B3: Financial Management

What would a lockbox most likely provide for receivables management?

A lockbox system expedites cash inflows (minimizes collection float) by having a bank receive payments from a company's customers directly, via mailboxes to which the bank has access. Payments that arrive in these mailboxes are deposited into the company's account immediately. Minimizing collection float.

Times Interest Earned Ratio

EBIT/Interest Expense

ROI

Income/Invetment Capital (D + E) Profit Margin x Investment turnover

Internal Rate of Return

Internal rate of return is defined as the discount rate at which the net present value of the project equals zero.

Operating Cycle

Inventory Conversion Period (# days to sell) + Receivables collection period (# days to collect)

DuPont Analysis (3 stages)

Net Profit Margin = Net income/Sales Asset Turnover = Sales/Average total assets Financial Leverage = Average total assets/Equity

The formula for the profitability index is:

Present value of net future cash inflows/Present value of net initial investment = Profitability index The profitability index is used to rank qualifying investments. Note: The denominator maybe the "present value of the cash outflows" as opposed to "original cash invested" if the investment is not all made at the time of the initial investment.

A multiperiod project has a positive net present value. Which of the following statements is correct regarding its required rate of return?

The required rate of return must be less than the project's internal rate of return (IRR). The IRR is the rate earned by an investment that equates to a net present value (NPV) of zero. By definition, a project with a positive NPV will have an IRR greater than the required rate of return used to compute that NPV.

To calculate the IRR:

First calculate: Net incremental investment (investment required)/ Net annual cash flows = Factor of the IRR Second: locate the factor derived above to identify the rate of return it represents.

Float

Float is the difference between the balance of checks outstanding, which have not cleared the bank and deposits made but which have not yet cleared the bank here.

The three elements needed to estimate the cost of equity capital are:

1. Current dividends per share (D) 2. Expected growth rate in dividends (G) and 3. Current market price per share of common stock (P) The question asks the candidate to identify the three elements needed to estimate the cost of equity capital for use in determining a firm's weighted average cost of capital. The cost of equity capital is defined by the following mathematical expression where the cost of capital or return (R) is: R = D1 / (P + G)

The optimal level of inventory is affected by:

1. The time required to receive inventory. 2. The cost per unit of inventory, which will have a direct impact on inventory carrying costs. 3. The cost of placing on order impacts order frequency, which affects order size and optimal inventory levels.

The amount of inventory that a company would tend to hold in stock would DECREASE as the:

1. Variability of sales decreases. 2. Cost of running out of stock decreases. 3. Length of time that goods are in transit decreases.

APR of quick payment discount

360/(pay period-discount period) x discount/100-discount %

What is the relationship between the allowance for doubtful accounts and working capital?

A company that records bad debt expense for a period also recognizes an increase in the contra-account, allowance for doubtful accounts. When this occurs, the company's net realizable value on outstanding accounts receivables declines, lowering its current assets. Because working capital is current assets less current liabilities, the company's working capital decreases for the period.

A company's average collection period is used to evaluate...

A company's average collection period is used to evaluate the liquidity of the firm through the calculation of the cash conversion cycle. Liquidity measurements focus on the ability of the company to meet obligations as they come due.

Current Ratio

CA/CL

Accounts Payable Turnover

COGS/Avg AP

Compensating Balances

Compensating balances are a bank requirement related to a loan. The bank will require a certain balance be maintained in cash. This amount cannot be used for working capital purposes.

The cash conversion cycle of an organization would improve under which combination of performance results (measured in days) shown below:

Decreasing inventory conversion and accounts receivable collection periods indicates that cash is being collected faster from sales of product and speedy collections from accounts receivable. The increasing deferral period on payables indicates that the cash disbursements are being held as long as possible. The cash conversion cycle is therefore becoming shorter and improving.

ROA

Net Income/Average total assets

The overall cost of capital is the:

Rate of return on assets that covers the costs associated with the funds employed. Firms must at least earn a return rate on investments equal to their cost of capital, or the investments are losing money and, therefore, decreasing the value of the firm.

