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Business Exam > Chapter 3 > Flashcards

Chapter 3 Flashcards

1
Q

Define Sunk costs

A

Sunk costs are those costs that have already been incurred, are unavoidable in the future, and will not vary with the course of action taken

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2
Q

What is the formula for after-tax cash flow

A

(1.0 - tax rate) x Pretax cash flows = after-tax cash flow

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3
Q

The formula for computing a depreciation tax shield is:

A

Tax rate x depreciation deduction = tax savings from the depreciation tax shield

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4
Q

What are the 3 general stages in which capital investment cash flows are categorized?

A
  1. Cash flows at the inception of the project
  2. Operating cash flows
  3. Cash flows from the disposal of the project
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5
Q

What approaches can management take to select the desired rate of return for a project?

A
  1. Use a weighted average cost of capital (WACC) method
  2. Assign a target rate for new projects
  3. Recommend that the discount rate be related to the risk of the project
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6
Q

Define net present value (NPV)

A

NPV is the difference between the present value of the cash inflows and outflows from a project

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7
Q

How are investment decisions made using the NPV method?

A

If NPV is positive, then the investment should be made

If NPV is negative, then the investment should not be made

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8
Q

What is the profitability index?

A

The ratio of the present value of net future cash inflows to the present value of the net initial investment

The higher the profitability index, the more desirable the project

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9
Q

Define internal rate of return (IRR)

A

The IRR is the discount rate at which the present value of the cash inflows equals the present value of the cash outflows from an investment or project

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10
Q

How are investment decisions made using the IRR?

A

An investment should be made when the IRR exceeds the hurdle rate

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11
Q

What is the payback method formula?

A

Net initial investment / Increase in annual net after-tax cash flow = Payback period

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12
Q

What is the equation to calculate the present value of $1?

A

PV = FV / (1 - r)nth power
Where:

PV = present value

FV = future value

r = interest rate

n = number of years

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13
Q

What is the equation to calculate the present value of an annuity?

A

(*Review formula on card 3-13)

Where:

PV = present value

FV = future value

r = interest rate

n = number of years

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14
Q

Define operating leverage

A

Operating leverage is defined as the degree to which a firm uses fixed operating costs, as opposed to variable operating costs

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15
Q

Define financial leverage

A

Financial leverage is defined as the degree to which a firm’s use of debt to finance the firm magnifies the effects of a given percentage change in EBIT on the percentage change in EPS

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16
Q

Define weighted average cost of capital (WACC)

A

The weighted average cost of capital is the average cost of debt and equity financing associated with the firm’s existing assets and operations

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17
Q

What is the after-tax cost of debt formula (kdx)?

A

kdx = Pretax cost of debt x (1 - tax rate)

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18
Q

What is the cost of preferred stock formula (kps)?

A

kps = Dps /Nps

Where:

Dps = Preferred stock cash dividends

Nps = Net proceeds of preferred stock

19
Q

What is the cost of retained earnings (kre) using the CAPM formula?

A

(*Review formula on card 3-19)

Where:

krf = Risk-free rate

bi = Beta coefficient of the stock

PMR = Market risk premium

km = Market rate

20
Q

What is the cost of retained earnings (kre) using discounted cash flow (DCF)?

A

kre = [D(sub1) / P(sub1)] + g

D(sub1) = Dividend per share expected at the end of one year

P(sub1) = Current market value or price of outstanding common stock

g = Constant growth rate of dividends

21
Q

What is the cost of retained earnings (kre) under bond yield plus risk premium (BYRP)?

A

kre = kdt + PMR

Where:

kdt = pretax cost of debt

PMR = Market risk premium

22
Q

Define the weighted average cost of capital by formula

A

This is the terminology used in the cost of capital and is part of the WACC formula:

wdx = (weighted for) long-term debt

wps = (weighted for) preferred stock

wcs = (weighted for) common stock equity

kws = weighted average cost of capital

“k” stands for the specific COST of each type of capital, and “w” stands for the WEIGHT of each.

So, WACC would be:

kwc = (kdx x wdx) + (kps x wps) + (kre x wcs)

23
Q

Define return on investment (ROI)

A

Return on investment is used to assess the percentage return relative to capital investment risk

ROI can be calculated as income divided by invested capital or as a product of profit margin (income/sales) and investment turnover (sales/assets)

24
Q

What are the limitations of ROI?

