BEC 3 - Financial Management & Capital Budgeting Flashcards

Question

_Managing Short-Term Debt Ratios_ Annual Financing Cost (AFC) vs. Cost of the Loan (Comp Balances) TESTED

Answer 1

Businesses may obtain short-term financing by purchasing goods on *Trade Credit.* To calculate the cost of ***NOT*** ***taking the discount***: (Annual Financing Costs) **AFC** = (%Discount / 100%-Discount%) x (360 / Total Pay Period-Discount Period) **Compensating Balances** - Demand deposit balances (set as a percentage of loans) that lenders may require as a condition for receiving loans. Having to maintain compensating balances in theory increases the effective interest paid on the loan. **Cost of Loan** = Interest Paid / Net Funds Available\* \*Net Funds = Principal - Compensating Balance

Answer 2

**Advantages:** * Flexibility of dividend payments are not fixed like interest * More equity means less risk to lenders which reduces borrowing costs * C/S are attractive to investors **Disadvantages:** * Cost of issuing C/S is more expensive than debt * New stock issuance can dilute ownership * Common dividends are not tax deductible * Higher cost of capital

Answer 3

Preferred Stock holders must be paid a preset dividend before any dividends may be paid to common stockholders. Some possible features of preferred stock: * Cumulative Dividends - accumulates * Callability * Convertibility * Redeemability - stockholders may demand repayment of face value at specific date * Participation - preferred stock holders recieve higher dividends when common dividends are increased * Floating Rate - dividends vary depending on interest or inflation index

Answer 4

Advantages: * Flexibility to skip preferred dividends * More equity equals less risk to lenders equals less borrowing costs * Doesn't affect common holder's control * Positive company earnings means preferred holders profit more Disadvantages: * Cost of issuance is higher * Preferred dividends are not taxable * Difficult to pay dividends in arrears

Answer 5

**DOL** - measures how the size of a business's *fixed costs* affects its performance when revenues change. **DOL = % Change in EBIT\* / % Change in Sales Vol** \*EBIT - Earning before income taxes

Answer 6

DFL - measures how much a business relies on *debt financing.* **DFL = % Change in EPS / % Change in EBIT**

Answer 7

**Cost of Debt** financing is **always after-tax** cost of interest payments as measured by yields to maturity. It can be calculated in two ways: * = Yield to Maturity x (1 - Effective Tax Rate) * = (Int Exp - Tax Deduction for Int) / CV of Debt

Answer 8

**Cost of Preferred** stock financing is the stipulated dividend divided by the net issue price of the stock. **Cost of Preferred = Dividend / Net Issue Price\*** **\***Net Issue Price = Issuance Price less Issuance Costs \*Dividend - Based on % times the par value of P/S

Answer 9

Cost of Existing C/S financing represents the expected rate of returns common shareholders, and is difficult to estimate. Some techniques are: 1. **Capital Asset Pricing Model (CAPM)** 2. Arbitrage Pricing Model 3. Bond Yield Plus 4. **Dividend Yield Plus Growth Rate**

Answer 10

**CAPM** - assumes that the expected return of a particular stock depends on its volatility relative to the overall stock market (beta). **CAPM = Risk Free Rate + [(expected mkt - risk free rate) x Beta]** **_NOTE_**: The **Beta** coefficient of an individual stock is the correlation between changes in the stock's price & changes in the price of the overall market. If for example, the market goes up 5% & the individual stock's price goes up 10%, the stock's beta coefficient is 2.0.

Answer 11

**Dividend Yield Plus Growth Rate** - adds the current divident (as a percentage of stock price) & the expected growth rate in earnings. **DYP = (Net Expected Dividend / Current Stock Price) + Expected Growth in Earnings**

Answer 12

**Cost New Common Stock** is a little higher than that of existing stock, since the business must recover the cost of issuing the new shares. + (Next Expected Div / [Current Stock Price - Floatation Cost]) + Expected Growth in Earnings **= Cost of New C/S**

Answer 13

**WACC** - An entity's effective cost of capital based on the returns paid to creditors, preferred stockholders, & common stockholders, weighted by the portion of financing each component. * A *low* total *WACC* tends to *reduce risk* as an investment would require a lower return to equal or exceed the WACC. * A company with a *high WACC* indicates *higher* *risk*; therefore it won’t be as attractive to potential shareholders. * A *decrease* to *WACC* will *increase* the *value* of a company, not an increase. * WACC includes the borrowing rate and the cost of equity. * _Optimal Capitalization = Lowest WACC_

Answer 14

**_For example_:** If 40% of capital was obtained through a LT debt at an effective cost of 6%, then 10% of capital was obtained by issuing preferred stock with an effective cost of 8%, and 50% of capital was obtained by issuing common stock expected to return 11% to shareholders, the WACC is: = (40% x 6%) + (10% x 8%) + (50% x 11%) = 2.4% + 0.8% + 5.5% = 8.7%

Answer 15

**Horizontal Merger** - involves a business that are in the *same* market (competitors). **Vertical Mergers** - involves businesses aquiring others in the *same supply chain.* **Conglomerate Mergers** - involves businesses acquiring others in *unrelated* markets.

Answer 16

Gross Margin = Gross Profit / Net Sales Operating Profit Margin = Operating Profit / Net Sales Free Cash Flow = NOPAT+Depr+Amort - Capital Expenditures - Net increase in working capital Residual Income = Operating Profit - Interest on Investment Economic Value Added = NOPAT - Cost of financing Cost of Financing = (total asset - current liabilities) x WACC Economic Rt of Rtrn on CS = (Divs + Change in Price) / Beg Price Return on Investment = Net income / Total Assets Invested Return on equity = Net Income / Avg common stock equity Investment Turnover = Sales / Average Investment

Answer 17

You answered correctly Correct! The profitability index divides net present value of an investment by the initial net investment and can be used to compare the relative profitability of investments. When resources are scarce, those with the highest profitability index will be selected since they represent the highest rate of return relative to the amount invested. Although the net present value method allows a comparison of which investments are most profitable, in terms of the present value of dollars, it does not take into account that a slightly larger net present value may require a substantially greater initial investment, an important factor when resources are scarce. Although both the internal rate of return approach and the return on investment approach allow for the determination of which investments will provide the highest return, neither takes into account the size of investment that may be required to earn the higher investment.

Answer 18

You answered correctly Correct! Present value calculations are based on cash flows. In most situations, this will consist of net income from the investment plus depreciation or revenues less expenses, excluding depreciation, and income tax.

BEC 3 - Financial Management & Capital Budgeting Flashcards

(42 cards)