Finance Terms combined 1

project evaluation

associated with capital budgeting; relates to mergers and acquisitions

sensitivity analysis

assumptions should be challenged to measure the bottom-line impact of changes to key variables

historical evaluations

at a minimum you should gather the necessary information to quantify the industry's historical sales growth, asset usage skill, porfitability, return on equity, dividend policy, liquidity and structure. test assumptions against this.

Matching

in their statements, firms should include all expenses incurred to realize the revenues that they report (GAAP)

factors related to a firm's industry include

industry definition, that is, what type of products are sold, how stable is the industry, on what basis do firms compete, etc.

Reliability

information that is provided must be complete and verifiable (GAAP)

Convertbles

instruments which can be converted to common stock. Conversion can occur at the company's discretion with or without investor approval. Categorized by voluntary or involuntary (usually bonds or preferred stock). Accompanied by call provisions. Usually time constrained.

Value is created on the left side of the balance sheet by

investing in assets that produce income, generate cash flows or reduce expenses in sufficient amount to offset their cost

capital investments

investments which provide returns for a period greater than one year. The most popular is capital budgeting.

Internal Rate of Return (IRR)

the discount factor necessary to make an investment's NPV=0.Cash flows positive and negative with applied discount rates. usually compared to the firm's hurdle rate. If the IRR is less than the firm's hurdle rate, then the investment will be rejected. IRRs also do not compare the magnitude of returns.

Internal Rate of Return (IRR)

the discount factor necessary to make an investment's net present value equal to zero

hurdle rate

the discount factor used within a firm to approximate its own risk. Firm's risk is equal to the rate of return required by owners. (approximate by using the firm's ROE or cot of capital)

Dividends

are taxable at the corporate level and at to the stockholder

cost of equity

= EPS after issue/current stock price (equivalent to the P/E inversion method)

Cost of debt

= annual interest payments/net proceeds of loan or issue

What is the present value of $108 to be received at the end of one year when discounted at 8%

$100; Naturally, compounding and discounting are reciprocal operations. In one we project a present amount forward to determine its future value. In the second, we express that future amount in terms of its value to us today by discounting it.

If you invest $100 for one year at 8% interest, how much will your investment be worth in a year?

$108; $100 is your present value, 8% is the rate of compounding, and the future value is $108

If Jack does pursue the 10% stock, how much does he need to invest so that he has precisely $15,000 in two years?

$12397; The present value of the $15K future amount when discounted at 10% for two years is: ($15,000/1.10^2) = $12397

$40,000 base years straight line depreciation equals how much per year?

$5000 (40,000/8)

three models for measuring the cost of equity

(1) P/E Inversion = earnings per share/market price, (2) dividend growth model = (projected dividend/share price)+[(1-payout percentage)x ROE] ; this is the most widely used.(3) Capital Asset Pricing Model (CAPM) historical measure

incremental cash flow costs

(1) acquisition costs, not necessarily purchase price, (2) annual operating costs and routine maintenance, (3) depreciation lost when old asset is sold, (4) tax consequences of capital gain on sale of old asset, (5) revenue lost from sale of old asset, (6) major overhauls

Incremental cash flow benefits

(1) additional revenue made possible by investment, (2) cost savings from new asset, (3) Tax shelter from new depreciation, (4) Tax benefits such as ITC or capital losses, (5) Cash proceeds from sale of replaced asset, (6) salvage value of new asset

Financial commandments

(1) financing chosen for an investment should match the term of the investment (2) investments should be analyzed independently of its financing. Marginal investments should not be pursued because of the financing that can be arranged for is (3) the value of money escalates over time because of its ability to generate returns.

the resolution of an investment/capitalization issue typically follows this pattern

(1) from the realm of proposals an investment is chosen (2) a capitalization package for financing the investment is envisioned (3) both are considered together

The capital budgeting process involves qualitative and quantitative considerations. These extend to the

(1) generation of investment ideas, (2) evaluation and ranking of alternatives, (3) selection of investments and (4) continuing appraisal of post investment performance

Three questions to answer in determining the financing situation

(1) how much financing is needed, (2) what is the capitalization policy, and (3) What is the firm's dividend policy?

Shortcomings of payback

(1) it disregards cash flows occurring beyond the payback period (2) it does not compensate for the timing of the cash flows within the payback period

Cost of debt is

(1-tax rate) x YTM

Earnings Before Interest and Taxes

(EBIT) the firm's total income from all sources before interest or taxes have been deducted

break even formula for financing with debt or equity

(EBIT-Interest payments)(1-tax rate)- preferred dividends / Number of common shares

Earnings Before Tax

(EBT) The firm's EBIT less interest charges

Consider the situation in which it has been proposed to replace an outmoded piece of equipment with a new machine. What about sales demand that the old equipment was able to satisfy and that the new machine will fill as well? This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost

(a) irrelevant; Because these sales are not incremental improvements over the status quo, they are not relevant to the cash flow analysis

Rather than focusing on asset replacement, let's now consider plant expansion. What is your opinion about sales generated by the machinery at the old plant? This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost

(a) irrelevant; Since the old plant would continue to turn out marketable products whether or not the new plant was built, sales revenue from the old plant is irrelevant

If you invested $100 in an account that would return $121 at the end of two years, and you discounted the returns from the investment at 10% annual interest, what is the present value of the investment? (a) $82.64, (b) $100, (c) $110, (d) $121

(b) $100; This illustrates a coincidental case in which the principal earns interest at exactly the same rate as the cash flows are discounted. In effect, the interest can be ignored and the present value is equal to the amount invested

Consider the situation in which it has been proposed to replace an outmoded piece of equipment with a new machine. What about direct labor charges that will no longer be necessary because of the increased speed of the new machine? This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost

(b) an incremental benefit; Labor savings are an obvious incremental benefit from the new machine

How about the increase in projected sales volume resulting from the new plant? This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost

(b) an incremental benefit; The incremental sales are probably the major benefit to be derived from the new plant

It has been proposed to replace an outmoded piece of equipment with a new machine. The company's sales demand has exceeded its machine capacity in the past. The new equipment has a higher output than the old machine. This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost

(b) an incremental benefit; The new sales that could be realized because of the new machine are incremental benefits

present value calculations (a) can hinder the creation of value, (b) can provide managers with a means of identifying the best investment choices, (c) cause managers to mix asset and financing considerations, (d) A & B, (e) B & C

(b) can provide managers with a means of identifying the best investment choices; Present value calculations allow managers to eliminate timing as a dimension of investment returns. Thus, investments can be compared regardless of the time frame over which the outlays are made of the return generated

As the interest rate used to discount future cash flows is increased, present value of future cash inflows (a) increases, (b) decreases, (c) remains the same

(b) decreases; The larger the interest rate used to compound the returns from an investment the larger will be the accumulated future value. Conversely, with a higher discount rate, a proportionately smaller amount of money needs to be set aside today to reach a target future amount. Thus, the present value decreases as the rate of discounting increases

NPV is the preferred method for ranking investments because (a) it quantifies the proportion of cash flows to initial investment, (b) it directly measures the creation of value, (c) it is insensitive to changes in the hurdle rate assumption, (d) A &B, (e) B & C

(b) it directly measures the creation of value; NPV reports in present dollar terms about how much value will be added to a company as the result of making a particular investment. Because it is an absolute measure, it is awkward to apply in a comparative perspective. NPV is inversely linked to the hurdle rate used to discount the cash flows - the higher the hurdle rate, the lower the NPV

If A & B were independent investment proposals and capital existed in abundant supply, which would you endorse for funding? (a) A Only, (b) B only, (c) A & B, (d) Neither

(c) A & B; Both projects meet the financial criterion imposed for projects for this risk level - that is, both earn returns in excess of 10% -- therefore, they should both be funded. It is only when capital is scarce (the normal state of affairs) that rationing among feasible projects is dictated

How about operating expenses for the new plant, which are comparatively lower than the old plant?

(c) an incremental cost. Since the new plant is not a replacement for the old plant, any expenses linked to its operation can be considered incremental costs

Consider the purchase of land, buildings and equipment. This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost

(c) an incremental cost; The price of land, buildings, and equipment is an incremental cost

Consider the situation in which it has been proposed to replace an outmoded piece of equipment with a new machine. Suppose the old machine had not been fully depreciated and that it would be sold when the new machine was installed. What about the tax shelter from the future depreciation of the old machine. This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost

(c) an incremental cost; This sort of incremental analysis can be confusing.. If the old machine had been retained, its future depreciation would have provided a benefit because of the tax shelter. However, because the depreciation will be foregone, it should be an incremental cost. The proceeds from the sale would be an incremental benefit

If the hurdle rate used to discount a stream of cash flows is raised, the IRR of the cash stream will (a) always increase, (b) always decrease, (c) not change, (d) increase if the NPV is negative or decrease if the NPV is positive

(c) not change. IRR is calculated from the undiscounted cash flows. The discount rate chosen has absolutely no bearing on iRR

Which of the following would not be included among the investment numbers of a capital budget (a) purchase price of asset, (b) trade-in value of an asset being replaced, (c) reduction in labor costs from a new asset, (d) investment tax credit from acquisitions, (e) installation cost of machinery

(c) reduction in labor costs from a new asset; The cash flows relevant to an investment include the purchase price of the asset plus whatever expenditures are necessary to make it operational (installation, labor, freight, etc.) less cash to be realized from the disposition of replacement equipment. Ongoing cash flows such as labor saving are the benefits to be realized from the investment and should not be included as part of the investment

If an investment's IRR is higher than the firm's chosen hurdle rate, then the investment (a) has a negative NPV, (b) is of greater risk than the overall risk of the firm, (c) should be qualitatively considered before selection, (d) A &B, (e) A, B & C

(c) should be qualitatively considered before selection; If the investment's IRR exceeds the hurdle rate, the NPV is positive, not negative. Also, if the return from a project exceeds the hurdle rate, no inference is made as to the relative risk of the investment of the firm.

A shortcoming of the simple payback method is that it (a) does not account for the time value of money, (b) does not recognize cash flows beyond the payback period, (c) relies heavily on salvage values, (d) A & B, (e) A, B & C

(d) A & B; Payback is generally thought to have two weaknesses; it disregards the timing of cash receipts within the payback period and it ignores all receipts that occur after the payback has been achieved

Residual cash flows are estimated when (a) the useful lives of alternatives are different, (b) one asset has a shorter economic life than its alternatives, (c) it is not convenient to evaluate the total useful life of an asset, (d) A & B, (e) A, B & C

(d) A & B; two or more investment alternatives rarely have the same useful life. Estimating residual cash flows is a means of compensating for differences in the useful lives of the alternatives. Residual cash flows should never be estimated simply as a matter of convenience

residual cash flows are estimated (a) when the useful lives of alteernatives differ, (b) when future depreciation of an old asset is lost, (c) in order to quantify cash flows of an investment beyond the chosen time horizon, (d) A & C, (e) A, B & C

(d) A & C; residual values are entered into cash flow forecasts in recognition of the fact that an investment cannot be evaluated into perpetuity. When comparing two investments with unequal lives, the residual value of the longer-lived asset is assumed to be realized at the termination of the shorter-lived asset, in this way assuring comparability of the investments

A differential analysis (a) should be used only to compare an alternative to the status quo, (b) can be used to compare any set of alternatives, (c) is easier to comprehend if a consistent frame of reference is employed, (d) B & C, (e) A, B & C

(d) B & C; A differential analysis is similar to examining incremental cash flows - it reveals how the results of one course of action differ from results of another course. Incremental analysis is an extreme case of differential analysis because the alternative is compared with the status quo

For capital budgeting purposes, an asset's depreciable life is (a) always equal to the time horizon of an evaluation, (b) equal to the asset's useful life, (c) equal to the asset's economic life, (d) an arbitrary period dictated by the tax code, (e) none of the above

(d) an arbitrary period dictated by the tax code; The only depreciation relevant to capital budgeting is an analysis of cash flows. Depreciation is a noncash expense; its value to a firm is that it reduced the amount of tax dollars a company must pay

Salvage value (a) is the best prediction of what an asset could be sold for at the end of the time horizon, (b) should be used to justify marginal investments, if necessary, (c) should not be used to justify marginally profitable investments, because salvage values are difficult to accurately predict, (d) A &B, (e) A & C

(e) A & C; In a cash flow forecast, salvage value is an estimate of the remaining worth of the asset at termination of the investment horizon. As you can imagine, such estimates are fraught with uncertainty, and should never be used as the basis for backing a marginal proposal

A discount factor (a) is the reverse of compounding future cash flows, (b) performs the reverse function of a compounding interest rate, (c) allows investors to quantify a figure which would make them indifferent to the returns from an investment, (d) B & C, (e) A, B & C

(e) A, B & C; All of the statements describe discount functions

Hurdle rates are used in an attempt to (a) screen out weak investments, (b) quantify the firm's opportunity costs, (c) quantify the firm's risk, (d) A &B, (e) A, B & C

(e) A, B & C; All of the statements regarding the use of hurdle rates are true

Capital budgeting includes (a) generation of ideas, (b) evaluation and ranking of alternatives, (c) selection and monitoring of investments, (d) B & C, (e) A, B & C

(e) A, B &C. Capital budgeting is a process that begins with brainstorming, continues through evaluation of the project returns, and is not complete until the performance of the investment has been analyzed after it has been brought online

Present value calculations allow managers to (a) choose assets which create the most value, even if their cash flows are timed differently, (b) choose the least expensive form of financing, (c) create value for the firm, (d) A & C, (e) A, B & C

(e) All of the statements are true

The present value of cash flow allows an investor to asses (a) the value of a present cash flow projected into the future, (b) the value of a stream of cash flows in terms of the best and most certain alternative, (c) what equivalent present payment would be equally acceptable in lieu of the investment under consideration, (d) A & B, (e) B & C

(e) B & C; these are both true because they address the concept of opportunity cost and timing - comparing a future stream of cash flows in terms of value today. Choice A describes future value, not present value.