A
  1. Short-term focus

2. Disincentive to invest

25
Q

Define return on equity (ROE)

A

ROE is a measure of the rate of return earned by a company on the equity component of its capital structure

It shows how well a company is using its funds to generate earnings

26
Q

What is the equation for the DuPont ROE?

A

DuPont ROE = Net profit margin x asset turnover x financial leverage

where:

Net profit margin = net income/sales

Asset turnover = sales/average total assets

Financial leverage = average total assets/equity

27
Q

What is the equation for the extended DuPont ROE?

A

Extended DuPont ROE = tax burden x interest burden x operating income margin x asset turnover x financial leverage

where:

Tax burden = net income/pretax income

Interest burden = pretax income/EBIT

Operating income margin = EBIT/sales

Asset turnover = sales/average total assets

Financial leverage = average total assets/equity

28
Q

Define residual income

A

The residual income method measures the excess of actual income earned by an investment over the hurdle rate

29
Q

What is the formula for residual income?

A

Residual income = Net income - Required return

Where the required return is equal to :

Net book value x hurdle rate = required return

If the amount of the income from the investment exceeds the computed required return, performance objectives have been met

30
Q

Define economic value added (EVA)

How does EVA differ from residual income?

A

EVA measures the excess of income after taxes earned by an investment over the rate of return defined by the company’s WACC

EVA differs from residual income in the following ways:

  1. WACC must be used to calculate EVA
  2. The income and investment numbers used to calculate EVA are generally adjusted to produce a more accurate analysis of economic profit
31
Q

Define the steps and formula for economic value added

A

Step 1: Calculate the required amount of return and income after taxes
Investment x cost of capital = required return

Step 2: Compare income to the required return
Income after taxes - required return = economic value added

32
Q

What is the formula for working capital?

A

Current assets - current liabilities = working capital

33
Q

What are three common motivations for holding cash?

A
  1. TRANSACTION MOTIVE: a transaction motive for holding cash concerns having enough cash to meet payments arising from the ordinary course of business
  2. SPECULATIVE MOTIVE: a speculative motive for holding cash concerns having enough cash to take advantage of temporary opportunities
  3. PRECAUTIONARY MOTIVE: a precautionary motive for holding cash concerns having enough cash to maintain a safety cushion so that unexpected needs may be met
34
Q

What methods can be used to speed collections?

A
  1. Customer screening
  2. Prompt billing
  3. Payment discounts
  4. Expedite deposits
  5. Concentration banking
  6. Factoring accounts receivable
35
Q

What methods can be used to delay disbursements?

A
  1. Defer payments
  2. Drafts
  3. Line of credit
  4. Zero-balance accounts
36
Q

What is the formula for computing the annual percentage rate for quick payment discounts?

A

(360 / pay period - discount period) x

discount percentage / 100% - discount percentage

37
Q

What is the cash conversion cycle formula?

A

Cash conversion cycle = inventory conversion period + receivables collection period - payables deferral period

38
Q

How is the inventory conversion period calculated?

A

Inventory turnover = (Cost of goods sold) / (average inventory)

Inventory conversion period = (365) / (inventory turnover)

39
Q

How is the receivables collection period calculated?

A

AR turnover = (Sales) / (Average AR)

Receivables collection period = (365) / (AR turnover)

40
Q

How is the payables deferral period calculated?

A

AP turnover = Cost of goods sold / average AP

Payables deferral period = 365 / AP turnover

41
Q

Explain factoring as a mechanism for speeding cash collections

A

Factoring involves the sale of accounts receivable to another party (a factor) in exchange for cash

The selling company will receive an upfront cash advance of X% of their receivables and will be charged both a fee on all receivables purchased and an interest rate on the upfront advance (while saving on collection related expenses)

The factor will collect the fees and interest, while assuming the responsibility of collecting on the receivables owed by the customers of the selling company

42
Q

What is the equation to calculate the reorder point for inventory?

A

Reorder point = safety stock + (lead time x sales during lead time)

43
Q

What is the equation for economic order quantity (EOQ)?

A

E = (Square root of) 2SO/C

Where:

E= order size

S= sales in units

O= cost per purchase order

C= carrying cost per unit

Business Exam (6 decks)

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