Chapter 3 Bec. Which of the following is a strength of the payback method?- it is easy to understand. Emphasis on liquidity.

Limitations of payback model- the time value of money is ignored, project cash flows occurring after the initial investment is recovered and not considered.

Bec chapter 3

The internal rate of return determines the compound interest rate of an investment where the present value of the cash inflows equals the present value of the cash outflows. The IRR is the discount rate that results in a net present value of zero. To calculate IRR first: Net increment investment/ net annual cash flows = factor of the IRR The internal rate of return (IRR) method is less reliable than the net present value (NPV) technique whne there are several alternating periods of net cash inflows and net cash outflows or the amounts of cash flows differ significantly. The IRR is strictly a percentage measure of return, while the NPV is an absolute measure. Due to this difference, the timing or amount of cash flows under IRR can be misleading when compared to the NPV method. Ex.: if an investment of $50 earns $100. Then 100/50= 200% return If an investment of $50,000 earns 25,000 then 25,000= 50 % return IRR suggests it is best to invest 50 dollars to earn 100 and 200% return, while npv will favor a larger npv for the 50,000 investment.

When the risks of the individual components of a projects cash flows are different, an acceptable procedure to evaluate these cash flows is to discount each cash flow using a discount rate that reflects the degree of risk. ( ex. 12% discount rate may be used for first 3 years of project and a 15% 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).

Annual cost of NOT taking disctount= 360/ total-discount * discount%/100%-97%

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 paid after tax.- higher debt to equity ratio 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 (lowest WACC= lowest cost of capital % required) The cost of capital considers the cost of all funds- whether they are short-term, long-term , new or old Debt is cheaper source of financing than equity to begin with. In addition the company issuing bonds receives a tax deduction for interest paid. This further reduces the cost of bond financing. WACC = percentage of equity* ( % equity market expected to earn) + percentage of debt *(after tax cost of debt) Financial leverage increases when the debt to equity ratio increases. Residual income is a better measure for performance evaluation of an investment center manager than return on investment because- desirable investment decision will not be neglected by highreturn divisions. Residual income measures actual dollars than an investment earns over its required return rate. Performance evaluation on this basis will mean that desireable investment decisions will not be rejected. Residual income controls and performance measires encourage managers to invest in projects that generate income in excess of the hurdle rate, thereby improving company profits and promoting the congruence of individual and corporate goals.

Return on investment = NET income/ investment (average workgin capital + average plant and equipment) Residual income = net income ( from income statement) required return Required return= net book value * hurdle rate ( CAPM) Working capital + plant and equipment= asset base Asset base * imputed interest rate= hurdle income Hurdle income + residual income target (required return)= target income ( net income) Revenue forecast target total income= require COSTS to achieve target (target) 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 When the average age of assets differs substantially across segments of business, the use of ROI may not be appropriate. old fixed assets may be undervalued and make comparison with a segment with newer assets inappropriate. Limitations of ROI- short term focus, disincentive to invest. ROI is no more or less capable of being independently verified or manipulated than other performance measure The basic objective of the residual income approach of performance measurement and evaluation is to have a division maximize its INCOME in excess of desired minimum amount. residual income is defined as INCOME in excess of desired minimum return. Historical weighted average cost is usually used as the target or hurdle rate in the residual income approach. the imputed interest rate used in the residual income approach historical weighted average cost of capital for the company.

The addition of an asset at year end serves to reduce both return on investment and residual income. ROI denominator is the AVERAGE TOTAL ASSETS not just the total assets at year end The net cost of debt is computed as the EFFECTIVE ( NOT coupon) interest rate net of tax (INCLUDING TAX). Coupon rate only used if it is same as effective rate and there are no flotation costs ROI disadvantage is that ROI may lead to rejecting projects that yield positive cash flows. The primary disadvantage of using (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 even though those projects might generate positive cash flows for the company as a whole. ( disincentive to invest) The benefits of debt financing over equity financing are likely to be highest when there is HIGH marginal tax rates and few non interest tax benefits ( The weighted average cost of capital is fequenstly used as the hurdle rate within capital budgeting techniques. Investments that provide a return that exceeds WACC should coninously add to the value of the firm. ( this rate is compared to IRR to see whether or not to make an investment) Firm borrows- minimum compensating balnce= net cash available. Annual interest/net cash available= effective interest rate on loan Effective annualized percentage cost financing= ANNUAL INTEREST ( month long term would need to * 12)/ net cash available Annual interst= face value amount received+ transaction costs

