A cost that has been incurred in the past, cannot be changed by current decisions, and is irrelevant to making current and future replacement decisions.
SUNK cost (i.e. original cost of machine and related accumulated depreciation)
Another way to say Cost of Capital
Rate of Return, companies will always seek to minimize the required rate of return (cost of capital) needed to attract shareholder investment in the corporation.
Opportunity Cost Defined
Opportunity cost is the discounted dollar value of benefits lost from an opportunity as a result of choosing another opportunity.
Remember that the gain on sale of the old item will be rolled into the disposal cost and is a SUNK cost.
Incremental Cost Defined
Incremental costs are those that are different between two or more alternatives under consideration. Remember that fixed costs are present regardless of which option is chosen and should not be considered when calculating incremental/differential cost.
Definition of Ordinary Annuity and Ordinary Annuity Due
OA = equal payments made at the end of each period.
OAD = equal payments made at the beginning of each period.
Present Value vs. Future Value
For present value, the higher the interest or discount rate, the lower the present value of a future amount. Since the higher the interest or discount rate, the more that is counted as interest, the less there is in present value.
For future value, the higher the interest rate, the greater the future value of a present amount. Since future value is computed as principal plus compounded interest, the higher the interest rate, the greater the amount of interest earned each period and, therefore, the greater the accumulated future amount.
Stated Interest Rate (nominal rate) and Real Interest Rate
What is difference between Real Interest Rate and Real Risk Free Interest Rate?
The stated interest rate (also called the nominal or quoted interest rate) is the annual rate specified in the loan agreement or comparable contract; it does not take into account the compounding effects of frequency of payments or the effects of inflation.
Real interest rate—as contrasted with nominal interest rate, refers to the rate of interest after taking into account the effects of inflation on the value of funds received. The calculation of the real interest rate (RIR) is: RIR = Nominal int. rate - inflation rate
The Real Risk Free Rate is the basic component of interest or another way of saying nominal.
Simple Interest and Compound Interest
Original principal only; no compounding in the interest computation.
Compound interest provides that interest be paid not only on the principal, but also on any amount of accumulated unpaid interest. Compound interest pays interest on interest; simple interest does not.
Compound Interest Formula (same as Future Value of $1 formula)
Compound interest and future value of $1.00 calculations are performed in the same manner. Both account for interest being paid on accumulated interest. For multiple period calculations either the formula above or a future value of $1.00 table can be used.
If asked to calculate the CI, formula attached with facts below.
- P = principal amount (the initial amount you borrow or deposit)
- r = annual rate of interest (as a decimal)
- t = number of years the amount is deposited or borrowed for.
- A = amount of money accumulated after n years, including interest.
- n = number of times the interest is compounded per year
Effective Interest Rate
The effective interest rate is determined as the full cost of a loan divided by the net cash proceeds.
Remember in calculating the proceeds, take into account the discount if any, compensating balances, origination fees etc.
Interest Cost = P x R x T EIR = (Int. Cost / P) / T
Annual Percentage Rate (APR)
One step past EIR, The annual percentage rate of interest is the annualized rate for a loan that is for less than a full year. NO COMPOUNDING
I = P x R x T (where T is length of loan, i.e. 1 quarter is 90/360)
going off example above, the APR is EIR x 4 for the full year APR.
Effective APR
The EAPR will always be higher than the APR due to compounding. The EAPR, also called the annual percentage yield, is the APR with compounding on loans that are for a fraction of a year.
As discussed under compounding, the assumption is that interest is paid on interest that would accumulate for each period during the year.
The formula for computing the effective annual percentage rate (EAPR) is: (1+I/P) P − 1
“2/10, net 30” Defined
Credit terms of “2/10, net 30” mean that the debtor may take a 2% discount from the amount owed if payment is made within 10 days of the bill, otherwise the full amount is due within 30 days.
The 2% discount is the interest rate for the period between the 10th day and the 30th day; it is not the effective annual rate of interest.
GAAP Fair value is…
Price received to SELL an asset or paid to transfer a liability. It is NOT an entry price.
