Corporate Finance Test 3

Profitability Index

Benefit-cost ratio Take investment if PI > 1 Cannot be used to rank mutually exclusive projects May be used to rank projects in the presence of capital rationing

Two major methods for determining the cost of equity

Dividend growth model SML, or CAPM

Questions to ask ourselves when evaluating capital budgeting decision rules

Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm?

• Why do we have to consider changes in NWC separately?

GAAP requires that sales be recorded on the income statement when made, not when cash is received. GAAP also requires that we record cost of goods sold when the corresponding sales are made, whether we have actually paid our suppliers yet. Finally, we have to buy inventory to support sales, although we haven't collected cash yet.

Which on of the following is the tax shield approach to computing the operating cash flow? assume there is no interest expense

(Sales- Cost) * (1-T) + Depreciation * T

Disadvantages of Payback Period

-Ignores the time value of money -Requires an arbitrary cutoff point -Ignores cash flows beyond the cutoff date -Biased against long-term projects, such as research and development, and new projects

Advantages of Payback Period

-easy to understand -adjusts for uncertainty of later cash flows -biased toward liquidity

Leveraged lease

A financial lease in which the lessor borrows a substantial fraction of the cost of the leased asset on a non-recourse basis

tax-oriented lease

A financial lease in which the lessor is the owner for tax purposes. Also called a true lease or a tax lease

Average Accounting Return

Average net income/ average book value

16) Which one of the following is a project cash inflow? Ignore any tax effects. A) Decrease in accounts payable B) Increase in accounts receivable C) Decrease in inventory D) Depreciation expense E) Equipment acquisition u

C) Decrease in inventory

what are leases governed by

FASB13

NPV Vs. IRR

Generally give us the same decision; except nonconventional cash flows- cash flow signs change more than once

Payback Period

How long does it take to get the initial cost back in a nominal sense?

If one of the following criteria is met, then the lease is considered a capital lease and must be showed on the balance sheet

Lease transfer ownership by the end of the lease term Lessee can purchase asset at below market price Lease term is for 75 percent or more of the life of the asset Present value of lease payments is at least 90 percent of the fair market value at the start of the lease

You should accept a project when the

Net present value is positive

Which on of the following statements is correct concerning the profitability index PI should be used to determine which on of two mutual exclusive projects should be accepted PI is the discount rate that makes the net present value equal to zero There can be multiple PI if the cash flows are unconventional PI is used to rank positive NPV projects when the available funds are limited

PI is used to rank positive NPV projects when the available funds are limited

Good Reasons for Leasing

Taxes may be reduced • May reduce some uncertainty • May have lower transaction costs • May require fewer restrictive covenants • May encumber fewer assets than secured borrowing

Cost of Equity

The cost of equity is the return required by equity investors given the risk of the cash flows from the firm

Which on of the following best describes an opportunity cost

The current market value of equipment you own that you want to use for a new project

Which on of the following statements is correct The discounted payback period is longer than the payback period The internal rate of return is used to determine which on of two mutually exclusive projects should be accepted The modified internal rate of return is used to evaluate different sized projects The payback period is considers the best method of project analysis from a financial point of view

The discounted payback period is longer than the payback period

Profitability Index (PI)

The present value of an investment's future cash flows divided by its initial cost. Also called the benefit-cost ratio.

Lease

a contractual arrangement by which the lessor (owner) provides the lessee (user) the right to use an asset for a specified period of time

Sale and leaseback

a financial lease in which the lessee sells an asset to the lessor and then leases it back

IF the Project has an IRR that is greater than the required return

accept the project

If the payback period is less than some preset limit

accept the project

If the project pays back on a discounted basis within the specified time

accept the project

if the AAR si greater than a preset rate

accept the project

If NPV is positive

accept the project • A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.

Opportunity costs

costs of lost options

Sunk costs

costs that have accrued in the past

Which on of the following will tend to increase a leveraged firm's cost of capital

decrease in the tax rate

Which on of the following decreases net income and increases the operating cash flow

depreciation

11. Which one of the following is a capital budgeting decision? a. deciding whether a bank loan should be secured or if bonds should be issued b. determining how many bonds versus how many shares of stock should be issued c. ascertaining the minimum amount of cash which should be kept on hand d. determining the optimal level of inventory to be maintained e. deciding whether or not a newly invented product should be produced

e. deciding whether or not a newly invented product should be produced

The crossover point

equates the net present value of two separate projects

The tax advantages of leasing exist primarily becasue

firms are in different tax position

direct lease

lessor is the manugacturer

Financial lease

longer timer lessee is responsible for

Depreciation

non-cash expense; consequently, it is only relevant because it affects taxes

lessor

owner

Side effects- positive and negative

positive- benefits to other projects Negative- costs to other projects

When Data tech applies the cost of capital of Wyoming Computers to a project, it is using the approach

pure play

Which one of the following is a requirement if a lease is to be concerned valid for tax purpose?

renewal options must be based on fair market value at the time of the renewal

Operating lease

short term lease, lessor is responsible

Captive Finance company

subsi

Net Advantage to Leasing (NAL)

the NPV that is calculated when deciding whether to lease an asset or buy it

Net Present Value

the difference between an investment's market value and its cost

Which on of the following correctly describes a criteria used by accountants to define a capital lease

the lease term is at least 75% of more of the estimated economic life of the asset

Cost of Preferred Stock

the ratio of the preferred stock dividend to the firm's net proceeds from the sale of preferred stock

Cost of Debt

the required return on our company's debt

IRR

the return that makes the NPV 0

Which of the following are good reasons to lease rather than buy

to avoid restrictive covenants to reduce uncertainty to lower transaction costs To lower taxes

Lessee can deduct lease payments for income tax purpose

true

Which one of the following tends to be the greatest concern of a lessee in regards to the leased asset

use

lessee

user of a leased asset

Advantages and dis. of dividend growth model

• Advantage - easy to understand and use • Disadvantages Only applicable to companies currently paying dividends Not applicable if dividends aren't growing at a reasonably constant rate Extremely sensitive to the estimated growth rate - an increase in g of 1% increases the cost of equity by 1% Does not explicitly consider risk

Why is cost of capital important?

• We know that the return earned on assets depends on the risk of those assets. • The return to an investor is the same as the cost to the company. • Our cost of capital provides us with an indication of how the market views the risk of our assets. • Knowing our cost of capital can also help us determine our required return for capital budgeting projects.