Capital Budgeting Decisions

Question 1

What is the tricky part when solving for the present value of a cash flow on a potential capital project?

Answer 1

You do not ever discount the cash flows with the same PVIF and you do discount these flows as an annuity. Just because the future cash flows are equal does not mean they discount to the PV at the same rate. Have to discount each cash flow according to the PVIF for each period it covers.

The discounted Payback Period gives you the clue on which period’s PVIF to use. (not annuity!)

Rule of Thumb - Do not discount with PVIFA ever!

Question 2

Residual Income

Answer 2

Operating Income
(ROI based on minimum required ROR)*

= Residual Income

*represents imputed interest

Residual is the income after deducting imputed interest from operating income

Question 3

Internal Rate of Return (IRR)

Answer 3

Focuses on profitability

Makes the NPV of all the cash flows $0

Reject projects whose returns are less than the IRR

Question 4

Discounted Payback

Answer 4

Focuses only on LIQUIDITY
Considers TVM
Still disregards cash flows past payback period

PV of Annual Cash Flow / Initial Investment Outlays = # of periods

Length of time to recover investment

Question 5

Payback

Answer 5

Focuses only on LIQUIDITY
No TMV considered
No profitability considered b/c ignores remainder of cash flows past payback period

Annual Cash Flow / Initial Investment Outlays = PB Period

Length of time to recover investment

Question 6

Profitability Index

Answer 6

PV of Cash Flows AFTER initial Investment / Initial Outlays = Profitability Index

• Considers TVM and salvage value
• Best for scenarios where capital will need to be rationed among multiple projects b/c you want to identify projects with the highest profitability and invest capital. You don’t want to invest in something that is not going to be profitable. – IN PLAIN ENGLISH, THIS IS THE ONLY APPROACH THAT READILY COMPARES CAPITAL PROJECTS! Does not compute a rate of return, just the level of profitability.
• Requires extensive analyses and forecasts to be useful

Question 7

Earnings Per Share (EPS)

Answer 7

NIAT / # of outstanding c/stk shares = EPS

*EBIT - I - T% = NIAT - debt financing offers interest as tax deduction

equity financing offers no tax deductions

Question 8

Computing EBIT for debt financing vs. equity financing (stock issuance)

Answer 8

Debt financing = interest is tax deductible

EBIT - I - T% = NIAT (if only Debt)

Equity financing = No tax deductions, even for preferred dividends

EBIT - T% = NIAT (if only Equity)

Question 9

What do preferred dividends, bonds, and fixed debt instruments have in common?

Answer 9

All have fixed payment streams. Treat preferred dividends like interest except it is not tax deductible.

Question 10

Capital Turnover and what do you use it with?

Answer 10

Sales / Capital Employed = Capital T.O.

Use in XXXX

Question 11

What do we need to be careful about discounting depreciation to the Present Value?

Answer 11

The tax implications. Depreciation is a tax benefit. Back in the income tax rate then discount it.

Ex - Bought a capital asset of $1.2M that is approved for MACRS depreciation. Never use salvage value for MACRS property. MACRS period is 4 years. Income tax rate is 40%. What’s the present value of MACRS depreciation in Year 4?

Ans:

Cost of the Asset x MACRS % for Year 4 x TAX % x PVIF for year 4 = the answer

Note we add back in tax because that is the savings back to the investor.

Question 12

What do IRR and NPV have in common and what is the difference between them?

Answer 12

IRR and NPV are both discounting methods. They use the TVM.

IRR is different from NPV because IRR focuses on finding the DISCOUNT RATE while NPV already has the discount rate. IRR focuses on finding the discount rate that would get the NPV of future cash flows discounted to $0. We compare the IRR to the minimum required ROR on whether to accept or reject (accept only if IRR exceeds required ROR). NPV has nothing to do with finding the discount rate!

Question 13

How do you find the cash flow based on the IRR?

Answer 13

Initial Investment = (Average Annual Cash Flow) x PVIFA

IRR (the discount rate, aka target rate)

Ex: $100,000 invested in asset for 5 years, 24% after-tax target rate, PV table provided. What’s the cash flow where the investor will be indifferent?

Solution - you know that the IRR is the rate that will discount the PV of average cash flows to $0.