Value is created in a firm through (a) asset acquisitions, which improve earnings or efficiencies, (b) capitalization decisions, (c) the reduction of operational and financial risks, (d) A & C, (e) A & B & C

(e) Value can be created through either side of the balance sheet. The traditional view of building value suggests investments in new assets which generate income in excess of their cost. However, value can also be created through financing, for example, by reducing the perceived risk of the firm.

what value of PVI would you guess would indicate the minimum acceptable return for a project to be approved?

1 - If the discounted cash inflows from a project equal the cash outflows, then the PVI is equal to one. As the inflows increase, the PVI grows larger than one

Steps in the dilution method

1. forecast the acquiror's net income for next year without the merger. 2. forecast the target's net income for he next year, with the merger (include synergies) 3. add the two net incomes from steps 1 and 2 4. calculate the acquiror's EPS for the next year, without the merger. 5. Divide the combined earnings from step 3 by the acquiror's projected EPS found in step 4 6. Subtract the number of shares that the acquiror has outstanding from the number of calculates in 5. This figure is the number of shares that the acquiror can issue without diluting EPS. 7. Multiply this number of issuable shares by the acquiror's current share price. This is equal to the maximum price that the acquiror should be willing to pay for the target.

steps for creating a pro forma statement

1. qualitative analysis 2.quantitative analysis 3. test the critical assumptions

payback

= investment/annual cash flows; if the investment does not return regular equal installments, then the payback can be found by adding each year's return successfully until a figure is obtained that equals the original investment. predicts when that money will be available for other investments. Downside is that this does not recognize returns beyond the payback date.

net book value

= purchase price+improvements-depreciation

cash flow in perpetuity

= relevant cash flow in last year/target's cost of equity; used if it can be assumed that the target firm's growth rate will have stabilized by the end of the investment evaluation horizon. determines residual values

Cost of Debt

=(1-Tax Rate) x Interest Rate; to include this in the cost of capitalization equation, this cost of debt needs to be multiplied by the percentage of debt in the firm's target capitalization.

Next best Cost of Equity

=(next year's dividend/current stock price)+Growth Rate; where Growth Rate = (1-Payout%) x ROE; This requires the analyst to predict the firm's growth rate. Assumption is that dividend payments will increase at the same rate that the firm grows. Predicated on the belief that the stock price reflects the present value of all future dividends. Disadvantages: it cannot be used if the firm pays no dividends; assumes that a firm's growth rate is constant.

Calculate absolute dividend payout

=EPS x PO

cash flows from operations

=Net income + depreciation

cash flows when accounting for working capital investments

=Net income + depreciation-capital investment - net working capital investment

determine if a company is managing capital appropriately

=Operating Cycle - Days Payable

Cost of Preferred Euity

=Preferred Dividends/Preferred Equity in Capital Structure; no tax shield - paid with after tax funds

CAPM Formula

=Risk Fre Rate + Beta(Market Return-Risk Free Rate)

dividend yield

=dividend/stock price

relevant cash flow valuation

=net income+depreciation-change in working capital-capital investments. This is the most straightforward type of cash flow valuation. The most sophisticated of the approaches.

implied price earnings ratio

=present value of future cash flow per share/current earnings per share; assumes the stock's value is equal to the present value of its future cash flows (dividends)

Total Required Return

=risk free rate + risk premium

book value is unlike liquidation value and replacement value because: a. the latter two are market driven, b. it depends more fully on accounting methods, c. it is the maximal obtainable price in the seller's eyes.

A & B; All three valuation methods are "asset-based" approaches. The book value approach is a function of accounting convention and elections made by the firm. Liquidation and replacement cost are more market driven in that the assets are valued based on what a third party would have to pay to recreate a similar bundle of assets.

How firm's cope with flexibility requirements

Because debt can provide finds more quickly that new equity, firms often leave room in the debt capitalization strategies to allow for this in the event of a flexibility crisis.

It is important for managers to establish an average hurdle rate because:a. hurdle rates are varied in accordance with risk, b. in order to vary hurdle rates, one must have a frame of reference, c. no two investments can be analyzed using the same hurdle rate.

A & B; in order to assure comparability of various investments, it would be unusual and ill-advised for a company to use more than a few different levels of hurdle rate. Thus, many investments could be analyzed using the same hurdle rate. Companies typically establish classes of investment according to the perceived risk of the new proposal. Cost reduction proposals might be considered low-risk investments, whereas new product proposals as a class would be analyzed using more stringent return criteria because they have higher than average risk

The point of equilibrium between the positive effects of financial risk and financial leverage is a. dependent on the company and the industry, b. theoretically results in the lowest P/E, c. theoretically results in the highest EPS

A & C. Remember the graph from the test. As leverage increases, EPS increases to the point that earnings suffer from prohibitive interest charges. That optimal point is represented by the peak in the graph just where the leverage point lies varies across industries and companies.

Flexibility issues are those which; a. deal with a company's financing reserves, b. involved recurrent disasters which typically befall firms in a given industry, c. impact the debt capacity that a firm should maintain

A & C; A flexibility crisis is a rare, unpredictable event, thus B is not correct. To prepare for this event, reserves (in the form of debt capacity) are set aside (A & C)

Which of the following statements is true about EBIT analysis?a. Only the incremental effects of a financing decision on EBIT are considered., B. it is the same as a FRICTO analysis, C. Common Stock, new interest and preferred dividends are important variables in the EBIT analysis

A & C; EBIT analysis is not the same as FRICTO analysis; it is a subset of the "Income" step in a FRICTO analysis.

Synergy between two companies: A. is a complementary situation where value is created in the joining of the firms B. results only if the bottom line is immediately improved for the acquiror, C. could be defined by purely qualitative benefits

A & C; Synergy is that mystical force that allows two plus two to equal five. The summed value of the two companies is greater than the value of either company operating independently. While the benefits may not be immediately felt, synergy can drive companies to manufacture better products than they would have been able to previously, and to deliver more efficiently their products to market

The marginal cost of capital is: a. the minimum cost of recreating a company's capital structure in the current marketplace, b. the maximum cost of recreating a company's capital structure in the current marketplace, c. used for an average hurdle rate because it includes the market's assessment of future company risk

A & C; the key word here is "marginal". If management had to refinance the company in the present debt and equity markets, the managerial cost of capital is the minimum cost that it would incur. The capital markets always price securities based on expectations of future performance, this the marginal cost of capital is also determined by the company's prospects.

Statistical methods can be employed to: a. smooth out historical performance trends, b. aid the analyst in making estimates, c. establish boundaries for sensitivity analysis, d. B & C, e. A, B & C

A B & C;

the following could be reasonable estimates of a firm's future terminal value: a. book value, b. liquidation or salvage value, c. a cash flow in perpetuity based on the flow in the final year of the evaluation horizon

A B & C; all of these are reasonable estimates of a firm's projected terminal value

When doing a comprehensive financial forecast, which account warrants the most thorough relational and trend analysis? a. sales, b. return on equity, c. earnings per share, d. common stock

A sales; Sales is generally the single most significant item in a financial projection, because changes in many expenses and working capital are closely correlated with changes in sales. Return on Equity and EPS are bottom line figures that are results of operations i.e. they are determined by sales. Changes in common stock are generally the result of management plans and market conditions, factors which would not be discovered through historical analysis.

Every financing decision involves: a.How much, b. what the target capitalization is, c. what the dividend policy is.

A, B & C; In every financing decision, three questions are addresses (1) how much funding is needed, (2) what is the capitalization policy and (3) what is the dividend policy

A target cost of capital is:a. always implied unless the term "existing" or "current" is used, b. the capitalization that management is "shooting for", c. the capitalization that will result after an asset is financed

A, B & C; Target cost of capital is determined by the underlying capital structure and can be viewed in either a long-term or short-term perspective. Over the long term, target capitalization reflects management's ambition for the ideal capital structure. Using a shorter frame of reference, target capitalization represents the capital structure after an investment as been financed.

The cost of capital can be defined as: a. the weighted average cost of attracting investors to the firm, b. the price of obtaining funding for the firm, weighted according to the target ratios in the capital structure, c. the weighted average return that investors in the firm require

A, B & C; all describe the same phenomenon from different perspectives.

The efficient market theory seems reasonable because: a. there are hundreds of financial analysts valuing securities, b. there are hundreds of investors trying to make money from improperly valued securities, and the market forces which result drive stock prices to a fair value, c. statistical assessments are becoming increasingly important in financial analysis

A, B & C; all of these statements are true. In the absence of inside information, it is difficult to "out guess" the market on a consistent basis since securities are generally valued by the market.

The advantage of using the marginal cost of capital as a company's average hurdle rate is: 1. capital market estimations of risk are probably more objective than the company's,b. it reflects the incremental cost of funding future investments, c. it is the basis of the market's assessments of a company's investment decisions

A, B & C; although company insiders have more information than the market, capital markets have no emotional attachment to risk-increasing investments. The markets are sober and mercenary. Management is not always so detached. We learned in the last chapter that investments must generate returns in excess of the discount rate in order to create value. The marginal cost of capital in large measure determines the discount rate.

Income issues deal with: a. the impact of a financial alternative on the income statement, b. factors which may affect shareholder income, c. Income dilution

A, B & C; these are all income issues (1)explicit costs, (2)EPS Dilution, (3) implicit costs.

when a cash flow in perpetuity is calculated, a. the appropriate cost of equity should be used if the cash flow forecast has included interest on debt obligations, b. the appropriate weighted-average cost of capital should be used if the cash-flow forecast has not included interest on debt obligations, c. the cash-flow's growth is assumed to have stabilized.

A,B & C are all true statements

In a healthy manufacturing company, which of the following ratios would typically have the smallest value? a. asset turnover, b. receivables turnover, c. inventory turnover

A. Asset Turnover (percent: 50%=0.50). In a manufacturing company, asset turnover is calculates as sales/total assets. Its value can range from less than 1 turn per yer to perhaps 3 or 4. Rarely would a manufacturer turnover its assets as often as 10 times per year. Receivables and inventory turnover should be at least 4-6 times per year for the avg. manufacturer

the marginal cost of debt: a. is an after-tax cost because interest expenses are deductible, b. is a before-tax cost because interest expenses are deductible, c. usually excludes new issue fees

A; Only A is correct because interest expenses are allowable deductions for computing taxes payable; the government, in effect, subsidizes the cost of debt.

Risk issues are those which: a. involve recurrent developments which may impact a firm's ability to meet contractual obligations, b. are on the same scale as a depression, c. ordinarily favor alternatives other than equity

A; Risk issues involve recurrent developments, not rare unpredictable events. Risk issues ordinarily favor alternatives other than debt, not equity, thus C is false.

On the basis of the numbers above which project would you support A or B? Project A: Payback 2.7, PV Paybakc 3.4, NPV $8,065, PVI 1.4, IRR 24.9%; Project B: Payback 2.5, PV Payback 3.0, NPV $6,973, PVI 1.14, IRR 16.1%

A; The most telling indicators are the PVI and IRR. In addition, B requires an investment of $50,000 to provide a return of $6,783. Project A generates a greater net present value from an investment, 40% as large

Which of the following statements are true about relevant cash flow valuations: a. they consider the target to be a going concern, b. they allow for the obligations to debt holders, c. no two investments can be analyzed using the same hurdle rate

ABC; contrary to the rule that we established in our discussion of capital budgeting, cash flows associated with the target's capital structure (financing) should be included in the relevant cash flow valuation. The reason for this contradiction is that any debt of the target's balance sheet is previously existing. Because the interest payments are included among the cash flows, the target's cost of equity is used as the hurdle rate.

Profit Margin Ratio or ROS

AKA Return on Sales Ratio: indicates a firm's ability to convert sales into earnings. Can compare across industry. = net income/net sales

Selecting Investments

After quantitative analysis, qualitative considerations must also be applied. Qualitative assessments should include: impact on personnel, the community, environment, and the law as well as the strategy of the company.

Financial Strength Ratios

Are often calculated differently at different firms. Analysts need to consider how they were calculated to ensure they are compared correctly.

Mergers are more difficult to evaluate than single-asset investments because: a. the tax issues are less involved, b. there are more valuation methods, c. there are synergies and purchase price negotiations

B & C; As you have seen, valuations can be based on assets, earnings or cash flow. Even with the multitude of valuation methods, the process is not exact; there is still room for negotiation

If a company consistently uses hurdle rates that are higher than its marginal cost of capital, then: a. it will certainly increase its earnings, b. it may have fewer and fewer investment alternatives, c. the risk of the firm will increase

B & C; increases in risk are compensated by increasing the return required from investments. This is reflected in higher hurdle rates. Using hurdle rates consistently in excess of its cost of capital, a firm will find that its investment options are limited and that its risk will systematically increase.

The final step in using pro formas is to: a. test the assumptions, b. compare the results of the sensitivity analysis to the decision-makers risk tolerance in the current situation, c. create best and worst case scenarios, d. A & C, e. A, B & C

B Compare the results of the sensitivity analysis to the decision maker's risk tolerance in the current situation; pro formas are generated because a decision has to be made. Thus, the analysis cannot end with analysis.

