Study Unit 10

Question 1

Profitability index

Answer 1

method to rank projects so limited resources used in investments that will have highest return per dollar
PI=PV of FCF or NPV/ Initial investment

Question 2

2 methods to assess Return generated for owners

Answer 2

return on investment
residual income
allow investor to assess how effective or efficient firm is in using assets to enjoy a return

Question 3

ROI

Answer 3

ROI=op income/Avg invested capital
=Op income/Total assets
ROI> cost of capital, add to S/h value

temptation to reject capital projects that would decrease ROI even though would increase s/h wealth

Question 4

ROI- Component

Answer 4

ROI= PM * Capital Asset Turnover
ROI= (Op Income/Sales) * (Sales/Avg Invested capital)
PM=Return on Sales

Question 5

Residual Income

Answer 5

RI= Operating income- Target return on invested capital
RI= 42000- (700k *5.5%)

derived by weighting avg invested capital with imputed interest rate

Question 6

ROA

Answer 6

ROA=NI/Avg total assets

Question 7

EPS

Answer 7

(NI-Preferred dividends)/common shares outstanding

Question 8

ROCE

Answer 8

measures amnt of income company earns per $1 invested by common s/h
(NI-preferred dividends)/Avg common equity

Question 9

Price-Earnings ratio

Answer 9

measures amnt investors will pay for $1 of earnings

P/E= Market price of share/ EPS

Question 10

Economic Rate of Return on Common Stock

Answer 10

measures relative amnt of s/h wealth generated during pd

(Dividends paid + Change in stock price)/Beginning Stock price

Question 11

Economic Value Added

Answer 11

residual income adjusted for opp cost of capital

EVA=After tax op income-(initial investment * cost of capital)

Question 12

EVA represents

Answer 12

true economic profit b/c charge for cost of equity is w/in cost of capital

measures marginal benefit by using resources in particular way; useful to determine if segment increases s/h value

coe is an opp cost

Question 13

EVA differs from accounting income

Answer 13

subtracts coe
more adjustments
-R&D may be amortized over 5 years
-true economic depreciated rather than tax depreciation may be recognized

Question 14

Solvency

Answer 14

ability to pay noncurrent debt as due and remain in business in long run
-ability to service debt out of current earnings is key to see if using leverage successfully

Question 15

Times interest earned

Answer 15

EBIT/Interest exp

Question 16

Debt

Answer 16

return on debt > interest paid, use of debt is advantageous
return enhanced bc fact interest pmts are tax deductible

more debt is risky

Question 17

Equity

Answer 17

permanent capital of an entity, from firm’s owners w/hopes of getting return

ROE is uncertain bc equity come from residual (claim left after all debt satisfied) interest in assets

Question 18

Total debt to Total Capital

Answer 18

low-more capital from s/h
creditors prefer ratio to be low to cushion against loss
TD/TC

Question 19

Debt to Equity

Answer 19

reflects LT debt pmt ability

lower means less debt burden, more likely to pay creditors

Question 20

LT Debt to Equity

Answer 20

lower means easier to raise new debt capital