U.S. GAAP Fair Value Hierarchy of Inputs
- Level 1 = highest quality inputs (unadjusted quoted prices for identical item in active market)
- Level 2 (quoted prices for similar (not identical) item in active market, quoted prices for identical item in non-active market)
- Level 3 = lowest quality (and typically not visible) inputs (entity assumptions and internal data)
Fair Value Framework approaches to developing FV
Market Approach
Income Approach (discounted cash flows)
Cost Approach (replacement cost)
Beta
Beta is the covariance of the asset’s returns with the returns of the overall portfolio. Therefore, it measures the systematic risk of the investment. Measure of volatility of an asset when compared to a benchmark for a whole class of that asset.
b = 1, asset moves in line with benchmark
b > 1, asset moves more than benchmark
CAPM Assumptions and Limitations
- Assumes there is both an asset class and benchmark for asset being valued.
- Assumes all investors have equal assets to all investments of class being valued and all use one time-period horizon.
- Assumes asset risk measured solely by variance of the asset being valued from asset class benchmark.
- Assumes no external cost or restrictions on borrowing.
- Uses historical data
kS (CAPM) = kRF + (kM − kRF)bi
CAPM is widely used, but primarily for:
- Securities Analysis
- Capital Budgeting
- Setting Fair Compensation for Regulating Monopolies
The risk-free rate of return is a measure of?
The time value of money.
The standard deviation of an investment’s expected return is?
A measure of its risk.
What type of risk does an investment with a beta of 1 have?
Average Systematic Risk
The riskier an investment, the higher the? What does the CAPM model truly measure?
Expected return
The capital asset pricing model (CAPM) measures the relationship between risk and reward.
Black Scholes Option Pricing Model
For Euro call options Stocks pay no dividends Stock prices increase in small increments RFR is assumed constant Uses probabilities Uses discounting
Binomial Option Pricing Model
Uses tree diagram to generate values at number of points between valuation date and expiration date.
True of False: Common-size analysis converts financial statements to percentages
TRUE
True or False: The asset approach to valuing a business is likely to be appropriate in valuing a failing business.
TRUE
P/E Ratio for CS
Market Price / EPS
Income Approach to Valuation of a Business
- Discounted Cash Flow
- Earnings Multiple
- Free Cash Flow
In a common-size income statement, each item is measured as?
A percentage of total revenues.
In a common-size balance sheet, each item is measured as?
A percentage of total assets (or total liabilities plus equity)
Approaches to valuing a going business
- Market
- Income
- Asset
The longer the forecasting time horizon, the more likely the forecasting will use which forecasting method?
Qualitative methods (subjective and long-range)
- Executive Opinion
- Market Research
- Delphi Method
What are the components of the Quantitative Method of business forecasting? Describe them.
- Time Series Models (assumes data patterns in the past will continue unchanged into the future)
- Causal Models (assumes the variable forecasted is related to other independent variables and makes a forecast based on those relations)
ST, Medium and LT Forecasting What Methods are best in what periods?
- ST - Time Series
- Medium - Time Series and Causal
- LT - Causal and Qualitative
Quantitative Forecasting - Causal Model Types
- Regression (linear or non-linear) i.e. trend analysis
- Input / Output Models
- Economic Models
Quantitative Forecasting - Time Series Model Types
- Naive (prior period)
- Simple Mean
- Simple Moving Average (each period weighed equally)
- Weighted Moving Average (assigns subjective weight)
- Exponential Smoothing (weighted avg. procedure)
- Trend Adjusted Exponential Smoothing
- Seasonal Indexes
- Linear Trend Line
A company invested in a new machine that will generate revenues of $35,000 annually for seven years. The company will have annual operating expenses of $7,000 on the new machine. Depreciation expense, included in the operating expenses, is $4,000 per year. The expected payback period for the new machine is 5.2 years.
- What amount did the company pay for the new machine?
Initial Investment is PP x Annual Revenue amount 5.2 x 32,000 = 166,400
Remember that depreciation is a non-cash expense and should not be included in the 7,000 opex.
Accounting Rate of Return
(Average Incremental Annual Revenue - Average Incremental Expense) / Initial (or avg.) Investment
- Ignores TVM and Cash Flow
- Depreciation (in full) explicitly considered as reduction in income
- Taxes (in full) explicitly considered as reduction in income
The hurdle rate or in other words, a firm’s discount rate is determined by what?
The firm’s WACC, the required return for investors to invest in the corporation
The calculation of depreciation is used in the determination of the net present value of an investment for what reason?