In projecting an income statement based on a balance sheet, which of the following categories would you content to be least likely to vary directly with a change in sales? a. accounts payable, b. depreciation, c. inventory, d. cost of goods sold

B depreciation; Receivables, inventory and cost of goods sold all would have a direct relationship with a change in sales

what financial statement indicates a firm's financial situation on a single day? a. income statement, b. balance sheet, c. statement of retained earnings, d. sources and uses statement

B. BALANCE SHEET; the purpose of the balance sheet is to present a snapshot of a firm's financial position at a point in time. All of the other statements suggest a period of time has elapsed.

In projecting an income statement based on a balance sheet, which of the following categories would you contend to be least likely to vary directly with a change in sales? a. accounts payable, b. depreciation, c. inventory, d. cost of goods sold

B. Depreciation; receivables, inventory and cost of goods sold all would have a direct relationship with a change in sales.

Which of the following ratios cannot be compared among firms? A. ROE, B. EPS, C. P/E, D. Payout Ratio, E. Debt/Capitalization

B. EPS: Because an EPS calculation is dependent on the number of shares of stock outstanding, and those numbers vary from firm to firm, it is meaningless to compare EPS figures. All of the other ratios cited are frequently compared across companies.

a shortcoming of the simple payback method is that it: a. rewards investments that return their cashflows later, b. does not recognize cash flows beyond the payback period, c. relies heavily on salvage values, d. A & B, e. A, B & C

B. does not recognize cash flows beyond the payback period; Payback is generally thought to have two weaknesses; it disregards the timing of cash receipts within the payback period and it ignores all receipts that occur after payback has been achieved

NPV is the preferred method for making investments because: a. it quantifies the proportion of cash flows to initial investment, b. it directly measures the creation of value, c. it is insensitive to changes in the hurdle rate assumption, d. a & b, e. B & C.

B. it directly measures the creation of value; NPV reports in present dollar terms aout how much value will be added to a company as the result of making a particular investment. Because it is an absolute measure, it is awkward to apply in a comparative perspective. NPV is inversely linked to the hurdle rate used to discount the cash flows - the higher the hurdle rate, the lower the NPV.

What does the sustainable growth calculation measure? a. how quickly a firm can expand sales given harsh economic conditions, b. how quickly a firm can expand its asset base with raising external capital, c. a company's historical 10-year sales growth, c. a company's projected 10 year sales growth

B. the sustainable growth calculation shows, in the absence of external financing, the maximum rate of growth a firm can enjoy. Simply calculated, it is ROE times the earnings retention rate: ROE x (1-PO)

Which of the following statements about bonds is always true? a. a bond's yield to maturity is equal to its coupon rate, b. the yield to maturity is equal to the internal rate of return of a bond's cash flows, c. the higher the rating on a bond the higher its rate of interest, d. bonds are of higher risk to investors than stock

B; A bond's yield to maturity is calculated in the same way an investment's internal rate of return is measured, by finding the discount rate at which its future cash flows exactly offset the initial cash flow.

Breakeven EBIT calculations enable managers to assess a. the probable EBIT level when an alternative is chosen, b. the point at which EPS dilution is equal for two financing alternatives, c. the point at which the fixed costs of a financing alternative are met d. none of the above

B; Breakeven EBIT enables a manager to determine the EPS dilution that equates debt with equity. Since interest is a fixed cost and equity participation can be thought of as a variable cost, if EBIT is above the breakeven point, debt will always be the less expensive alternative. Below breakeven, equity is less expensive.

Jack expects tuition and fees to be $15K/yr. He is considering a stock with 8% ROI and 10% ROI. If Jack wants to minimize his current cash outlay, which stock should he buy, A or B?

B; Since B has a higher interest rate, its present value, given the same future value is less

The flexibility step in a FRICTO analysis allows managers to consider financing alternative a. in light of cyclical risk, b. in terms of predicted funding needs that would be required in rare, firm threatening situations, c. A & B, D. None of the above

B; The flexibility step concerns itself with rare situations, not cyclical or known funding needs.

Preferred stock shares characteristics of

Both debt and common stock. These securities typically do not participate in the growth of the firm like common stocks and the company is legally bound to make periodic dividend payments

The issue of control is not important: a. if managers hold less than a controlling interest in the firm, b. if there are no large stockholders, c. if debt is issued, d. all of the above, e, none f the above

C if debt is issued; If debt is issued, control is not important. Control deals with the composition and scope of the firm's ownership. Thus its a concern associated with equity, not debt

If a firm's marginal weighted average cost of capital is 15%, an appropriate hurdle rate for investments of lower-than average risk to the firm would be: a. 14.5%, b. 15%, c. 12%, d 18%, e. 20%

C. 12%; If the financial criteria for an average risk level investment requires 15% rate of return, then a lower than average risk investment does not need to generate as lofty a return, since increased risk is compensated with increased return. The difference in required return between an average investment and a ow-risk investment should probably be several percentage points

what potential hazards arise when a company reduces its investment in inventory? The company: a. antagonize its creditors, b. lose good customers if it restricts credit too severely, c. lose sales if it overly restricts the amount of inventory that it carries, d. all of the above, e. B & C

C. Lose sales if it overly restricts the amount of inventory that it carries. From a cash perspective, the inventory reduction is positive; however, this may cause stockouts and the resulting lost sales.

which of the following ratios is the best indicator of a firm's ability to manage its assets? a. ROS, b. EPS, c. ROA, d. GM

C. ROA; Return on Assets. It describes a firm's success in converting its investment i assets (of any form) into profit. This ratio is frequently used by top managers to measure the success of profit center managers.

the most significant difference between projecting balance sheets and projecting cash flow is that: a. a projected balance sheet will show dividend distributions, b. the balance sheet does not require a plug figure to balance because assets equal liabilities plus equity, c. the cash flow statement shows the periodic increase or decrease in the plug figure, d. none of the above

C. Statement C is correct because the cash flow statement, like an income statement, measures activity between two points in time. Since it reports changes in cash flow, and the balance sheet plug figure represents the accumulated excess or shortage of cash flow, projecting a cash flow statement shows the increase of decrease in the plug.

If an investment's IRR is higher than the firm's chosen hurdle rate, then the investment: a. has a negative NPV, b. is of greater risk than the overall risk of the firm, c. should be qualitatively considered before selection, d. A & B, e. A, B & C

C.; The question is best answered by process of elimination. If the investment's IRR exceeds its hurdle rate, its NPV is positive, not negative. Also, if the return from a project exceeds the hurdle rate, no inference is made about the relative risk of the investment or the firm.

the weakest link in the earnings valuation is: a. projecting the current stock price, b projecting the post-merger earnings, c. projecting the post merger P/E, d. projecting the P/E in absence of a merger

C; Although there are dozens of statistical tools that could be employed to project an independent firm's P/E, any such method would fall apart in the face of a merger. Projecting a post-merger P/E may be as unscientific as looking at the P/E ratios of other similarly merged companies (if they exist) and assuming the same ratio

Project investments are generally less complicated than mergers because: a. project investments rarely have tax implications, b. project investments do not involve extensive qualitative evaluations, c. the potential benefits of project investments are more obvious, d. project investments are generally for smaller amounts than mergers

C; Both project investments and mergers can result in significant tax increases or decreases. Similarly, investments in projects or companies require careful consideration of qualitative issues, furthermore, a project investment may dwarf an acquisition in terms of its size, but regardless of the size of an investment, the same evaluation of potential benefits should be performed

capital gains are a tax consequence of the sale of an old asset if: a. the asset is sold for any amount other than the book value, b. the asset is sold for less than the book value,c. the asset is sold for more than the book value, d. the future depreciation is not lost, e. the future depreciation is lost

C; Capital gains are the excess of the sales price of an asset over the tax basis of the asset. Tax basis is defined as the original purchase price plus the cost of major improvements less accumulated depreciation. In essence, the tax basis is book value for tax purposes.

The most significant difference between projecting balance sheets and projecting cash flow is that a. a projected balance sheet will show dividend distributions, b. the balance sheet does not require a plug figure to balance because assets equal liabilities plus equity, c. the cash flow statement shows the periodic increase or decrease in the plug figure, d. none of the above

C; The cash flow statement, like an income statement, measures activity between two points in time. Since it reports changes in cash flow, and the balance sheet plug figure represents the accumulated excess of shortage of cash flow, projecting a cash flow statement shows the increase or decrease in the plug.

The following should not influence managers to select marginal acquisitions:a. synergies, b. justifiable prices, c. residual values

C; because of their uncertainty, residual values should never be the foundation on which a merger is based.

Cost of convertible funds: a. is an after-tax cost, b. is a before tax cost, c. depends on whether a conversion has taken lace, d. is usually more than the marginal cost of debt, e. none of the above

C; convertible issues are among the more difficult financing vehicles to price. The most important assessment is how close to conversion the issue might be. Convertible debt that is far from conversion to equity is priced as debt, whereas issues closing on on strike price or beyond conversion would generally be priced more like equity.

A company that hasn't issued stock since 1932, has $198M in retained earnings and no debt would be most interested in what financial product or service? a. Innovative securities, b. convertible debentures, c. cash management, d. preferred stock

C; given the apparent conservative nature of the business and its tremendous liquidity, cash management would be its most likely interest

Which of the following would not be included among the investment numbers of a capital budget? a. purchase price of the asset, b. trade-in value of an asset being replaced, c. reduction in labor cost from the new asset, d. investment tax credit from acquisition, e. installation costs of machinery

C; the cash flows relevant to an investment include the purchase price of the asset plus whatever expenditures are necessary to make it operational (installation, freight in etc.) less cash to be realized from the disposition of replacement equipment. Ongoing cash flows such as labor savings are the benefits to be realized from the investment and should not be included as part of the investment.

A firm's marginal cost of capital can be used as its average hurdle rate because: a. the cost of capital is exactly what it would cost the firm to go to the markets to raise its next dollar of debt or equity, b. the terms are synonymous, c. it is a composite figure which represents the average risk of the firm

C; the weighted average cost of capital reflects the average risk as assessed by the providers of capital for all investments made by a firm. Because the cost of capital is a blend of debt and equity charges, it would not be representative of the cost of either vehicle alone.

If an analyst uses the percentages of debt and equity on a firm's balance sheet and the interest charges from its income statement to calculate the cost of capital, then: a. a marginal cost will result, b. the target weighted average will result, c. the current weighted average will result, d. the marginal target cost of capital will result

C; unless a firm's capital structure is the same as its target capital structure, the balance sheet will reveal historical rather than target capitalization. Using the income statement, though, will only coincidentally provide the long-term cost of debt since historical interest rates are not necessarily the same as future interest rates.

Investment =

Cash paid - sale of old

Equity =

Common Stock + Retained Earnings

Debt to Capitalization

Compare across Industry. Measures long term debt which can vary across firms. Many include deferred income taxes in the LTD. = LTD/ (total equity+LTD). A lower Debt Capitalization (debt capacity) means that the firm has more capacity to add to its debt.

Comparative Analysis

Compare across industry and size. Must account for different accounting methods and strategies at various firms.

Vertical Percentage

Compare percentage changes across a specific benchmark, for example Sales. In this example we would determine what the % of Cost of Goods Sold was of Sales p. 17

Trend Analysis

Compare year over year or through Horizontal and Vertical Percentages

comparative balance sheet

Compares balance sheets for more than 1 year. Compares the two side by side

whenever an investment's NPV is negative, its IRR will be lower than the discount rate used

Conversely, a positive NPV implies that the IRR is greater than the discount rate

Determine which company has the most control over the costs to produce its products

Costs of Goods Sold %

An effective way to discern trends in a company is through the use of a. horizontal percentage analysis for several years, b. vertical percentage analysis for several years, c. ratio analysis for several years, d. all of the above, e. A & B

D. All of the Above; horizontal percentage analysis compares and reports changes in a company's financial results from year to year. This analysis reveals trends that can be compared with earlier trends. Other trends can be seen by performing vertical analysis and ratio analysis over several years.

When performing sensitivity analysis: a. statistical methods can be usefully employed, b. electronic spreadsheets can save time, c. assumptions should be changed one at a time, d. all of the above, e. B & C

D. All of the above

An assumption is considered critical if: a. it is questionable, b. it affects the bottom line greater than other assumptions do, c. it reflects a judgment about the firm's ability to perform one of the "keys to success", d. B & C, e. it is related to the general economy

D. B & C: critical assumptions are those around which an analysis is built. Since they represent the foundation of the analysis, they probably have a material impact on the bottom line. In addition, they should also be rooted in the key success factors as determined in the qualitative analysis.

A differential analysis: a. should be used only to compare an alternative to the status quo, b. can be used to compare any set of alternatives, c. is easier to comprehend if a constant frame of reference in employed, d. B & C, e. A, B & C

D. B & C; A differential analysis is similar to examining incremental cash flows - it reveals how the results of one course of action differ from the results of another course. Incremental analysis is an extreme case of differential analysis because the alternative is compared with the status quo.

How can a company reduce its working capital position? a. by reducing the amount of inventory it carries, b. by "extending" its account payable, c. A & B, d. none of the above

D. NONE OF THE ABOVE; the working capital position of a firm measures current assets less current liabilities at any given time. Charges in current accounts do not impact the working capital position.

during the qualitative portion of developing pro formas: a. economic issues are ignored because they will be reflected in the sales levels of various years later in the quantitative analysis, b. relative marketing strategies are not considered, c. industry-wide consideration are more important than company-specific ones because they are more applicable, d. industry-wide considerations may be less important than company specific issues

D. You are projecting the statements of a company and no company moves exactly the same footsteps as the industry in which it competes. It makes sense, then, to spend more of your time on company-specific issues than more global industry phenomena.

From an acquirer's perspective, the absolute extremes of a negotiating range in an acquisition are defined by: a. the target's book vale and the maximum dilution-free price, b. the replacement cost of the firm's target assets and the present value of the target's enhanced cash flows, c. the justifiable price and the present value of the target's cash flows without synergies, d. the justifiable price and the present value of the target's enhanced cash flows.

