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What is the second stages formula for determining the future annual cash inflows from operations
Pre-tax cash inflow (1-tax rate)
+ (Depreciation marginal tax rate)
(depreciation tax shield)
= After tax annual cash flows
What is the third stages formula for determining the one time terminal year inflow
Proceeds when asset is sold [proceeds on sale -- taxes paid on gain OR + taxes saved on loss (g/l tax rate)]
-- Expenses incurred for the disposal/removal [include the amount after taxes are subtracted out]
+ If asset is scrapped or donated [include the amount after taxes are subtracted out]
+ Decrease in working capital
= terminal year net inflow
Which types of cash flows are relevant to capital budgeting, pre-tax or after-taxwhat are the formulas for both
After tax = RELEVANT
Pre-tax cash inflow (1-tax rate)
Pre tax
Income before taxes + Amortization + Depreciation
Generally, what would result in the highest present value for cash flows
A decrease in taxes
Which method is the best one to use for capital budgeting
Net present value
Financial Analysis Discounted Cash Flows (DCF)
The DCF valuation method, which includes the net present value (NPV) and internal rate of return (IRR), are methods
that use what
The time value of money to measure the PV of the cash flows expected from a project
When should you use discounted cash flows
When the risks of the individual components of a project's cash flows are different
The desired rate of return for the project is also known as whatWhat are some characteristics about it
The hurdle rate
o It compensates for all risk assumed
For partial years do: amt needed to recover remaining initial investment CF for that entire yr =
amt of partial yr that needs to be added to full yrs
The initial inv inc. exp. CF is best used when only given 1 yr of info
If you have multiple years given, then do the [exp CF savings dep = NIBT tax rt = tax exp] steps for
each year and keep adding up the years till it reaches initial investment
o Note: depreciation does not include WC in calculation
If you know total fixed and variable costs: fixed cost variable cost = DOL
Operational-- What does the DOL formula and answer tell you
If the numerator changes by a bigger amount than the denominator, that firm is employing leverage
So if a firms EBIT increases by 21% as sales increase by 7% then the DOL is 3.
o Meaning for every 1% increase in sales, profit increases by 3%
A higher DOL implies that a small increase/decrease in sales will have a greater effect on profits and shareholder value
(more sensitive). But also more risk.
Financial-- What is financial leverage
The degree to which a firms use of debt to finance the firm magnifies the effects of a given percentage change in
earnings before interest and tax (EBIT) and earnings per share (EPS)
Financial When making financing decisions, a firm can choose to issue debt or equity. Is debt and equity fixed or
variable costs
Debt = fixed because interest expense is independent of the potential profit
Equity = variable because dividend distribution is dependent on profit and are not required to happen
Financial -- How is the degree of financial leverage (DFL) calculated
% change in EPS [or net income]
% change in EBIT
= Degree of financial leverage
Financial -- What can the DFL formula and answer tell you
Firms with a higher percentage of fixed financing costs will have a higher degree of financial leverage
A higher DFL implies that a small change in EBIT will have a greater effect on profits and shareholder value (more
sensitive). But also more risk.
Total Combined-- What is the total combined leverage
The use of fixed operating costs and fixed financing costs to magnify returns to firm owners
Total Combined-- How is the total combined leverage (DCL) calculated
% change in EPS
% change in sales
= Degree of total combined leverage
OR
Degree of total combined leverage = DOL DFL
Total Combined-- What does the DCL tell you
A high leverage implies that a greater portion of sales goes to the bottom line
The Weighted-Average Cost of Capital
What is the purpose of the weighted-average cost of capital (WACC)
It serves as a major link between the LT investment decisions associated with a firm's target or optimal capital structure
and to maximize the net worth/wealth of the firm
o Its the average cost of debt and equity financing associated with a firms existing assets and operations
o Its frequently used as the hurdle rate within capital budgeting techniques. Investments that provide a return
that exceeds the weighted-average cost of capital should continuously add to the value of the firm.
