fin 431 test 2
what does receivables collection period measure
After a company sells its inventory, it needs to get paid for it. The lower this figure, the faster a company is getting cash from its sales.
profitability ratio definition
Answers the question...how well the firm generates operating profits and net profits from its sales
what is project sequencing
Some projects must be undertaken in a certain order, or sequence, so that investing in a project today creates the opportunity to invest in other projects in the future
An analyst collects the following information about Oxford Corporation: • It has issued one-year, $1,000 par value bonds with a 7% annual coupon and are currently selling for $972.73. What is Oxford Corporation's cost of debt?
The cost of debt can be found by the yield of the one year coupon-bond the company has issued: Bond Price = $1,000 x (1 + 7%) / (1 + YTM) = $972.73→ YTM = 10% (cost of debt)
An analyst collects the following information about Ole Miss Corporation: The firm is contemplating the issuance of a 10% preferred stock that they expect to sell for $87 per share. The cost of issuing and selling the stock is expected to be $5 per share. What is Ole Miss Corporation's cost of preferred shares?
The dividend is = 10% x $87 = $8.70 𝐷𝐷 The net proceeds, N = $87 - $5 = $82 The Cost of Preferred Shares =$8.70/$82 = 10.6%
what are the management concerns
They are concerned with all aspects of the firm's financial situation, and attempt to produce financial ratios that will be considered favorable by both owners and creditors
who are current and prospective shareholders
They are interested in the firm's current and future level of risk and return, which directly affect share price.
who are creditors
They are interested in the short-term liquidity of the company and its ability to make interest and principal payments
what is the key to the current ratio
a key way to think about if a supplier should extend credit to a company and if a company will be able to survive the next six or twelve months.
what does DuPont analysis measure
a way to decompose ROE, to better see what changes are driving the changes in ROE. For instance, a firm could have a high volume/low margin strategy, which would be reflected in high asset turnover but low profit margins or the reverse
Home Depot, a home improvement supply store, issued $2 billion in debt in late 2016. What is the main difference between debt and other liabilities, like accounts payable? a) Debt carries an explicit interest rate. b) Debt represents ownership in the company. c) Debt is a residual claim. d) Debt is only owed to suppliers.
a) Debt carries an explicit interest rate
Which of the following companies is most likely to have the highest inventory turnover a) Subway, a fast-food restaurant company b) Books-A-Million, a bookstore chain c) Whole Foods, a grocery store d) British Airways, an airline
a) Subway, a fast-food restaurant company
independent project definition
accept/Reject decision for a project is not affected by accept/reject decisions of other projects.
Jensen and Meckling (1976)
agency cost of theory and financial structure
what debt to equity ratio should be used
anticipated market value leverage ratio (book value of D is sometimes OK; book value of E never!)
What types of companies are more likely to have high leverage? a) Companies with high growth opportunities in new industries. b) Companies in stable, predictable industries with reliable cash flows. c) Technology companies. d) Companies with low profitability.
b) Companies in stable, predictable industries with reliable cash flows.
Which ratio is a distinguishing feature of retail companies? a) High ROE b) Low receivables collection period c) High inventory turnover d) High total debt/total assets
b) Low receivables collection period
Which of the following constituencies care most about a company's current ratio? a) Stockholders b) Suppliers c) Competitors d) Customers
b) Suppliers
what is the appeal to the quick ratio
companies with high-risk inventory ,it provides a more skeptical view of their liquidity
what is cross-sectional analysis
comparing form to other firms or to industry
what is time series analysis
comparing sam firm across time
internal rate of return definition
discount rate that causes the NPV of the project to equal zero
what is the cost of debt (Rd) definition
equired rate of return on debt (i.e. the cost of debt). In other words, it is the financing cost associated with raising new funds through long-term borrowing
what is the greater liquidity trade off
higher liquidity ensure that the company doesn't goes bankrupt but highly liquid assets do not provide much of a return
what does asset turnover measure
how effectively a company is using its assets to generate revenue
what does inventory turnover measure
how many times a company turns over or sells all its inventory in a given year. The higher the number, the more effectively the company is managing its inventory as it sells products
what increases the ROE
increases in leverage ratio and asset turnover ratio leads to higher ROE, however, more leverage does not always lead to higher ROE. As leverage rises, so does the interest burden. Hence, the positive effects of leverage can be offset by the higher interest payments that accompany more debt
what cash is relevant to evaluate a new investment project
incremental cash flows contributed by the project
activity ratio definition
indicate the efficiency of a firm in utilizing its various assets.