D. the negotiating range is bounded on the low end by the present value of the target's cash flows, assuming no merger takes place (the justifiable price), and on the high end by the present value of the target's enhanced cash flows.

statistical analysis should not be performed: a. on an item subject to great uncertainty, b. on an item which comprises a major proportion of the projected data, c. until the best and worst case scenarios are complete, d. on a predictable, immaterial item

D: Sensitivity analysis should be performed on items that will have a material impact on the outcome of the forecast and which are subject to some uncertainty.

From the acquiror's perspective, the absolute maximum price that should ever be paid for a target is: a. the liquidation price of the target's assets, b. the current market value of the target's stock, c. the replacement cost of the target's assets, d. the PV of the target's enhanced cash flows, discounted by the target's appropriate cost of capital

D; D is the only choice that recognizes the target firm might have a latent value not reflected by the cost of its assets or the market value of its stock. Discounting the cash flows provided by the target (synergies included) is an analysis very similar to the capital budgeting examples in Ch. 4

Sensitivity analysis should not be performed a. on an item subject to great uncertainty, b. on an item which comprises a major proportion of the projected data, c until the best and worst case scenarios are complete, d. on a predictable, immaterial item

D; Sensitivity analysis should be performed on items that will have a material impact on the outcome of the forecast and which are subject to some uncertainty

Which of the following is the most likely reason that a merger will not be as financially rewarding as initially projected? a. the cost of capital of the acquiring firm will change, b. the cost of capital of the target company will change c. the tax code will change, d. the projected cash flow enhancements will not materialize

D; despite the complexity involved in analyzing an acquisition, a merger is still an investment. If the projected cash flows are not managed effectively, the investments may become a failure.

Assets =

Debt + Equity

a firm announced plans to refinance the debt that is currently in its capital structure with debt that has a substantially lower interest rate and less restrictive terms. the firm's former interest obligations had just been above the highest acceptable industry average. The dividend yield that the acquired firm pays will

Decrease. Because risk is reduced, the market price of the stock will increase. However, since the dividend will be unchanged, the dividend yield will fall. Remember, risk and return is a double edged sword; as risk falls, he return that an investor can demand will fall as well. The lower yield however, applies only to new buyers of the stock. Those who bought when the price was low would enjoy the same lofty returns as long as the dividend was maintained and would also benefit from the increase in value of the shares.

As the interest rate used to discount future cash flows is increased, present value of the future cash inflows

Decreases. The larger the interest rate used to compound the returns from an investment, the larger will be the accumulated future value. Conversely, with a higher discount rate, a proportionately smaller amount of money needs to be set aside today to reach a target future amount. Thus, the present value decreases as the rate of discounting increases.

what benefits can accrue to a company which reduces its investment inventory? a. less dependence of short-term credit, b. management can focus more clearly on long term objectives, c. improved cash flow, d. all of the above, e. A&C

E. A & C; cash flow improves as inventory is reduced. This may mean less dependence on short-term credit.

the qualitative portion of a financial analysis is analogous to the hypothesis forming stage of scientific investigation because: a. assumptions are not tested until the numbers are run, b. false hypotheses (assumptions) may be formed, c. empirical measurement is performed later, d. A & B, e. A, B & C

E. A, B & C: all of the statements equate qualitative analysis and hypothesis testing

Statistical methods can be employed to: a. smooth out historical performance trends, b. aid the analyst in making estimates of future performance, c. establish boundaries for sensitivity analysis, d. B & C, e. A, B & C.

E. A, B & C; statistical analysis of historical data such as regression or time-series techniques sharpens a forecaster's vision of the future. All are facilitated through statistical analysis

Timing issues involve: a. the cost of the alternative forms of capital, b. sequencing of alternatives, once funding amounts are know, c. the marriage of A & B, d. A & B, e, All of the above

E. All of the above

which of the following are important qualitative issues which should be considered before one begins the quantitative portion of a financial analysis? a. general economic relationships, b. sectoral economic factors, c. the bases of competition in the industry, d. the firm's chosen strategy, e. all of the above

E. All of the above. An analyst needs to assess all relevant qualitative issues before crunching the numbers. All should be considered.

what is the most compelling reason to project a firm's income statement before projecting its balance sheet? a. it is easier to project sales than assets, b. the change in retained earnings is determined by net income and dividend payments, c. working capital account balances are affected by sales levels, d. A & C, e. B & C

E. B & C: it is necessary to know the balance of retained earnings before the plug figure can be calculated to balance the balance sheet. The change in retained earnings is a consequence of the income statement. Accounts receivable and inventory, among other current assets and current liabilities, will change with changes in sales or other income statement accounts.

The ratio which observers use to quantify the stock market's opinion of a firm is the: a. ROE, b. EPS, c. D/E, d. E/A, e. P/E

E. P/E; price over earnings hows the multiple of the most recent year's income at which the stock is trading. It is a measure of the market's optimism of the future earning potential for a company.

which of the firm's statements record a firm's financial situation on a single day? a. Statement of financial Position, b. balance sheet, c. statement of cash flows, d. all of the above, e. Both A and B

E.) Both A & B

coverage ratios a. represents an important method of quantifying the riskiness of financing alternatives, b. show EPS dilution, c. can be calculated in terms of cash or earnings, d. A & B, e. A & C

E; A & C are true. Coverage ratios, generally speaking, tell how many times a firm's earnings or cash flow would be able to cover its contractual obligations for interest and sinking fund payments. It shows how much cushion the firm has in covering its fixed charges.

What is the most compelling reason to project a firm's income statement before projecting its balance sheet? a. it is easier to project sales than assets, b. the change in retained earnings is determined by net income and dividend payments, c. working capital account balances are affected by sales levels,d. A & C, e. B & C

E; It is necessary to know the balance of retained earnings before the "plug" figure can be calculated to balance the balance sheet. The change in retained earnings is a consequence of the income statement. Accounts receivable and inventory, among other current assets and current liabilities, will change with changes in sales or other income statement accounts.

A breakeven P/E calculation a. requires an estimation of the market's reaction to funding choices, b. is only relevant when a comparison can be made to the firm's historical P/E, c. requires a prior EBIT analysis, d. A & B, e. A B & C

E; Statements A, B & C are true. Calculating a breakeven P/E requires a comparison of funding alternatives. This comparison involves EBIT analysis and historical P/Es. Once these are determined, an estimation of the market's reaction is made. Thus, all three statements are true.

Timing issues involve a. current financial needs, b. future financial needs, c. status of the capital markets at the time funding is needed, d. A &C, e. A, B & C

E; Timing involves all three items - current financial needs, future financial needs and most important, status of the capital markets at the time funding is needed. Needs are one thing, but the status of the markets is everything.

calculate market value of share price

EPS X shares x P/E

Sources of Equity

Earnings or issued stock

Types of debt

Equity and Financing

Easier to gain large amounts of financing through

Equity rather than debt; managers tend not to want to finance with equity for fear of losing control which is short sighted as interest rates can increase just as likely for stock prices to fall. Managers need to also consider financing for future projects and incorporate it into their analysis.

Common stock is more forgiving than debt

Even though dividends are expected by shareholders, the company has the option of reducing or suspending dividend payments without the threat of bankruptcy

Unless an addition to working capital is permanent, it should not be considered among the cash flows of a capital budget

FALSE - any increase in working capital, whether permanent or temporary, requires a use of cash and should be included in the cash outflows of a capital budget.

If managers have discovered an attractive investment but financing opportunities are not as good as they have been, they should probably delay the acquisition.

FALSE. Another tenet of finance is that one should not mix decisions to invest with decisions about hot to finance. If analysis of an investment opportunity indicates that value will be added to the firm, even considering the high current cost of financing, then the project should be funded through the most appropriate package of debt and equity available at the time.

If managers do not foresee investment opportunities in the coming year that are as attractive as they have seen in the past, it is time to raise the dividend to the level that mature companies pay

FALSE. Changing a firm's dividend policy based on a one-year outlook is an example of poor financial management. Investors cherish stability, not willy-nilly changes in their returns. A firm should change its dividend policy only if it foresees a permanent leveling in its growth prospects, or if its funding needs would be best met through internal sources.

Financial Strength ratios indicate a firm's earning power

FALSE: Financial strength ratios measure how a company is capitalized. Operating performance ratios tell of a firm's earning power.

qualitative considerations are rarely as important as the numerical comparisons in the financial analysis. True/False

FALSE: The wisdom in comparative financial analysis lies in the interpretation, not the derivation of the results. To be able to interpret the outcome of an analysis demands an understanding of the key success factors, cost structure and future direction of a firm in the industry in which it competes

If projected assets exceed liabilities and owner's equity, it is assumed that the difference is funded through excess cash.

FALSE: a projected excess of assets over liabilities and equity implies a shortfall, not an excess of cash. This shortfall is typically assumed to be financed with short-term or long-term debt.

A payment of dividends reduces the balances of the cash and common stock accounts on a balance sheet

FALSE: dividends are a distribution of a company's net income. Since they are paid of to shareholders, the earnings are not retained, hence, retained earnings (not common stock) decreases. The only way the balance in a company's stock declines is if shares are repurchased by the company from the open market and are retired.

On an income statement, all of the expenses which reduce a firm's earnings involve an outlay of cash

FALSE: expenses such as depreciation (a periodic charge to income which allocates the cost of long-lived assets to the periods benefited) or amortization are non-cash charges. That is, although they are reported as expenses they do not require an outflow of cash.

The greater the detail in a pro forma the greater the accuracy will be

FALSE: false assumptions can be built on with great precision and result in poor pro formas. Do not confuse accuracy with precision - it is much more important to be accurate when forecasting than it is to be precise.

when making financial projections, if a particular expense item cannot be predicted with any degree of confidence, it should b forecast at the highest level it would ever likely reach, so as to make the pro forma conservative

FALSE: if a projected data item is subject to great uncertainty, it is probably better to project a most likely value rather than the extreme value, unless you are piecing together a "best-case" or "worst-case" scenario. In general, if items cannot be predicted, projecting at the midpoint of a range, will on average, allow errors from over-estimates to cancel errors from under-estimates.

The most accurate pro formas contain the most detail

FALSE: it is important not to confuse accuracy with precision . Projections that accurately anticipate future reality provide meaningful information on which to make decisions. Precise forecasts which may be supported by great detail are useless if they do not approximate reality

Unlike capital budgeting derivations, it is best when evaluating mergers to rely on a single quantitative method: this ensures consistency

FALSE: mergers, even more than capital investments or cost of capital calculations, warrant the use of several approaches to determine whether the acquisition target is desirable and what constitutes a fair negotiating range.

A future feasibility study to determine the environmental impact of a planned investment should not be included in the incremental cash flows of an investment analysis.

FALSE: the key word here is future. If the study must be performed before the investment can be undertaken, then it should be included among the relevant cash flows. Had the study already taken place, it would be classified as a sunk cost and should be ignored in the analysis.

If an investment's net present value is zero then its IRR must also be zero.

FALSE: this statement would be true under only one condition: if the investment generates no returns at all. In any other case, the IRR will be equal to the hurdle rate if NPV is zero

Because accounting practices vary, comparisons between a firm and its industry as a whole are considered useless.

FALSE: when making industry comparisons, and implied assumption behind the analysis is that, on average, the accounting methods of the firms within the industry will neutralize the effects of extreme policies. Generally though, firms in the same industry tend to pursue similar accounting policies so that they will not be misunderstood or punished by the investing community.

If projected assets exceed liabilities and owner's equity, it is assumed that the difference is funded through excess cash

FALSE; A projected excess of assets over liabilities and equity implies a shortfall, not an excess of cash. This shortfall is typically assumed to be financed through short-term or long-term debt

Legalities determine whether merger should occur; a valuation determines what form the business combination shall be

FALSE; A valuation by an acquiring firm of the post-merger cash flow potential of the combined entity will determine whether it is worthwhile to make the acquisition. The form taken by the combined firm is a product of legal and accounting conventions.

FRICTO analysis can point out poor investments

FALSE; FRICTO analysis addresses financing issues, not investment choices

A FRICTO analysis enables prudent managers to assess investment decisions

FALSE; FRICTO analysis is an analytical framework that is useful in addressing the important issues in asset financing. It is used after addressing the important issues of funding amount, dividend and capitalization policies have been decided. It is not used to assess investment decisions.

The income step should be more important than the flexibility step in influencing managers' funding choices.

FALSE; In FRICTO analysis, no one step should be more important than any other step. This axiom is particularly true at the beginning of an analysis; however, as a debt vs. equity analysis proceeds, some steps do assume greater importance than others.

Firms that payout a large portion of their earnings in dividends will have a higher cost of equity than firms that pay no dividends

FALSE; In the theoretical world of finance, whether a firm retains or distributes its earnings is irrelevant since the cost of equity includes costs for dividends and retained earnings. The cost of equity is a function of risk, not dividends policy. In reality, dividends are necessary outlays for many firms because of shareholder expectations. However, higher dividends do not necessarily result in higher costs of equity.

The most accurate pro formas contain the most detail

FALSE; It is important not to confuse accuracy with precision. Projections that accurately anticipate future reality provide meaningful information on which to base decisions. Precise forecasts which may be supported by great detail are useless if they do not approximate reality

The risk-free rate of return used to determine a firm's cost of capital will vary depending upon the financial and operating risk level of the firm.