Depreciation increases cash flow by reducing income taxes.
Do not use the full depreciation amount…only the tax impact as an addition to cash flow.
A project should be accepted if the present value of cash flows from the project is?
Greater than 0.
- Investment Cost of a Project Formula
- PV Factor Formula
- Investment Cost = Annual Cash Inflow (or savings) x PV Factor
- PV Factor = Initial Cost / Annual Savings
What will increase/decrease the internal rate of return?
Remember the formula for a PV Factor:
Initial Investment in Project / Annual Savings
Anything (such as reduced tax credits on an asset) that increases the cost of the asset/project, will increase the numerator in the formula above and hence lower that internal rate of return (or the discount rate).
Which one of the following forms of short-term financing is least likely to be considered a spontaneous source of funding? Short-term notes payable Accrued taxes payable Accrued salaries payable Trade accounts payable
STNP
Spontaneous financing occurs automatically in the carrying out of day-to-day operations. Financing through the use of short-term notes payable does not occur automatically as a result of carrying out day-to-day operations, but rather requires negotiation with a lending institution, usually a commercial bank, and the execution of a promissory note.
The other forms of payable occur spontaneously as a result of normal business operations.
Inventory Secured Loan Arrangements
- Floating lien agreement – The borrower gives a lien against all of its inventory to the lender, but retains control of its inventory, which it continuously sells and replaces.
- Chattel mortgage agreement – The borrower gives a lien against specifically identified inventory and retains control of the inventory, but cannot sell it without the lender’s approval.
- Field warehouse agreement – The inventory used as collateral remains at the firm’s warehouse, placed under the control of an independent third-party and held as security.
- Terminal warehouse agreement – The inventory used as collateral is moved to a public warehouse where it is held as security.
Define the “Financial Structure” of a firm vs. the “Capital Structure” of a firm.
- Financial Structure is overarch. FS is all the debt and equity of a firm.
- Capital Structure strictly pertains to the Long-term debt and equity position of the firm.
Other names for:
- Working Capital Financing
- Capital Financing
- WCF = Short-term financing
- CF = Long-term financing
Long-term Capital Financing - When to accept a a project using a Financial Lease as opposed to one of the traditional capital budgeting analysis’s.
Project should only be accepted if the traditional capital budgeting analysis measures the project not to be economically feasible AND the leasing based analysis shows the project to be economically feasible or both are feasible but the lease provides a better “return.” Note this lease would be considered a financial lease and NOT operating.
Financial Leases -
Net Lease vs. Net-Net Lease
- NL = lessee assumes costs associated with ownership during period of lease (executory costs, maintenance, taxes, etc.)
- NNL - assumes executory costs plus a pre-established residual value.
What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?
The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt would be to reduce the risk, and therefore the interest rate, on debt being issued.
Debt covenants place contractual limitations on activities of the borrower to help protect the lender.
As such, they reduce the default risk associated with a debt issue and, therefore, reduce the interest rate on that debt.
Long-term promissory notes wherein the borrower, in return for buyers’/lenders’ funds, promises to pay the bondholders a fixed amount of interest each year and to repay the face value of the note at maturity.
Bonds -Indenture - bond contract -Par value - “principal” returned at maturity of the bond. -Coupon - annual interest rate printed on bond and paid on par value.
Security Classifications of Bonds
- Mortgage Bond - secured by pledge of specific property.
- Collaterial Trust - secured by financial assets of the firm.
- Debenture - unsecured, high risk, so firms must have excellent credit rating.
- Subordinated Debenture - bond with claims subordinated to other general creditors in event of bankruptcy.
- Income Bond - with interest payments that are contingent on firm’s earnings.
Other Types of Bonds
- Convertible
- Zero Coupon
- Floating Rate
- Convertible - holder has option to convert the bond to a specified number of stock (of issuing company)
- ZC - debt security bond that does not pay interest during it’s life. Payment made only at maturity.
- Float - pays at a rate of interest that fluctuates over the life of the bond.
How is the bond selling price determined?
The price at which a bond will sell is the present value of its future interest payments plus the present value of its face value. - Periodic Interest - discounted as PV of an annuity - Maturity Face Value = discounted as PV of a single amount.
