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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
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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)
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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.
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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
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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)
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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
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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.
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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
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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)
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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.
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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
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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
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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.
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Interest expense is considered a [fixed/variable] cost.
- Fixed
- Payments are a set amount (even if using a variable rate bond)
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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
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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 ORDFL = EBIT / (EBIT - Interest)
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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)
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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
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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
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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.
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Financial leverage increases when ...
A company uses more debt rather than issuing equity to acquire new assets.
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