Acid test ratio evaluates short term liquidity Return on total assets evaluates profitability of firm a/c turnover measures the overall efficiency of the firm gross margin ratio measures a companys profitability. Current ratio measures liquidity. Debt to total assets measures solvency. Average collection period is used to evaluate the liquidity of the firm. Sales/ asset turnover= total assets Sales /total assets= asset turnover Investment turnover= sales/ average investment Economic rate of return on common stock= (dividends + change in price)/ beginning price
Establishing a strategic vision is not normally included as part of the logical steps to reach a decision., the process of deriving the vision is not considered part of the decision-making process. Decision making- obtaining information as a basis for selecting between alternatives, selecting alternatives , identifying alternative course of action from which to choose . Relevant costs- future revenues and costs are deemed to be relevant if they change as a result of selecting different alternatives. Costs that do not change as a result of a course of action are not relevant. (relevant= direct= variable)

Discretionary costs- Cost such as that of advertising, preventive maintenance,research and

development, that a manager may eliminate or postpone without disrupting the firm's operations or affecting its productive capacity in the short run. A discretionary cost is usually specific in amount, or is determined by a formula such as a certain percentage of sales revenue. Also called discretionary expenditure or managed cost.

The proposed cost for plant service for the grounds at corporate headquarters is an example of an avoidable cost that is discretionary. Historical cost is generall y not relevant in a decision analysis situation

The following ARE RELEVANT in a decision analysis situation- incremental cost, avoidable cost, opportunity cost Incremental costs are the additional costs incurred to produce an additional amount of the unit over the present output, Avoidable costs result from choosing one course of action instead of another. As a result the firm avoids the cost associated with the other course of action. Absorption costs represent the allocated portion of fixed manufacturing overhead. Absorption costs are not relevant to future decisions to the extent that they represent unavoidable fixed costs- (rent, deprecetiation) The relevance of a particular cost to a decision is determined by potential effect on the decision. Relevant costs are expected future costs that vary with the action taken. All other costs are assumed to be constant and thus have no effect on the decision. Capital budgeting decisions DO NOT include the fiancning of short- term working capital needs which are more operation in nature. Capital budgeting include financing short-term working capital needs. A depreciation tax shield is one of the most common indirect cash flow effects. The annual tax depreciation expense reduces income taxes by an amount equal to the firms MARGINAL tax rate ( tax on the next dollar of income) times the depreciation amount. MACRS and straight line depreciation will be equal in total ( only the timing differs) The timing of depreciation tax shields will differ. The discounting will result in different present values based on the differing timing. End of life= Page 12 out of 86
Tax basis may be reduced by allowances for depreciation. Such reduced basis is referred to as theadjusted tax basis. Adjusted tax basis is used in determining gain or loss from disposition of the asset. Tax basis may be relevant in other tax computations 40% tax rate, Tax basis= 75,000 at end of the year., removal costs- 40,000, salvage= 10,000 Equipment value net cash inflow = 75,000* .4 Removal net cash outflow= 40,000*. 6 Salvage net cash inflow= .10000*.6

Relevant to a manufacturing equipment replacement decision- disposal price of the old equipment. ( gain or loss on the disposal of the old equipment is not relevant. The gain or loss is an accounting computation that combines the book value which is not relevant and disposal value which is relevant. The result is meaningless) The expansion of working capital (CA-CL) is an increase in investment. All of the following are included in discounted cash flow analysis- future operating cash savings, current asset disposal price, tax effects of future asset depreciation, future asset disposal price. ( the future asset depreciation expense is not included , JUST THE TAX EFFECTS OF IT) The net present value method recognized the time value of money and discounts cash flows over the life of the project, using the minimum desired (hurdle) rate. IRR does not assume a desired rate of return. The rate is calculated that produces a NPV of zero. The method of funding has no effect on the NPV, it uses a hurdle rate to discount cash flows.