FALSE; at any one time for a given time horizon (debt maturity), there is only one risk-free rate. Different maturities will have different risk-free rates because of liquidity preferences and speculation about future interest rate movements. The varying rates are reflected in a yield curve

relevant cash-flow valuations are determined through the use of the target's weighted average cost of capital

FALSE; because the target's relevant cash flows include amounts paid for interest on the debt in its capital structure, it would be double counting to discount the interest payments using the weighted-average cost of capital. The cost of equity of the target is a more appropriate discount rate.

It is impossible for the acquisition price of a target firm to ever fall below book value

FALSE; the savings and loan industry is a poignant example of an entire industry that traded at levels well below book value. In the early 1980s when interest rates soared to record heights, savings and loans, whose asset base consisted almost entirely of long-term mortgage loans, found themselves in a market that would pay only 20-30% of book value for their assets

The utility of sensitivity analysis is not nearly as great in merger valuations as it is in capital budgeting

FALSE; this is most certainly a false statement. The uncertainty surrounding a combination of companies is far greater than the uncertainty surrounding the acquisition of a piece of machinery. Sensitivity analysis can assist in planning for the uncertainty.

Many analysts prefer the current ratio to the quick ratio because the latter compares only cash equivalents to current liabilities

False: it is because of this reason that analysts prefer the quick ratio. Non-liquid assets like inventory or prepaid expenses can distort the liquidity impression one might get from a current ratio alone.

a future feasibility study to determine the environmental impact of a planned investment should not be included in the incremental cash flows of an investment analysis T/F

False; The key word here is future. if the study must be performed before the investment can be undertaken, then it should be included among the relevant cash flows. Had the study already taken place, it would be classified as a sunk cost and should be ignored in the analysis

Balloon Payments

Firms with exceptionally strong credit ratings may be allowed to forego sinking funds, and repurchase the bonds at maturity with a single one of these.

A company that hasn't issued stock since 1932, has $198M in retained earnings and no debt would be most concerned with what part of the FRICTO analysis?

Flexibility. The large amounts of cash and no debt indicates concerns regarding flexibility.

a firm announced plans to refinance the debt that is currently in its capital structure with debt that has a substantially lower interest rate and less restrictive terms. the firm's former interest obligations had just been above the highest acceptable industry average. The firm's stock price will likely

Increase. The stock price will increase because financial risk will be reduced as a result of the low contractual obligations (interest payments) and less restrictive covenants.

Marginal cost of capital

Further refinement of the target cost of capital; based on the prices that are reflected in the current capital structure. Uses the "target" capitalization but its costs are based on the prices which exist in the current market. This is based on the prices that a company will have to pay, to re-create that target structure, in the current marketplace.

GM% Gross Margin Percent

Gross Margin/net sales (an outdated but still used synonym for gross margin is "gross profit")

a firm has recently announced plans to issue bonds which will carry its debt/equity ratio a point well above the industry standard for companies of its size. Assuming no change in policy, the firm's dividend yield will be

Higher. A lower stock price and constant dividend translates into a higher dividend yield. This makes sense given out assertion that increased risk necessitates and elevated return.

Calculating the cost of convertibles

If the instrument has not been converted, its value is calculated the same way as equity or debt. An unconverted bond is treated as debt. An unconverted convertible preferred share is treated as preferred stock; Cost of New Equity = (next year's dividend/stock price x (1-Fee%))+ Growth Rate; OR Cost of New Debt = (Interest on Coupon Payment/proceeds debt issue) x (1-tax rate) p.58

A capital budget is a forecast

It is forward looking. Funds spent in the past are sunk costs which are irrelevant to the incremental analysis, thus they should be excluded from the projections.

Capital budgeting has to do with budgeting on the ___side of the balance sheet

Left side - Assets

suppose Jack's daughter planned to take a year of after HS to "find herself", so that he now has three years to amass the $15,000 for her tuition. Would he have to set aside more or less to achieve the future value?

Less; the longer his investment is earning money, the smaller its present value needs to be to achieve the specified future amount

Low risk firm has a

Low beta

Retained Earnings =

Net Income - Dividends

to calculate dividend payout

Net Income-Dividends = change in retained earnings OR Net Income - Change in Retained Earnings = Dividends

Types of Hybrids

Preferred Stock and Convertibles

If Jack could muster $12K for the stock yielding 10% and planned to pay the tuition in two years would he have enough money?

No; The future value of Jack's $12K is $12,000*(1.10^2)=$14,520. He might have to get a student loan for the rest

Risk

Not all events are unforeseen and unpredictable (think recession) and plan for these risks. This is backward looking at historical performance during similar times. favors financing options with funds other than debt. (dividend policies can change while interest rates do not). Uses coverage ratios

Taxable savings =

Operating Cost Saved - Net Depreciation

types of earnings valuations

P/E valuation, implied price earnings ratio, earnings dilution

Comparison to Industry

Quantitative Analysis can be conducted using the ratios, but must also include a qualitative analysis. Qualitative analysis should precede the quantitative portion because it will highlight the numbers of greatest interest.

a firm announced plans to refinance the debt that is currently in its capital structure with debt that has a substantially lower interest rate and less restrictive terms. the firm's former interest obligations had just been above the highest acceptable industry average. The financial leverage of this firm will

Remain unchanged. Since old debt is replaced with new debt the relative percentage of debt and equity are unchanged.

The most reliable financial comparisons can be drawn between companies of the same size in the same industry. True/False

TRUE: comparisons among companies are generally most beneficial if the operating characteristics of the organization are similar.

EBIT Analysis

Step 2 in Income analysis and determine's the financing choice's impact on dilution of the company's earnings. Two sets of comparison for each alternative (place in a chart usually current earnings and projected with the chosen financing option)

Equity should be chosen as a financing option when

Stock prices are relatively high, additional debt would take the firm precariously close to its debt ceiling and/or the rapid growth suggests a continuation of its low dividend payout. Even if interest rates drop.

Financial Strength Ratios

Strength of long term debt and equity. indicate the risk which can be associated with the way a company has packaged the debt and equity that it uses to finance its assets; Debt to Total Assets, Stockholder's Equity to Assets, Debt to Capitalization, Debt to Equity

it is possible for stock appreciation to offset a dividend reduction and create value for shareholders

TRUE. A shareholder's return is comprised of both dividend and increase in stock value. If the increase in stock value (resulting from increased profit potential or reduced risk) is greater than the dividend surrendered, then the value has been created for the shareholder.

If stockholders perceive that the financial risk of a firm has increased without an offsetting increase in earnings, then the stock rice will probably fall.

TRUE. Remember the financial axiom that an increase in risk must be matched by a commensurate increase in return. In this example, if the perceived risk of an investment has increased, then a higher return will be demanded. If earnings remain unchanged, then investors will not be willing to pay as much for the stock and the stock price will fall.

if managers care about their firm's stock price, then they make it their business to understand the firm's stockholders

TRUE. This statement is true because different individuals will react to the same action in different ways. Investors interested in growth over the long term may with to dispose of a stock that suddenly carries a dividend. In contrast, "widow and orphan" stock companies except in extreme difficulty, cannot defer or abolish dividends because of the dependence their shareholders have on the dividends for income.

Useful comparisons can be made between companies of similar size through the use of horizontal and vertical percentage analysis

TRUE: Intercompany horizontal and vertical analysis are among the most revealing forms of financial analysis.

Even though the goal of a firm is to create wealth for its shareholders, there are times when ethical or strategic considerations outweigh the profit incentive, causing managers to reject investments with positive net present values.

TRUE: Judgment can never be reduced to numbers. Managers have the responsibility to determine how an investment moves the firm toward its qualitative and quantitative goals. Potentially profitable investments that are not consistent with a firm's policies or strategies probably should be rejected, unless no alternative uses for its financial reserves exists.

Hypothesis that are formed during the qualitative analysis can be verified when the analyst reviews the firm's historical performance.

TRUE: One of the purposes of historical analysis is to test the hypothesis you have established, such as key success indicators or perceived trends

management can improve its ROA by reducing investments in property, plant & equiment

TRUE: by allowing the existing asset base to depreciate without replacement, ROA can be improved if the same level of profitability can be maintained.

Horizontal and vertical percentage trends are useful in projecting future financial statements

TRUE: horizontal analysis can help you identify trends over time that can be extrapolated into the future. Vertical analysis allows you to project items relative to a benchmark, such as sales.

In a stable, predictable industry, an average of the previous ten years' sales growth figures probably provides a more accurate forecast than assuming the same level of sales next year as in the current year

TRUE: whenever information is available which would support an educated forecast, employing that information should provide a more accurate projection than would assuming the naive "last year repeated" forecast

analysts within a company are more likely to fall into the "false accuracy trap" when they develop pro formas than would external analysts because insiders have access to more detailed information.

TRUE: whether analysts are inside or outside a company, they should not lose sight of their objectives in doing financial forecasts. As a rule of thumb, the greatest attention should be directed to those items that have the most material impact on the pro forma because of 1) magnitude or 2) their uncertainty

Valuations determine whether a merger is feasible; tax consequences and control considerations help shape the resultant firm's legal structure

TRUE; Asset valuations, earnings valuations and cash-flow valuations all strive to indicate whether an acquisition is financially viable. The form of merger or acquisition taken is a product of the acquiring firm's degree of ownership and certain tax considerations

A crucial step in income analysis is the determination of a financing decision's impact on the dillution of the company's earnings.

TRUE; Earnings dilution is the essence of income analysis. It is essential to make this determination when considering the finance decision.

The risk of illiquidity is more pronounced for debt holders than it is for share owners in a public company

TRUE; Illiquidity is the inability of an investor to readily convert their holdings to cash or cash equivalents. This is considered a risk because firms may have to forego investment opportunities if their funds are "tied up" in other investments. Publicly traded stock certificates are very liquid instruments. The stock market allows stockholders to "get in and out" of their ownership positions very quickly. There is no such debt instrument for loans.

Unstable markets can cause managers to weight one element of a FRICTO analysis more heavily than another

TRUE; Other issues in addition to FRICTO analysis may involve the emphasis of one element over another. Unstable markets might cause a manager to wait it out expecting better times ahead, or choose equity instead of debt because of volatile interest rates.

"Other" Issues may cause managers to assign more importance to one FRICTO element than others

TRUE; Other issues such as risk tolerance may cause managers to emphasize one element of the FRICTO analysis at the expense of others

Value can be created through financing by choosing the least expensive alternative

TRUE; Vale can be created on the right hand side of the balance sheet as well as the left hand side

The earnings dilution method is not a valuation method at all; it merely establishes the maximum price that the company can pay without experiencing a lower EPS next year

TRUE; earnings dilution considers the income that the target firm would add to the acquirers net income and computes the number of shares that could be issued without diluting the EPS for the existing shareholders. As such, it is not a valuation of the target as much as it is a measure of the acquirer's ability to pay.

A firm with substantial fixed costs such as manufacturing overhead will have a higher degree of risk in the trough of a business cycle than will a firm with high variable costs and limited fixed costs

TRUE; firms with substantial fixed costs are said to have high operating leverage. In a business cycle trough if sales volume drops off, such firms are particularly vulnerable since they must cover their overhead with fewer dollars. However, in good times such firms are very successful after they have covered their fixed costs because of their sizable margins.

Hypothesis that are formed during the qualitative stage can be verified by reviewing historical records

TRUE; part of the analysis consists of testing your hypotheses against the facts

Qualitative considerations are as important as cash flow in investment selection.

TRUE; qualitative considerations are certainly as important, if not more so than quantitative criteria when performing an investment analysis. For example, if an investment is inconsistent with company strategy, it might not even reach the stage of quantitative analysis.

In order to use a cash flow in perpetuity as a residual value for an asset, it must be reasonable assumed that the cash flow from that asset has leveled off

TRUE; the value of any asset, if it is assumed that its cash flow is constant, is the annual cash flow divided by a discount rate, or in the case of a company valuation = relevant cash flow from target in final projected year/target's cost of equity

The price of a bond can be determined by discounting the remaining coupons and value at maturity by a factor which is equal to the prevailing yield to maturity earned on bonds of similar risk.

TRUE; we may wish to find the issue or current price of a bond that pays coupon amounts equal to 8% of the face value of the bonds when similar instruments are yielding 10%. We would know intuitively that the lower-than-market coupon payments would force the bonds to sell at a discount

FASB required reporting for firm's

The financial position at period's end (balance sheet), the cash flows for the period(statement of cash flows), the earnings for the period, the comprehensive income for the period (income statement), the investments by the distribution in Owners for the period (balance sheet income statement, statement of owner's equity and statement of cash flows)

Other Issues

The other category typically lends managers to weight one of the FRICTO items more than the others and are often related to the manager's own risk tolerance. This can also be impacted with how quickly the firm can get the money through the various financing means depending on their needs.

Maturity of Bonds

The time that the issuer agrees to repurchase them from holders usually 5-30 years.

A debt issue alleviates a manager's concern for the impact of a new financing decision on control

True: Control is an issue of equity financing, not debt financing

In many ways, managers can consider the opinions of capital markets and the firm's shareholders to be identical

True: the firm's shareholders are a subset of the millions of shareholders comprising capital markets. As such, this shareholder sample of the capital markets represents the "capital market opinion" of the larger population

If a convertible bond has been converted to common stock, then its current cost is the same as the cost of retained earnings

True; The only difference between the cost of new equity (common stock) and retained earnings is the charge for issuing new shares, mainly underwriting legal fees.

Timing

Two timing issues around all financing decisions: (1) sequencing of financial alternatives and (2) status of the capital markets at the time funding is needed.

Preferred Stock

Type of equity (hybrid) but has qualities much like bonds. Provides holders with ownership in a firm, without exposure to many of the risks that common shareholders experience. Receive dividends at a fixed percentage of the par value. Difference from bonds: not an expense that firms can deduct from taxable income. These holders are considered superior to stock holders in the face of liquidation. Do not have voting rights but are protected by fixed dividends if the dividend is decreased but also do not reap benefits if it increases.

in every case

accuracy diminishes with the length of time.