The basic objective of the residual income approach of performance measurement and evaluation is to have a division maximize its:

Residual income is defined as income in excess of a desired minimum return.

The segment margin of an investment center after deducting the imputed interest on the assets used by the investment center is known as:

Residual income is the segment margin of an investment center after deducting the imputed interest (hurdle rate) on the assets used by the investment center.

Accounts Receivable Turnover

Sales/Avg AR

EOQ

Sq. Rt of: 2 Annual Sales x Order Cost/Carrying Cost per Unit

The theory underlying the cost of capital is primarily concerned with the cost of:

The cost of capital considers the cost of all funds, whether they are short-term, long-term, new or old.

A working capital technique, which delays the outflow of cash, is:

The use of a draft delays a cash disbursement and increases payable float.

The working capital financing policy that subjects the firm to the greatest risk of being unable to meet the firm's maturing obligations is the policy that finances:

The working capital financing policy that finances permanent current assets with short-term debt subjects the firm to the greatest risk of being unable to meet the firm's maturing obligations.

Debt-to-Equity Ratio

Total Debt/Total SE

Debt-to-Capital Ratio

Total debt/Total Capital (D+E)

Working capital increases...

Working capital (WC) increases only if current assets are increased or current liabilities are decreased. Exchanging accounts payable (current liability) for a two-year note payable (long-term liability) would decrease current liabilities and increase working capital.

Accounts Payable Deferral Period

365/AP Turnover

Inventory Conversion Period

365/Inventory Turnover

Receivable Collection Period

=Days Sales Outstanding (DSO) = 365/AR Turnover

Capital investments require balancing risk and return. Managers have a responsibility to ensure that the investments that they make in their own firms increase shareholder value. Managers have met that responsibility if the return on the capital investment:

A capital investment whose rate of return exceeds the rate of return associated with the firm's beta factor will increase value of the firm.

A company uses its company-wide cost of capital to evaluate new capital investments. What is the implication of this policy when the company has multiple operating divisions, each having unique risk attributes and capital costs?

A company-wide cost of capital averages risks to arrive at required return for investments. The company-wide cost of capital will be lower than the cost of capital specific to high-risk projects and higher than the cost-of-capital specific to low-risk projects. If a company is comprised of multiple divisions with unique risk characteristics, higher risk divisions will automatically beat the threshold for investments and invest in higher risk projects that beat the company wide average. Meanwhile, their lower risk counterparts will find it hard to achieve the risk return that beats the average (artificially inflated) returns that are driven by higher risk divisions and will under invest in new projects.

The cost of debt most frequently is measured as:

Actual interest rates minus tax savings is the most frequently used measure for cost of debt (kdt). After-tax interest fully considers both the costs and tax shield advantages of financing charges which reduce the cost of debt to its most relevant amount.

Which one of the following factors might cause a firm to increase the debt in its financial structure?

An increase in the corporate income tax rate might cause a firm to increase the debt in its financial structure because interest is tax deductible, while dividends are not tax deductible.

Inventory Turnover

COGS/Avg Inventory

Quick Ratio

Cash + Marketable Securities +Receivables/Current Liabilities CA - Inv. - Prepaids/CL

When the risks of the individual components of a project's cash flows are different, an acceptable procedure to evaluate these cash flows is to:

Discount rates may be adjusted to factor differences in risk into cash flow analysis. For example, a 12% discount rate may be used for the first three years of a project and a 15% discount rate for subsequent years to reflect the greater risk associated with the cash flows in the later time periods. Discount rates may also be adapted to compensate for expected inflation.

Various methodologies can be used to develop the fair value of common shares. The most objective methodologies are considered to be:

Discounted Cash Flow (DCF) methods are considered the most rigorous and objective of the valuation methods.

