BEC 3 Flashcards
(40 cards)
Define sunk costs.
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.
What is the formula for after-tax cash flow?
(1 - tax rate) x Pre-tax Cash Flows = After-tax Cash Flow
The formula for computing a depreciation tax shield is:
Tax rate x Depreciation deduction = Tax savings from the depreciation tax shield
What are the three general stages in which capital investment cash flows are categorized?
- Cash flows at the inception of the project
- Operating cash flows
- Cash flows from the disposal of the project
What approaches can management take to select the desired rate of return for a project?
- Use a weighted-average cost of capital (WACC) method
- Assign a target rate for new projects
- Recommend that the discount rate be related to the risk of the project.
Define net present value (NPV).
NPV is the difference between the present value of the cash inflows and outflows from a project.
How are investment decisions made using the NPV method?
If NPV is positive, then the investment should be made. If NPV is negative, then the investment should not be made.
What is the profitability index?
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.
Define internal rate of return (IRR).
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.
How are investment decisions made using IRR?
An investment should be made when the IRR exceeds the hurdle rate.
What is the payback method formula?
Net initial investment / Increase in annual net after-tax cash flow = Payback period
Define operating leverage.
Operating leverage is defined as the degree to which a firm uses fixed operating costs, as opposed to variable operating costs.
What is the degree of operating leverage formula?
DOL = % Change in EBIT / % Change in Sales
Define financial leverage.
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.
What is the degree of financial leverage formula?
DFL = % Change in EPS / % Change in EBIT
What is the degree of combined leverage formula?
DCL = % Change in EPS / % Change in Sales
Define weighted-average cost of capital (WACC).
The weighted-average cost of capital is the average cost of debt and equity financing associated with the firm’s existing assets and operations.
What is the after-tax cost of debt formula (kdx)?
kdx = pre-tax cost of debt x (1 - tax rate)
What is the cost of preferred stock formula (kps)?
kps = Dps / Nps Dps = Preferred stock cash dividends Nps = Net proceeds of preferred stock
What is the cost of retained earnings (kre) using the CAPM formula?
kre = Risk free rate + [beta x (market rate - risk free rate)]
What is the cost of retained earnings (kre) using discounted cash flow (DCF)?
kre = (D1 / P0) + g D1 = Dividend per share expected at the end of one year P0 = Current market value or price of outstanding common stock g = Constant growth rate of dividends
What is the cost of retained earnings (kre) under bond yield plus risk premium (BYRP)?
kre = kdt + PMR kdt = pre-tax cost of debt PMR = market risk premium
Define the weighted-average cost of capital by formula.
The is the terminology used in the cost of capital and is part of the WACC formula:
-wdx = (weight for) long-term debt
-wps = (weight for) preferred stock
-wcs = (weight for) common stock equity
-kwc = 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)
Define return on investment (ROI).
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).
