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BEC Chapter 3
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Gravity
Terms in this set (82)
Capital budgeting
a process for evaluating and selecting the long-term investment projects (adding value)
Stages of Cash Flows
Inception - todays cost = initial outflow
Working capital requirement - net current assets
Additional WC needed - Buy WC - $ outflow
Reduce WC needed - Sell WC - $ inflow
Replaced asset abandonment or sale
Abandoned = SP - NBV = Gain or Loss
Sell = SP - (gain x tax) or + (loss x tax) ["net proceeds"]
Annual Operating Cash Flow
Inflow = pretax CF x (1 - tax rate)
Discounted Cash Flow model
a technique that uses time value of money concepts to measure the PV of cash inflow and outflows expected from a project
if PVCF > Todays cost = Profit = ACCEPT
Rate of return desired
rate of return is the compensation for all risks assumed
Also called the discount rate, or hurdle rate
Net Present Value method
Used to screen capital projects for implementation
Purchase or invest in a capital assets that will yield more than the management designed hurdle rate
NPV calculation
Estimate CF (initial outflow, annual OCF, final year CF)
Ignore depreciation (dep x tax = $ saved = inflow)
Discount all cash flows to present value based on hurdle rate
Subtract initial outflow
Positive result of NPV method
= make investment; infer IRR > hurdle rate
Negative result of NPV method
= do not make investment; infer IRR < hurdle rate
Interest rate adjustments for required return
Advantage of NPV over IRR methods
FV / (1+r) = PV
As risk increases, the required return increases, and PVCF decreases
In an inflation, there is loss of purchasing power where risk increases, RR increases, and PVCF decreases
Advantage of NPV for rate usage
Having the ability to use multiple rates is considered superior than the IRR method
PV factor calculation (if not given PV in current year)
= 1/(1+r)^t
12% return; year 6
1/1.12^6 = .5066
Unlimited capital vs limited capital
unlimited capital = make any investment with a positive NPV
limited capital = make investments base on ranking and importance
Profitability index
The excess present value index or simply the present value index, measures CF return per dollar invested
= PVFCF / PVcost (PI > 1 = positive NPV)
Used to rank decisions when it comes to investments
IRR method
single rate that will set the PCFCF = todays cost - zero NPV
expected rate of return of a project sometimes called the time-adjusted rate of return
Objective of IRR
focuses decision on the discount rate in which the PC of cash inflows = the PV of cash outflows
Accept or decline when (IRR > or < hurdle rate)
accept = profit = IRR > hurdle rate = PI > 1
decline = loss = IRR < hurdle rate = PI < 1
Limitation of IRR
CF are assumed to be reinvested at the IRR
IRR is less reliable where there are several alternating periods of net cash inflows and net cash outflows
Does not tell you $ added like NPV
Payback method
the time required for the net after-tax cash inflows to recover the initial investment period
if it takes longer to get your return back, the risk is increased as it may not ever happen
Payback method calculation
= initial outflow / increase in annual net after tax CF
assuming uniform cash flows, but you can do it without uniform CF if you use the cumulative approach
Discounted payback method
computes payback period using expected CF that are discounted (also referred to breakeven time method [BET]
Operating leverage
degree to which a company uses fixed operating costs rather than variable operating costs
capital intensive operations = high leverage
labor intensive operations = low leverage
Degree of Operating Leverage calculation
= (change in EBIT) / (change in sales)
21% change in EBIT and 5% change in sales = DOL = 4.2
= (change in sales) / (change in operating income)
What does a high degree of operating leverage mean?
They must produce sufficient revenue to cover its high fixed-operating costs, they would also have greater risk but higher potential returns
Degree of Financial Leverage
degree to which a company uses debt rather than equity to finance the company
Degree of Financial Leverage calculation
= (change in EPS) / (change in EBIT)
42% increase in EPS as a result of 21% increase in EBIT = DFL of 2
= Assets / Equity
= (change in EBIT) x (Assets/Equity) = Change in EPS
Degree of total leverage
DOL x DFL, or;
(change in EPS) / (change in sales) = DTL
Weighted average cost of capital
major link between the long-term investment decisions associated with a corporation's capital structure and the wealth of a corporation's owners
* often used internally as a hurdle rate for capital investment decisions. Theoretical optimal capital structure is the mix of financing instruments that produce the lowest WACC
(free cash flow of firm) / WACC = firm value
** lower WACC = higher firm value
WACC calculation
= (cost of equity x % equity in capital structure) + (weighted average cost of debt[after tax] x % of debt in cap. structure)
example of WACC calculation
cost of equity = 17.8%; cost of debt (b4 tax) = 10%
tax rate = 30%; 75% equity 25% debt
(17.8 x 75) + (7 x 25) = %15.1
Calculating after-tax cash flows
= YTM x (1- tax rate)
Components of "cost of capital"
weighted average interest rate = (effective annual interest payments) / debt cash available
after-tax cost of debt
= pretax cost of debt x (1 - tax rate)
Cost of preferred stock
= preferred stock dividends / net proceeds
Net proceeds of preferred stock = SP x Float costs
WACC = 10%; float cost of pref stock = $5; par value = $100
10 / (100 - 5) = .10526
Cost of retained earnings
rate of return required by the firms common stockholders
Common methods of computing cost of retained earnings
Capital asset pricing model (CAPM), discounted cash flow (DCF), and bond yield plus risk premium (BYRP)
Capital asset pricing model (CAPM)
= riskfree rate + risk premium
= riskfree rate + (beta x market risk premium)
= riskfree rate + (beta x (market return - riskfree rate))
Beta = volatility (risk) of the stock relative to the market
Risk premium = nondiversiable risks associated with the overall stock market
DCF to calculate cost of retained earnings
= (dividends (future year) / current mkt price) x G
G = constant growth in dividends
Future year dividends = CY dividends x (1 + G)
Bond yield plus risk premium (BYRP) to calulate cost of RE
= pretax cost of longterm debt + market risk premium
Are you able to average the three cost of retained earnings models?