Unless a company is routinely faced with investments in short duration, present value calculations are superior as they take into account the time value of money

Using a combination of these is preferred to compare investments. Once ranked and compared, an investment is selected.

Dividend Discount Methods

When a firm has no foreseeable attractive investment opportunities, it must begin returning investor capital.Presumes that a stock market's value is determined by the present value of future dividend payments. Fundamental assumption: the maximum price that investors are willing to pay for a stock is the present value of the future dividends that they will receive. p.54

Estimating Beta

When difficult to determine 3 methods are used: (1) A company whose risk is equal to the average stock in the market has a beta of 1 - conforms to that of the market; (2) A company whose risk is less than the average stock in the market has a beta less than 1. Indicates that the stock value will move in the same direction as the total market, but not as far.; (3) A company whose risk is greater than the market as a whole has a beta greater than 1. Indicates that he stock's value will change in the same direction as the market index but will change more. OR use a historical number (not accurate).

risk of liquidity

When investing, a company's money can be tied up somewhere preventing them from investing in a better opportunity. The lack of liquidity, or access to funds, can prevent them from participating in the better investment.

Rather than focusing on asset replacement, let's now consider plant expansion. What if a selling point of the new plant is that it increases capacity, but that capacity could be satisfied by running a second shift at the old plant. Should the wages that would be paid to the second shift work force be included in the analysis?

Yes; The point of differential analysis is to compare the company's status given the alternative of choices of actions. In this case, assuming that demand exists to justify the additional output, there are at least two solutions to the problem -- build a new plant or add a second shift. No doubt there are others. To compare apples with apples, it is essential to operate with consistent assumptions. The wages should be included in the analysis

FRICTO Analysis

a framework conducted by analysts to assist managers in determining the most beneficial financing solution. (Flexibility, Risk, Income, Control, Timing and Other). Management determines which are most important though all can be equally important depending on the industry. Does not favor debt issuance. Asset financing.

discount rate

a large discount factor reduces future cash flows at a faster rate than a smaller one. investors compensate for riskier investments by using higher discount factors.

Target cost of capital

a refinement of current cost of capital which is more accurate. Same calculation as current cost of capital BUT alters the % on the balance sheet to reflect the addition of a financing under consideration, or the future percentages that the company intends to maintain.

vertical integration

a situation where a target firm lies upstream or downstream in the production or marketing chain of the products which the acquiring firm produces. This can provide lower production costs or more efficient distribution. both benefit the acquiring firm's earnings or cash flows

horizontal integration

a situation where the target firm produces similar products, and has unused and compatible production resources or a marketing capability that the acquiring company could use. Both benefits can reduce production costs and/or increase sales

statement of retained earnings

a subset of the statement of owner's equity statement. Only includes the changes in the firm's retained earnings account for the period. May also be incorporated on the income statement. Retained earnings are retained by the firm and are not distributed in dividends to stockholders

differential analysis

a technique that is widely used to identify incremental benefits as well as incremental costs. Simply a table in which the benefits and costs are compared. When computing, very important to choose and retain a reference point for comparison.

quick ratio

a variation of the current ratio which uses only assets which can readily be converted into cash in the numerator. also called the acid test. determines the firm's ability to convert assets other than cash equivalents, like inventory, completely into cash. a high quick ratio means the firm may not be productively employing its cash. not comparable. = (cash+marketable securities+accounts receivable)/current liabilities

weighted cost of capital

a weighted average of the various kinds of financial instruments in the firm's capitalization - also called marginal weighted average cost of capital. = ((cost of debt x total debt)/total capital) x ((cost of equity x total equity)/total capital) + ((cost of hybrid securities x total hybrid capital)/total capital). It is irrelevant to consider historical costs of capital when looking ahead.

when doing a comprehensive financial forecast, which account warrants the most thorough relational and trend analysis? a. sales, b. return on equity, c. earnings per share, d. common stock

a. Sales; sales is generally the single most significant item in a financial projection, because changes in many expenses and working capital are closely correlated with changes in sales. Return on equity and EPS are bottom line figures that are results of operations (ie determined by sales). Changes in common stock are generally the result of management plans and market conditions, factors which would not be discovered through historical analysis.

the marginal cost of equity: a.should be derived from a comparison of several available techniques, b. should always be calculated with the new issue costs included, c. is usually less than the cost of debt.

a.; Deriving the marginal cost of equity is an imprecise endeavor. The most reasonable approach is probably to use a variety of techniques (dividend-growth modes, risk -premium assessments, P/E inversions) and to compare the results. Issue costs do not always need to be included in the cost of equity because retained earnings is "whatever it takes to keep stockholders happy"--whether it be earnings growth or dividend payout.

the costs associated with investments

acquisition costs and operating costs

Net Cash flow

add depreciation to net income

Covenants

agreements between borrower and issuer of debt. Most often these place limitations on the borrower's freedom to do things which could jeopardize its repayment of the loan.(like retaining a certain current ratio or dividend policy). If violated the loan can be found in default and can recall the loan. Loan covenants are more restrictive for high-risk borrowers.

A discount factor a. is the reverse of compounding future cash flows, b. performs the reverse function of a compounding interest rate, c. allows for investors to quantify a figure which would make them indifferent to the returns from an investment

all of the above. All can describe discount factors

Coupon Rate

also called interest rate-remains constant for the life of the bond

Income statement

also called statement of earnings or profit and loss statement; fulfills the requirement that a firm disclose its earnings for a period and show a comprehensive report of the factors that influenced those earnings during that period. Matches the company's expenses with its revenues for an entire reporting period (quarter, month, FY)

present value calculation

also called the discount factor; used to determine if it is better to invest than hold onto the money. what amount of money today would make me indifferent to accepting the offer? = FV/(1-interest rate or discount factor)power number of periods

Cost of Goods Sold

also known as Cost of Sales. Deducted from the revenues to determine the gross profit.

Capital Structure

also known as capitalization; a combination of debt and equity which balances a firm's assets

opportunity cost

also known as cost of capital; determined from the perspective of the firm and also called the hurdle rate . Usually a firm will use Return on Assets (ROI) or Return on Equity (ROE) to help define this number. These are historical and it is important to note that what happened in the past cannot be guaranteed in the future. Generally set by external forces.

Statement of Owner's Equity

also known as statement of stockholder's equity. Fulfills the requirement that a company publicize all investments in the firm and all distributions to owners, during the course of the reporting period. Describes all changes that have been made in the owner's equity accounts. (reports investments from stockholders and distribution/dividend payments)

strike price

also known as the call provision.

balance sheet

also known as the statement of financial position. Fulfills he FASB requirement that a firm report its financial position at period's end. Assets = Liabilities + Owner's Equity.

projections in a pro forma

always remember that the most significant portions of your projections are, no matter how carefully contrived, are still little more than educated guesses

investment tax credit

amounts to a credit equal to a certain percentage of the cost of an investment and for capital budgeting purposes would be considered a reduction in the initial outlay

excess cash

an acquirer may have large cash reserves which need to be employed to enhance earnings or reduce the threat of becoming a target itself.

Assets=Debt+Equity; Equity = Common Stock+Retained Earnings

and Retained earnings = net income + dividends p.31

present value calculations a. can hinder the creation of value, b. can provide managers with a means of identifying the best investment choices, c. cause managers to mix asset and financing considerations

b. Can provide managers with a means of identifying the best investment choices. Present value calculations allow managers to eliminate timing as a dimension of investments' returns. Thus, investments can be compared regardless of the time frame over which the outlays are made of the returns are generated.

pro forma statements

balance sheets come after the income statement.

Debt is a riskier source of financing then equity

because debt imposes contractual obligations on a firm to make timely payments of interest and principal, regardless of business cycles, labor walkouts, unfair competition or hard times

Yield to maturity is equal to

before tax cost of the bond (in calculating the Cost of Debt, use this as the interest rate)

Valuation Methods

book value, liquidation and replacement (asset based), earnings and cash flows (consider the firm as a going concern rather than a bundle of assets)

simple valuation methods

book value, liquidation value, replacement cost, market capitalization (all asset based valuation)

what is the major advantage of using the present value index (PVI) instead of NPV or IRR for comparison of alternative investments? a. analysts are more familiar with PVI, b. PVI does a better job of measuring the time value of money, c. PVI accounts for the relative size of the initial investment

c. Because PVI is the ratio of an investment's discounted cash inflows divided by its investment, it automatically accounts for the relative size of the initial investment. PVI, NPV and IRR will usually give the same go/no-go signal.

If the hurdle rate used to discount a stream of cash flows is raised, the IRR of the cash stream will: a. always increase, b. always decrease, c. not change d. increase if the NPV is negative or decrease if the NPV is positive

c. not change; Internal Rate of Return is calculated from the undiscounted cash flows. The discounted rate chosen has absolutely no bearing on IRR

Pro forma cash flow analysis

calculated after the forecasted balance sheet

Cost of Debt

calculated the same for loans and bonds. Always calculated AFTER TAXES. Interest payments are tax deductible expense.

earnings valuations

calls for the analyst to predict what the target's post merger P/E will be. this is then multiplied by the target's EPS for the previous four quarters resulting in the post merger value per share which is then multiplied by the number of outstanding shares to determine the value of the firm.Considers how much would be added to the acquiror's income statement through the business combination and measures the dilution of earnings per share that would occur.

time horizon

can be chosen arbitrarily but usually conform to a periodic time that the analyst can be confident in the predicted figures. frequently selected to match the new asset's depreciable life. When considering alternatives, equal time horizons must be used.

Benefits of investments

can be thought of as sources of cash. Includes operating cost savings, additional revenues, tax savings, cash proceeds fro the sale of assets that are replaced, and predicted salvage value.

market valuation

can only be performed for public companies. the acquiror learns the current market price of the target's securities and multiplies the value times the number of outstandingshares

taxes

can provide costs and benefits for a firm.

days sales outstanding

converts the receivables turnover figure into the equivalent number of days. most useful when compared to the same firm over time. = number of days in period/receivables turnover

Valuation of a target firm is similar to

capital budgeting analysis but more complex.

an increase in a current liability is a source of

cash (therefore it is an increase in accounts payable source in the cash flows statement)

sunk cost

cash flow that a company will have to bear even if the investment is not undertaken

forecasting cash budget

combines methods used in forecasting income statements and balance sheets. detailed info is necessary to include working capital policy, planned purchases, operating cycle, and typical seasonal sales patterns. (usually projected month by month). analysts rarely have access to this so they usually forecast cash flow from operations

Consolidate

combining two company's balance sheets and evolving into a firm with a new name

identifying alternatives

companies that are more creative will be more successful. unfavorable conditions in financial markets should not preclude considerations of new investments. managers must design an organization which ensures that the best ideas are fully considered. An alternative to every investment is to maintain the status quo.

Return on Assets (ROA)

considered by many to be the best indicator of a firm's asset usage skill. Includes returns for owners and creditors. Also referred to ROI Return on Investment. = Profit Margin x Asset Turnover OR =(Net Income/Net Sales) x (Net Sales/Avg Total Assets) OR Net Income/Avg total assets. Can compare across industry.

Risk-free investments

considered to be government securities like treasury bills and bonds.

Relevant cash flow valuations

considered to be more reliable valuation and takes into account present value. Sensitivity analysis is critical

days inventory

converts the inventory turnover ratio into days in the same manner as DSO. = number of days in period/inventory turnover.

What to consider when evaluating debt

cost of the source, the firm's capital structure, how much is needed; most significant is how the markets will receive their financing choice

call provision

covenants for bond provisions. Permits a firm to repurchase bonds at either their market or par value, if the market value of a bond reaches a certain point. If a bond appreciates to a certain value above par, then this means that its YTM has decreased below the level yielded at the time of issue. Allows the company to buy the bonds back and the provision dictates at what rate they can do so. p.53

The important consequence of an asset acquisition should be that it

creates new income, cash flows, or efficiency that outweighs its costs. This will result in value for the firm.

Residual cash flows are estimated when: a. the useful lives of alternatives are different, b. one asset has a shorter economic life than its alternatives, c. it is not convenient to evaluate the total useful life of an asset, d. A& B, e. A, B & C

d. A & B; Two or more investment alternatives rarely have the same useful life. Estimating residual cash flows is a means of compensating for differences in the useful lives of the alternatives. Residual cash flows should never be estimated simply as a matter of convenience.

residual cash flows are estimated: a. when the useful lives of alternatives differ, b. when future depreciation of an old asset is lost, c. in order to quantify the cash flows of an investment beyond the chosen time horizon, d. A & C, e. A, B & C

d. A & C; residual values are entered into a cash flow forecast in recognition of the fact that an investment cannot be analyzed in perpetuity. When comparing two investments with unequal lives, the residual value of the longer-lived asset is assumed to be realized at the termination of the shorter-lived asset, in this way assuring comparability of the investments

for capital budgeting purposes, an asset's depreciable life is: a. always equal to the time horizon of an evaluation, b. equal to the asset's useful life, c. equal to the asset's economic life, d. an arbitrary period dictated by the tax code, e. none of the above.

d. An arbitrary period dictated by the tax code. The only depreciation relevant to the capital budget is that which shelters the income from taxation. Remember, capital budgeting is an analysis of cash flows. Depreciation is a noncash expense; its value to a firm is that it reduces the amount of tax dollars a company must pay.

