BEC 2 - Capital Structure 2

  1. When is using the WACC as a hurdle rate appropriate vs not appropriate?
    The WACC should be used when the risk due to the project is approximately the same as the risk as the entire corporation; otherwise, use different measures to assess new project viability
  2. What is the formula for the growth rate? What is this used for?
    • Financial valuation. To provide assurance that the company will meet its obligations and provide a positive return over time.
    • (1 - payout rate) x ROE OR
    • Retention Rate x ROE OR
    • Payout rate can be calculated as (dividends per share / earnings per share)
  3. When reviewing the growth rate formula, how does the payout of dividends, or the increase in interest-bearing debt affect the result?
    • Each of these factors affects the growth rate, but dividends payments are optional, while debt interest payments are not.
    • The paying of dividends affects the retention rate.
    • The increase in debt reduces the net income and reduces the ROE.
  4. What is the formula for ROE? This provides a measure of the company's (1) liquidity, (2) solvency, (3) profitability, (4) leverage / risk?
    • Profitability measure: how well does the company earn income using only the money provided by shareholders or kept by the company from previous earnings.
    • Net Income / Avg Equity OR
    • Use the DuPont formulas
  5. What is the formula for ROA? This provides a measure of the company's (1) liquidity, (2) solvency, (3) profitability, (4) leverage / risk?
    • Profitability measure: how well does the company earn income using the total resources provided to the company?
    • Net Income / Avg Assets OR
    • Net Margin x Asset Turnover which is (Net Income / Sales) x (Sales / Avg Assets)
  6. What is the formula for ROI? This provides a measure of the company's (1) liquidity, (2) solvency, (3) profitability, (4) leverage / risk?
    • Profitability measure: how well does the company earn income using both the money provided by shareholders or kept by the company from previous earnings and the interest bearing debt obtained.
    • Note that a quick method is to take all liabilities + equity = assets.
    • Net Income / Avg Total Capital Investment
  7. Define Operating Leverage. Which types of manufacturing -- capital intensive or labor-intensive -- have a higher operating leverage? Does a higher/lower DOL indicate higher risk?
    • The degree to which a company uses fixed operating costs vs variable costs.
    • Capital Intensive entities have a higher operating leverage as they tend to use machines rather than people for manufacturing.
    • The higher the operating leverage the greater the risk from a downturn in the economy as the entity must still pay its fixed costs regardless of amount of income.
  8. What is the formula for Operating Leverage and what is its purpose?
    • How well does a company generate profit using its fixed costs.
    • OL = % change in sales / % chg in EBIT OR
    • Quantity(Sales Price-Variable Cost) / Quantity(Sales Price-Variable Cost)-Fixed Cost OR
    • Fixed Cost / Contribution Margin-Fixed Cost OR
    • Total Fixed Costs / Total Variable Costs
  9. Looking at the capital asset mix. When a company has a lot of debt, an investor would prefer to see more [current assets / LT assets]. What are the benefits and drawbacks with having more [current assets / LT assets].
    • More current assets (such as cash) in order to pay the interest costs on the debt.
    • Benefits: current assets are highly liquid, less risk of financial distress.
    • Drawback: poor return on assets (cash in a bank account makes less than return from a fixed asset)
  10. Looking at the capital asset mix. What are the advantages and disadvantages when a company has a lot of equity and very little debt.
    There is little risk of entity financial distress, but also lowers the opportunity for return on equity.
  11. What is time series analysis vs cross sectional analysis of profitability.
    • Time Series: comparison of a company's profitability period to period
    • Cross Sectional: comparison of profitability of your company to another
  12. How would you forecast a change in EBIT based on a change in sales?
    • % change in sales x degree of operating leverage = % change in EBIT OR
    • % change in sales x degree of financial leverage = % change in EBIT
    • Degree of either Operating or Financial Leverage is a magnifier
  13. True / False: A degree of operating leverage (DOL) of 2.0 is better than a DOL of 2.5?
    Neither true or false. DOL is a measure of risk. If your risk appetite is higher, you would prefer the 2.5. If lower, you would prefer the 2.0.
  14. Interest expense is considered a [fixed/variable] cost.
    • Fixed
    • Payments are a set amount (even if using a variable rate bond)
  15. A company that is highly leveraged will have a [higher/lower] credit rating than a competitor with a lower leverage rate? How will this affect the company?
    • Will have a lower credit rating
    • It will be more difficult to obtain credit in the future
    • Creditors may require more debt restriction covenants (such as restricted cash or compensating accounts)
    • Investors may require more liquid assets or a longer term demonstration of growth & profitability
  16. What is the Degree of Financial Leverage? How is this used?
    • Measures the sensitivity of a company's EPS to fluctuations in its operating income as a result of changes in its capital structure.
    • DFL = % change in EPS / % chg in EBIT OR
    • DFL = EBIT / (EBIT - Interest)
  17. What is the general purpose of all of these different ratios? How does this apply to (1) profitability ratios, (2) solvency ratios, (3) leverage ratios?
    • To determine the risk associated with choices the company makes.
    • (1) Profitability ratios: the higher the number, the lower the risk (more money being made for the assets, debts, or equity used)
    • (2) Solvency ratios: the higher the number the greater the risk (more debt [a fixed cost] being used compared to other capital)
    • (3) Leverage ratios: the higher the number the more effect on earnings (if earnings increase, it will benefit more; if earnings decrease, the loss will be greater)
  18. What is the formula for debt-to-total-capital ratio? This provides a measure of the company's (1) liquidity, (2) solvency, (3) profitability, (4) leverage / risk?
    • Solvency: the ability of an entity to meet its long term obligations
    • Total debt / Total capital, where total capital is interest bearing debt + equity OR (total liabilities - operating liabilities) + equity
  19. What is the formula for debt-to-equity ratio? This provides a measure of the company's (1) liquidity, (2) solvency, (3) profitability, (4) leverage / risk?
    • Solvency: the ability of an entity to meet its long term obligations
    • Total debt / total equity
  20. What is the formula for the times interest earned? This provides a measure of the company's (1) liquidity, (2) solvency, (3) profitability, (4) leverage / risk?
    • Solvency
    • EBIT / interest expense.
    • The higher the number, the lower the risk of being insolvent.
  21. Financial leverage increases when ...
    A company uses more debt rather than issuing equity to acquire new assets.
Author
BethM
ID
330945
Card Set
BEC 2 - Capital Structure 2
Description
Becker Review
Updated