Business Finance Exam 3

Balanced sheets are arranged in order of ______

liquidity

Liquidity

How fast you can convert assets into cash while maintaining its value

What are the most liquid assets?

Cash, accts receivable, inventory

Current Assets =

Cash + accts receivable + inventory

Current Liabilities =

accts payable + current long-term debt

List out assets of a balance sheet

Cash, accts receivable, inventory = current assets, PPE or NFA, goodwill (intangibles)

List out liabilities of balance sheet

Accts payable, current long-term debt = current liabilities, long-term debt, equity

List out income statement

Sales (revenue) - COGS - SGA = EBITDA - Dep = EBIT - Int = EBT - tax = NI

Income statement focus on…

long-run (finance profit = economic profit, NOT NI)

What is known as accounting profit

net income

Free Cash Flow (FCF)

cash available to return to capital suppliers without impacting the economic viability of the firm

True/False: the FCF can be calculated using both the assets side and the liabilities side.

True

The FCF on the assets and liabilities side should

equal

Operating Cash Flow (OCF)

real cash generated from normal activities of firm

Adjust OCF for non-cash items

items treated as a cost from GAAP, but don’t require actual cash payments

What is the most important non-cash item?

Depreciation

What does adjusting for depreciation account for when calculating the OCF?

real loss of value of an asset

What is not a normal business activity expense?

Interest expense

What are the two things you need to adjust for on an income statement?

Depreciation and interest expense

Net Working Capital (NWC)

day-to-day cash being generated and used

What does CAPEX stand for?

Capital Expenditure (Net Capital Spending/Expenditure)

What does CFTC stand for?

Cash Flow to Creditors

What does CFTS stand for?

Cash Flow to Shareholders

Marginal Tax Rate

tax due on the next dollar earned (you pay the percentage on the difference between your income and lower range #)

Average Tax Rate

total tax liability divided by earned taxable income (use set percentage)

What is the debt-equity ratio telling us?

For every one dollar of equity, how much debt financing does the company have

What does the Dupont Identity /Ratio ask…

What is impacting return of equity

What equation is associated with the Dupont Identity?

Return of Equity (ROE)

Return of Equity (ROE)

measure of accounting profitability

What is the measure of operational profitability

Profit Margin

What is the measure of asset utilization

Total Asset Turnover (TAT)

What is the measure of leverage

Equity Multiplier (EM)

What does the Return on Asset (ROA) tell

profitability through assets

What does the equity multiplier (EM) tell us?

How much debt is in the capital structure

more debt =

high ROE (not necessarily a good thing)

What is another name for the average tax rate?

Effective tax rate

What does the price-earning ratio (P/E) tell us

for every $1 of accounting earnings, how much investors are willing to pay

Capital Budgeting

process a firm uses to select its projects and estimate the return provided by the projects

What are the tools used for capital budgeting decision-making

Payback period, discount payback period, Net Present Value (NPV), Internal Rate of Return (IRR)

What does IRR stand for

Internal Rate of Return

What does NPV stand for?

Net Present Value

What would make a good capital budgeting tool?

time value of money, giving management an unambiguous decision, considering all relevant cash flows from projects being considered, considering risk of project (TVM)

Payback Period

time that it takes for a project to “payback” or recover the cost of its initial investment

What can we assume with payback period

that all cash flow generated by project is received uniformly across time

Rule for Payback Period

accept the project if payback is less than some selected hurdle period

What are downsides of Payback Period

isn’t unambiguous, doesn’t consider TVM, doesn’t consider ALL cash flows, not super reliable

Why is payback period still commonly used?

simplicity and is conservative (good for smaller businesses)

Discounted Payback Period

functionally same as payback period, but discount cash flows

Net Present Value (NPV)

gold standard for capital budgeting (when in doubt, use NPV)

Which tool addresses all assumptions of capital budgeting?

NPV

What is the decision rule(s) for NPV

accept all projects with a positive NPV (>0), if need be, consider budgeting constraints (regarding multiple projects), and accept projects that give highest total NPV, that you can afford

How is NPV related to the goal of financial management?

NPV is the additional value you will add to the company by doing the project (therefore achieving the goal)

what is the goal of financial management

Maximize equity of firm

Internal Rate of Return (IRR)

the return that an investment would make if all cash flows could be reinvested at that rate

How do you determine IRR

It is the discount rate needed to make NPV = 0

Decision rule of IRR

accept project is IRR is greater than the WACC (discount rate), or without WACC, some selected hurdle rate

Downsides of IRR

scale invariance, can product multiple possible IRRs (pick lowest), prefers less risky projects

NPV Profile

graphs showing NPV of several projects together

What does a NPV profile tell us

can help determine which project to select in case of mutually exclusive projects

what are mutually exclusive projects

if you do one, you can’t do the other

True/False, the flatter curve is riskier on a NPV profile graph

False

Cross-over rate

discount rate where both projects give the same NPV (indifferent)

If the WACC < cross over rate…

we should select the riskier project

if WACC > cross over rate…

we should select less risky project, as long as the IRR > WACC

the WACC is the appropriate discount rate to use for projects assuming…

the project being considered is “risk typical” to the firm

What is the Security Market Line

graph that shows relationship between the expected return and systematic risk (beta)

points above the Security Market Line indicate

the stock was underpriced given its risk, therefore you receive higher returns

points below the Security Market Line indicate

the stock was overpriced given its risk, therefore you receive lower returns

Stand Alone Principle

Each project should be evaluated by itself

Three implicit economic costs of the stand alone principle

cannibalization (erosion), opportunity costs, sunk costs

Which implicit cost should NOT be considered

Sunk costs

Cannibalization (erosion)

the lost sales or economic income from an existing project should a new project be introduced

Example of erosion (service example)

Starbucks quick expansion

Example of cannibalization (product example)

new Apple Iphone

Opportunity Costs

value given up for doing one action versus all other possible economic actions (scarcity)

Sunk Costs

Costs that have been incurred in the past and can not be recovered

Example of a sunk cost

deciding whether to continue waiting in line (despite already waiting for 10 minutes)

What does the tax shield approach of OCF recognize

to support a new project, the firm will need to purchase new assets. These assets will generate depreciation expense which produces a tax shield for the firm

Cost Savings Projects

Do not generate revenue, but instead reduce cots to the firm

How do we estimate the FCF from a project?

Build out a pro-forma financial statement or if not full pro-forma, at least the data we need to construct the FCF

Steps for estimating the FCF from a project

1. start with sales forecast

2. build out pro-forma income statement and balance sheet

3. consider long-term fixed assets to support project

4. generate parts needed for FCF (OFC, NWC, CAPEX)

5. generate FCF estimates

6. use capital budgeting tools

Depreciation Methods

Straight line depreciation and MACRS

two forms of straight line depreciation

Straight line to zero, straight line to some value

Steps in determining straight line depreciation

1. Determine relevant life span of asset through the book value.

2. Determine what we want the ending book value of the asset to be

MACRS

Depreciable amount in any year is equal to purchase price times the allowable depreciation percentage based on the MACRS table

Why do we find MACRS attractive in finance

we can depreciate more of the asset earlier, which betters the tax shield

What is the half-year assumption

when you bought the asset, you bought it half-way through the year

Purchase price is always at what percentage when finding depreciation

100%

After-Tax Salvage Value (ATSV)

Cash flow from sale of an asset

Why is ATSV important when considering projects

It is equal to CAPEX (capital expenditure)

What is the most important aspect to pay attention to when calculated the FCF of a project

change in NWC