The market determines the

debt capitalization of the firm.

a firm has recently announced plans to issue bonds which will carry its debt/equity ratio a point well above the industry standard for companies of its size. Their stock price will likely

decrease. As the financial risk of the firm increases, its stock price is likely to decrease

Operating Income

deducted from the Gross Profit on the Income Statement. The firm's income after operating expenses from its main line of business, before inclusion of income from investments and before interest or taxes can be deducted

Financial leverage

describes the proportion of debt in a company's structure. A higher amount of debt means that the firm has more financial leverage (Debt to Equity).

Sustainable Growth Ratio

determine how much the company can grow without seeking outside financing. Also called the internally funded sustainable growth rate. = (sales/assets)x(net income/sales)x(total assets/total debt)x(total debt/total equityx(1-payout ratio)

Quantitative analysis (follows qualitative)

determine time horizon, apply the assumptions made to first the income statement (sales first because it is the largest) followed by expenses to be historically consistent. Can use statistical methods

Two methods for quantifying the returns that equity investors expect

dividend discounts and risk premium assessments

issuing new equity can be troubling because

dividends will increase dramatically, EPS will be diluted considerable, and the senior manager's control could be jeopardized

which of the following does not contribute to the derivation of return on equity using the dupont formula? a. net income/sales, b. assets/equity, c. dividends/net income, d. sales/assets

dividends/net income

projecting pro forma statements

don't be concerned with accuracy yet. do not over compensate by making overly conservative assumptions. determine sales figures first, then income statement using the vertical analysis % to project.

salvage value: a. is the best prediction of what an asset could be sold for at the end of the time horizon, b. should be used to justify marginal investments, if necessary, c. should not be used to justify marginally profitable investments, because salvage values are difficult to accurately predict., d. A & B, e. A & C

e. A & C; In a cash flow forecast, salvage value is an estimate of the remaining worth of the asset at termination of the investment horizon. As you can imagine, such estimates are fraught with uncertainty, and should never be used as the basis for backing a marginal proposal.

Hurdle rates are used in an attempt to: a. screen out weak investments, b. quantify the firm's opportunity costs, c. quantify the firm's risk, d. A & B, e. A. B & C

e. A, B & C; all of the statements regarding the use of hurdle rates are true.

capital budgeting includes: a. generation of ideas, b. evaluation and ranking of alternatives, c. selection and monitoring of investments, d. B & C, e. A,B & C.

e. A,B & C; Capital budgeting is a process that begins with brainstorming, continues through evaluation of the projected returns, and is not complete until the performance of the investment has been analyzed after it has been brought on line.

qualitative analysis

enables the analyst to identify the synergies which will make a merger worthwhile

maximum justifiable price

equal to target's post merger cash flow, with synergies included discounted by its cost of equity. The justifiable price is usually the minimum a target will accept unless that value is exceeded by its liquidation, replacement or market value. The maximum justifiable price is the most an acquiror will pay unless that value exceeds the price that would dilute its post-merger earnings per share.

coverage ratios

equal to the firm's annual cash flows divided by annual obligations (must allow for after tax dollar obligations if necessary)

payback

equal to the investment divided by the annual cash inflows. It is not a present value method used to rank alternatives

Net present value

equates the cost of the investment with the present value of its future cash flows. In order to obtain the present value, a discount factor must be used, typically the hurdle rate. Generally speaking, the hurdle rate measures the overall risk to the firm; when the value is positive it add value

The Dilution Method

establishes a maximum acquiror's price based in the philosophy of value creation. This solves for the break even point and is heavily dependent on an analyst's prediction of the target's post merger earnings. Results should be subject to a sensitivity analysis. solves for the number of shares that a firm could offer in exchange for another company without diluting its earnings per share. The acquiring firm can rarely create value if it pays more than this price.

operating cycle

estimates how long it takes a business to complete the cycle of purchasing inventory, converting the inventory to finished goods, sales of the goods and finally collecting the receivable. Corollary to the current ratio. = DSO+ Days in Inventory

Income analysis addresses the following cconsiderations

explicit costs, EPS, dilution and implicit costs for each financing alternative - use "cost of raising capital" calculations to conduct this type of analysis

Income

favors choices that benefit the firm's stock price to maximize EPS or P/E. Maximized by using those financing options that are least dilutive or least expensive (low cost of debt).

plug

figure used in the balance sheet to make it balance in a pro forma statement projection. (assets=liabilities + owner's equity). projected balance sheets will never balance on their own.

analysts, managers and investors both internal to and external to a firm have interests in making

financial projections

Accounting periods

financial reports should be prepared periodically and cover periods of equal length. Companies may choose the time of year that they desire their accounting periods to end. (GAAP)

If stock is trading a a low P/E then

financing through stock issue will be difficult

Consistency

firms should strive to use consistent accounting methods so that their statements can be compared over time (GAAP)

Conservatism

firms, given a situation where measurement uncertainties produce equally likely profit figures, should report the lowest figure. Firms should strive to anticipate all expenses, and not report revenues until they can be properly recognized. Deliberate understatement is forbidden. (GAAP)

investment tax credit (ITC)

first ordained by congress in the 1960s as a means of stimulating the economy by encouraging investment in machinery and equipment. In Capital Budgeting Analysis this should be considered a reduction in the initial outlay of cash

a firm seeks to save some debt capacity

for unexpected lucrative investments, because it can be obtained faster with new equity and for unseen disasters, where the firm's survival is at stake

Net Income

found on the Income Statement. Difference between the firm's revenues and expenses including taxes. Also called net profit, net earnings or profit after tax.

Non cash expenses

found on the Income Statement. depreciation and amortization. Reduces net Income but does not reduce a firm's cash position because noncash expenses do not involve a transfer of cash.

"net proceeds" of a debt issue

funds that remain after the necessary fees have been deducted.

Cost of Capital

generally the weighted cost, expressed as a percentage, that a company has paid for the funds in its capital structure. Determined by the proportion of debt and equity on the financing side of the balance sheet; =(%debt x cost of debt) + (%Equity x Cost of equity)

Ways to determine the risk premium

guess (not accurate), Capital Asset Pricing Model (CAPM)

Current Assets and Liabilities

has a due date less than 1 year. Found on the balance sheet. Assets: Cash, marketable securities, accounts receivable, inventories, prepaid expenses and other assets; liabilities: bank notes payable, current portion of long term debt, accounts payable and accrued expenses, accrued taxes

Long Term Assets and Liabilities

has a due date more than 1 year. Found on the Balance Sheet. Assets: Investments, Land, Equipments, (P.P.E), buildings; Liabilities: long term debt deferred income taxes

equity-like convertibles

have different costs at different times. When a convertible is projected to rise above its strike price, its cost will be the same as the cost of equity. Before conversion, its cost is closer to the cost of debt or preferred stock.

Rule of 72

helps to determine in approximate terms what combination of interest rate and years will cause an investment to double.

When receiving payments from an investment the more attractive present value is the

higher present value as it means more money sooner for the investor.

Present Value Index(PVI or PI)

identical to Benefit/Cost ratio except that it allows for the time of the cash flows; = Total PV of Annual Cash flows/Initial Investment. This is the most accurate representation of an investment's return as it takes into account the time of cash flows and accounts for the relative size of the initial invstment. also known as profitability ratio

Present value payback

identical to payback except that present values of the annual cash flows are used in place of future values; = initial investment/PV of Annual Cash Flows. still fails to recognize return beyond the payback.

statistical analysis method

if the historical observations are indistinguishable, that is, there were no unique influences, then other averages, variances, standard deviations and other statistical methods should be employed.

acquisition costs

include the cash payments that are required for ownership, and any subsequent expenditures required to extend the life of the asset, such as a major overhau

reductions in equity

include the distribution of dividends, and the purchase and retirement of outstanding stock

a firm has recently announced plans to issue bonds which will carry its debt/equity ratio a point well above the industry standard for companies of its size. When it issues the bonds, the financial leverage of this firm will

increase. The firm's leverage will increase because debt will increase as a percentage of capitalization

Capital budgeting alternatives are evaluated on the basis of

incremental cash flows

If an investment has a negative net present value, its present value payback is

indeterminate

Accounts Payable Turnover

indicates how far a company is "stretching" its trade payable obligations. = purchases/avg. account payable. Control of this ratio is at the discretion of the creditors and what payables have been previously extended. = number of days in period/accounts payable turnover

Times Interest Earned (X/I)

indicates how many times a firm's earnings exceed its interest obligations. Used by creditors as a rough estimate of the firm's ability to meet its payments. It is only an approximation since earnings are not equal to cash flows. = EBIT/Interest Obligations.

receivables turnover

indicates how quickly a company ordinarily converts accounts receivable into cash. very misleading since the balance sheet is a snapshot and will vary throughout the year. = net sales/avg. accounts receivable

Gross Profit Margin Ratio

indicates the average percentage by which the sales price of a company's goods or services exceeds the cost of those goods or services. Can compare across industry. = cost of goods sold/revenue

Debt to Total Assets

indicates the percentage of the company's assets which is being provided by creditors. Aggressively managed firms will maximize this ratio. Acceptable maximums range from 0.3-over 1.0. Compare to Industry Norms. = total liabilities/total assets

Debt to Equity

indicates the proportion of borrowing to equity in the capital structure. = Total Liabilities/Total Equity

inventory turnover

indicator of how well a company is managing its working capital accounts. generally try to maximize the ratio and best used internally. should look for trends within a company when you consider this. Like DSO, when an inventory is slipping it should be of concern( increasing inventory disproportionally to sales). = cost of goods sold/avg. inventory

benefit cost ratio

indicator of investment profitability but in isolation is of limited utility. Sum of the cash inflows/the initial investment. In the absence of the time value of money, a ratio greater than 1 suggests the investment should be pursued

risk of illiquidity

investors/holders of debt are exposed to this type of risk if a borrower is unable to provide. Loan issuers are at a greater risk than equity holders as there is no commercial marketplace to buy/sell loans. Long term loans have higher interest rates than short term loans because of the risk.

effective rate of bond

is determined by the issue price and term of the bond

preferred stock

is more expensive than debt because dividends are not tax-deductible

One should evaluate the cost structure of the industry (qualitative)

is the industry more susceptible to a drop in volume or a drop in prices

Boards determine dividend policies and are wary of

issuing stock if there are shareholders who own large percentages of stock. Issuing stock could wreck the current balance of power

If the firm has reached its maximum debt percentage then

it will not choose to finance through debt

If an investment has a negative net present value

its present value payback is indeterminate

Short Term Needs Are

limited to working capital and cash (capital investments can be postponed). Temporary expanding of capital investments are typically secured through short term debt and is often thought of as a "given". companies need to review and understand short term financing needs so that they can comfortably meet all current obligations a well as secure financing.

Long term assets are financed with

long term debt - more expensive terms than short term

Bonds

long-term security which a firm issues to investors in return for their capital. Firm's that issue these, pay investors interest on the original value of the bond for as long as they hod them or they mature.

when paying out a loan the more attractive present value is the

lower present value because it is being paid to a creditor

Whenever an investment's NPV is negative, its IRR will be

lower than the discount rate used. Conversely, a positive NPV implies that the IRR is greater than the discount rate.

Internal forces to a firm's debt capitalization

management's risk tolerance, management's ownership in the firm, control of ownership in the firm. The greatest external factor is the market

creation of value

managerial intentions should be enacted only when the can add value to the firm. Value is added to a firm when earnings are enhanced, operational or financial risks are reduced or when efficiencies result as the consequence f a decision.

quantifying the alternatives

once alternatives are identified, each must be evaluated and ranked. These are evaluated based on costs and benefits in terms of incremental cash flows (also known as relevant cash flows).

economic value

may differ greatly depending upon depreciation methods, inventory valuation, or the nature of the assets themselves.(different than book value)

Liquidity Ratios

measure a firm's ability to meet its short term obligations, and its skill in managing working capital; Current Ratio, Quick Ratio, Receivables Turnover, Days Sales Outstanding, Inventory Turnover, Days Inventory, Operating Cycle, Accounts Payable Turnover, Days Payable.

Operating performance ratios

measure a firm's profitability and asset usage skill; profit margin (Return on Sales), Gross Margin, Asset Turnover, Return on Assets, Return on Equity, Earnings Per Share, Price-Earnings, Payout, Times Interest Earned. These ratios are the most common form of financial analysis of statements.

Asset Turnover

measure's a firms ability to generate sales through its assets. Consider this with qualitative issues. =net sales/avg total assets.Can compare across industry.

current ratio

measures a company's ability to meets short-term obligations and unforeseen needs and is stated in terms of working capital. = current assets/current liabilities. creditors accept lower current ratios in stable industries than others. not comparable due to multiple working capital makeup across industry.

Horizontal Percentage Changes

measures differences from year to year in discrete components of financial statements. For example, Percentage Increase.

Return on Equity (ROE)

measures the return on investment for the firm's shareholders a bit more discretely than the ROA ratio. Can compare across industry. = net income available to shareholders/avg. owner's equity

legal ways to combine companies

merger, acquisition, consolidate and parent-subsidy

Merger decisions may be prompted by

more qualitative than quantitative criteria. The methodology suggested only establishes a basis for defining a negotiating range.

P/E Ratio cost of equity

most naive form as it doesn't allow for the time that may pass before future earnings may be returned to the investor. =projected EPS/Stock Price. Used widely as a "rough estimate". Simplest Dividend Discount Method.

revenues (or sales)

net revenues. Top of the income statement

book value

net worth; often considered the lowest value a target will accept. equal to the figure obtained by subtracting total liabilities from total assets (net assets).

payables and accruals includes

notes payable, accounts payable and other current liabilities.