what is ratio analysis
it involves methods of calculating and interpreting financial ratios to analyze and monitor the firm's performance
why do you measure leverage
its critical because it enables you to do things you couldn't otherwise do and because it magnifies your returns
what does the ratio of debt to assets measure
measures the proportion of all assets financed by debt. It provides a balance sheet perspective on leverage
what does profit margin compare
net profit, or the income after all costs and expenses, and compare it to sales
net present value definition
present value of all the after tax cash flows associated with a project (subtracting a project's initial investment), using the cost of capital (usually WACC) as the discount rate
What is capital structuring?
process of interchanging debt and equity
what does debt to capitalization measure
provides a somewhat more subtle measure of leverage by emphasizing the mix of debt and equity. This ratio tracks what proportion of a company's financing comes from debt
what is the cost of preferred shares (Rps) definition
ratio of the preferred stock dividend to the firm's net proceeds from the sale of preferred stock
valuation ratio definition
ratios used in Relative Valuation
what is WACC
reflects the expected average future cost of capital over the long run; found by weighting the cost of each specific type of capital by its proportion in the firm's capital structure.
which ratio answers how much profit does a company generate for every dollar of assets
return on assets
what does assets to shareholders equity measure
tells us precisely how many more assets an owner can control relative to their own equity capital. In other words, it also measures how returns are magnified through the use
M&M proposition 2
that the expected return on a levered firm's equity (rl) rises with the debt-to-equity ratio: r/=rA+(rA-rD)(D/E) or rA=rL(E/D+E)+rD(D+e)
what does leverage provide
the ability to control more assets than an owner would otherwise have the right to control
what is the terminal cash flow
the after-tax non-operating cash flow occurring in the final year of a project. It is usually attributable to liquidation of the project
why are there different ways to measure profitability
the appropriate measure changes depends on the specific question being asked
what does interest coverage ratio measure
the degree to which a company can make its interest payments. It measures a company's ability to fund interest payments from its operations and uses only data from the income statement
what does cost of capital represent
the firm's cost of financing or raising money through all the above three methods.
what is the operating cash inflows
the incremental after-tax cash inflows resulting from implementation of a project during its life
impact of taxes on him value
the levered firm pays less in taxes than does the all-equity firm. Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm. Under MM I with tax, firm value increases with leverage due to tax shield: Vl=Vu+PV(tax shield)
what is the initial investment
the relevant cash outflow for a proposed project at time zero.
what is the cost of equity (Re) definition
the required rate of return on equity (i.e. the cost of equity or the cost of common stock).
what do liquidity ratios measure
the risk of a company going bankrupt from running out of cash by emphasizing the company's ability to meet short-term obligations with assets that can quickly be converted into cash
what is GAAP ratio definition
there is no definition, key is to use the same definition throughout to make valid assumptions
what is capital rationing
which means that it will have to prioritize the projects it will be able to undertake. Again, the goal here is to take up those projects which maximize shareholders' value, given its available capital
M&M proposition 1
A firm's total value is independent of its capital structure. i.e., Value of the firm is determined by the left hand side of the balance sheet (the assets) rather than the right hand side (the capital structure). Vl=Vu
liquidity ratio definition
Indicate the ability to pay short-term obligations.
what is capital budgeting
It involves the analysis of potential projects (usually over a period longer than a year), as these long-term decisions of whether to accept or reject a project often involve large expenditures and can be very important to the firm's future. Making good capital budgeting decisions is consistent withmanagement's primary goal of maximizing shareholder value.
what is payback period
It is the number of years it will take to recover the original investment. The disadvantage is that it ignores the time value of money and the cash flows received after the payback period
mutually exclusive projects definition
It means that only one project in a set of possible projects can be accepted and that the projects compete with each other
agency costs of outside equity
Managers who own less than 100% of the firm have an incentive to expropriate wealth from the firm's investors. Excessive perquisite consumption Less effort devoted to increasing firm's value Debt can be used to overcome the agency costs of outside equity:Using debt means a firm can sell less external equity and still finance its operations. using debt reduces managerial perquisite consumption. External debt serves as a bonding mechanism. Debt subjects managers to direct monitoring by public capital markets.
what does the return on equity compare
Net profit, or the income after all costs and expenses, and compare it to shareholders' equity
Do firms should always prefer debt financing to equity financing?
No! Beware of websites that claim that, "debt is always cheaper than equity" - The WACC fallacy! Such faulty line of thinking ignores the "hidden" cost of debt:
should Firms should choose their financial policy to maximize EPS?