Current Yield on Bonds Calculation
The current yield represents the interest rate of a security and is most commonly associated with bonds. The current yield is calculated by dividing the annual interest payment by the current bond price. By comparing the difference of the annual interest and current price of the bond, it gives a measurement of what the investor can expect to make in a years time. Below is the current yield formula: Current Yield = Annual Bond Coupon/Current Bond Price
For example, if a bond is priced at $110.45 and the coupon rate is $7.83, the current yield would equal 7.08%.
Bonds - Yield to Maturity Also known as the current cost of capital for the firm’s bonds.
YTM = (also called the Expected Rate of Return) : The rate of return required by investors as implied by the current market price of the bonds is the yield to maturity.
Bond Financing - Advantages and Disadvantages
Advantages - source of large sums of capital - does not dilute EPS - interest payments are tax deductible Disadvantages - Default can result in bankruptcy. - may require restrictive covenants
True of False: The market price of bonds changes inversely with changes in the market rate of interest.
TRUE
Bonds with longer maturity dates will also have what?
What bond is most likely to maintain a constant market value?
Remember that when interest rates are rising, bonds values increase. Interest rates and bonds have a direct relationship.
- Higher interest rate risk
- Floating-rate, the interest rate changes and is typically based on a market rate benchmark so it is closely aligned with the current market.
How Preferred Stock is different from Common Stock
Remember it is said to have some characteristics of Debt.
- PS typically does not have voting rights whereas CS almost always does.
- Different classes with different preferences
- Features which grant preferences with regards to dividends, convertibility, protect shareholder interests, call provisions.
Preferred Stock Value (PSV)
PSV = Annual Dividend / Required Rate of Return
Preferred Stock Rate of Return (PSER) Remember this changes over time with market price.
PSER = Annual Dividend / Market Price Can also be understood to be the current cost of preferred stock financing.
Advantages / Disadvantages of Preferred Stock
- Advantages - Cheaper than Common Stock (lower cost of capital) No maturity date or security required or voting rights or periodic payment requirement.
- Disadvantages - dividend expectations are high and payments are not tax deductible. Higher cost of Capital over Bonds
Cost of Preferred Stock Financing
Annual Dividend / Net Proceeds of Stock Issuance
Preferred Stock Dividend
Typically the Par Value x the stated Rate.
I.e. 9% PS with 20 Par would have a $1.80 annual dividend per share.
Economic Return on An Asset
Common Stock Expected Return (CSER)
Economic Rate of Return
= (Dividends + change in price) divided by beginning price
Common Stock Expected Return (CSER)
= (Dividend in 1st Year/Market Price) + Growth Rate
Order of Cost of Capital and Financing Strategies
- Historic Rates of Return for Bonds, PS and CS
Presented in order of least expensive to most expensive. Note cost is correlative with historical returns on investment.
- Retained Earnings - cheapest cost of additional capital
- Bonds - lowest rate 5.9%
- PS - mid range between Bonds and CS
- CS - highest return 12.3% - most expensive cost of additional capital
True or False: The hedging principle of financing generally holds that the length of financing should be compatible with the timing of cash flows expected from the asset financed.
TRUE Under the hedging principle of finance, assets are acquired with financing that matches the life of the asset. Thus, short-term assets would be financed with short-term liabilities and long-term assets would be financed with long-term liabilities or equity.
True or False: At some level of debt financing, increasing the proportion of financing sought through debt, relative to equity financing, will result in a higher cost of capital. Generally, the higher the proportion of debt financing relative to equity financing, the higher the cost of capital.
TRUE
Financial Leverage
Fixed-interest debt in the financing mix of a firm’s capital structure. While the use of debt can produce high returns to stockholders, it also increases their risk. Since debt generally is a less costly form of financing, a firm will generally attempt to use as much debt for financing as possible. However, as more and more debt is issued, the firm becomes more leveraged and the risk of its debt increases, causing the interest rate on additional debt to rise. Therefore, the optimal capital structure for a firm involves a mixture of debt and equity.
DFL = % change in EPS / % change in EBIT
Effects on Working Capital wrt Length of Production Cycle
- Remember that a firm and both over invest and under invest in WC
The longer the production cycle, the higher the level of working capital that would be expected to be devoted to the process. i.e. more WIP inventory would be incurred in a longer production cycle.
