Week 7 Terms

Negative Bonus:

Negative bonuses can be indirectly achieved by lowering base salaries and increasing bonus opportunities (by lowering the threshold performance where bonuses are paid). Another indirect way to impose negative bonuses is by reducing base salaries and offering enhanced bonus opportunities (through reduced bonus thresholds). Consider a CEO with a competitive base salary of $850,000 and an upside-only bonus equal to 1% of operating income in excess of $75 million. Instead of offering the cash compensation contract: Suppose that Expeditors realized annual operating income of $50 million. Under Mr. Rose's actual contract, he would receive a bonus of approximately $500,000 and total compensation of approximately $610,000. Under the hypothetical "competitive contract," he would receive his base salary of $850,000 but would not be eligible for a bonus. Therefore, while Expeditors would indeed report a bonus of $500,000 for Mr. Rose, it would be more informative to understand that he actually received a negative bonus of $240,000, representing the difference between his actual compensation and what he would have received if his base salary had been set at the competitive level of $850,000.

WACC

(Weight of Debt)(Cost of Debt) + (Weight of Equity)(Cost of Equity)

cost of capital

1. Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make a given investment. 2. A company's overall cost of capital is a mixture of returns needed to compensate all creditors and stockholders. This is often called the weighted average cost of capital and refers to the weighted average costs of the company's debt and equity. 3. is the cost an organization pays to raise funds (e.g., through bank loans or issuing bonds), expressed as an annual percentage.

return on assets

1. ROA tells you what earnings were generated from invested capital (assets) 2. assets of the company are comprised of both debt and equity 3. ROA=Net income/Average Total Assets

four general ways to create value in organizations:

1. invest in projects that earn more than their cost of capital 2.increase profits produced from existing capital 3.reduce assets devoted to projects that earn less than their cost of capital 4.educe the cost of capital

cost of equity

DEFINITION OF 'COST OF EQUITY' In financial theory, the return that stockholders require for a company. The traditional formula for cost of equity (COE) is the dividend capitalization model: A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.

Economic Profit

Return on Capital - Cost of Capital) × Capital. Economic Profit = Operating Profit - (Cost of Capital) × Capital, EVA is the calculation of what profits remain after the costs of a company's capital - both debt and equity - are deducted from operating profit. The idea is simple but rigorous: true profit should account for the cost of capital.

return on capital

Return on capital, in addition to using the value of ownership interests in a company, also includes the total value of debts owed by the company in the form of loans and bonds. Ex: $100 million in debts, the return on capital would drop to 1% ($2 million divided by the sum of $100 million in equity and $100 million in debts).

Return on equity

Return on equity measures a company's profit as a percentage of the combined total worth of all ownership interests in the company. ROE, is a company's net income divided by its average stockholder's equity. ROE is more than a measure of profit; it's a measure of efficiency. A rising ROE suggests that a company is increasing its ability to generate profit without needing as much capital. Stockholder's equity is also referred to as net assets. EX: 2 million for a period, and the total value of the shareholders' equity interests in the company equals $100 million, the return on equity would equal 2%

return of capital

The general equation for return on capital is: (Net income - Dividends) / (Debt + Equity) Return on capital is also known as "return on invested capital (ROIC)" or "return on total capital." For example, Manufacturing Company MM has $100,000 in net income, $500,000 in total debt and $100,000 in shareholder equity. Its operations are simple -- MM makes and sells widgets. (Net income - Dividends) / (Debt + Equity) = (100,000 - 0) / (500,000 + 100,000) = 16.7%

Operating profits

cash flows, pre-tax income, net income, or EBIT (earnings before interest and taxes

cost of debt

effective interest rate that a company pays on its current debt. This can be measured in either before- or after-tax returns before-tax rate by one minus the marginal tax rate (before-tax rate x (1-marginal tax) were 40%, the company's after-tax cost of debt would be only 3% (5% x (1-40%))