Net cash outflow= purchase price of machines+ shipping + REQUIRED INCREASE IN WORKING CAPITAL When a company has unlimited capital funds to invest the decision rule for the company to follow to maximize shareholder wealth is to invest in all projects having a NPV greater than zero. In an inflationary environment, furutre cash flows ( besides cash flow generated from the tax effect of deprectioation) should be increased to the extent of predicted inflation. An inflationary factor should be added to the discount rate for internal consistency.) The following are rates used in NPV analysis- cost of capital- cost of borrowing, ( hurdle rate, discount rate, Required rate of return are synonyms) For capital budgeting purposes, management would select a high hurdle rate of return for certain projects because management wants to factor risk into its consideration of projects. Management would select a high hurdle rate for certain projects to factor risk into its consideration, the higher hurdle rate discounts future cash flows more, creating a smaller present value. By devaluing the cash flows of certain projects, risk has been compensated for. When finding the NPV- discount rate the PV for the depreciation tax shield and the annual profit (savings) and the SALVAGE ., DON'T multiply the discount rate by the machines outflow for (COST OF CAPITAL) An increase in the discount rate will decrease the present value of future cash inflows and therefore decrease the NPV. NPV assumes that cash flows are reinvested at the DISCOUNT RATE used in the analysis .if the npv of a proposed investment is negative the discount rate used must be greater than the projects IRR

The npv method of capital expenditure evaluation does not provide the true rate of return on investment. The npv indicates whether or not an investment will earn the hurdle rate used in the NPV calculation. If the NPV is positive, the return on investment will exceed the hurdle rate. If the NPV is negative the return on investment will be less than the hurdle rate. If NPV is zero the return on investment will be exactly the hurdle rate. The use of an accelerated method of depreciation rather than the straight line method has the effect of increasing the PV of the depreciation tax shield. Depreciation tax shield= depreciation expense * marginal tax rate The internal rate of return can be determined by finding the discount rate that yields a NPV of zero for the project. The internal rate of return is the rate of interest that equates the present value of cash outflows and the present value of cash inflows. It is the technique that determines the PV factor such that the present value of the after-tax cash flows equals the initial investment on the project. Alternatively, the IRR is the discount rate that produces and NPV of zero. The hurdle rate is the Minimum rate of return set by management to evaluate investments IRR is the rate of interest where NPV = zero It is the return of all cash flows produced by the INVESTMENT ( not operational) Accounting rate of return divides annual after-tax net income by average investment amount. The length of time required to recover the initial outlay of a capital project is determined by using the PAYBACK PERIOD Payback period DON'T DO THE PRESENT VALUE OF ANNUITY= net initial investment /increase in annual net after tax cash inflow- ( does not consider the time value of money) Pre-tax cost of debt payback period is the time period required for cash inflows to recover the initial investment. The emphasis of the technique is on liquidity ( cash flow) the term underwriting spread refers to the difference between the price the investment banker pays for the new security issue and the price at which the securities are sold. Beta coefficient is- %change in stock price/ % change in market price Operating leverage= quantity* (sales price- cost)/ quantity *(s-vc)- Fixed cost Quantity( sales- Vc) FC = operating leverage Financial leverage= EBIT : quantity* (s-vc)- fixed costs / EBIT-interest expense-(preferred dividend / (1tax rate) If carlise company did not have preferred stock the degree of total leverage would decrease in proportion to a decrease in financial leverage- without preferred stock, the denominator in the total leverage calculation would be larger ( because preferred stock is subtracted to arrive at the denominator). The