Objective of Cash Management
To maintain a minimum balance consistent with operating needs (operating cash). Holding too much cash results in loss of return to the firm. Holding too little cash puts the firm at risk of not meeting debt obligations and operating needs.
In a lock-box system…
Customer payments are made to a post office box that is accessed directly by the company’s bank. Payments are sent directly to the company’s financial institution. Therefore, collection float is minimized. This is a common receivables management strategy.
Zero-balance account
A zero-balance account is a cash management technique that permits control over cash outflows by using a checking account that has a zero ($0) real balance because payments made from the account exactly equal deposits to the account.
APR’s for: 2/10, n/30 5/10, n/30
36.7% & 94.74% respectively, formula base below.
- Safety Stock
- Delivery Time Stock
- ST - minimum level of inventory to be maintained.
- DTS - also known as lead time stock or the length of time it takes to receive inventory after it has been ordered.
Which inventory management technique focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as work-in-process and raw materials?
Materials Requirement Planning (MRP)
- MRP is a production planning, scheduling, and inventory control system used to manage manufacturing processes. Most MRP systems are software-based, while it is possible to conduct MRP by hand as well.
An MRP system is intended to simultaneously meet three objectives:
- Ensure materials are available for production and products are available for delivery to customers.
- Maintain the lowest possible material and product levels in store
- Plan manufacturing activities, delivery schedules and purchasing activities.
Permanent Financing Provided by Trade Accounts Payable (TI for example with Advanced Payments)
Just as some amount of current assets is a permanent use of financing, some amount of current liabilities provides a permanent amount of financing. For example, to the extent a minimum balance always remains in trade accounts payable, that minimum amount is a form of permanent financing.
Which one of the following constitutes (measures) the operating cycle of an entity?
Inventory conversion cycle + accounts receivable conversion cycle.
Cash Cycle Formula
The operating cycle (i.e., inventory conversion cycle + accounts receivable conversion cycle) less the accounts payable conversion cycle.
Financial Risk is borne by the firm’s debt holders?
FALSE - it is borne by the Common Stock shareholders. Financial Risk is the risk that results from the use of debt financing and preferred stock which require payment before the CS shareholders get their ROI.
Swap Agreement and uses
What happens with an interest rate swap?
Derivative instrument used to hedge interest rate risk or to speculate on changes in the expected direction of underlying prices.
In an interest rate swap, two companies exchange their debt servicing obligations on some amount of debt principal. The actual exchange of funds during the agreement is in the form of a net payment from the party owing the greater amount for the period.
- Essentially, the first company agrees to exchange with the second company the difference between the interest charges on its own borrowings and the interest charges on the borrowings of the second company.
NPV Formula
How does NPV compare to the IRR?
NPV = PV of Future Cash Inflows - Initial Investment
Net present value works better than the internal rate of return in a situation in which a choice must be made among a group of investments. The IRR implicitly assumes that the cash inflows from an investment can be reinvested at the same internal rate of return and therefore, the traditional IRR criteria may not arrive at the best solution in all cases. As a result, many firms rely on NPV criteria when evaluating competing proposals.
NPV is the difference between the required investment and the present value of the future cash flows. Since all future cash flows are included in the analysis, the inflow of cash from the salvage value of the project and the tax benefit from depreciation are included in the calculation.
Treasury Bills are considered to be risk free except for what?
The risk free rate of interest and any inflation premium. The government can’t protect you against inflation.
Financing some current assets with long-term debt is considered to be?
A conservative financing policy. Financing with long-term debt is more conservative and more expensive.
Which of the following types of merger is most likely to contribute to the formation of an oligopoly? -Horizontal -Conglomerate -Divestiture -Vertical
Horizontal - This answer is correct. An oligopoly is formed by the combination of firms in the same line of business, as in a horizontal merger. An oligopoly is a market for a good or service that is dominated by a small number of firms.
Economic Order Quantity
(EOQ = how much to order)
The amount to be ordered is known as the economic order quantity (EOQ).
The EOQ minimizes the sum of the ordering and carrying costs.
The total inventory cost function includes carrying costs (which increase with order size) and ordering costs (which decrease with order size).