Economic Value Added

Economic value added is a firm's (investment center's) net operating profit after taxes (NOPAT) less its required return (after-tax cost of capital on the investment). NOPAT is calculated by multiplying EBIT × (1 - Taxes), whereas the required return is determined by multiplying the investment (total assets) by the cost of capital or WACC. EVA = NOPAT - $WACC

Which of the following terms represents the residual income that remains after the cost of all capital, including equity capital, has been deducted?

Economic value-added is a residual income technique used for capital budgeting and performance evaluation. It represents the residual (excess) income of project earnings in excess of the cost of capital (including cost of equity) associated with invested capital.

The imputed interest rate used in the residual income approach for performance measurement and evaluation can best be characterized as the:

Historical weighted average cost of capital is usually used as the target or hurdle rate in the residual income approach.

In inventory management, the safety stock will tend to increase if the:

If lead times became more variable, the amount of safety stock needed to reduce the risk of stock outs will increase.

If the net present value of a capital budgeting project is positive, it would indicate that the:

If the net present value of a project is positive, it would indicate that the rate of return for the project is greater than the discount percentage rate (hurdle rate) used in the net present value computation.

Which of the following inputs would be most beneficial to consider when management is developing the capital budget?

In developing its capital budget, management would find the employee input associated with equipment requests from various profit centers most helpful. Departmental requests, appropriately justified, would provide key insights into the capital requirements of the business that are not otherwise known.

Cash Conversion Cycle/Net Operating Cycle

Inventory Conversion Period (# days to sell) + Receivables collection period (# days to collect) - Payables Deferral Period (Payables)

The internal rate of return is computed as follows:

Investment / Cash Flows = Present Value Factor The higher the present value factor, the lower the computed rate (internal rate of return). Increases to the investment or decreases to the cash flows serve to increase the present value factor.

Why would a firm generally choose to finance temporary assets with short-term debt?

Matching the maturities of current assets with liabilities as they come due is designed to ensure liquidity and reduce risk of cash shortages. Temporary assets (such as inventories, generally, and seasonal inventories, specifically) might be financed with short term debt such that the earnings from the sales of those temporary assets could be used to liquidate the related obligations as they come due and ensure that cash is available to meet cash flow requirements.

What is the inventory management technique that focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as work-in-process and raw materials?

Materials requirements planning (MRP) is an inventory management technique that projects and plans inventory levels in order to control the usage of raw materials in the production process. MRP primarily applies to work in process and raw materials.

Net present value as used in investment decision-making is stated in terms of which of the following options?

Net present value, like most capital budgeting techniques, focuses on cash flow. Cash flow is a pure measure of financial performance that isolates relevant information for decision making. The amount of cash the firm takes in and pays out for an investment affects the amount of cash the firm has available for operations and other activities.

Operating Leverage

Operating leverage is defined as the degree to which a firm uses fixed operating costs, as opposed to variable operating costs. A firm that has high operating leverage has high fixed operating costs and relatively low variable operating costs and uses this cost structure to magnify the financial results of each additional dollar in sales.

Return on investment (ROI) is criticized as a performance measure since it is not a well balanced measure. What characteristic of effective performance measures does the ROI lack?

ROI encourages shortsighted behavior that defers or avoids investment for the sake of current ROI performance. Short-term benefits are emphasized over long-term commitments.

Profitability Index RULE

RULE: The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. The profitability index is also referred to as the "excess present value index" or simply the "present value index." Companies hope that this ratio will be over 1.0, which means that the present value of the inflows is greater than the present value of the outflows. Present value of net future cash inflows/ Present value of net initial investment = Profitability index

As a company becomes more conservative with respect to working capital policy, it would tend to have a (n):

RULE: Working capital policy is deemed to be more conservative as an increasing portion of an organization's long-term assets, permanent current assets, and temporary current assets are funded by long-term financing. An increase in the ratio of current assets to non-current assets would be indicative of an increasingly conservative working capital policy. With no other information, an increase in current assets would indicate that a growing percentage of current assets are financed by non current liabilities and that, nominally, the absolute amount of working capital and the current ratio is improving.

