significantly (whereas dividend payouts are not tax deductible)
if inflation takes place, the dollars eventually used to repay the bonds are worth less than the ones that were received on the day of issuance—a financial benefit
Disadvantage: Creditors can force a company into bankruptcy and shareholders cannot so debt is viewed as a more risky method to raise funds.
least expensive source of long-term capital
Long term debt is generally cheapest for two reasons:
1) the interest rate on the debt is tax deductible and
2) debt is repaid first so it has less risk
ex-dividend date
first date on which you buy stock without being entitled to receive a declared dividend
chronological:
declaration date, ex-dividend date, date of record, and payment date
Founders shares
are issued to the original owners of the firm.
A put option
allows you to sell at a fixed rate for a fixed period of time
Preemptive right
Common stock owners right to purchase a pro rata share of new issues of common stock to maintain their ownership percentage in the firm.
How often are dividends usually paid by U.S. corporations?
Quarterly
advantages of issuing the bonds over issuing CS
use the money to increase income by more than the cost of the interest, this leveraging increases net income without any additional funds from the owners.
interest expense is tax deductible so that its cost is reduced significantly (whereas dividend payouts are not tax deductible)
if inflation takes place, the dollars eventually used to repay the bonds are worth less than the ones that were received on the day of issuance—a financial benefit
Disadvantage: debt raises the risk of company bankruptcy.
cost of issuing common stock ignoring any transactions costs
cost of common stock is next period’s dividend divided by the net proceeds (market price less any transaction or flotation costs to sell).
The resulting percentage is added to the forecasted growth rate percentage.
ex-dividend date
first date on which you buy stock without being entitled to receive a declared dividend
leveraged buyout
transaction mostly financed by taking on debt with little money being contributed by the owners.
pooling of interests
old accounting term no longer used for new acquisitions.
congeneric merger
merger where two companies operate in related industries but do not offer the same products.
reverse acquisition
private company acquires a public firm to bypass the complex and costly process of going public
more common in recent years due to foreign firms wanting to enter the U.S. capital markets
degree of financial leverage
reflects how well a company uses borrowed money to increase the income applicable to the owners of common stock.
It is calculated by:
% increase EPS/% increase EBIT
Money market securities
have a maturity of one year or less.
Treasury bills
Commercial paper
Bankers acceptance
Negotiable certificate of deposit
four reasons to hold cash
transactions (to meet day to day cash outflows) compensating balances (required by banks) precautionary balances (to meet unexpected events) speculative balances (to take advantage of opportunities)
Cash Conversion Cycle CCC
Days it takes to buy inventory, pay for it, sell it and collect on sales.
Time inventory takes to be sold plus the time the accounts receivable takes to be collected shortened by the length of time accounts payable take to be paid.
Inventory (conversion period/age)
+ Receivables (collection period/age)
- Payables (deferral period/age)
Credit policy has 4 components.
(1) Credit period–when the payment is due;
(2) Credit standards–criteria as to which customers are granted credit;
(3) Collection policy–enforcement of the collection process
(4) Discount–reductions offered to speed up payments.
Aging schedule is not part of the credit policy but a listing of accounts by their age.
A bankers’ acceptance
a promissory note
backed by a letter of credit
that has become a money market security
A letter of credit
states that the bank will guarantee payment
if the customer defaults
credit terms of 2/10 net 30
cost of not taking the discount and paying on the 30th day
Extra Cost x Annualized Cost
.0204081 x 18.25 = .3724 = 37.24%
Discount/(1 - Discount) = Extra cost
.02/.98 = .0204081
Annualized Cost = 365/#days saved
365/20 = 18.25
*% as decimal or
cents per dollar saved/cents per dollar spent
Just In Time (JIT)
inventory strategy implemented to improve return on investment by
reducing in-process inventory and
lowering inventory carrying costs
introduced by the Japanese automobile industry
Instead of holding inventories, the manufacturer subcontracts with suppliers to provide the necessary inputs for that day’s or week’s expected production.
Economic Order Quantity points (EOQ)
Annual Demand = 1,600
Fixed Cost per order = $50
Variable Cost of carrying inventory units for a year (calculated on avg inventory balance) = $1
how many to order at one time
square root of:
2 times annual demand x cost of placing an order/
cost of carrying a unit for a year
(2 x 1,600 x 50)/1 = 160,000.
