Corporate Finance Test 3
Profitability Index
Benefit-cost ratio Take investment if PI > 1 Cannot be used to rank mutually exclusive projects May be used to rank projects in the presence of capital rationing
Two major methods for determining the cost of equity
Dividend growth model SML, or CAPM
Questions to ask ourselves when evaluating capital budgeting decision rules
Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm?
• Why do we have to consider changes in NWC separately?
GAAP requires that sales be recorded on the income statement when made, not when cash is received. GAAP also requires that we record cost of goods sold when the corresponding sales are made, whether we have actually paid our suppliers yet. Finally, we have to buy inventory to support sales, although we haven't collected cash yet.
Which on of the following is the tax shield approach to computing the operating cash flow? assume there is no interest expense
(Sales- Cost) * (1-T) + Depreciation * T
Disadvantages of Payback Period
-Ignores the time value of money -Requires an arbitrary cutoff point -Ignores cash flows beyond the cutoff date -Biased against long-term projects, such as research and development, and new projects
Advantages of Payback Period
-easy to understand -adjusts for uncertainty of later cash flows -biased toward liquidity
Leveraged lease
A financial lease in which the lessor borrows a substantial fraction of the cost of the leased asset on a non-recourse basis
tax-oriented lease
A financial lease in which the lessor is the owner for tax purposes. Also called a true lease or a tax lease
Average Accounting Return
Average net income/ average book value
16) Which one of the following is a project cash inflow? Ignore any tax effects. A) Decrease in accounts payable B) Increase in accounts receivable C) Decrease in inventory D) Depreciation expense E) Equipment acquisition u
C) Decrease in inventory
what are leases governed by
FASB13
NPV Vs. IRR
Generally give us the same decision; except nonconventional cash flows- cash flow signs change more than once
Payback Period
How long does it take to get the initial cost back in a nominal sense?
If one of the following criteria is met, then the lease is considered a capital lease and must be showed on the balance sheet
Lease transfer ownership by the end of the lease term Lessee can purchase asset at below market price Lease term is for 75 percent or more of the life of the asset Present value of lease payments is at least 90 percent of the fair market value at the start of the lease
You should accept a project when the
Net present value is positive
Which on of the following statements is correct concerning the profitability index PI should be used to determine which on of two mutual exclusive projects should be accepted PI is the discount rate that makes the net present value equal to zero There can be multiple PI if the cash flows are unconventional PI is used to rank positive NPV projects when the available funds are limited
PI is used to rank positive NPV projects when the available funds are limited
Good Reasons for Leasing
Taxes may be reduced • May reduce some uncertainty • May have lower transaction costs • May require fewer restrictive covenants • May encumber fewer assets than secured borrowing
Cost of Equity
The cost of equity is the return required by equity investors given the risk of the cash flows from the firm
Which on of the following best describes an opportunity cost
The current market value of equipment you own that you want to use for a new project
Which on of the following statements is correct The discounted payback period is longer than the payback period The internal rate of return is used to determine which on of two mutually exclusive projects should be accepted The modified internal rate of return is used to evaluate different sized projects The payback period is considers the best method of project analysis from a financial point of view
The discounted payback period is longer than the payback period
Profitability Index (PI)
The present value of an investment's future cash flows divided by its initial cost. Also called the benefit-cost ratio.
Lease
a contractual arrangement by which the lessor (owner) provides the lessee (user) the right to use an asset for a specified period of time
Sale and leaseback
a financial lease in which the lessee sells an asset to the lessor and then leases it back
IF the Project has an IRR that is greater than the required return
accept the project
If the payback period is less than some preset limit
accept the project
If the project pays back on a discounted basis within the specified time
accept the project
if the AAR si greater than a preset rate
accept the project
If NPV is positive
accept the project • A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.
Opportunity costs
costs of lost options
Sunk costs
costs that have accrued in the past
Which on of the following will tend to increase a leveraged firm's cost of capital
decrease in the tax rate
Which on of the following decreases net income and increases the operating cash flow
depreciation
11. Which one of the following is a capital budgeting decision? a. deciding whether a bank loan should be secured or if bonds should be issued b. determining how many bonds versus how many shares of stock should be issued c. ascertaining the minimum amount of cash which should be kept on hand d. determining the optimal level of inventory to be maintained e. deciding whether or not a newly invented product should be produced
e. deciding whether or not a newly invented product should be produced
The crossover point
equates the net present value of two separate projects
The tax advantages of leasing exist primarily becasue
firms are in different tax position
direct lease
lessor is the manugacturer
Financial lease
longer timer lessee is responsible for
Depreciation
non-cash expense; consequently, it is only relevant because it affects taxes
lessor
owner
Side effects- positive and negative
positive- benefits to other projects Negative- costs to other projects
When Data tech applies the cost of capital of Wyoming Computers to a project, it is using the approach
pure play
Which one of the following is a requirement if a lease is to be concerned valid for tax purpose?
renewal options must be based on fair market value at the time of the renewal
Operating lease
short term lease, lessor is responsible
Captive Finance company
subsi
Net Advantage to Leasing (NAL)
the NPV that is calculated when deciding whether to lease an asset or buy it
Net Present Value
the difference between an investment's market value and its cost
Which on of the following correctly describes a criteria used by accountants to define a capital lease
the lease term is at least 75% of more of the estimated economic life of the asset
Cost of Preferred Stock
the ratio of the preferred stock dividend to the firm's net proceeds from the sale of preferred stock
Cost of Debt
the required return on our company's debt
IRR
the return that makes the NPV 0
Which of the following are good reasons to lease rather than buy
to avoid restrictive covenants to reduce uncertainty to lower transaction costs To lower taxes
Lessee can deduct lease payments for income tax purpose
true
Which one of the following tends to be the greatest concern of a lessee in regards to the leased asset
use
lessee
user of a leased asset
Advantages and dis. of dividend growth model
• Advantage - easy to understand and use • Disadvantages Only applicable to companies currently paying dividends Not applicable if dividends aren't growing at a reasonably constant rate Extremely sensitive to the estimated growth rate - an increase in g of 1% increases the cost of equity by 1% Does not explicitly consider risk
Why is cost of capital important?
• We know that the return earned on assets depends on the risk of those assets. • The return to an investor is the same as the cost to the company. • Our cost of capital provides us with an indication of how the market views the risk of our assets. • Knowing our cost of capital can also help us determine our required return for capital budgeting projects.