Eurobonds
Increasing importance in today’s global market. A Eurobond is a bond payable in the borrower’s currency but sold outside the borrower’s country.
As an example, the bond of a U.S. firm, payable in U.S. dollars, might be sold in Germany, London, and Japan through an international syndicate of investment bankers. The registration and disclosure requirements for Eurobonds are less stringent than those of the SEC for U.S. issued bonds. Therefore, the cost of issuance is less.
During periods of inflation, investors typically tend to invest heavily in what?
Precious Metals, their relative scarcity causes their values to increase during periods of inflation.
What 3 factors affect the variance of a portfolio?
What type of risk does a portfolio allow investors to diversify?
- % of Portfolio invested in each asset
- Variance of ROA
- Covariance of ROA
- Unsystematic Risk
When to reorder inventory?
The objective is to order at a point in time so as to avoid stockouts but not so early that an excessive safety stock is maintained. Safety stocks may be used to guard against stockouts; they are maintained by increasing the lead time (the time that elapses from order placement until order arrival). Thus, safety stocks decrease stockout costs but increase carrying costs. Examples of these costs include
Cost to Carry Inventory Formula
Average Inventory Level for year X Unit Cost X Cost of Capital
or
(Order Size / 2) X Unit Cost X Cost of Capital
Serial Bonds vs. Term Bonds
- Serial bonds are bond issues that mature in installments (i.e., on the same date each year over a period of years). Serial bonds may be desirable to bondholders because they can choose their maturity date.
- “Term” means life of the bond issue. Term bonds, on the other hand, are bond issues that mature on a single date.
The variance of a single investment (as opposed to a portfolio) captures what type of risk(s)?
Variance of a particular single investment captures the Total Risk, both the Systematic and Unsystematic Risk. However, since unsystematic risk can be eliminated by diversification, the variance of a specific investment is not a particularly useful measure when considering a portfolio of assets.
The benefits of debt financing over equity financing are likely to be highest in which of the following situations?
- High marginal tax rates and few noninterest tax benefits.
- Low marginal tax rates and few noninterest tax benefits.
- High marginal tax rates and many noninterest tax benefits.
- Low marginal tax rates and many noninterest tax benefits.
High marginal tax rates and few noninterest tax benefits.
This answer is correct because when the marginal tax rate is high and the company has few noninterest tax benefits, the deduction for interest on debt is maximized.
Operating Leverage
Operating leverage measures the degree to which a firm builds fixed costs into its operations. If fixed costs are high a significant decrease in sales can be devastating. Therefore, all other things being equal, the greater a firm’s fixed costs the greater its business risk. On the other hand, if sales increase for a firm with a high degree of operating leverage, there will be a larger increase in return on equity.
DOL = % change in operating income / % change in unit (sales) volume
Describe a bond that has a call feature
The bonds may have a call provision allowing the firm to force the bondholders to redeem the bonds before maturity. Call provisions typically call for payment of a 5 to 10% premium over par value to redeem the bonds. Investors generally do not like call features because they may be used to force them to liquidate their investment.
Internal Rate of Return (IRR)
How is the IRR related to NVP? see pic
Another discounted cash flow method. The IRR determines the rate of discount at which the present value of the future cash flows will exactly equal the investment outlay (i.e., the rate that results in a NPV of zero).
PV (investment today) = TVMF × Cash flows
Note IRR does NOT recognize salvage value
Consumer Price Index (CPI) = a measure of inflation
CPI is measured as the price that urban consumers paid for a fixed basket of goods and services in relation to the price of the same goods and services purchased in some base period. It is therefore inappropriate for measuring what companies buy. The producer price index (PPI) is the measure used by companies.
Payback Period
Initial Investment / Annual Cash Flow
Does not consider the TVM
Exchange rates are determined by?
Supply and demand in the foreign exchange market.
Theoretically, the proceeds from the sale of a bond will be equal to?
- The sum of the face amount of the bond and the periodic interest payments.
- The face amount of the bond.
- The face amount of the bond plus the present value of the interest payments made during the life of the bond discounted at the prevailing market rate of interest.
- The present value of the principal amount due at the end of the life of the bond plus the present value of the interest payments made during the life of the bond, each discounted at the prevailing market rate of interest.
4.