Square root of 160,000 = 400 units per order
1600/400 = 4 orders per year
Reorder Point (parts)
Operates 365 days per year
Produce 3,650 per year
5 days to delivery (lead time)
In the absence of a safety stock:
RP = Daily Usage x Delivery (Lead) Time
3,650/365 = 10 x 5 (days to deliver/lead time) = 50
three forms of short term secured loans used to purchase inventory
Blanket (Broad Form) Lien - covers an entire group of usually low cost homogeneous items
Trust Receipt - lender holds title and borrower has possession of collateral
Warehouse Receipts - lender controls title and possession of collateral
Operating Cycle
Average age of inventory (inventory period)
+ Average age of accounts receivable (receivables period)
Subtract average age of accounts payable to calculate Cash Conversion Cycle (CCC)
Factoring
Factors are businesses that buy accounts receivable from firms at a discounted price.
Provides the seller with immediate cash.
Usually transfer the costs associated with collection to factor.
The sale is referred to as factoring.
number of days sales in inventory
number of days it takes to sell an item
Avg Inventory/Daily Avg COGS
Avg Inventory = (Beg Inventory + End Inventory)/2
COGS =
Beginning Inventory
+ Purchases
- Ending Inventory
Daily Avg COGS = COGS/365 (or 360)
average time to collect accounts receivable
Avg AR/ Avg Daily Credit Sales
Avg Daily Credit Sales = Credit Sales/ 365 days
Avg AR = (Beg AR + End AR)/2
Concentration Banking
Companies have payments sent by customers directed to local banks around the country that can electronically forward the money to the company which speeds up cash collection by several days.
In managing cash, companies like to receive payments from customers as quickly as possible.
Mail sent over a long distance can take several days to arrive.
forward exchange contract
fluctuation of currency values is always a concern
it can be managed through this hedge
company has a payable, so establishes a receivable
Company pays more for receivable than the current value of the payable which is the cost of establishing the hedge.
futures contract
contract to buy or sell
a specified commodity
at a certain date in the future,
at a market-determined (futures) price
Commercial paper
unsecured obligation issued by a corporation or bank
to finance short-term credit needs.
maturities typically up to 270 days,
wide range of denominations,
either discounted or interest-bearing,
usually limited or nonexistent secondary market,
typically issued by companies with high credit ratings, so the investment is viewed as having relatively low risk
Acid-test Ratio
evaluate ability to pay current liabilities if they immediately come due
(Cash + AR + ST investments)*/Current Liabilities
*Exclude Inventory (less liquid)
Inventory Turnover (Ratio)
used to measure the speed at which a company is able to sell its inventory
COGS/Avg Inventory
how many times during the year that the reporting company sells an amount equal to its average inventory
average age accounts receivable balance
End AR/ Avg Daily Credit Sales
Avg Daily Credit Sales = Credit Sales/ 365 days
Net operating income
difference between revenues and operating expenses.
Net income
difference between revenues (and gains) and expenses (and losses)
Gross margin (also called gross profit)
difference between revenue and cost of goods sold
Contribution margin
difference between revenue and variable expenses
Sales - Variable Costs
Contribution Margin = 600 & 30% of Sales
Net Income = 420
Find Break Even Sales
Sales - Variable Costs = Contribution Margin
100% Sales - X% Sales = 30% Sales
VC = 70% Sales
Contribution Margin* - Fixed Costs = Net Income
600 - FC = 420
FC = 180
*(Sales - Variable Costs) - Fixed Costs = Net Income Break Even Net Income = 0 Break Even Sales - 70% Sales - 180 = 0 30% BE Sales = 180 BE Sales = 600
Cost Volume Profit (CVP) underlying assumptions
1) selling price does not change with activity level,
2) sales mix remains constant,
3) cost can be separated into fixed and variable elements,
4) TOTAL fixed cost are constant,
5) variable costs PER UNIT are constant
Equipment Purchase = $1,000 Expected Life = 5 years Depreciation - S/L, 0 salvage value Revenue Increase Year 1 = $300 Income tax rate = 35%
Calculate after-tax cash flow of purchase Year 1.
