Financial management
When I am given a problem with different project options to choose from the one that I will choose is:
1) Under the NPV, whichever project that has an net present value greater than 0. If for example, I only have a capital budget of $100,000 and there are three projects with NPV>0, then I will need to pay attention to the initial investment required. If project A, requires an initial investment of $50,000, project B of $30,000 and project C of 45,000, then I can only choose the two projects that have the highest profitability rate. I cannot choose projects that exceed my capital budget.
What criteria is important for a bank that is considering to lend money to two different companies?
Banks or creditors don't tend to lend money to firms that have a debt to equity ratio or financial leverage above the industry's average, because they are at more risk for repayment.
How do we calculate effective rate without having to do math, just by using the interest rates and compensating balances (%) given in a problem?
Effective rate=Stated rate/100%-compensating balance %
Rayonier Services paid its current-year dividend of $0.70 per share of common stock, which was selling for $45 a share on the market. The company's current tax rate is 20%. The company projects long-term growth of equity to be 3%. Flotation costs are expected to be 2%. What is the after-tax cost of equity?
First of all, there is no tax on equity, so there is no tax effect to calculate. Cost = [(Dividend × (1 + Growth)) ÷ Price per share] + Growth rate = [($0.70 × 1.03) ÷ ($45 × (1 - 2%))] + 0.03 = 4.63% (rounded)
How do I calculate the net present value?
I will calculate the cash inflows after tax (the same as I calculate for payback method- deducting from the cash inflows the depreciation, net the tax effect and add depreciation back) and multiplying for the PV annuity factor, then add the salvage value discounted to the present value, and then deducting the initial investment as it is (no need to do anything with it). If we wanted to calculate the profitability ratio, we would divide the gross present value cash flows (meaning what we calculated before without deducting the initial investment) and then dividing it by initial investment.
Inventory carrying costs include:
Inventory carrying costs include: - Storage - Insurance - Opportunity cost of investing in inventory instead of something else (Carrying costs do not include inspection costs).
Payback period
It answers the question: how long does it take to recover the initial investment. The formula is= Initial investment/annual cash inflow after tax. They will give us the amount of the initial investment, but for the annual cash inflow after tax, we will have to calculate annual inflow and deduct any expenses or depreciation, and then calculate tax on that amount. Lastly, we will have to add back depreciation, since that did not involve cash.
Cost of debt
It is calculated by dividing interest paid (par value*stated interest rate) by the bond price (consider if it was sold at a premium or discount) minus flotation costs. However, if it doesn't give me the bond price, but it gives me the effective or market interest rate, then the cost of debt will be that market rate * (1-tax rate).
How do we calculate the average accounting rate of return?
It is net income (after taxes) divided by average investment (if there is just one value, we divide it into two).
Net Present Value
It is one of the methods used for capital budgeting, meaning, to determine what projects are viable to invest in. Be careful that if the problem says that the investment will generate $60,000 of cash revenues each year, I cannot discount that amount. I will have to determine the NET future cash flows after tax, so if I am given depreciation of 10,000 and interest rate of 40%, I will multiply the discount rate for annuity of (60,000-10,000)*(1-0.4)+10,000. I am adding back depreciation.
A key disadvantage of long-term financing by the borrower compared to short-term financing is:
Long-term debt has higher financing costs than short-term debt, which reduces profitability.
How do I calculate the profitability index?
Profitability index=Present value of future inflows/initial investment This formula is sometimes used to determine the net present value of a project. If I am given the profitability index and the initial investment amount, I can figure out Present value of future inflows, and if we deduct initial investment to this, then we will have net present value of the project.
While ratio analysis can be very helpful, the user must be aware of its limitations. Which of the following is not a cause of distortion within ratio analysis?
Ratio analysis tends to be more useful for narrowly focused firms as it is difficult to develop industry averages for large firms that have different divisions in different industries. Inflation, seasonal factors, and different accounting policies and practices can all distort ratios and/or comparisons between companies.
How do I calculate the reorder point of inventory and what is it?
Reorder point = Usage per day × Lead time The reorder point is the inventory level at which an order for the inventory item is submitted. For example, if 10 days are required to order and receive X part, and the daily demand for this part is 1,000 units, the formula is: Reorder point = 1,000 units × 10 daysReorder point = 10,000 units
What is the degree of financial leverage (DFL) and how is it calculated? How do combinations of equity and debt affect the DFL?
The degree of financial leverage (DFL) is the percentage change in earnings available to common stockholders related to a given percentage change in EBIT (earnings before interest and taxes). DFL=% change in net income/% change in net operating income= EBIT/EBIT-interest expense where EBIT is income before interest and taxes When there is no debt financing used, the DFL will equal 1, because there is no interest expense. The more debt the company uses, the higher the interest, and the higher the DFL, which means that the DFL will be higher (when the denominator goes down, the ratio will go up). Also, a change in EBIT will result in a greater proportional change in the earnings per share. So if DFL was 2, then a 10% increase in EBIT, will result in a 20% increase in earnings per share (2*10%=20%).