Theoretically, market price (proceeds) of an obligation is equal to the present value of all future cash flows (i.e., the time value of money is considered). A bond has two sets of cash flows: periodic interest payments and the principal amount due at the end of the life of the bond. Such cash flows would be discounted at the prevailing market rate of interest at the time of the bond’s issuance.
Bonds: Market Rate vs. Contract Rate
Bonds generally provide for periodic fixed interest payments at a contract rate of interest. At issuance, or thereafter, the market rate of interest for the particular type of bond may be above, the same, or below the contract rate. If the market rate exceeds the contract rate, the book value will be less than the maturity value. The difference (discount) will make up for the contract rate being below the market rate.
Conversely, when the contract rate exceeds the market rate, the bond will sell for more than maturity value to bring the effective rate to the market rate. This difference (premium) will make up for the contract rate being above the market rate. When the contract rate equals the market rate, the bond will sell for the maturity value.
Accelerated vs. Straight-line Depreciation and it’s impact on Tax Expense
AD would result in less tax expense in the earlier years and, therefore, increase the rate of return on the investment.
Stock Dividend vs. Stock Split
SD’s are ratable distributions of additional shares to common stockholders. Such dividends are designed to signal to investors that the firm is performing well, but it does not require the firm to distribute cash. Remember that cash dividends, property dividends and liquidating dividends REDUCE retained earnings and there REDUCE the shareholders equity in the corporation.
Stock Splits are similar to stock dividends but they are generally designed to reduce the stock’s price to a target level that will attract more investors. As an example, a 2-for-1 stock split doubles the number of shares outstanding and it would be expected that the price of the stock would drop approximately in half.
he market value of a firm’s outstanding common shares will be higher, everything else equal, if?
Investors have a lower required return on equity. Investors value common shares more highly if they have a lower required return because then they apply a lower discount rate to the expected future dividend stream of the company.
Receivables Collection Period
Average Receivables / Credit Sales Per Day
As an example, assume that the average receivables balance is $3,000,000 and credit sales are $40,000,000; the receivables collection period is equal to 27 days as calculated below.
Receivables collection period = $3,000,000 / ($40,000,000/365 days)
=
27 days
Capital Budget
The capital (capital expenditures) budget displays the financial effects of purchases and retirements of long-lived assets. This information is needed to budget the cash and financing needs of the firm. Because of the need to plan for purchases of long-lived assets, capital budgets tend to span several years.
Net Cost of Debt
Net cost of debt is calculated as the effective interest rate times one minus the marginal tax rate.
EIR (1 - tax rate)
Residual Income
Residual income
Residual income is net income (or operating income after taxes) minus a cost of capital based on capital invested in a division or project.
Net income – Interest on investment
=
Net income – (Required rate of return × Invested capital)
Call vs. Put Option
A call option gives its buyer the option to buy an agreed quantity of a commodity or financial instrument, called the underlying asset, from the seller of the option by a certain date (the expiry), for a certain price (the strike price). A put option gives its buyer the right to sell the underlying asset at an agreed-upon strike price before the expiry date.
Free Cash Flow
Free cash flow =
NOPAT
- Depreciation and amortization
- – Change in working capital
- – Capital expenditures
An effective portfolio is one in which?
The investments are negatively correlated. Thus, when the return on some investments is declining the return on others is increasing.
Book Value per Share
BVPS = Common Stock Equity / Number of Shares of CS Outstanding
where CSE = CS + RE
General Rule for Nominal Interest Rates being Lower
Least frequent compounding. For any given quoted nominal rate, the least frequent compounding is associated with the lowest effective annual percentage cost. Annual compounding is less frequent than semiannual, quarterly, or monthly. Note that the term of the loan is not relevant to the calculation of the effective annual percentage cost of financing.
Name the critical success factor to efficient supply chain management.
A key aspect of supply chain management is the sharing of key information from the point of sale to the final consumer back to the manufacturer, to the manufacturer’s suppliers, and to the suppliers’ suppliers.
The zero coupon method is used to determine the fair value of what?
Interest rate swaps
The zero-coupon method is a present value model in which the net settlements from the swap are estimated and discounted back to their current value. The key variables in the model include
- Estimated net settlement cash flows (explained in the example below).
- Time of the cash flows as specified by the contract.
- Discount rate.
