FINC325
When will a firm start generating positive profits?
The total number of units sold exceeds the accounting break-even point
Which of the following is true about allocated costs?
These costs are allocated to more than one project and they benefit more than one project
How do cost cutting projects create value?
Through reducing: -annual operating coats -taxes (through depreciation tax shields) -working capital investment
An increase in depreciation expense will do what to the cash flows from operations?
increase them
The percentage of sales approach separates accounts on the pro forma income statement and balance sheet into those that change directly with ______ and those that do not.
sales
Working Capital
short-term materials that are used up during the operating period (inventory and supplies)
If a firm has an accounting profit break-even point of 3,000 units, what are the taxes?
$0. A firm with a pretax profit of $0 will also have an aftertax profit of $0 because no taxes are paid if no pretax profit is reported. Thus, the number of units needed to break even on a pretax basis must be equal to the number of units needed to break even on an after tax basis
A pro forma balance sheet indicates that total assets will increase by $300,000. If a debt-equity ratio of .5 is maintained, then debt must increase by
$100,000. If D/E=.5, an increase in assets of $300K will be financed with $100K of debt and $200K of equity. $100/$200= 0.5
A firm needs $300 million in new assets and has projected retained earnings of $72.4 million, what is the external financing needed?
$227.60
Dot's financial planning model shows assets are projected to increase by $800,000 but liabilities and equity increase by $395,000. What is the external financing needed (EFN)
$405,000
Incremental costs/sales/depreciation/OCF means
'How the firm changes'
Turner's return on equity is 12% and its retention ratio is 60%. What is its sustainable growth rate?
(.12 x .60)/1-(.12x.60)=7.76%
Compute the net accounting profit based on the following info: Variable costs: $1600 Fixed Costs: $700 Depreciation: $300 Tax: 20%
(4000-1600-700-300)(.8)= $1,120
In a financial plan using the percentage of sales approach, why is it assumed that some assets increase with sales?
Additional working capital and fixed assets are needed to support growth
In a financial plan, how is the amount of borrowing determined?
By managements D/E decision
What is Equivalent Annual Annuity (EAA) mean?
By using money today, we have to make interest payments (it's putting the initial capital outlay in year 0 into yearly payments) Found on financial calc using PV, I/Y, and N and computing for PMT
NWC equation
CA - CL (Cash+Inv+AR) - (AP+ACC)
Contribution Margin Equation
Contribution Margin = Sales - Variable Costs
Contribution Margin
Contribution made by each additional unit sold to pretax profits
Fixed Cost
Cost that remains as the level of business activity changes
Increasing payout ratio does what to sustainable growth?
Decreases it
How does depreciation affect the operating cash flows
Depreciation expense reduces the taxable income and taxes, and increases the operating cash flow
Where does ROE come from?
DuPont ROE= PM*TATO(Asset Productivity)*(1+(D/E))
Accounting Break Even is the quantity sold where _______ is equal to zero
EBIT=0
A contribution margin of $35 means
Each sale of an additional unit will contribute $35 to the profit
True or false: Given external financing needs in a financial plan, the firm must borrow long-term and short-term funds
False: the financing decision is separate from the financial plan
Which will always be higher: financial or accounting break even analysis quantities?
Financial After incorporating time value and the depreciation tax shield, it will require more units to be sold to have profits break even with costs
A high growth firm will have a relatively _______ need for external financing than a low growth firm
Higher because it will have a relatively higher need for external financing than a low growth firm. Funds are needed to add to assets in a growing firm.
Increasing ROE does what to sustainable growth?
Increases it
NCS cash flow with replacing old machines with a new one
Initial cost of the new machine - salvage value of replaced machines then the negative salvage value of the new machine at the end of the project
What are the two policy constrained growth rates?
Internal and Sustainable Growth Rate
What is the impact of cost cutting projects on working capital?
It is ambiguous -Investment in fixed assets may increase the NWC needed -Some projects may also reduct the amount of NWC we need
What does the $ value of NPV imply?
It is the dollar amount added to the value of the firm if the project is accepted
If the sales price per unit increases and the variable cost per unit decreases, what would be the contribution margin?
It will increase
What is the numerator of the accounting break even equation (Deprec + FC) variant with?
Level of operations
Financial break even is the quantity sold when ______ is equal to zero
NPV = 0
Are Sunk Costs included?
No. They are costs incurred in the past that is irrelevant to the capital investment decision process
The sustainable rate can be used to assess what?
Planned growth. Sustainable growth rate translates management choices about profitability, efficiency, leverage and dividend policy into a benchmark to assess growth plans.
How is sustainable growth calculated when equity used in the calculation of ROE is the beginning value?
ROE x B
--NPV Table----Pessimistic----Expected Market Share----($1310)---------$2000---- Variable Cost----$1000----------$2000---- Fixed Costs------$1800----------$2000---- Initial Costs------$1850----------$2000---- These values were generated on a sensitivity analysis. Where should managers focus their attention?
Retaining market share because a change in market share leads to the largest deviation in NPV
The percentage of sales approach separates accounts on the pro forma income statement balance sheet into those that change directly with ______ and those that do not.
Sales
Why does the PV break-even point differ from the accounting profit break even point?
The PV break-even point adjusts for the time value of money and the depreciation tax shied benefit
What does it mean if a company's capital intensity ratio is 2.4?
The firm requires $2.40 in assets to generate $1 in sales
Leverage (D/E) means what for sustainable growth?
The more debt your firm uses, the more sustainable growth it has
What does a positive free cash flow mean?
