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Definitions |
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NPV:
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Chapter 10
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Leverage
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Chapter 12
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Capital Budgeting
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Account Receivable Turnover:
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Credit Sales
___________________
Accounts Receivable
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Asset
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Liability + Owner's Equity
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Common Stock:
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A variable-return security
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Chapter 8
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Risk and Return
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Valuing Preferred Stock:
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= Dividends / Discount rate
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Inventory Turnover:
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Cost of Goods Sold
Inventory
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Debt Ratio
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= Total Debt
Total Assets
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Bonds:
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Vehicles by which corporations raise debt capital. They are primary means of borrowing money used in the present corporate world.
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Prices Vs Yield
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Inverse relationship between prices and yields.
If Interest rate ↑, price of existing bond falls
If Interest rate ↓, price of existing bond falls
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Lower Dividend Ratio:
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Lowering dividend payment decreases DFN as more income is retained within the company.
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Dividends
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Calculation:
Old RE + Net Income - New RE
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Non Spontaneous Accounts:
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Notes Payable
Long term financing accounts
Common Stock
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Types of Leverage:
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1. Operating Leverage
2. Financial Leverage
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What do we call an equally-spaced sequence of equal cash flows?
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annuity
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Preferred Stock:
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Hybrid Security, meaning it has some element of that resemble equity and others that resemble debt.
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New Retained Earnings:
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= Old Retained Earnings - Dividends
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Discounted Cash Flow Method:
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Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment.
T
Vfirm = ∑ FCFFt / (1+ WACC)t
t=1
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Payback method:
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Number of years required to recover the initial cash outlay.
Payback method is subject to
- reject a good project
-accept a bad project
Not a good method for capital budgeting
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Two sources of Risk:
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1. Operating (Business) risk: Variability associated with operating income
2. Financial Risk: Risk of distress or bankruptcy due to use of fixed cost financing
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Evaluating cash flow (Cont):
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Differential Cash Flows:
For each year of projects life, calculate
Incremental Revenue
- Incremental Costs
- Depreciation on project
= Incremental Earnings before Taxes (EBT)
- Tax on incremental EBT
Incremental Earnings after taxes (NI)
+ Depreciation reversal
= Annual Cash Flows
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Profitablility Ratios:
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ROA = Net Income / Total Asssets
ROE = Net Income / Total Equity
Gross Margin = Gross Profit / Sales
Net Margin = Net Income / Sales
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Zeros:
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Bond with no coupon payment i.e. no interest payment
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Spontaneous Accounts
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Accounts on the income statement and balance sheet that change automatically in proportion with sales.
Includes:
Most Current Assets
Accounts Payable
Accruals ( Accrued Wages, accrued taxes)
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Current Assets
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Cash or assets what will be converted into cash within the next year. Commonly current asset includes:
Cash
Marketable Securities
Accounts Receivable
Inventories
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Coupon Rate:
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Interest rate of the bond. Example: If 5% is coupon rate for a $1000 par value bond, bond will pay $ 50 interest every year.
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CAPM formula:
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R = Rf + ß(Km - Rf)
Where
R is the expected rate of return on a securityRf is the return rate of a "risk-free" investmentKm is the return rate of the appropriate asset class
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Operating Leverage:
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Operating Leverage is the use of fixed operating costs (rent, property tax, administrative salaries) as opposed to variable operating costs.
Firm with high fixed cost has high operating leverage.
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Maturity:
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The number of years from when the bond is issued to when it expires is its maturity.
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Incremental Cash Flows:
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Cash flows that result from accepting a project.
In short, Incremental cash flows are additional cash minus additional cash out when we are looking at the company as a whole.
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The financial planning method in which accounts vary depending on a firm’s predicted sales level is called the _____ approach.
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percentage of sales
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Pro forma financial statements are:
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projected accounting statements based on a sales forecast
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Cost of Equity:
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The annual rate of return that an investor expects to earn when investing in shares of a company is known as the cost of common equity.
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Better ways for Capital Budgeting:
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1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)
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Cash Flow from Operations:
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Net Income
+ Non cash expense
( Depreciation and Amortization)
+ Decrease in current assets ( other than Cash)
- Increase in current assets ( other than Cash)
+ Increase in current liabilities ( other than notes payable)
- Decrease in current liablities ( other than notes payable)
= CFO
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Risk and Acceptance:
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Risk of the project should be properly evaluated. Firm can finally accept or reject the project based on NPV or IRR.
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Yield to maturity:
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Return on the bond if held till maturity and bond does not default
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Two stage growth model:
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Estimate cash flows of two different growth stages
Stage1 : Dividends grow at above-average rates
Stage 2: Dividends grow at the industry average rate
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Statement of Cash Flows:
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Cash flow from Operations
+ Cash flow from Investing
+ Cash flow from Financing
= Change in Cash
+ Beginning Cash
= End Cash
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The cost of Debt:
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Generally cost of debt is cheaper than debt.
After tax cost of Debt = Before tax cost of debt - tax savings
= Before tax cost of debt × (1- tax rate)
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Example: Find the beta on a stock XYZ given that its expected return is 12%, the risk-free rate is 4%, and the expected return on the market portfolio is 10%.
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Ans:
r = Rf + beta x (Km - Rf)
12% = 4% + beta x (10% - 4%)
Beta x = 12% - 4% / 10% - 4%
Beta x = 1.33
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The dividend payout ratio is calculated as:
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cash dividends divided by net income
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When fixed assets on a pro forma statement are projected to increase at a rate equivalent to the projected rate of sales growth, it can be assumed that the firm is
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operating at full capacity
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Criteria for the ideal evalutation:
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- includes all cash flows that occur during the life of the projects
- consider the time value of money
- incorporate the required rate of return
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Degree of Combined Leverage (DCL) :
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= DOL × DFL
OR
= (Sales - Variable Cost)/ (EBIT -1)
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DOL Example:
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If a firm has DOL of 1 then 1% change in sales will change EBIT by 1%.
Similarly, if DOL is 2, 1 % change in sales will change EBIT by 2%
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The intrinsic value of an asset:
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The present value of the stream of expected cash flows discounted at an appropriate required rate of return.
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Total value of an asset :
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The present value of the stream of expected cash flow discounted at the required rate of return
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Why do we do financial forecasting?
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To predict how much financing our firm will need in the future.
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Internal Rate of Return (IRR) :
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Rate of return that the firm earns on its capital projects
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