Which of the following ratios should be used to compare the profitability of two electronics companies that differ in size?

Return on assets (ROA) is a profitability ratio that produces a percentage output, making it easy to compare companies that differ in size. For instance, Company A may have net income of $2,000 and assets of $20,000, for an ROA of 10%. Company B may have $1 million in net income and assets of $10 million, also resulting in an ROA of 10%. The companies are very different in terms of size, but an ROA output allows them to be easily compared.

Extended DuPont Model (5 stages)

Tax Burden = Net Income/Pretax income Interest Burden = Pretax income/EBIT Operating Margin = EBIT/Sales Asset Turnover = Sales/Average total assets Financial Leverage = Average total assets/Equity

CAPM

The CAPM (capital asset pricing model) is one of the methods used to calculate the required rate of return on retained earnings (equity). The model is calculated as follows: Cost of retained earnings = Risk-free rate + [Beta × (Market return - Risk-free rate)]

Minon, Inc. purchased a long-term asset on the last day of the current year. What are the effects of this purchase on return on investment and residual income?

The addition of an asset at year end serves to reduce both return on investment and residual income. The addition of an asset increases then denominator in the ROI computation and increases the threshold earnings required using the residual income approach. Both measures would suffer as a result of addition of assets.

The discount rate is determined in advance for which of the following capital budgeting techniques?

The discount or hurdle rate is determined in advance for computations of net present value. Project cash flows are discounted based upon a predetermined rate and compared to the investment in the project to arrive at a positive or negative net present value. Advance determination of management's required return is integral to the development and evaluation of net present value.

The capital budgeting model that is generally considered the best model for long-range decision making is the:

The discounted cash flow model is the best for long-term decisions. Discounted cash flow methods include NPV, IRR, and profitability index.

What inventory management approaches orders at the point where carrying costs equate nearest to restocking costs in order to minimize total inventory cost?

The economic order quantity (EOQ) method of inventory control anticipates orders at the point where carrying costs are nearest to restocking costs.

Which of the following assumptions is associated with the economic order quantity formula?

The economic order quantity formula (EOQ) assumes that periodic demand is known. Annual sales volume is a crucial variable in the EOQ formula.

The Efficient Market Hypothesis

The efficient market hypothesis implies that markets are efficient enough such that technical analysis (weak form), technical and fundamental analysis (semi-strong form), and both analyses plus insider information (strong form) do not provide an advantage to investors. Benefits from timing of purchases and sales of securities (which relates to technical analysis) would not exist under any form assuming the markets are efficient.

Which of the following decision-making models equates the initial investment with the present value of the future cash inflows?

The internal rate of return method computes the rate of return where net present value equals zero. The method equates the initial investment with the present value of the future cash inflows.

Actual interest rates minus tax savings is the most frequently used measure for cost of debt (kdt). After-tax interest fully considers both the costs and tax shield advantages of financing charges which reduce the cost of debt to its most relevant amount.

The optimal capitalization for an organization usually can be determined by the lowest total weighted-average cost of capital (WACC). Capitalization at WACC serves to maximize shareholder's equity.

What is the primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investment center managers?

The primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investment center managers is that ROI may lead to rejecting projects that yield positive cash flows. Profitable investment center managers might be reluctant to invest in projects that might lower their ROI (especially if their bonuses are based only on their investment center's ROI), even though those projects might generate positive cash flows for the company as a whole. This characteristic is often known as the "disincentive to invest."

Which methods should be used if capital rationing needs to be considered when comparing capital projects?

The profitability index is used for capital rationing. The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. Ranking and selection of investments is made by listing projects in descending order. Limited capital resources are applied in the order of the index until resources are either exhausted or the investment required by the next project exceeds remaining resources.

Debt-to-Assets Ratio

Total Debt/Total assets