Yes, if there is sufficient consistency between the three methods
Return on investment
- ideal performance measure for investment in SBU's
= income / invested capital, or;
= profit margin x investment tunover
Profit margin and investment turnover calculations
PM = net income / sales
IT = sales / invested capital
Return on assets
= net income / average total assets
Net book value
historical cost - depreciation
(generally lowest)
Gross book value
historical cost prior to reduction for accum. depreciation
Replacement cost
FMV (cost to replace assets at their current level of utility)
Liquidation value
the selling price of productive assets
Limitations of ROI
- residual income may be superior
- short term focus by management
- investment myopia (overemphasis on investment balances)
- disincentive to invest
Return on equity
ROE = net income / total equity
goal for ROE > CAPM
Dupont ROE
= net profit margin x asset turnover x financial leverage
NPM = net income / sales
AT = sales / average total assets
FL = average total assets / equity
Extended Dupont ROE calculation
= tax burden x interest burden x operating income margin x asset turnover x financial leverage
TB = net income / pretax income
IB = pretax income / EBIT
OI Margin = EBIT / sales
AT = sales / average total assets
FL = average total assets / equity
Asset turnover
efficiency in which a company is using its assets
Tax burden
extent to which a company retains profits after paying taxes
Interest burden
how much pretax income a company retains after paying interest
Residual income
= net income (from the income statement) - required return in $ on equity
required return = NBV (equity) x hurdle rate
Benefits of residual income method
Realistic target rates in $, focus on target return and amount in $
Economic value is added ("is WACC")
= NOPAT - $$WACC
NOPAT = profit before interest but after tax
$$WACC = investment x WACC = required return in $
Positive EVA vs. Negative EVA
positive EVA = meeting standards = stock price increase
negative EVA = not meeting standards = stock decrease
Debt-to-Capital ratio
= total debt / total capital = debt (D + E)
* measure of financial leverage - risk
** lower the ratio, the greater level of solvency and the greater presumed ability to pay debts
Debt-to-Assets ratio
= total debt / total assets
* the lower the ratio, the lower the protection afforded to creditors
Debt-to-Equity ratio
= total debt / total shareholders equity
* the lower the ratio, the lower the risk involved
Times-interest earned ratio
= EBIT / interest expense
* as interest decreases, debt levels decrease, which means higher equity, which means a lower ROE
Working Capital
= current assets - current liabilities
* adequate working capital reserves mitigate risk, potentially reduce returns, and increase profitability
Aggressive vs. Conservative WC management
Aggressive - increase ratio of current liabilities to noncurrent liabilities (WC down, current ratio down, risk up)
Conservative - increase the ratio of current assets to noncurrent assets (WC up, current ratio up, risk down)
Current ratio
Best single indicator of a company's ability to meet short-term obligations, but not for the overall health of the business
Deteriorating current ratio (WC down, risk up)
Improving current ratio (WC up, risk down)
Quick (Acid Test) Ratio
= cash + marketable securities + receivables / current liabilities
* inventories and prepaid are left out from CA
** higher the better
Less WC increases or decreases risk?
Decreases by exposing a company to the likelihood of a possible failure to meet current obligations ad may reduce a firms ability to obtain additional financing
Management of cash
too little cash - higher risk
too much cash - lower ROA
Motives for holding cash
Transaction motive - hold cash to meet payments
Speculative motive - may need to take advantage of temporary opportunities
Precautionary motive - safety cushion
Ways to increase cash levels
The objective of financial managers is to shorten the operating cycle
Speeding collections (customer screening and credit policy, prompt billing, payment discounts), expedite deposits, concentration banking, factoring AR
Annual cost (APR)
= (360 / pay period - discount period) x (discount / 100 - discount %)
Methods to delay disbursements
defer payments (take advantage of grace period for more interest), draft (pay by check hoping they'll take longer to cash it), line of credit, or zero-balance accounts
Managing float
- difference between the balance in a company's cash account and the balance of the banks records
Cash Conversion cycle
* length of time from the date of initial expenditure to the date cash is collected
= (# of days to sell) + (# of days to collect) - payables deferred period
LOWER THE BETTER
Inventory turnover
= COGS / average inventory
conversion period = 365 / inventory turnover
Receivables collection period
AR turnover = sales / average AR
collection period = 365 / AR turnover
Payables deferral period
= COGS / average AP
deferral period = 365 / AP turnover
Management of inventories
too low = lost sale = cost
too high = carrying costs = lost profit
*depends on the accuracy of sales forecasts
Reorder point
= safety stock + (lead time x sales during lead time)
Economic order quantity
tradeoff between carry costs and ordering costs
"2SOC"
E = order size
S = annual sales (in units)
O = cost per order
C = carrying cost per unit
Management of Marketable securities (if highly liquid)
Least Risk
- T-bills
- CD's
- Bank acceptances (short-term IOU's guaranteed)
- Commercial paper (notes/drafts)
- Equity securities of public companies (risk due to volatile)
- Eurodollar (US $ in foreign banks)
Most Risk
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