A project has an initial investment of $100,000 and a project profitability index of 1.15. The firm's cost of capital is 12%. The net present value of the project is:
The formula for a project profitability index is: Profitability index=Present value of future inflows/initial investment. Since I have 1.15 and the $100,000, I can find out the present value of future inflows (1.15*100,000=115,000). Then, to get the net present value of the project, I will have to deduct the initial investment from the present value of future inflows (PV of future inflows-initial investment=115,000-100,000=$15,000).
CAPM (Capital Asset Pricing Model)
The formula is required rate of return=RFR(risk free rate)+Beta*(current return in market-risk free rate)
What is the internal rate of return?
The internal rate of return is the discount rate that sets the net present value of a project equal to zero. The formula is: IRR=Expected cash flows/(1+discount rate)t-total investment costs
Bryce Enterprises receives monthly invoices for materials acquired that are used in its operations. Terms are 1/10, net 45. Due to cash flow issues, Bryce pays at the end of the 45-day period. Bryce's bank will grant Bryce an 8.5% short-term loan for working capital purposes. How much will Bryce save if it borrows to take advantage of the cash discount on a $30,000 invoice?
The net annual savings is the cost of the bank loan less the discount allowed: Discount allowed = 1% × $30,000 = $300 Bank loan cost = [$30,000 × (100% - 1%)] × 8.5% × (45 days - 10 days) ÷ 365 days = $242.08 Savings = $300 - $242.08 = $57.92 Note that the bank loan is for 99% of 30,000, not 30,000, because the purpose of asking for the loan is to get the discount.
How much income is earned per dollar invested by common shareholders?
The question is basically asking for return on equity (ROE). ROE is a profitability ratio that shows the effectiveness of asset performance while considering long term financing. The formula is.. ROE=Net income-preferred dividends/Average common equity
Wilson Sports received an invoice from a supplier that provided terms of 3/10, net 60. If Wilson fails to take the discount on the due date, what is Wilson's effective annual interest rate cost assuming a 365-day year and simple compounding?
The way to calculate the effective rate is: (Discount %/Available funds)*(365/net days period-discount period). In this case it is, 3%/97%*(365/60-10)=
What is the before-tax cost of X company debt financing?
This question is asking about the effective interest rate that is calculated by dividing the interest paid for debt financing (issuing bonds- par value multiplied by stated rate), by the bond price (if it was sold at a premium, for example, the company received 1% more than its par value- so the denominator will be 101% of par value, and if there are flotation costs, it will be deducted from the denominator).
To determine the inventory reorder point, calculations normally include the:
To determine the inventory reorder point, calculations normally include the average daily use. The reorder point (RP) is the inventory level at which an order is placed. The reorder point is average demand during the lead-time period plus any safety stock. The ordering cost and carrying cost are used to compute the best quantity to order, but not the reorder point. The economic order quantity (EOQ) is the quantity of inventory that should be ordered at one time in order to minimize the associated costs of carrying and ordering inventory, such as purchase-order processing, transportation, and insurance.
How do we calculate the EBIT-EPS indifference point for two alternatives, stocks and bonds?
We can equate the EPS for the stocks and the bonds and solve for EBIT. The formula of EPS for stocks is EBIT*(1-tax rate)/number of shares. The formula of EPS for bonds is ((EBIT-bond interest)*(1-tax rate))/number of shares.
When I have several projects (A,B,C,D) and I am presented with the internal rate of return and the net present value for each of these projects, which one will we choose?
We will choose the one that has the highest net present value, even if it doesn't have the highest internal rate of return.
When a company increases its payout ratio, what happens to its capital structure?
When a company increases its payout ratio it means it is paying out more dividends from its earnings, meaning Retained Earnings will go down. If RE goes down, the growth rate will decrease, because instead of reinvesting the money in the company, it will pay dividends to shareholders. As a consequence, the weighted proportion of debt will increase.
Which of the following factors is inherent in a firm's operations if it utilizes only equity financing? Financial risk, interest rate risk, marginal risk and business risk.
Both financial risk and interest rate risk deal with the concept of financial leverage and the cost of debt, and since the firm only utilizes equity financing, these risk types do not apply. Marginal risk is the risk that is assumed by the issuer of a foreign exchange contract or debt (forward contract) in the event that the investor goes bankrupt. It is related to the risk of the last dollar of a transaction defaulting. Business risk is the uncertainty associated with the ability to forecast EBIT (earnings before interest and taxes) due to such factors as sales variability and operating leverage. This risk is inherent in equity financing.
Cash conversion cycle
Cash conversion period= Inventory conversion period (365/inventory turnover) +Receivables collection period (365/receivables turnover) -payable deferral period (365/AP turnover).
Advantages for companies that use commercial paper market for short term financing..
Commercial paper is a short-term note payable which is unsecured and usually discounted. It is issued in large denominations with maturities ranging from 2 to 270 days. There are several advantages to a corporation using commercial paper for short-term financing. The commercial paper market provides more funds at lower rates than other methods available. There is no required compensating balance at a lending bank. There is a broad and efficient distribution and the borrower's name becomes more widely known through this market. A disadvantage is that there are restrictions as to the companies that have access to this financing option, since commercial papers are issued in denominations of $100,000 or more, making it only accessible to big corporations.