Change in Revenue - Change in Expense (Depreciation) = Change in Operating Income
300 - 200 = 100
Change in Operating Income x Tax Rate = Change in Income Tax Expense
100 x 35% = 35
Net Change in CF = Change in Revenue - Change in Income Tax Expense
300 - 35 = 265 OR
Change in Operating Income - Change in Income Tax Expense = Change in Net Income
100 - 35 = 65
Net Change in CF = Change in Net Income + Change in Noncash Expense (Depreciation)
65 + 200 = 265
consider when estimating cash flow from a potential investment
Opportunity cost
Cannibalization (erosion in cash flow to existing projects)
Impact of the project on net working capital requirements
NOT Sunk costs
cash flow attributable to a potential investment project
Increase Cash Flow:
Increase Salvage Value (increase CR at project end) Increase Depreciation (decrease taxable income)
Decrease Tax Rate (decrease income tax paid)
Decrease Interest Rate (decrease interest expense)
Decrease Cash Flow:
Decrease Salvage Value (decrease CF at project end) Decrease Depreciation (increase taxable income)
Increase Tax Rate (increase income tax paid)
Increase Interest Rate (increase interest expense)
target # of units to sell
target profit/contribution margin per unit
variable cost per unit
Decreases
Increases contribution margin ( sales price-variable cost) Decreases break even point (easier to get to)
Increases margin of safety (greater difference between sales and break even point)
Increases
Decreases contribution margin (sales price-variable cost) Increases break even point (harder to get to)
Decreases margin of safety (lesser difference between sales and break even point)
Three transfer pricing strategies
Full Cost - includes transferring a product from one division to another at the first division’s full absorption cost, which includes fixed costs. This method can lead to reduced morale and rejection of otherwise viable special projects.
Market Price - should be reduced to reflect costs savings from not transferring the product to an outside customer
Dual transfer pricing - allows the transferring division to record one price, and the receiving division to record another, which can reduce issues related to morale and unnecessary rejection of special orders.
transfer pricing strategies
Choose between a cost-based, market price, or negotiated price approach to transfer pricing.
Design to encourage divisional managers to maximize the profits of the company as a whole not within their individual divisions.
Base on opportunity cost plus any outlay required to transfer the product to another division.
If a division has idle capacity, there is no opportunity cost involved with providing a product to another division within a firm.
Floor and Ceiling in a transfer pricing decision
Floor - opportunity cost plus costs of outlay to transfer the product to another division within the firm
Ceiling should be the market price.
Actual transfer price should fall between these two prices.
marginal analysis applied to an outsourcing decision
compare the costs
fixed costs are unavoidable, so not relevant
cost of producing in house = variable costs (direct materials, direct labor, variable overhead) + opportunity cost
Cost-plus pricing strategy
bases prices upon a certain level of mark-up over costs or
at a target return on investment for stakeholders.
Cost-plus pricing is NOT a strategy limited to the public sector.
Short-term pricing strategy
often determined using a contribution margin approach
can be for special orders
Target pricing strategy
sets prices based on what a firm believes customers will be willing to pay
based on the product’s perceived value
sets a target cost to achieve a desired level of profit.
Three general categories of Business Forecasting methods
- Observed Relationships - regression analysis, ranging from a simple high-low method to multiple regression analysis
- Historical Data - Moving average calculates average sales for a rolling number of periods, exponential smoothing method adjusts moving average to place more weight on recent, relevant periods, trend analysis utilizes regression techniques to create a trend line of historical data in a time series
- Predictions of Customer Behavior - Markov techniques and polling
For All:
Consider factors such as cyclicality, seasonality and sensitivity . Sensitivity analysis can provide foresight into the effects of differences between forecasted amounts and actual results.
NOT Probability Analysis - uses the probability of various outcomes to predict the expected value of an investment during capital budgeting risk analysis
Economic value added
a firm’s residual wealth
Net Operating Profit (adjusted for taxes)
- Cost of Capital
financial value created beyond the cost of capital
popularly used as a component of executive compensation
an example of value-based management
Using EVA alone as the basis for incentive pay does not capture all elements of value creation in an organization.
DuPont analysis
breaks the ROI metric into the product of
Return on Sales x Asset Turnover Ratios
helps break ROI into meaningful components
Return on investment (ROI)
ROI = Net Income/Total Assets*
*AVG Invested Capital
ROI = Profit Margin** x Capital Employed Turnover Rate**
**Net Income/Sales x **Sales/Invested Capital
value-based management (VBM)
increase pay when value is added to the firm
VBM is most effective when long-term growth strategies and a range of financial and non-financial measures are incorporated into measures of performance.
Using any single metric alone as the basis for incentive pay does not capture all elements of value creation in an organization.
Effects of Deflation and Inflation
Deflation - more damaging than inflation (discourages business investment as companies are reluctant to invest in equipment in a period of declining prices)
High rates of inflation - associated with economic contraction and a redistribution of wealth
internal controls over significant financial transactions
Financial controls and processes must be in place (due to the significant company funds involved) to ensure that:
- transactions are properly recorded,
- management’s assumptions are documented, evaluated for reasonableness, and results are assessed
- approvals are received and documented
value of preferred stock
A preferred stock is perpetuity.