PVIFA is n = 5, i at 24% => 2.7454

$100,000 = 2.7454x

X being the cash flow in question —> solve for X

x = $36,425 is the cash flow that the investor will be indifferent b/c NPV will be discounted to $0

Question 14

Financial Leverage

Answer 14

% Change in Net Income
DFL = ——————————–
% Change in Net Operating Income

aka

EBIT -------------------- EBIT - Interest  (amount of income available to commonSHE)

Represents the return available to companies when they finance their asset purchases with debt. The higher DFL, the better.

The higher the ratio (means EBIT increases or Interest is reduced), the more money the company has available AFTER financing asset purchases

Question 15

Net Present Value method

Answer 15

*Computes the Rate of Return by discounting the average future cash flows to PV LESS Initial Investment.

NPV = Initial investment - PV of cash flows

Note the future cash flows are also netted (outflows - inflows) to arrive at net cash flows then discount to the present

Accept if NPV is $0 or higher. Never, ever accept a negative NPV because it means LOSS.

Question 16

Quick ratio

Answer 16

(Cash + MES + A/R*) / CL = Quick Ratio

*think: “cashmere”

Question 17

Operating Leverage

Answer 17

Represents how SENSITIVE the company’s profits are to changes in sales volume.

% change in Net Operating Income*
————————————————— = DOL
% change in Sales

aka

 CM ------------ CM - FC

*Net Operating Income is EBIT – Earnings BEFORE interest & tax b/c we are only focusing on income generated by the company’s operations. Income is financing item, not operational.

DOL zeros in on company’s amount of FIXED COST because the more fixed cost, the lower its EBIT will be. The firm will have a HIGH operating leverage and will suffer MORE severe reductions in earnings (EBIT) when sales drop compared to firms having lower fixed costs. (Opposite of DFL b/c high DOL is bad news b/c means too much of the operations is leveraged with fix costs than variable costs.)

Remember that variable costs are controllable costs. The more VC than FC, the more the firm can control and have a lower leverage.

Think of FC as holding the company’s EBIT as hostage and more so when sales start declining. The fewer sales, the less earnings to offset FC. When the firm’s operations can’t cover its FC, it will shutdown.

Question 18

Depository Transfer Checks (DTCs) - Official Bank Checks

Answer 18

A way for moving funds from one account to another account WITHIN the banking system.

It is payable to a specific account in a specific bank.

The payer issues the check and it is sent to a Concentration Bank, which serves as clearinghouse within the banking system (usually the lockbox is at the concentration bank to speed up collection).

Concentration Bank clears the check and sends it to the central bank.

Payer’s bank is notified of the clearance and deducts the funds from the payer’s account.

Float occurs during the clearing process.

Question 19

Difference between Temporary Current Assets and Permanent Current Assets

Answer 19

Temporary current assets

• fluctuate with the business cycle as sales vary with corresponding changes in A/R and inventory between maximum and minimum levels of the business cycle
• represents sudden increase/decrease in A/R and inventory due to sudden increase/decrease in sales (fluctuating asset)

Think: Temporary Current Assets = Seasonal

Permanent current assets

- the minimum amount of current assets needed, even though they are replaced within a year    (ex) Inventory, A/R, cash, and depreciating assets

-more permanent b/c they are still retained by the co

Question 20

Rule of Thumb for Financing Current Assets and Risks to Beware of?

Answer 20

Rule of thumb is the Maturing Matching Approach

• use SHORT-term financing for TEMPORARY asset needs
• use LONG-term financing for PERMANENT asset needs

Rule of thumb helps to minimize default risk

Aggressive approach - using short-term financing to cover temporary current assets AND some permanent current assets.

 - Highest profitability because short turnaround time on eating the interest cost
 - Carries the most risk of default because:

   1) there might not be enough time for the permanent current assets to start paying for itself in order to pay off the short term loan.  
    2) Can get into more trouble if the interest rate jump and the perm assets' cash flows are not enough to repay the increased interest cost.
   3) The lender can opt to not renew or extend anymore loans when the company realizes that it needs more financing

Conservative approach - Vice versa of the aggressive approach, meaning use long-term financing to pay for permanent current assets AND some temporary current assets.
-Lowers the risk, but hurts profitability b/c have to eat the interest cost for a much longer period of time.