The project generated more cash than needed to make investments for operations, made a net cash payment to our investors
Break Even Analysis
The quantity sold where the benefits exactly equal the costs
The sustainable growth rate can be used to
assess planned growth
Taxes are based on the difference between the
book value and sales price
Positive NWC
bought more current assets/reduced current liabilities
What is net working capital
current assets minus current liabilities
There will be a tax savings if the book value exceeds
exceeds the sales price
All else equal, when the rate of growth in sales or assets in a financial plan is higher, external financing needs will be:
greater
Payback period
how long an investment takes to recoup the initial costs
Payback Rule
if a project pays back fast enough, its acceptable (most common in 1 year)
Interest expenses are
ignored
Interest on municipal bonds is
ignored for tax purposes but included as income for FASB accounting
An increase in profit margin will _________ a firm's sustainable growth rate
increase
If the tax rate increases, the value of the depreciation tax shield will
increase
Financial planning is what type of process?
iterative (mathematical)
What is the denominator of the accounting break-even equation (price per unit-variable costs per unit)
marginal contribution
Sustainable growth rate is the ____________ rate of growth a firm can maintain without _____________ its financial leverage.
maximum; changing
Financial planning using the percentage of sales approach produces
pro forma financial statements
Negative NWC
sold off current assets/accessed more current liabilities
If the firm grows at exactly the _______________ rate, their debt-equity ratio and payout ratio will remain constant
sustainable
Book value represents the purchase price minus
the accumulated depreciation
Allocated costs must be treated as relevant or incremental costs only if...
the costs being allocated are affected by the proposed project
Corporate managers care about the break-even point because it indicates
the level to which sales can fall before a project will start losing money
Net working capital arises when
-Cash is kept for unexpected expenditures -Credit sales are made -Inventory is purchased
Optimistic Sensitivity Analysis
-High sales -Low costs -Cheap fixed asset investment
Pessimistic Sensitivity Analysis
-Low sales -High Costs -Expensive fixed asset investment & depreciation
The three main sources of cash flows over the life of a typical project
-Net cash flows from sales and expenses over the life of the project -Cash outflows from investment in plant and equipment at the inception of the project -Net cash flows from the salvage value at the end of the project
Based on the sustainable growth rate, which of the following factors affect a firm's ability to sustain growth?
-Profit Margin (PM) -Financial Policy -Dividend Policy (d)
A financial planning model can be used to test the feasibility of a planned growth rate because it incorporates 3 things
-The firm's dividend policy -The asset turnover rate -The firm's use of financial leverage
Sustainable Growth Rate
-The maximum sales growth rate without the use of external equity -If a firm grows at exactly the sustainable rate, their debt-equity ratio AND payout ratio will remain constant ROE
Internal Growth Rate
-The maximum sales growth rate without the use of external financing -Growth at this rate has the effect of continually shrinking a firm's debt to equity ratio ROA
Sensitivity Analysis is also known as
-What if Analysis -BOP (best, optimistic, and pessimistic) analysis
BC Corp's ROA is 22% and its plowback ratio is .5. What is the internal growth rate?
.11/.89= 12.36%
How many inputs are changed during a sensitivity analysis?
1
After doing forecast, what is the process of sensitivity analysis?
1. Choose a variable (p,q, v, FC, etc.) 2. Change it to an optimistic value (increases NPV) 3. Compute NPV 4. Repeat for pessimistic value (decreases NPV) 5. Repeat for all of the others
Two main drawbacks of sensitivity analysis
1. It may increase the false sense of security among managers if all pessimistic estimates of NPV are positive 2. It does not consider interaction among variables
Two main benefits of performing sensitivity analysis
1. It reduces a false sense of security by giving a range of values for NPV instead of a single value 2. It identifies the variable that has the most effect on NPV
Present value is superior to accounting profit break-even point method because it accounts for 2 things:
1. Time value 2. Depreciation tax shield effect
What do you identify in sensitivity analysis? (2 Things)
1. Value Drivers 2. Sources of uncertainty
Alpha Star's net income is $300 on $2,000 of sales. The company has $5,000 in assets and equity of $3,000. The firm paid out $125 in cash dividends. What is the dividend payout ratio?
125/300= 41.67%
Alpha Omega's percentage of sales models forecasts sales growth of 20% next year. If cost of goods sold are proportionate at 80% of sales, then cost of goods sold will increase by
20%. In a percentage of sales model, expenses that are proportionate will grow at the same rate of sales.
Incremental NCS difference
Cash flows with Replacement LESS cash flows without replacing the old machines
According to the bottom up approach, what is the OCF if $600, depreciation is 1800, and tax is 30 percent
Depreciation has already been subtracted through EBIT so it must be added back so just 1800 x (.7x600) = 2,200
Scenario Analysis
Determines the impact on NPV of a set of events relating to a specific scenario
What does a negative free cash flow mean?
Invested more in assets than generated from operations, received a net cash flow from our investors
Why is NPV considered a superior capital budgeting technique
It considers the time value of money and all of the cash flows
NCS cash flows without replacement
The salvage value of replaced (old) machines at the end of the project
What is the 'net' in NCS
the spending in the excess of salvaging
What is the purpose of accounting profit break-even analysis
to determined the level of sales at which profits are equal to zero
In the percentage of sales approach to financial planning described in the textbook, it is assumed that any surplus funds
were used to pay off debt
Accounting break even point of 2,000 means the firm
will start generating profits if it sells more than 2,000 units