Gross Profit

or gross margin = revenues- cost of goods sold.

par value

original value of the loan

treasury stock

outstanding shares that have been purchased but are not yet retired.

qualitative & quantitative factors

p.21 Industry Definition, Sales Influences, cost structure

Stakeholder's Equity to Assets

percentage which compliments the Debt to Total Assets Ratio by describing the percentage of assets paid through contributions of the firm's shareholders. The closer to 1.0 this is, the less liabilities the firm has. = Total Equity/Total Assets. Compare across Industry.

Time Horizon

period of time defined for financial analysis. Can be any amount of time but would be applied to companies being compared so that they were measured for the same time.

Yield to maturity is calculated from the

perspective of the purchaser of a bond. As Yield to Maturity increases, the price of the bond decreases

Flexibility

predict how effectively the firm could weather the financial consequences of a "disastrous occurrence". Such unpredictable events could diminish the firm's bottom line to the point of bankruptcy. Important for the firm to be resilient to these unforeseen events. Managers will determine the amount of funding that should be kept in reserves for this purpose.

The Dupont Formula

presents a snapshot of almost every key ingredient of a firm's financial performance. By comparing over a series of accounting periods, analysts can determine which figures have most influenced the firm's profitability or determine what may have caused the changes. Measures Return on Equity = (Net Income/Sales)x(Sales/Assets)x(Assets/Equity)

The medium used to look into an organization's financial future is the

pro forma statement

After an industry assessment is done (evaluating industry, sales influence and cost structure) the analyst should also evaluate (qualitative)

product line, management, facilities, market strategy, and cost structure for the same types of companys

short term assets are financed with

short term debt - less expensive than long term

Capital Asset Pricing Model (CAPM)

quantifies a company's risk premium by relating the historical returns of that company, or the industry in which it competes, to the performance of the market of a whole.

Better projections can generally be derived by first studying the environment in which a firm competes both for

quantitative and qualitative factors

liquidation value

refinement of book value. the appraised asset value, less the firm's liabilities. (value of assets on the open market). also frequently thought of as the minimum value a target is willing to accept.

Capital Asset Pricing Model (CAPM)

related the historical financial performance of a firm or industry to the market as a whole. A risk premium is added to the risk-free rate of return based on the stock's tendency to "move with the market"; = risk free rate + (beta x (market return - risk free rate))

Relevance

reports should contain information that is relevant to the decisions at hand, and be user-oriented (GAAP)

Plug

represents excess cash or a deficit of capital given the forecaster's assumptions.

Cost of Capital

represents the market's definition of a firm's risk. This is a composite figure based on the proportion of debt and equity that is in a company's capital structure. This is used as a proxy for the average hurdle rate, because it is the best obtainable indication of the firm's risk.

In order to equalize time horizons, sometimes it is necessary to estimate

residual values for the asset. In theory, the residual value is the present value of all future cash flows.

A set dividend policy limits the amount of equity that can be raised through

retained earnings

yield to maturity

return earned on a bond. Must be commensurate with the risk to the bond issuer. Divided into 9 classes. AAA bonds have the lowest yield but has the highest likelihood of repaying its debt. C ratings mean that they are unlikely to repay the bonds and are sometimes referred to as junk bonds.

CAPM is often used to determine

return required by investors= company's cost of securing investors.

Statement of Cash Flows

reveals the company's sources of cash and generally is used to isolate the changes in the balance sheet across various periods. Includes cash flows from operating activities, cash flow from operating activities, and cash flow from financing activities. Depreciation is added to net income here because it is a noncash expense.p. 7.

In choosing a second set of numbers to assess risk, if numbers are relatively optimistic you would then

revise numbers downward to consider possible economic downturns to consider what the impact the alternative financing vehicles would have on earnings under economic downturn

operational risk

risk associated with a company's ability to produce and market its products.

Other industry factors include (qualitative)

sales influence - how is the economy affecting the industry, and what are the marketing strategies of the competitors.

The claims of a company's debt holders are nearly always _______ to the company's stockholders

senior

price negotiating range

several valuation methods are used to determine this range to then determine between the acquirer and the target

Types of loans

short term and long term or lines of credit. Paid for by the company borrowing through interest payments. Interest payments can be fixed or variable based on how much of the principal is left to be paid or at a variable prime rate.

Not included in cost of debt

sinking funds and other principal payments since they are after tax cash flows. ONLY INTEREST PAYMENTS OR COUPON PAYMENTS are considered to be the cost of debt. (exception to the rule- where loans require that a compensating balance be maintained. The "unproductive" compensating amount would effectively increase the cot of the funds actually received).

Determine implicit costs of a financing alternative

step 3 in the INCOME portion of FRICTO analysis; Not usually the most precise. Managers should review several companies within their industry to determine when the reached the ultimate debt capitalization to predict how to maximize their own. Often used to develop P/E ratios for different financing soltuions

Value is created on the right side of the balance sheet by

structuring the firm's capitalization in optimal proportions of debt and equity, or by devising unique, clever financial instruments

sensitivity Analysis

tests the assumptions made in the financial forecasting. Test the validity of the calculations. (economy plays a part). Vary the assumptions on by one in the financial statements to see how they would effect the projections. Create best and worst case scenarios

The optimal capital structure

that point from which adding or removing debt on a relative basis would cause the firm's market valuation to decrease.

diversification

the acquiror may be seeking to reduce its operational risk through the purchase of an unrelated but profitable business.

Earnings Per Share (EPS)

the company's net income available to shareholders/avg number of shares of common stock outstanding. Short term perspective and sensitive. Should not be compared across industry.

the useful life of an asset

the estimated economic life of an asset which is the number of years an asset is expected to be productive

useful life

the estimated economic life of the asset, which is the number of years that the asset is expected to be productive.

salvage value

the expected sales price at he end of an assets useful life (recorded as a cash inflow at the end of the time horizon)

statistical assessment of sales and cost structures will be useful when

the industry is mature and stable and the industry performance is widely documented.

Understanability

the information contained in reports should be written at a level that a reader with a reasonable comprehension of business principles can understand (GAAP)

yield to maturity

the internal rate of return of the cash flows from a bond.

market undervaluation

the market may have discounted a target firm's worth, or may not have foreseen the value which could be created if the target firm were to be acquired

Price-Earnings Ratio (P/E)

the market price of the company's stock divided by the EPS. The multiple of a firm's earnings per share that investors are willing to pay for one of the company's shares. The stock market's opinion of a company's prospects for growth and earnings as well as the market's opinion to the firm's risk. Can be compared across industry.

when stock is sold on the open market, whether the seller is the issuing company itself (primary market) or a holder of the stock from an earlier purchase (secondary market)

the market price of the shares will be the same. For the company, the higher the stock price climbs, the lower the cost of equity

Net Present Value (NPV)

the most popular; present value of future cash flows - the investment. Expresses an investment's returns in excess of the initial payment in present dollars. Downside is that it disregards the size of the investment as a percentage like PVI would do so that large outlays of cash are difficult to compare to small ones. If an NPV is positive, the investment as created Value.

dividend-growth model

the most widely used. Assumes that whether dividends are paid of retained is irrelevant because any retained earnings would be reinvested by the company, causing it to grow.

present value

the notion that money has a different value over time . In performing this projection,evaluate: size, duration, return and timing of the return.

depreciable life

the number of years that the company will depreciate the asset and is a function of the depreciation method that is chosen

depreciable life

the number of years that the company will depreciate the new asset, and is a function of the depreciation method that is chosen

If the bond is purchased at a premium

the overall interest rate decreases. This is likely to happen if the interest rate of the bond is better than the market's. Purchased at a higher price than original issue. changing Yield to Maturity does not change the value of the bond.

If the bond is purchased at a discount

the overall interest rate increases. This is likely to happen if the interest rate of the bond is worse than the market's. Purchased at a lower rate than original issue. changing Yield to Maturity does not change the value of the bond.

Payout Ratio (PO)

the percentage of earnings per share that a company distributes in the form of dividends. The percentage of net income that a company pays out in dividends. = Dividends/Net Income

operating costs

the periodic (usually annual) costs associated with using the asset. These costs are normal, recurring expenses, whereas a major overhaul is not.

justifiable price

the present value of a target's cash flows used for the acquisition. Equal to the per-merger cash flows discounted by its cost of equity.

dilution

the process by which a given level of earnings is spread over a greater number of shares

financial risk increases when

the proportion of debt in the capitalization structure of the company increases. However, this is countered by increased leverage

benefit/cost ratio

the ratio of the total incremental cash flows to the acquisition cost. thi fails to compensate for the time value of money.

residual cash flows

the residual value the present value of the future cash flows for the new asset as of the last year of the chosen time horizon. in otherwords, the old asset may force the shortened time horizon

Risk Premium

the returns that investors require in excess of the returns that are available in risk-free investments. There are some risk-free investments and the investor must receive higher returns to be enticed to invest in these riskier ventures. The additional return above risk-free is this.

future value

the sum of the payments received at a future time; = (1+periodic interest rate)power number of periods x initial investment

financing capability

the target firm may have unused debt capacity which could be beneficial to the acquiror

enhanced cash flow

the target firm may produce attractive annual cash flows, or it may have large cash reserves on its balance sheet

financial risk

the uncertainty associated with a company's ability to convert operating income (earnings before interest and taxes) to a given level of earnings per share, and as a result, a commensurate level of dividends per share. Shareholders/markets tend to approve of managerial decisions which enhance earnings per share, dividends or operating cash flow

Financial risk

the uncertainty associated with a firm's ability to translate EBIT into earnings per share. This increases with financial leverage.

If any of the items on the right side (debt, equity, common stock, retained earnings, net income, dividends) are fixed

then financing choices have been limited.

if a company has experienced a cash outflow that it will have to bear even if the investment is not undertaken

then that flow should not be considered an incremental cost during an analysis

efficient market theory

theory to explain how the market is able to accurately reflect a firm's risk. At any given moment, the prices of securities reflect all that is of can be known about a company's future. This exists because there are hundreds of investors who are trying to find "values" to exploit.

justifiable price

there is a maximum an acquiror will pay, a minimum a target company will except and then there is this. Typically determined by the acquiror and then compares that figure to the maximum price that could be paid without diluting its earnings per share.

After relevant cash flows for the target firm are determined

they are discounted by a factor equal to the cost of equity in the target firm, not the acquiror's. Use the targets so that the valuation doesn't change depending on the acquiror as well as that the target's cost of equity may not change to the acquiror's upon merger.

replacement cost

this estimate is difficult and if used, is considered to be the maximum price that a target could hope to obtain, based strictly on the current market value of the target's assets.

Incremental costs and benefits

those which will exist only if an investment is implemented. (does not necessarily demonstrate the effect that an investment will have on a firm's income statement: cash flows are not earnings)

Historical company-specific

trend analysis is used as one means of estimating the future.

In every case, with total returns being equal, the investment which provides cash flows sooner is the superior choice

true - they can be put back to work faster and are therefore worth more

capital markets prefer debt

true- this varies by industry and company but generally, companies fair better when they have some amount of debt.

synergy

two companies may be worth more together than apart. In general, this enhances an acquiror's earnings or cash flows. these are not always readily apparent.

loans and bonds

two dominant forms of debt

current cost of capital

use equation for cost of capital; takes numbers from the balance sheet and multiplies the % by the actual cost.

when calculating the PV for an entire loan amount

use the interest/discount factor for all years and then add to find the total PV of the first payment

Internal Rate of Return

used frequently to measure profitability in investment analysis and bonds; uses discounted cash flows to determine where NPV=0

beta

used in CAPM and measures the magnitude of covariance in stock performance between a firm and the total stock market. The covariance in performance between a stock and the market in general is a measure of the amount and direction that an individual stock's value changes for a given change in the market's composite performance.

pro forma statement

used in creating financial projections

merger

used interchangeably with acquisition; typically refers to any business combination which occurs when two firms combine their balance sheets and the "acquired" company ceases to exist as a separate entity

Breakeven P/E

used to determine implicit costs of financing decisions when predicting P/E; = Stock price/ projected EPS

Earnings dilution

used to predict a maximum price that an acquiror is willing to pay for an acquisition.

present value payback

uses discounted cash flows to determine how long an investment will take to payback

sustainable growth formula

uses implied growth rates to determine changes that must occur in the firm's working capital to support that growth in pro forma valuation statements

forecasted balance sheet

uses trends and ratios to develop along with a plug figure to make it balance.

cash flow from operations

usually calculated instead of cash flow budget. These are projected annually. Net Income is the only thing needed.

Control

usually considered neutral in preference of debt or equity; Primarily concerned with the roles of the board of directors. This is an issue whenever equity is considered for financing along with the size of the issuance.

ranking the alternatives

usually numerically ranked by returns. mostly based on present value method though sensitivity analysis is always appropriate

forecasting statements

usually only balance sheets and income statements. all remaining statements if required can be derived from these statements

synergy can result from the following circumstances

vertical integration, horizontal integration, financing capability, enhanced cash flows, diversification, market undervaluation, excess cash.

Testing investments

very important that once investments have been chosen, they are monitored and tested for accuracy to use in future investments.

Sinking Funds

way to retire bonds; schedule of payments

parent-subsidy

when one firm acquires greater than a twenty percent share in another company

plug method

where assets have been projected to grow at a rate faster than liabilities and equity, the plug would indicate outside financing (either debt or equity) must be obtained.

industries that are made up of few large competitors

will survive years of innovation from others. It is unlikely that a single competitor could render its competitors obsolete overnight especially considering anti-trust considerations.

Cost of Equity

with the exception of fees that must be paid to issue new stock, cost of equity is equal to the cost of retained earnings (equal to the return that its equity holders expect in return for the use of their capital). DOES NOT ALLOW FOR TA SHIELD. Dividends are paid with after-tax dollars