Example of short-term financing: spontaneous credit through trade credit on A/P

Great example: “If a new factory is financed with short-term funds, it is unlikely that the new facility would have been built and produced a large enough cash flow at the end of one year in order to repay the loan at maturity. In this scenario, if the lender refused to renew the loan, the company would be in a difficult position. If the new facility had been financed with long-term debt, the cash flows provided by the new operation would have more closely matched the repayment cash outflows, and the need for refinancing is less likely to arise.” - NINJA

Question 21

of Days of Cash Cycle

Answer 21

Avg # of Days in Inventory + Avg # of Days in A/R - # of Days in A/P = # of Days in Cash Cycle

Inventory and A/R are cash INflows b/c cash is still tied up

A/P are cash OUTflows b/c cash is used to pay off the payable

Question 22

Payback method for IRR computation

Answer 22

Initial Investment / Annual Savings (or Outflows) = Payback Period

*Payback periods gives fair approximation of the annuity factor value to use in PVIFA in order to start figuring out the discount rate that is the Internal Rate of Return (IRR)

Question 23

Objectives of Cash Management

Answer 23

Objective is to find the optimum level of cash by considering:

• Having enough cash on hand to cover disbursements
• Minimizing idle cash by investing to maximize WEALTH for shareholders (making money with money)
• timing of cash flows as determined by the cash budget

NOTE - Management is NOT concerned about maximizing cash balances b/c it is can still become idle cash (opportunity cost!!!)

Question 24

SWOT Analysis

Answer 24

Used in strategic planning. Helps the organization to develop a plan for achieving its goals by tailoring its strategic plan to the company’s unique attributes. Unique attributes can be internal and external as follow:

S = Strengths - resources and capabilities that enable us to have a competitive edge over other companies

W = Weakness - lack of resources and capabilities, which give other companies a competitive advantage over our company

SW = internal factors

O = Opportunities - chances to maximize profits in the marketplace. Have to look at our environment to see what prospects we can pursue.

T = Threats - represent dangers that impede our ability to achieve our goals

OT = external factors

Question 25

IRS-approved methods for setting transfer prices following “arms-length” rule

Answer 25

Comparable uncontrolled price
Resale
Cost-Plus

Question 26

Inflation vs. Deflation

Answer 26

Inflation = general increase in prices and interest rates

Deflation = general decline in prices and interest rates

Question 27

Recession

Answer 27

Real GDP is declining (output falls)

Companies start to sell off inventory and cut labor hours

Question 28

Expansion

Answer 28

Real GDP is climbing (output rises)

Companies start to re-build inventory and increase labor

Question 29

Microcomputer

Answer 29

Also known as a Personal Computer (PC) and is used in End User Computing (EUC)

Has limited capabilities.

Major disadvantage is it is easy for anyone to access the files and alter them. Plus, it is harder to detect whether these files were altered. With paper, it is easy to see if someone erased a number or marked up a number using a different color pen. On a microcomputer, you have no way of figuring that out.

Question 30

Hedging a foreign exchange risk

Answer 30

It is to insulate the firm from exposure to fluctuations in exchange rates by locking in the purchase price for the exchange currency.

Question 31

Order of budgeting

Answer 31

1) Sales forecast
2) Identify level of Ending Inventory
3) Production budget (always before purchases, so you’ll know how much to buy or whether you don’t need to)
4) Purchases
5) Selling, G&A
6) draft the I/S
7) draft the Cash Budget (forecast)

Note - cash budget is always LAST

Question 32

Performance measures

Answer 32

are for determining how well subunits and managers are meeting the organization’s goals. (This is a broad term)

Question 33

Safety Stock formula and Reorder Formula

Answer 33

(Delete the other $hit) This is the right way to do it:

(Max LT Days - AVERAGE LT Days) x Daily Use = SS

*Daily use = Total units / # of days in the year

RP = (AVERAGE Lead Time x Daily Use)* + SS

*want to convert Lead Time into Lead Time UNITS

Question 34

Forward Contract

Answer 34

An arrangement between two parties to exchange currencies at a specified exchange rate at a later date

Question 35

What ways does the Federal Reserve Bank control the money supply (M1)?

Answer 35

• selling/buying government securities
• changing the reserve ratio
• changing the discount rate