A downward-sloping yield curve depicting the term structure of interest rates implies that…
Prevailing short-term interest rates are higher than prevailing long-term interest rates. A downward sloping curve means short-term rates are higher than intermediate-term rates which are higher than long-term rates.
- Profitability Index Defined
- The profitability index is a variation on which of the following capital budgeting models?
- The excess present value (profitability) index computes the ratio of the present value of the cash inflows to the initial cost of a project. It is used to implement the net present value method when there is a limit on funds available for capital investments. Assuming other factors are equal, this is accomplished by allocating funds to those projects with the highest excess present value indexes.
- NPV - The profitability index is calculated as the ratio of the net present value of the project to its initial cost.
PI = (NPV / Initial Investment) x 100
What happens to investments when expected interest yields increase?
Stock price will decline. If the nominal rate of interest increases, investors will expect a higher yield from all investments. Therefore, the stock price will decline.
Bond Current Yield Basics
- Remember:
- Both CY and Interest Rates have inverse relationship with Bond Discount/Premium and Price respectively
- When the bond is selling at a discount, the current yield will be higher than the discount rate
- If the current yield is less than the coupon rate, the bond would be purchased at a premium
- When interest rates rise, bond prices fall
- When interest rates fall, bond prices rise
Sensitivity Analysis
A technique that explores the importance of assumptions underlying a forecast. Sensitivity analysis explores the importance of variables by manipulating variables one at a time to determine their importance to the forecast.
Vertical Financial Statement Analysis
Vertical analysis involves presenting everything within a financial statement as a percentage of a base. For a common-size income statement all items would be presented as a percentage of net sales.
Example: Interest expense as a percentage of net sales.
In which stage of a firm’s development is it most likely to seek and obtain external equity financing in the form of venture capital?
- Formation
- Rapid Growth
- Growth to Maturity
- Maturity and Industry Decline
Rapid Growth
At the rapid growth stage, if a company is reasonably profitable it will experience financing needs in excess of funds available either internally or from trade credit or bank credit. Additional debt financing would often result in an unreasonable amount of financial leverage at this stage of development and public equity financing is not yet available to the company. This is the stage at which the company is most likely to seek and obtain venture capital financing.
Cost of Equity on Common Stock
The cost of common equity is calculated by dividing the expected next dividend by the current stock price and adding the results to the expected growth rate in earnings.
Next Dividend / Market Price/share + Growth Rate = CCE
In statistical analysis, a weighted-average using probabilities as weights is the…
- Standard deviation
- Expected value
- Coefficient of variation
- Objective function
Expected Value. Of the four alternatives only expected value uses probabilities as weights in determining the probability of outcome. Each possible outcome is multiplied by an appropriate weight (probability). These are then summed to determine the expected value.
When calculating the cost of capital, the cost assigned to retained earnings should be?
- Zero
- Lower than the cost of external common equity
- Equal to the cost of external common equity
- Higher than the cost of external common equity
Lower than the cost of external common equity
New common equity has floatation costs that increase its cost above retained earnings.
Operating Margin
Operating Income / Sales
where operating income equals Sales - COGS - SGA expenses = operating income.
This is different from profit margin which is equal to Net Income / Sales.
Times Interest Earned
EBIT / Interest Expense
where EBIT = Sales - COGS - SGAexp - Depreciationexp.
Systematic Risk
In finance and economics, systematic risk (in economics often called aggregate risk or undiversifiable risk) is vulnerability to events which affect aggregate outcomes such as broad market returns, total economy-wide resource holdings, or aggregate income.
All market actors are vulnerable to systematic risk, it cannot be limited through diversification (but it may be insurable).
Difference Between JIT and MRP systems
MRP and JIT (materials resource planning and just in time processing) are two methods of controlling production and inventory levels for manufacturers.
- MRP focuses on production of finished goods based on forecast requirements, while
- JIT focuses on production as a response to actual orders. Both MRP and JIT rely heavily on computerized information processing.
Solvency vs. Liquidity
- Solvency refers to a firm’s ability to pay its debts.
- Liquidity refers to how quickly a firm can convert its liquid assets to cash.
In portfolio analysis a measure that is used to express the extent of the relationship among a set of investments is the:
- Standard deviation
- Expected return
- Coefficient of correlation
- Percentage return
Coefficient of correlation