How is WACC computed
(Cost of equity % equity in capital structure)
+ (weighted-average cost of debt % debt in capital structure)
= WACC
Example =
The optimal capital structure is the mix of debt and equity financing that produces the __(highest or lowest)__ WACC
which maximizes the firm value
Lowest
Cash receipts
Days accelerated
= Increased cash receipts
Annual interest rate
= Marginal revenue
-- Lockbox fee
= Benefit or loss
When you have different amounts (multiple credit terms and a bank rate) how do you determine if you 1) should
borrow/not borrow from the bank and 2) which credit term to take
Borrow/not borrow = Take the lower of the banks annual rate OR the annual cost when not taking the discount
Credit term = Chose the company with the highest APR (annual cost when not taking discount)
A float occurs when there is a difference between the bank and book balance. What is the difference between a
disbursement float V. a collection float
Disbursement = (positive) - checks have been written but not received by vendor and recorded by the bank
Collection = (negative) - deposits have been recorded on the company's books but not recorded by the bank
The cash conversion cycle is the average number of days it takes to create cash from the core business. What is the cash
conversion formulaDo you want a high or low answer/result
The shorter/lower a cash conversion cycle the better
Cash conversion cycle = inventory conversion period + A/R collection period -- Payables deferral period
want low/happen quickly
want low/happen quickly
want increase/delay
What are the inventory turnover and the inventory conversion period formulas
Inventory Turnover= COGS Average Inventory
Conversion Period = 365 Inventory Turnover
What are the AR turnover and the AR collection period (aka days sales outstanding) formulas
AR Turnover = Sales Average AR
Average Collection Period on AR= 365 AR Turnover
What are the AP turnover and the AP deferral period formulas
AP Turnover = COGS Average AP
Average Days of AP Outstanding = 365 AP Turnover
How would you determine the number of days sales in AR or the average collection period
Day discount ends % of sales for that time
+ Day payment is due % of sales for that time
= Total days
Management of A/R
The main objective in A/R is to convert A/R into cash quickly enough to meet short-term obligations without angering
customers. What variables are included in a credit policy
Credit period = length of time buyers are given to pay for their purchases
Credit standards = the required financial strength of credit customers
Collection policy = its strictness or leniency in collecting delinquent accounts
Discounts = includes the discount and time period
How would you determine the result/change in credit policy when different factors are altered
Make 2 columns, 1 with the old policy and 1 with the new policy and compare them at the end
Sales projection
Credit sales ratio OR Variable cost & Required rate of return (if any)
= Sales on credit OR Variable margin
Collection ratio
= A/R
If a company has an increase in sales, increase in discounts taken, decrease in the amount of bad debt, and decrease in
the investment in A/R, what happened to the average collection period
It decreased
What is the purpose of factoringHow would you determine the annual cost of financing as an amount & a percentage
To speed up cash collections
Companys A/R fee % (days in year days in collection period) = Subtotal
-- Amount not advanced
= Amount subject to interest annual rate
= Subtotal
Cost to company (add all subtotals)
-- Expenses saved
= Net cost
Net cost amount subject to interest = APR
Management of A/P
Trade credit or A/P provides what
Provides the largest source of short term financing for small firms
o It is also spontaneous
o Subject to risk of buyer default
How would you compute the weighted average annual interest rate for trade credit
Ex) Monthly purchases: 25,000
50,000
Credit term
2/10, net 30 5/10, net 90
Apply the following formula to each vendor, then add them up to get weighted average:
(Discount % (100% Discount %))
2/98 = 0.0204
5/95= 0.0526
360 (Total pay period Discount period)
360/20= 18
360/80 = 4.5
(purchases total purchases)
25,000/75,000 = 0.33
50,000/75,000 = 0.67
= Total weighted average rate
= .122
= .158
= 28%
Management of Inventory
Inventory represents the most significant current noncash resource of an organization. What factors influences the
amount of inventory companies will carry (describe)
Carrying cost
o The lower the carrying cost of inventory, the more a company is willing to carry
Storage costs
Insurance costs
Opportunity costs of inventory invested
Loss of inventory due to spoilage or it becoming obsolete
Cost of capital invested for inventory
Safety Stock-- Many companies maintain a safety stock to ensure that manufacturing or customer supply requirements
are met. What factors determine the safety stock
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2.
3.
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6.
Safety Stock-- How would you compute the total cost of safety stock
Safety stock unit level
Inventory investment per unit
Stock out cost/ unit
Carrying cost percentage
= Total stockout cost
= Carrying cost per unit
Probability at 100% stock out
Stockout units
Total orders per year
= Carrying costs
= Expected stockout costs
= Total annual cost of safety stock
Reorder Point-- The reorder point is the inventory level at which the company should order or manufacturer additional
inventory in order to meet demand and to avoid incurring stockout costs. What is included in stockout costs
Loss of income from the product unavailability
Cost of restoring goodwill
Additional expenses incurred to expedite shipping
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Return on Investment (ROI) = Profit Margin Investment Turnover OR = Net Income Invested Capital
Profit margin = Net Income Sales
Investment turnover = Sales Invested Capital
[Invested Capital = Avg PPE + Avg WC]
o Measures the performance of a business based on the efficiency of an investment
Want a high percent
Return on Assets (ROA) = Net Income / Average Total Assets
o A measure that can be used to evaluate the efficiency of asset usage
Want a high percent
Return on Total equity (ROE) = (Net Income / Sales) (Sales / Assets) (Assets / Equity)
o Measures a corporation's profitability by revealing how much profit a company generates with the money shareholders
have invested.
Want a high percent
Residual Income (RI) = Net Income Required Return in Dollars
Required Return = Net Book Value of Assets Hurdle Rate (aka required rate of return/imputed int, WACC)
o Measure the excess of actual income earned by an investment over the hurdle rate
Want a positive amount
Economic Value Added (EVA) = Investment Cost of Capital = Required Return
Then: Income After Taxes Required Return = EVA
o Measures the excess of income after taxes earned by an investment over the return rate set by cost of capital
Want a positive amount
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Activity Ratios
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