No! → EPS can go up when a firm increases its leverage. (True)→ Firms should choose their financial policies to maximize EPS. (False) The EPS fallacy!→ Confusion of expected returns and risk EBIT is unaffected by a change in capital structure Creditors receive the safe (or the safest) part of EBIT Expected EPS might increase but EPS has become riskier! (Again, see MM- II)→ Implication: • Be careful when comparing P/E ratios of firm with different capital structures
what is the incremental cash flow equation
Firm's CFs with Project - Firm's CFs without Project
to implement target capital structure
-Undertake all positive NPV projects. -Issue equity when leverage rises above the target range. -Buy back stock (or pay dividends) or issue new debt when leverage falls below the target range.
what does productivity mean based on a finance perspective
1. Increases in productivity mean that you can squeeze more from less. 2. More narrowly, productivity ratios measure how well a company utilizes its assets to produce output
problem with IRR
1. Multiple IRR or No IRR 2. conflicting project rankings, choose highest NPV
what does each aspect of the DuPont analysis measure
1. Net Profit margin is a measure of the firm's operating efficiency - how well it controls costs? 2. Asset turnover is a measure of the firm's asset use efficiency - how well it manages its assets? 3. Equity multiplier is a measure of the firm's financial leverage
what are the limitations of ratio analysis
1. Ratios that reveal large deviations from the norm merely indicate the possibility of a problem. 2. A single ratio does not generally provide sufficient information from which to judge the overall performance of the firm. 3. The ratios being compared should be calculated using financial statements dated at the same point in time during the year. 4. It is preferable to use audited financial statements. 5. The financial data being compared should have been developed in the same way. 6. Results can be distorted by inflation. 7. Management could potentially manipulate earning
steps involved in capital budgeting
1. Search for potential investment opportunities. 2. Estimate all cash flows for each project. 3. Evaluate the cash flows (using various investment rules such as NPV, IRR, Payback Period Rule etc.). 4. Make the accept/reject decision. 5. Periodically, re-evaluate the past investment decisions.
How do you estimate the cost of debt for a firm if its debt is not publicly traded?
1. Take a "spread" over a risk-free benchmark based on the firm's risk/credit profile, for instance, you may use the firm's current (or implied) credit ratings. 2. Obtain a quote from the debt capital market (DCM) professionals. 3. If the firm recently borrowed money from a corporate bank, you can find out what the interest rate was. 4. Look to see if a comparable firm has publicly traded debt or has had a recent debt issuance. 6. Sometimes people also estimate the cost of debt on the basis of the at-issuance coupons. However, you have to be cautious as this method is backward-looking and may not reflect the firm's cost of raising debt capital under prevailing market conditions
what are the perfect capital market assumptions
1. The firm's investment decisions are pre-determined. 2. There are no corporate or personal taxes. 3. There are no costs of financial distress. 4. Shareholders, creditors, and managers all have equal access to the same information. (No information asymmetry) 5. There are no transaction or issuance costs. 6. Competitive Markets: Individual and firms are price-takers. 7. All agents are rational. 8. Individual and Firms can undertake financial transactions at the same prices (e.g., borrow at the same rate).
what decreases ROE
1. decreases in tax burden ratio or interest burden ratio 2. higher taxes
what are The three most common ways of raising money (or capital) by corporations are
1. equity 2. debt 3. preferred shares
5 broad classes of ratios
1. liquidity ratio 2. solvency ratio 3. profitability ratio 4. activity ratio 5. valuation ratio
types od payouts
1. regular cash dividends 2. non-cash dividends 3. share repurchase
principles to keep in mind about cash flows
1. sunk costs do not matter 2. opportunity costs matter 3, side effects or externalities matter 4. taxes matter 5. how you raise money to finance the project should not matter 6. timing of cash flows matter
what questions does the current ratio answer
1. will this company be able to pay its suppliers if it needs to close 2. Will its current assets be sufficient to pay off its current liabilities (including those owed to suppliers)
A firm with a P/E ratio of 10 wants to take over a firm half its size with a P/E ratio of 25. What will be the P/E ratio of the merged firm?
12.5 Suppose the acquirer has a value of $100, then it needs to have earnings of $10. The target has a value of $50, so it needs to have earnings of $2. This means that the combined firm will have earnings of $12 and value of $150. Its P/E ratio will thus be 150/12 = 12.5.