The value of perpetuity is
Annual Cash Flow/Required Rate of Return
When interest rates increase, bond prices
decrease
lower bond price = higher current yields and eventual capital gains (which increases the bond’s YTM)
Dividend Discount Model
value of a share of stock
= Dividend per share/(discount rate less the dividend growth rate)
Increasing the dividend growth
decreases the denominator
so the resulting value is higher
internal growth rate (G) in earnings
Return on Equity x Retention Rate*
Retention Rate (percentage kept of each dollar earned) Dividends per share/ EPS = payout rate *1 - payout rate = retention rate
taxable equivalent yield
municipal bond rate/1 - tax rate
techniques to value stock
multiples of: Earnings Cash flow Book value Sales Commissions
EBITDA
Super Normal DDM (stock must pay a dividend )
dividend payout ratio
dividend per share/earnings per share
percentage of the reported income that goes to the owners in the form of dividends
CPU
Central Processing Unit
primary hardware component where the actual processing of data occurs
contains: Primary storage (temporary main memory that holds program, data and results during processing, RAM (Random Access Memory) and ROM (Read Only Memory)), Control unit (reading or interpreting the program instructions and directing execution) and Arithmetic/logic unit (circuitry that performs these operations)
bus
circuitry connecting the CPU to the primary memory and to peripheral devices
Input and output devices
transfer data in and out of the CPU
keyboard, monitor, scanner, printer, mouse, modem, joystick, touchpad, bar code reader, etc.
Peripheral equipment
any device that is not a part of the CPU but can be accessed by the CPU.
secondary storage and any input or output device
Secondary storage
consists of devices external to the CPU consisting of disks, flash drives, hard drives etc.
secondary storage is more permanent
Machine language
binary (on/off) language
interpreted by the computer hardware
lowest level or first generation language
machine dependent
writing programs in machine language is difficult and prone to error
a compiler is required to translate higher level languages into machine language
Assembly language
second generation language that requires an assembler to translate assembly language into machine language
machine dependent language utilizing short commands for repetitive tasks
easier to write programs in assembly language than machine language
Procedural languages
third generation language that allows programmers to concentrate on the procedures and functions of the programs
programmer writes the program in source code which is then converted or translated into object code
source code is more similar to English while the object code is the machine language for a particular type of computer
FORTRAN, COBOL and BASIC all forms of procedural languages
third generation languages
must be converted from source code to object or machine code
FORTRAN (FORMula TRANslation) - designed for scientific purposes
COBOL (Common Business Oriented Language) - designed for business operations
BASIC (Beginner All purpose Symbolic Instruction Code) -designed for educational purposes
Fourth generation languages (4GL)
have many routine commands and procedure pre-programmed.
often associated with a dataBase management system and are relatively easy for programmers to use.
designed to reduce programming effort and improve the process of software development.
efficiency can come at the cost of computer resources.
GUI
Graphical User Interface
allows the user to navigate the system and access programs though a series of graphical icons, visual indicators, scroll bars, pictorial and graphical symbols.
can eliminate the need for a user to learn a complex set of commands
A patch
change or modification to an existing program.
to correct an error in programming or as a result of a change in requirements.
may also be added for fraudulent purposes.
Operating System (O/S)
manages and schedules application programs and system functions.
tracks, coordinates and allocates memory, inputs, outputs and performs security functions.
Windows, Unix and Linus, MVS and DOS
Job Control Language or JCL
command language that initiates programs,
specifies processing priorities, running sequences, databases used and files used
virtual storage/memory
saves time and money
operating system divides a program into pages or segments and brings only the pages of the program required for execution into memory.
unneeded portions of the program remain in less expensive secondary memory
applications program
designed to perform a specific process or series of tasks.
artificial intelligence (AI)
software designed to help humans make decisions.
attempt to mimic the human thought process.
deals with processes that involve a structured or predicable approach.
using a computer to reach the same conclusion as a human
an expert system is a form of AI
reaches a conclusion much faster than an human
Computer hardware is extremely reliable, primarily due to
chip technology
self diagnostics
provided by the manufacturer and activated when the system is booted up;
boundary protection - maintains separate areas of processing so that multiple programs can run simultaneously;
echo check - used in transmissions where the receiving hardware sends back the data received as a confirmation;
parity check - one bit is added to a block of bits so that the ones in the block always add up to either an odd or even number;
periodic or preventative maintenance - the systems is serviced regularly to ensure that it is operating as intended. -