same holds true for financial leverage. Therefore both financial and total leverage would decrease in proportion. A firm with a higher degree of operating leverage when compared to the industry average implies that the firms profits are more sensitive to changes in the sales volume. Operating leverage is the presence of fixed costs in operation, which allows a small change in sales to produce larger relative change in profits. ( GREATER RISK GREATER REWARD WITH HGIHER LEVERAGE) Higher variable costs imply a lower degree of operating leverage. A firm using a significant amount of debt financing has a higher degree of FINANCIAL LEVERAGE The CAPM model- risk free rate + beta(RM-RF) = EQUITY ( REQUIRED RETURN ON EQUITY) If mixing with debt must take this percentage * equity portion % + debt portion %* after tax cost of debt A firms target or optimal capital structure is consistent with the MINIMUM WEIGHTED AVERAGE COST OF CAPITAL Page 45 preferred stock The CAPM incorporates the expected market earnings, the current US treasury bond yield and the beta coefficient. Expected market earnings (market returns) US treasury bond yield (risk free rate earned on US tresuary bonds) Finding the cost of funds for a preferred stock- if the face value is 100, sold for 101, underwriting fee is 5 dollar and annual dividends is 10 dollars then the cost to the company is 10/(101-5) TAX RATE IS NOT APPLIED CAPM model to find the cost of common equity= CAPM= cost of equity= capital risk free rate +beta(market rate- risk free rate) FINDING THE BEFORE TAX COST OF DEBT FINANCING?? interest rate/ sales price- flotation costs Page 43 Appropriate working capital management matches the maturity life of each asset with the length of the financial instrument used to finance that asset. Determining the appropriate level of working capital for a firm requires offsetting the benefit of current assets and current liabilities against the probability of technical insolvency. As a company becomes more conservative in its working capital policy, it would tend to have an increase in the ratio of current assets to units of output. A cash advance made to a divisional office does not change the current ratio because the reduction of cash is offset by an increase in accounts payable.

When managing cash and short term investments a corporate treasurer is concerned with liquidity and safety. The BOD and general management would be interested in maximizing rate of return on company operations. The tax manager would be interested in minimizing taxes, and investing in common stock due to dividend exclusion for federal income tax purposes. An increasre in sales collections resulting from an increased cash discount for prompt payment would be expected to cause a decrease in the cash conversion cycle and operating cycle and in the bad debt losses Shipping coists are part of sellinbg costs not cost associated with carrying inventory. Insurance, cost of capuial invested in inventory and cost of obsolecense are associated with inventory. Stockout costs= stockout units * stockout costs per unit* probability of stock ouit = average cost per cycle Average cost per cycle * orders per year = annual stockout costs Handling costs are NOT carrying costs When the EOQ model is used for a firm that manufactures its own inventory, ordering costs consist primarily of production set-up. EOQ attempts to minimize ordering and carrying costs. The model can be applied to the management of any exchangeable good. EOQ assumes that demand is known and constant throughtout the year so no stockout costs are considered. If EOQ is 200 units and Edwards maintains a 50 unit safety stock what is the average inventory for A. Reorder quantity/2 = average inventory excluding safety stock. Add safety stock and the average inventory including safety stock= 150 Trade credit generally provides the largest source of short term credit for small firms Accounts payavle provide a spontaneous source of financing for a firm, debentures and preferred stock takes time to issue, accounts receivable take time to factor Trade credit is subject to risk of buyer default ( financing for small firms) it is an expensive source of external financing Operating levearage=fixed costs/ variable costs The most logical sequence in planning an controlling capital expenditures is to begin with identifying capital addition projects and other capital needs Developing budgets is the same as planning and controlling capital expenditures. Return on assets is a profitability measure and can be used to evaluate the efficiency of asset usage and management, and the effectiveness of business strategies to create profits.

Gross profit marginis a measure of profitability that indicates how much is left of each sales dollar to over operating expenses and profit. Residual income measures the amount of operating income earned above the imputed cost of capital for the operating unit. If the measure is positive, returns exceed the cost of financning the operating unit. When calculating the turnover, total assets may need to be refined by the elimination of assets that do not relate to sales as the inclusion of these items could distort the measure. Gross profit margin has limited usefulness for comparative analysis In evaluating the adequacy of the budgeted annuial OPERATING income, you would include the return on assets, long range profit objectives and industry average for earnings on sales. IRR is for CAPITAL budgeting Page 49 The imputed interest rate used in residuatl income approach can best be described as the target return on investment set by the companys management ROI= OPERATING income/ total assets Residual income: sales/ capital turnover= average invested capital. Residual income= operating incomeaverage invested capital Asset turnover * profit margin on sales = current year percentage return on assets ROI = net income/ average invested capital ROI= gain on investment- cost of investment/ cost of investment Cost of funds from retuaned earnings = dividend/ selling price- DONT INCLUDE FLOTATION COSTS OR UNDERVALUATION 7/100= 7%