Ole Miss Inc. has a net profit margin of 12%, a total asset turnover of 1.2 times, and a financial leverage multiplier of 1.2 times. Ole Miss' ROE is:
17.3%
trade-off theory debt, costs of bankruptcy and financial distress
Bankruptcy costs are distinct from the decline in firm value that leads to financial distress. Poor management, unfavorable movements in input and output prices, and recessions can push a firm into bankruptcy, but they are not examples of bankruptcy costs. Bankruptcy costs refer to direct and indirect costs of the bankruptcy process itself. Therefore, bankruptcy costs become a deterrent to using leverage.
agency costs of outside debt
Bondholders begin taking on an increasing fraction of the firm's risk as firms use more debt. Shareholders and managers still control the firm's investment and operating decisions, so managers have incentives to transfer wealth from bondholders to themselves and other shareholders. For example, managers might sell bonds and then pay a huge dividend to shareholders, leaving bondholders with an empty corporate shell. Overinvestment is the promise to invest in a safe asset to obtain an interest rate reflecting low risk, and then substituting a riskier asset promising a higher expected return. Underinvestment occurs when a firm's shareholders refuse to invest in a positive-NPV project because most of the benefits would be realized by bondholders.
Which of the following statement about NPV and IRR is FALSE? a. The discount rate that gives an NPV of zero is the project's IRR. b. The IRR is the discount rate that equates the present value of the cash inflows with the present value of outflows C. For mutually exclusive projects, if the NPV method and the IRR method give conflicting rankings, you should use the IRRs to select the project. D. The NPV method assumes that cash flows will be reinvested at the cost of capital, while IRR rankings implicitly assume that cash flows are reinvested at the IRR.
C. For mutually exclusive projects, if the NPV method and the IRR method give conflicting rankings, you should use the IRRs to select the project.
If a firm has $100 in inventories, a current ratio equal to 1.2, and a quick ratio equal to 1.1, what is the firm's Net Working Capital?
CA/CL=1.2 and (CA-100)/CL=1.1=> solve and find CL=1,000 and CA=1,200 =$200
in general which one (Equity or Debt or Preferred Shares) do you think is most risky and which one the least risky?
Common Shares (Equity) are riskier than Preferred Shares which in turn are riskier than Debt
Which of the following statement about NPV and IRR is FALSE? A. The IRR can be positive even if the NPV is negative B. The NPV method is not affected by the multiple IRR problem. C. When the IRR is equal to the cost of capital, the NPV will be zero. D. The NPV will be positive if the IRR is less than the cost of capital
D. The NPV will be positive if the IRR is less than the cost of capital
what does days inventory measure
Dividing the number of days in a year (365) by the inventory turnover provides the average number of days a piece of inventory in kept inside a company before it is sold
why is capital structure important
Enables one to "optimize" the value of a firm or its WACC by finding the "best mix" for the amounts of debt and equity on the balance sheet - Provides a signal that the firm is following proper rules of corporate finance to "improve" its balance sheet. This signal is central to valuations provided by market investors and analysts
should firm value increases if it issues different securities tailored for different clienteles of investors!
No! → Investors differ in their preferences and needs, and thus want different cash flow streams. (True) → Some investors like debt while others prefer equity. (True) → Firm value increases if it issues different securities tailored for different clienteles of investors. (False) The Win-Win fallacy! → Investors can borrow/lend on their own account. Investors who like leverage can create "home-made leverage" by borrowing. Investors who dislike leverage can "undo" corporate leverage by lending.
Is a high ROE always a good thing?
No- While a high ROE is desirable, it is not always a good thing...the elements that make up that ROE can help to determine whether that ROE is sustainable or built on a foundation that will destroy the company. For example, a high ROE can be created by leverage, rather than profitability.
what is The "Multiple IRR" and "No IRR" problem
Non-conventional/non-normal cash flows can result in multiple IRRs or no IRR. When a project has cash outflows after cash inflows during its life in addition to its initial cash outflow. Note that the IRR rule leads to the same decisions i.e., accept or reject as the NPV rule if all negative cash flows precede all positive cash flows
why does the quick ratio take out inventories
One might think inventories are about operations, but to finance people, inventories represent risk that needs to be financed. And, inventory can be very risky. Think about BlackBerry, which competed in the smartphone market where products quickly grow obsolete.
implications of the tase off model
Profitable firms should borrow more than unprofitable firms because they are more likely to benefit from interest tax shields. Firms that own tangible, marketable assets should borrow more than firms whose assets are intangible or highly specialized. Safer firms should borrow more than riskier firms. Companies should have a target debt ratio.
solvency ratio definition
Provide information on the firm's financial leverage and ability to meet its longer-term obligations